Pike Robert, Neal Bill. Corporate finance and investment: decisions and strategy
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Chapter 20 Acquisitions and restructuring 545
Table 20.3
Cross-border acquisi-
tions involving UK
companies
UK firms acquired UK firms’ acquisitions
by foreign firms of foreign firms
Year Number Value Number Value
1992 210 4,139 679 7,264
1993 267 5,187 521 9,213
1994 202 5,213 422 15,164
1995 131 12,817 365 11,967
1996 133 9,513 442 13,377
1997 193 15,717 464 19,176
1998 252 32,413 569 54,917
1999 252 60,860 590 111,193
2000 227 64,618 557 181,285
2001 162 24,382 371 41,473
2002 117 16,798 262 26,626
2003 129 9,309 243 20,756
2004 171 29,815 278 20,321
Source: National Statistics, 2005 (First Release, www.statistics.gov.uk).
acquisitions by UK firms of overseas enterprises. Although it is by no means one-way
traffic, in most years, UK firms’ involvement in takeover activity as acquirors out-
weighs their involvement as acquirees. Again, 2000 was the peak year in both cate-
gories by value.
However, 2001 saw a substantial drop in world merger activity, falling from
$3.5 trillion in 2000 to $1.75 trillion, marking an end to eight straight years of increased
activity. Three main reasons were put forward for this:
■ Companies whose finances were damaged by the worsening economic recession
had insufficient cash resources to hunt prey.
■ Stock market volatility made it difficult to assess market values, and hence, bid
valuations.
■ Increasingly uncertain business conditions increased the difficulty of predicting the
future profitability of acquisitions.
2001 was described as ‘the year of the broken promise’ because many large take-overs
failed to come to fruition. Among the jilted partners were German media giant
Bertelsmann and EMI, British banks Abbey National and Lloyds TSB, telecom giants
Alcatel and Lucent, and, notoriously, Dynergy and Enron. Moreover, the European
competition authorities blocked the takeover of Honeywell by GE on the grounds that
competition would be harmed within Europe, thus raising the prospect of more active
scrutiny of future amalgamations. However, on the EU front the reverse has occurred.
Following three dramatic reversals of its policy decisions in the European Court of First
Instance in 2002, the EU has introduced a new merger Directive which many regard as
more ‘friendly’ towards merging firms. This may help to explain the uptick in activity
involving UK firms in 2004.
■ The regulation of takeovers
UK takeovers are regulated in three ways, two of them formal and the third informal.
First, the UK statutory provisions as laid down in the Fair Trading Act 1973 and the
Competition Act 1998 give responsibility for dealing with mergers to three entities:
■ The Secretary of State for Trade and Industry (the SOS).
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546 Part V Strategic financial decisions
■ The Director General of Fair Trading (the DGFT).
■ The Competition Commission (the CC).
The system relies on flexible interpretation of the regulations, and intervention at
the discretion of the authorities. In principle, mergers are judged as to whether they
are against the ‘public interest’. In practice, this means whether they are likely to
reduce competition. The burden of proof lies on the authorities to prove that the merg-
er is harmful, rather than the parties having to prove that it is beneficial. The authori-
ties are heavily dependent on information provided by the parties to the merger.
The role of the DGFT is to:
■ assess mergers that come to his attention, e.g. by complaints or by notification by
the firms involved.
■ consider whether a merger qualifies for reference to the CC for more detailed inves-
tigation, i.e. whether worldwide assets taken over exceed million, or whether a
UK market share above 25 per cent is to be created.
■ hear the view of interested parties relating to qualifying mergers.
■ advise the SOS on whether qualifying mergers should be referred to the CC for
investigation whether the merger is against the public interest.
■ where appropriate, advise the SOS on accepting ‘statutory undertakings’, e.g. prom-
ises to divest assets, in lieu of reference to the CC.
■ advise the SOS on action in response to the CC report.
■ seek undertakings from the parties involved.
■ monitor compliance with undertakings.
The Secretary of State’s role is:
■ to decide whether a merger should be referred to the CC.
■ to decide whether to accept undertakings in lieu of reference.
■ to receive and publish the CC report.
■ to decide on action in response to the report.
In response to an adverse report, the SOS may decide:
■ to block the merger.
■ to require the parties to meet certain conditions before approval.
The role of the CC is:
■ to hear evidence from all interested parties
■ to weigh the evidence to decide whether the merger may operate against the pub-
lic interest.
■ if so, to recommend possible remedies
■ to submit the report to the SOS.
The Department of Trade and Industry website (www.dti.gov.uk/cp/ukmergerguide.htm)
carries a detailed flow chart that summarises these activities and shows how they
interrelate.
The second mode of regulation is under the competition policy of the European
Union, set out in Articles 81 (formerly Article 85) and 82 (formerly 86) of the Treaty of
Rome. Article 82 prohibits the abuse of a dominant firm position insofar as it may
affect trade between member states. The EC Merger Regulation (ECMR) provides that
a merger that creates a dominant position, as a result of which competition would be
significantly impeded, shall be declared incompatible with the common market. The
Regulation applies to all mergers with a ‘Community Dimension’, defined in terms of
turnover levels. The ECMR was designed to provide ‘one-stop’ merger control to
avoid the risk of mergers being investigated under two or more jurisdictions. National
authorities may not normally apply their own competition laws to mergers falling
within the ECMR, which are investigated by the Competition Commission.
£70
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Chapter 20 Acquisitions and restructuring 547
In 2002, the EU was forced to overhaul its procedures after losing three court cases
in which the plaintiffs had challenged the prohibition of their respective mergers. The
Court of First Instance (CFI) criticised both the EU’s procedures and also the quality
of its economic analysis, especially its reliance on the theory of ‘collective dominance’.
The EU’s interpretation of this was that a reduction in the number of competitors in an
industry would necessarily lead to anti-competitive behaviour by the survivors, which
was not necessarily so, according to the CFI. In response, the EU has introduced a
tighter Merger Regulation that came into force in May 2004, which incorporated clear-
er guidelines for firms wishing to merge, including access to official files and to the
investigating officials themselves. The Competition Commission also created a new
post of Chief Economist to enhance the economic expertise at its command. (For fuller
details on EU merger policy, see www.europa.eu.int.)
The third control on takeovers is operated by the Takeover Panel, formed in 1968
to counter the perceived inadequacy of the statutory mechanisms for regulating the
conduct of both parties in the takeover process. The Panel consists of representatives
from City and other leading business institutions, such as the CBI, the Stock Exchange
and the ICAEW accounting body, thus representing the main associations whose
members are involved in takeovers, whether as advisers, shareholders or regulators.
The Panel promulgates and administers the City Code, a set of rules originally with
no force of law, reflecting what those most closely involved with takeovers regard as
best practice. It does, however, have some sanctions to enforce its authority, such as
public reprimands, which damage the reputation of violators of the Code, perhaps
leading to the collapse of the bid and, for financial advisers, to long-term loss of busi-
ness. The Panel’s ultimate sanction is to request its members to withdraw the facilities
of the City from offenders, although this is extremely rare (it has only happened once).
In 2006, a new EU Directive on Takeover Bids is due to come into force. This is very
largely based on the existing UK City Code, but with one important difference in that
it is has statutory backing. Accordingly, in January 2005, the Takeover Panel
announced how it would comply with the new directive. It stated that it ‘would intend
to exercise its power to seek a court order only as a matter of last resort, or in urgent
cases’, i.e. business will be pretty much as usual.
■ The chronology of a hostile bid
The following schedule details the necessary timing of bids and provision of informa-
tion as required by the City Code.
Day 1: bid announced. Bidder has 28 days in which to make a formal offer to tar-
get’s shareholders.
Day 14 after formal offer is made: deadline for target company to publish its ‘defence
document’.
Day 21 after formal offer: first date at which the contest can be ended. Bidder must
disclose how many of target’s shares have been voted in its favour. If over 50 per
cent, bidder has won; if less, it may choose to walk away.
18 days later: last day for defender to produce new arguments to encourage share-
holder loyalty.
4 days later: last day for bidder to increase its offer. Beyond this, bidder cannot buy
any of target’s shares that will take its stake above 30 per cent.
14 days later: by 5 p.m., bidder must declare how many shares have been voted in its
favour. If over 50 per cent, the bidder has won. If less, the target remains independ-
ent. The bidder is barred from making a further bid within one calendar year.
Normally, the maximum time span allowed for the whole process is 60 days,
although the Takeover Panel may ‘stop the clock’ pending clarification of key points.
In the event of a reference to the MMC, the process is halted sine die to await its report.
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548 Part V Strategic financial decisions
This can take upwards of six months, during which the initial ‘urge to merge’ has been
known to evaporate.
The behaviour of defending managers is tightly circumscribed:
1 Shareholders must be given equal access to relevant information to enable them to
make an informed decision.
2 Shareholders must be given adequate information to reach a decision, and no rele-
vant information should be withheld.
3 Directors must not act out of personal interest, either to frustrate or to encourage a
bidder.
4 Directors are prohibited from taking action to frustrate a bona fide offer without the
approval of shareholders.
5 The company must not seek to influence the market price of its shares by offering
finance or guarantees to others to induce them to buy its shares.
The bidder must also observe certain rules:
1 Any stakeholding above 3 per cent must be openly declared.
2 In the past, bidders and their advisers often made ‘dawn raids’ on the market to
capture a major stake in the target before people realised that a bid was under way.
Companies are now prohibited from acquiring, in any seven-day period, shares that
would raise their aggregate stake above 15 per cent.
3 If a company accumulates over 30 per cent of the shares, it must make a formal bid
to remaining shareholders at a price no less than the highest price paid in the pre-
vious twelve months.
20.3 MOTIVES FOR TAKEOVER
Managers seeking to maximise the wealth of shareholders should continually seek to
exploit value-creating opportunities. There are two situations when managers feel able
to enrich shareholders via takeovers:
1 When managers believe that the target company can be acquired at less than its ‘true
value’. This implies disbelief in the ability of the capital market consistently to
value companies correctly. If a company is thought to be undervalued on the mar-
ket, there may well be opportunities for ‘asset-stripping’, i.e. selling off the com-
ponents of the taken-over company for a combined sum greater than the purchase
price.
2 When managers believe that two enterprises will be worth more if merged than if operated
as two separate entities. Thus for two companies, A and B:
The principle of value additivity would refute this unless the amalgamation result-
ed in some form of synergy or more effective utilisation of the assets of the combined
companies.
In practice, it is very difficult to differentiate between these two explanations for
merger, especially as many mergers result in only partial disposals, when activities
that appear to fit more neatly into existing operations are retained. Companies are val-
ued by the market on the basis of information that their managements release regard-
ing market prospects, value of assets, R&D activity, and so on. Market participants
may suspect that an under-performing company could be operated more efficiently by
an alternative management team, but until a credible bidder emerges, poor results
may simply be reflected in a poor stock market rating.
V
A B
7 V
A
V
B
value additivity
The notion that other things
being equal, the combined
present value of two entities is
their separate present values
added together
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Chapter 20 Acquisitions and restructuring 549
■
How different types of acquisition create value
Acquisitions can be split into three types:
1 Horizontal integration – where a company takes over another from the same industry
and at the same stage of the production process: for example, a hotel chain acquiring
a competitor e.g. Greene King’s acquisition of Belhaven Brewer, in 2005. The motiva-
tion is usually enhancement of market power and/or to obtain production economies.
2 Vertical integration – where the target is in the same industry as the acquirer, but
operating at a different stage of the production chain, either nearer the source of
materials (backward integration) or nearer to the final consumer (forward integra-
tion), e.g. Ford’s takeover of Kwikfit.
3 Conglomerate or unrelated diversification – where the target is in an activity
apparently dissimilar to the acquirer although some activities such as marketing
may overlap (known as concentric diversification in this case). These takeovers are
often said to lack ‘industrial logic’, but can lead to economies in the provision of
company-wide services such as Head Office administration and access to capital
markets on improved terms, i.e. financial economies.
In reality, most mergers are difficult to classify into such neat categories, as they are
motivated by a complex interplay of factors, which will hopefully enhance the value
of the bidder’s equity. The more specific reasons cited for launching takeover bids usu-
ally reflect the anticipated benefits that a merger is expected to generate:
1 To exploit scale economies. Larger size is usually expected to yield production economies
if manufacturing operations can be amalgamated, marketing economies if similar
distribution channels can be utilised, and financial economies if size confers access
to capital markets on more favourable terms.
2 To obtain synergy. This term is often used to include any gains from merger, but, strict-
ly, it refers to benefits unrelated to scale. Gains may emerge from a particular way of
combining resources. One company’s managers may be especially suited to operat-
ing another company’s distribution systems, or the sales staff of one company may be
able to sell another company’s, perhaps closely related, product as part of a package.
3 To enter new markets. For firms that lack the expertise to develop different products,
or do not possess the outlets required to access different market segments, takeover
may be a simpler, and certainly a quicker, way of expanding.
The Daimler–Chrysler merger in 1998 was driven by the desire by each firm to
‘fill in’ its product line – Daimler was strong in highly-engineered luxury vehicles
while Chrysler’s expertise lay in volume production of automobiles and the fast-
growing market for sports utility vehicles (SUVs). In December 2001, Britain’s
Compass group, the world’s largest catering company, made a million cash
acquisition of Seiyo Food Systems, Japan’s third-largest contract catering firm, in
order to strengthen its presence in Asia.
4 To provide ‘critical mass’. As many product markets have become more global and the
lifespan of products has tended to diminish, greater emphasis has to be placed on
R&D activities. In some industries, such as aerospace, telecommunications and
pharmaceuticals, small enterprises are simply unable to generate the cash flows
required to finance R&D and brand investment. This factor was largely responsible
for the sale by Fisons and Boots of their drug-development activities in 1994 to
much larger German companies. There is also a credibility effect. For example, com-
panies may be unwilling to use small firms as a source of components when their
future survival, and hence ability to supply, is suspect.
5 To impart or restore growth impetus. Maturing firms whose growth rate is weakening
may look to younger, more dynamic companies both to obtain a quick, short-term
growth ‘fix’, and also for entrepreneurial ideas to achieve higher rates of growth in
the longer term. BAT used the substantial cash flows from its mature tobacco business
to acquire Allied Dunbar (pensions) and Eagle Star (insurance) in the UK and Farmers
in the USA, perceiving the financial services sector as a potential growth area.
£200
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550 Part V Strategic financial decisions
6 To acquire market power. Obtaining higher earnings is easier if there are fewer com-
petitors. Competition-reducing takeovers are likely to be investigated by the reg-
ulatory authorities, but are often justified by the need to enhance ability to
compete internationally on the basis of a more secure home market, as in the case
of the three-way merger of European steel firms mentioned earlier. In addition,
backward vertical integration, mergers undertaken to capture sources of raw
materials (e.g. US oil firm Chevron’s acquisition of Unocal in 2005 to increase its
exploration and production capability), and forward vertical integration to secure
new outlets for the company’s products have the effect of increasing the firm’s
grasp over the whole value chain, and are thus competition-reducing in a wider
sense. Many past brewery takeovers were mounted not to obtain production
capacity, but to secure access to the target’s estate of tied public houses, and to
acquire brands, as in the case of Scottish and Newcastle’s purchase of Theakstons.
7 To reduce dependence on existing, perhaps volatile activities. In Chapter 10, we conclud-
ed that risk reduction per se as a motive for diversification may be misguided. There
is no reason why two enterprises owned by one company should have greater value
unless the amalgamation produces scale economies or some other synergies. If
shareholder portfolio formation is a substitute for corporate diversification, there is
no point in acquiring other companies to reduce risk – rational shareholders will
already have diversified away specific risk, and market risk is undiversifiable.
There are two major qualifications to this argument. First, diversification into over-
seas securities may lower market risk, given that different economies, and hence
stock markets, are not perfectly correlated (Madura, 1995). Second, it is possible
that achieving greater size via conglomerate diversification may lower the costs of
financial distress.
8 To obtain a stock market listing. This is achieved via a ‘reverse takeover’ in which an
unlisted firm acquires a smaller listed firm. This ‘back-door’ method of achieving a
listing is conducted by the listed firm issuing new shares in order to acquire the
unlisted firm. Because of the difference in size, the bidder has to issue so many
shares that the shareholders in the unlisted company emerge with a majority stake
in the expanded firm.
■ The ‘market for management control’
Several of the above motives for merger suggest that some companies can be more effi-
ciently operated by alternative managers. A more general motive for merger is thus to
weed out inefficient personnel. There are three ways in which the market mechanism
can penalise managerial inefficiency:
1 Insolvency, which usually involves significant costs.
2 Shareholder revolt, which is difficult to organise given the diffusion of ownership
and the general reluctance of institutional investors to interfere in operational
management.
3 The takeover process, which may be regarded as a ‘market for managerial con-
trol’. The threat of takeover provides a spur to inefficient managers, while remov-
ing inefficient managers lowers costs and removes barriers to more effective
utilisation of assets. Theory suggests that incompetently managed firms will be
acquired at prices that ensure the owners of the acquirer suffer no loss in value. If
a bid premium over the market price is payable, this should be recoverable from
the higher cash flows generated from more efficient asset utilisation. To this
extent, takeover activity is seen by authors such as Jensen (1984) as a perfectly
healthy expression of the workings of the market system, potentially benefiting
all parties.
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Chapter 20 Acquisitions and restructuring 551
■
Managerial motives for takeover
The motive of diversification to reduce risk suggests a second possible explanation for
takeover activity. With the divorce of ownership and control, and the consequent high
level of managerial autonomy, managers are relatively free to follow activities and poli-
cies, including acquisition of other firms, which enhance their own objectives, both in
monetary and non-pecuniary forms.
Managerial salaries and perquisites are usually higher in large and growing firms,
and since growth by acquisition is usually easier and swifter than organic growth,
managers may view acquisition with some eagerness. If acquisitions are ‘managerial’
in this sense, then acquirers may be prepared to expend ‘excessive’ amounts to gain
ownership of target companies simply to secure deals that promote managerial well-
being, but at the expense of shareholder value. If this explanation is correct, acqui-
sitions may result in a transfer of wealth from shareholders of acquiring firms to
shareholders of acquired companies, even when presented as promoting the best
interests of the former.
Takeovers may also be related to the way managers are remunerated. In the 1980s,
UK managers were increasingly paid by results, with the commonest criterion of per-
formance being growth in EPS. This is a notoriously unreliable measure of perform-
ance, as it is not only dependent on accounting conventions, but relatively easy to
manipulate. For example, shutting down a loss-making activity can raise reported EPS.
Self-assessment activity 20.1
Suggest some ‘managerial’ motives for growth by takeover.
(Answer in Appendix A at the back of the book)
■ How to increase EPS by takeover: Hawk takes over Vole
A common means of increasing EPS has been to acquire other companies with lower
P:E ratios than one’s own, these being companies out of favour with the market, either
through poor performance or because too little was known about them. The acquisition
of such companies, in certain conditions, can raise both EPS and share price. Consider
the example in Table 20.4. Hawk, with a P:E ratio of 20, reflecting strong growth expec-
tations, contemplates the takeover of Vole, whose P:E ratio is only 10. Hawk proposes to
make an all-share offer. If it were able to obtain Vole at the current market price, it would
have to issue 5 million shares to Vole’s shareholders in exchange for their 20 million
shares, i.e.
Table 20.4 shows the impact of the exchange if the P:E ratio of the expanded company
were to remain at 20. The new EPS is resulting in a post-bid share
price of and an overall market value of million. This apparently magical
effect seems to have generated wealth of million. If it works out this way, the£21
£441£4.20,
1£22 m>105 m2 21p,
15 million £42 120 million £12 £20 million.
Table 20.4
Hawk and vole
Pre-bid Post-bid
Hawk Vole
Number of shares 100 m 20 m 105 m
Earnings after tax £22 m
EPS 20p 10p 21p
P:E ratio 20:1 10:1 20:1
Share price £4.20
Capitalisation (market value) £441 m
105 m £4.20£20 m£400 m
20 21p£1£4
£22 m 105 m
£20 m £2 m£2 m£20 m
100 m 5 m
Hawk Vole
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552 Part V Strategic financial decisions
beneficiaries are the two sets of shareholders: Hawk’s existing shareholders find their
100 million shares valued at a price higher by 20p, i.e. million in total, and Vole’s
former shareholders find they now hold shares valued at million, rather than the
value of million placed on Vole prior to the bid, i.e.:
This so-called ‘boot-strapping’ effect may simply be ‘financial illusion’ because
it is unlikely to occur quite like this in reality. First, it assumes the absence of a
bid premium. In practice, Hawk would have to offer above the market price to
tempt Vole’s shareholders into selling, thus altering the balance of gain. Second, it
assumes that the market applies the same P:E ratio to the expanded group as the
pre-bid ratio for Hawk. If no synergies were expected, then the likely post-bid P:E
ratio is the total pre-bid value of the two firms relative to their total pre-bid earn-
ings, i.e.:
However, if Hawk is expected to reorganise Vole and impart the same growth impe-
tus expected from Hawk itself, the P:E ratio post-bid could exceed this figure, and
approach Hawk’s pre-bid P:E value of 20. If this occurs, then both groups of share-
holders can enjoy the value created by the expectation of a more efficient operation of
Vole’s assets and higher cash flows thereafter. Conversely, expectations of integration
difficulties might offset such gains.
It does not follow that a higher EPS will lead to a higher share price. If the acquisi-
tion moved Hawk into riskier areas of operation, its activity Beta should rise accord-
ingly and the higher expected cash flows will be discounted at a higher required
return. Similarly, if instead of financing the bid by a share exchange, Hawk had bor-
rowed the required million, then the share price might not rise if the greater gear-
ing and accompanying financial risk resulted in a higher equity Beta. The suspicion
remains that many acquisitions, including some of the ‘mega-mergers’ of the 1980s,
ostensibly undertaken to raise the acquirer’s share price, were really undertaken for
‘managerial’ reasons (see Gregory, 1997).
Certainly, the subsequent difficulties experienced in post-merger integration and
operation do not support the view that mergers are always in the best interests of the
bidders’ shareholders (see below).
£20
1£400 m £20 m2
1£20 m £2 m2
£420 m
£22 m
19.09
Total gain
ˇ
£21 m
Gains to Vole’s shareholders
ˇˇˇ
£1 m
Gains to Hawk’s shareholders £20 m
£20
£21
£20
20.4 FINANCING A BID
Table 20.1 showed data on the three main ways of financing takeovers: cash, issue of
ordinary shares and fixed-interest securities (loan stock, convertibles and preference
shares). Clearly, the first two methods predominate, although their relative importance
varies over time. As a rule of thumb, share exchange is favoured when the stock mar-
ket is high and rising, while cash offers are used more when interest rates are relative-
ly low or falling, given that many cash offers are themselves financed by the acquirer’s
Self-assessment activity 20.2
Suggest how managerial pay schemes might encourage takeovers against the interests of
shareholders.
(Answer in Appendix A at the back of the book)
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Chapter 20 Acquisitions and restructuring 553
borrowing. This pattern is illustrated clearly by the figures for the early 2000s, when the
stock market was depressed and interest rates low and falling. Increasingly, however,
bidders offer their targets a choice of cash or shares, or even a three-way choice between
straight cash, cash with shares, or shares alone.
For example, in 1991, when bidding for its main UK competitor, Tootal, the textile
company Coats Viyella offered two alternatives. Shareholders of Tootal could either opt
for a full cash consideration of 80p per share, which would not qualify them to receive
an imminent dividend of 3p per share, or accept 83.3p per share in cash and paper,
based on the Coats share price at the date of the offer. The second option involved
in cash and 23 newly issued Coats shares for every 100 Tootal shares owned.
Such complex offers are designed to appeal to the widest possible body of share-
holders. The chosen package depends on the balance of relative advantages and
disadvantages of the different methods, from both the bidder’s and the target
shareholders’ viewpoints.
■ Cash
Everyone understands a cash offer. The amount is certain, there being no exposure to
the risk of adverse movement in share price during the course of the bid. The targeted
shareholders are more easily able to adjust their portfolios than if they received shares,
which involve dealing costs when sold. Because no new shares are issued, there is no
dilution of earnings or change in the balance of control of the bidder (unless, in the case
of borrowed capital, creditors insist on restrictive covenants). Moreover, if the return
expected on the assets of the target exceeds the cost of borrowing, the EPS of the bid-
der may increase, although perceptions of increased financial risk may mitigate this
apparent benefit. A disadvantage from the recipient’s viewpoint is possible liability to
Capital Gains Tax (CGT).
■ Share exchanges
Any liability to CGT is delayed with a share offer, and the cash flow cost to the bidder
is zero, apart from the administration costs involved. However, equity is more costly to
service than debt, especially for a company with taxable capacity, and an issue of new
shares may interfere with the firm’s gearing ratio. There could be an adverse impact on
the balance of control if a major slice of the equity of the bidder came to be held by insti-
tutions looking for an opportunity to sell their holdings. The overhanging threat of a
substantial share sale may depress the share price of the bidder.
■ Other methods
The use of other financing instruments is comparatively rare. When fixed-interest secu-
rities are used, they are usually offered as alternatives to cash and/or ordinary shares.
Convertibles have some appeal because any diluting effect is delayed and the interest
cost on the security, which qualifies for tax relief, can usually be pitched below the
going market rate on loan stock, due to the expectation of capital gain on conversion.
Preference share financing in general is comparatively rare, owing to the lack of tax-
deductibility of preferred dividends and to limited voting rights.
£51.02
Self-assessment activity 20.3
Why might the shareholders of a target company prefer to be paid in cash rather than
shares?
(Answer in Appendix A at the back of the book)
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554 Part V Strategic financial decisions
Evaluating an acquisition is little different from other investments, assuming the
motive of the bid is economic rather than managerial, i.e. designed to maximise the
post-bid value of the expanded enterprise. It would be worthwhile Company A taking
over Company B so long as the present value of the cash flows of the enlarged com-
pany exceeds the present value of the two companies as separate entities:
Thus, measures the increase in value. The net cost to the bid-
der is the value of the amount expended less the value of the target as it stands:
so that the net present value of the takeover decision is the gain less the cost, i.e.:
The NPV will depend on the method of financing and, of course, the terms of the
transaction. Essentially, the bidder is hoping to extract the maximum value of any expect-
ed cost savings and synergies from the takeover for its own shareholders. Conversely, the
offer must be made attractive to the owners of the target to induce them to sell.
■ Fewston plc and Dacre plc
An example will illustrate the way in which the division of the spoils can depend on
the method of financing. Fewston plc is launching a cash bid for Dacre plc, both are
quoted companies and both are ungeared. The market value of Fewston is million
(100 million 50p shares, market price ) and that of Dacre is million (10 million 50p
shares, market price ). Fewston hopes to exploit synergies, etc., worth million
after the takeover. It offers the shareholders of Dacre million in cash. The NPV of
the bid to Fewston is thus:
The overall gain from the takeover (i.e. the synergies of million) is split equally
between the two sets of shareholders. The need to make a higher bid or the appear-
ance of another bidder would tilt the balance of gain towards Dacre’s shareholders.
If the bid is made in the form of a share-for-share offer to the same value, the arithmetic
alters. In this case, Fewston is giving up part of the expanded firm and hence a further
share of the gains to Dacre’s shareholders. Assuming a bid to the same value, Fewston
must offer them shares. This would result in a total share issue of
125 million shares, i.e. Fewston is handing over 20 per cent of the expanded company to
Dacre’s shareholders. In this case, the gain enjoyed by Fewston’s shareholders will be
lower. The NPV of the takeover is still the gain less the cost; but the cost is greater, i.e. the
proportion of the expanded company handed over less the value of Dacre as it stands:
Hence, the NPV of the takeover from Fewston’s perspective is:
NPV 1gain in value cost2 1£20 m £12 m2 £8 m
1£52 m £40 m2 £12 m
Cost a
25 m
100 m 25 m
£260 mb £40 m
1£50 m>£22 25 m
£20
1£200 m £40 m £20 m2 £200 m £50 m £10 m
NPV V
A B
V
A
Outlay
£50
£20£4
£40£2
£200
V
A B
V
A
Outlay
NPV V
A B
1V
A
V
B
2 3Outlay V
B
4
Net cost 3Outlay V
B
4
3V
A B
1V
A
V
B
24
V
A B
7 V
A
V
B
20.5 EVALUATING A BID: THE EXPECTED GAINS FROM TAKEOVERS
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