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External Growth through Mergers 20 Chapter Outline Mergers as a means of increasing operating efficiency and for financial motives Acquiring of companies through cash or the exchange of shares Potential impact of mergers on earnings per share and assessment of stock value Diversification benefits Unfriendly buyouts Largest Acquisitions Ever Motives for Business Combinations Merger A combination of two or more companies in which the resulting firm maintains the identity of the acquiring firm Consolidation Two or more companies combined to form a new entity Might be utilized when the firms are of equal size and market power Financial Motives Merger allows acquiring firms to enjoy a potentially desirable portfolio effect Achieve risk reduction while maintaining the firm’s rate of return Variability in performance may be reduced for the business firms with opposite phases of the business cycle Portfolio diversification becomes complicated with respect to practicalities It improves the financing posture as a result of expansion Financial Motives (cont’d) Larger firms may enjoy greater access to the capital market Can attract larger and more prestigious investment bankers to handle future financing Greater financing may also be inherent in the merger itself, especially likely when: The acquired firm has the strong cash position A low debt-equity ratio that can be used to expand borrowing by the acquiring firm Tax Loss Carryforward May be available in a merger if one of the firms has previously sustained a tax loss Assuming Firm A acquires Firm B, which has a $220,000 tax loss carryforward The assumption is that the firm has a 40% tax rate. The tax shield value of a carryforward to Firm A is equal to the loss involved times the tax rate ($220,000 X 40% = $88,000) The company can reduce its total taxes from $120,000 to $32,000, and thus could pay $88,000 for the carryforward alone The income available to stockholders also has increased by $88,000 Firm B’s anticipated ope