F3 Chapter 11

Financial and strategic implications of
mergers and acquisitions:

Chapter 11
If one entity acquires majority shareholding in another the

company is said to have acquired by the first.
If 2 entities join together to submerge their separate entities into a

new entity the process is called a merger.
Types of mergers=
Horizontal integration:
Results when two entities in the same line of business combine. For
example, recent bank and building society mergers are a good
example of this type of integration.
Vertical integration:
Results from the acquisition of one entity by another which is at a

different level in the ‘chain of supply’ – as an example, UK breweries
have moved heavily into the distribution of their product via public
houses.
A conglomerate:
Results when two entities in unrelated businesses

combine
Reasons for mergers/acquisition=
a) Increased market share/power

b) Economies of scale.
c) Combining complementary needs (smaller entities lack
engineering and sales expertise so join up with big
companies)
d) Improving efficiency
e) A lack of profitable investment opportunities/ surplus cash
f) Tax relief
g) Reduced competition
h) Asset-stripping (predator acquires asset and sells the easily
separable ones)
i) Big data opportunities.
Big data:
There are several definitions of Big Data, the most commonly used
referring to large volumes of data beyond the normal processing,
storage and analysis capacity of typical database application tools.
Although Big Data does not refer to any specific quantity, the term is
often used when speaking about petabytes and exabytes of data
Why is Big Data so important?
Several major business benefits arise from the ability to manage Big
Data successfully:
a) Driving innovation by reducing time taken to answer key

business questions and therefore make decisions
b) Gaining competitive advantage
c) Improving productivity
Reasons why entities merge are of questionable validity:
The following reasons why entities merge are of questionable

validity:
Diversification, to reduce risk. While acquiring an entity in a different

line of activity may diversify away risk for the entities involved, this is
surely irrelevant to the shareholders. They could have performed
exactly the same diversification simply by holding shares in both
entities. The only real diversification produced is in the risk attaching
to the managers’ and employees’ jobs, and this is likely to make
them more complacent than before – to the detriment of
shareholders’ future returns.
Shares of the target entity are undervalued. This may well be the
case, although it would conflict with the efficient market’s theory.
However, the shareholders of the entity planning the takeover would
derive as much benefit (at a lower administrative cost) from buying
such undervalued shares themselves. This also assumes that the
acquirer entity’s management are better at valuing shares than
professional investors in the market place.
Synergy=
2 or more companies coming together because one cannot

independently obtain it. MV of AB is greater than MV of A+ MV of
B. Also called 2+2=5. In an efficient market a valid question to ask
would be why increase in value should occur.
Sources of synergy:
a) Operating economies= economies of scale, Economies of

vertical integration (cutting out the middle man),
Complementary resources, elimination of inefficiency.
b) Financial synergy= Diversification, diversification and

financing (a stable cash flow is more attractive to
creditors thus correlation should be lower than 1), The
boot strap or P/E game (Higher P/E ratio can acquire and
impose their high P/E on the victim firm)
c) Other synergistic effects= surplus managerial talent,

surplus cash, market power, speed.
Impact of mergers on stakeholders=
a) Impact on acquiring companies’ shareholders:
The existence of synergy has been discussed above as a key

benefit to shareholders of an acquisition. All companies have
a primary objective to maximise shareholder wealth, so it is
clear that if synergy can be achieved, an acquisition should
benefit the acquiring company's shareholders
b) Impact on the target companies’ shareholders:
The acquiring company will often pay a premium to the

shareholders of the target company, to encourage them to
sell their shares. Therefore, there is also a financial benefit
to them when a takeover happens.
c) Impact on lenders/debt holders:
Debt is often repayable in the event of a change in control.
d) Impact on managers and staff=
Redundancies to avoid duplication of roles, thus managers

and employees of target company dread a takeover.
e) Impact on society as a whole=
Governments won’t allow takeovers which are not in the

interests of the whole society.
Detailed reasons why mergers/acquisitions fail=
a) The fit/ lack of fit syndrome= management styles or cultures

don’t match.
b) Lack of industrial or commercial fit= unexpected problems for

the acquirer in terms of product range or industrial position.
c) Lack of goal congruence
d) Cheap purchases= turnaround costs of a cheap company

might be a high multiple of the purchase price.
e) Paying too much.
f) Failure to integrate effectively
g) Inability to manage change.

Tax implications or mergers and acquisitions=
a) Differences in tax rates and double tax treaties=
OECD is an organization of developed countries whose main

purpose is to maintain financial stability and the expansion
of world trade. The doubt taxation treaty is to decide which
country shall have the right to the tax income.
b) Group loss relief=
Members of group companies may surrender losses to other

profitable group members for corresponding accounting
periods. Must be set against claimant companies’ taxable
total profits of a corresponding accounting period. Group
relief ceases to be available once arrangements are in place
to sell the shares of a company.
c) Withholding tax=
Also called retention tax. Is a government requirement for

the payer or an item to withhold or deduct the tax from the
payment and then pay it to the government
Treated as a payment on account of the recipient’s final tax

liability. Refunded if tax is less or need to pay more if final
tax liability is more than withholding tax.
Detail on competition authorities=
a) Anti-competitive= creation of a new entity cannot have

more than 25% market share.
b) Public interest= consider national security, media quality,
financial stability.
c) Investigations.
Divestment= Reasons for divestment=
Sum of the parts of the entity may be worth more than the whole: As
identified earlier in this chapter, businesses which combine will
attempt to find areas where resources can be combined to generate
synergy.
However, it may be that a business with many disparate parts

actually ends up suffering from the opposite effect.
Diverting unwanted or less profitable parts.
Strategic change (focus on core activities)
A response to crisis (when cash is needed quickly)
Sell-offs or trade sale (sale of a party of an entity usually to a third

party in return for cash). Sell-offs are mainly done to= divest a less
profitable business, to protect rest of the business from takeover,
generate cash in time of crisis.
Spin-off or demerger (new entity created where shares are held by

the shareholders of the entity that made the transfer of the assets.
ownership has not changed and value of both entities will also be
same. Reasons= investors now know the true value of the business,
leads to a clear management structure; reduce the risk of a
takeover bid for the core entity.
Management buyouts=
Purchase of an existing business from the management team

generally in association with a financing institution. Usually
management provide some of the capital for the buyout but
majority is provided by other financiers such as venture capitalists
and financial institutions.
Often management buyouts are carried out by the use of

convertible debt.
Considerations before an MBO=
a) Do the current owners wish to sell?

b) Potential of the business (management are taking a risk so
need to analyze everything well before investing)
c) Loss of head office support
d) Quality of management team (united approach is
important)
e) The price
Leveraged buyout=
Occurs when an investor, typically a private equity firm acquires a

controlling interest in a company’s equity and where the significant
purchase price is financed through leverage(borrowing)
Role of venture capitalists=
Give funds for 5 to 10 years and expect a 25% return on their

investment.
a) Form of finance= Management will want to keep at least

50% of equity for themselves which is a controlling stake so
venture capitalists can only raise the other 50%.
Convertible preference shares used preferably.
b) Exit strategy
c) The involvement of the institution (some require board

representation)
d) Ongoing support
Role of private equity firms=
Private equity firms mostly buy mature firms that are already
established, private equity buy 100% of the firm so have total
control. Also, they streamline operations of failing companies in
hope of making profits from them. Concentrate all their efforts on
one single entity at a time unlike venture capitalists. Chances of
absolute losses are minimal because they have invested in already
established companies.
Suggested financial structure for an MBO:
a) Secured borrowings
b) Senior debt
c) Junior debt= Usually called mezzanine finance, which is an
intermediate stage between senior debt and equity finance
in both return and risk.
MBO’s considerations for financiers= key points for investors

usually banks and institutions in deciding whether to support an
MBO=
a) What is actually for sale
b) Whether the activities are profitable and enjoy a

satisfactory return in cash
c) Whether the management is sufficiently strong
d) Where the price is sufficient and reasonable contribution is

made by managers.
Main risks why MBO’s fail=
a) The bid price offered by the MBO team might be too high
b) A lack of experience in key areas such as financial
management
c) A loss of key staff who either perceive the buyout too risk or
do not have enough capital to invest.
d) A lack of finance
e) Problems in convincing employees and fellow colleagues of
the need to change working practices or to accept
redundancy.
Exit strategies for equity holders=
Trade sale=
In a trade sale all the shares are normally acquired by the bidding
company, so the management team would have to sell their shares
too. They will not like this because the main part of an MBO is
management wanting to own a company rather than reporting to
shareholders.
IPO=
Company will have to follow certain stringent criteria to get listed.
Independent sale to another shareholder=
Mangers could try to increase their shareholdings in the company by

“buying out” other financiers. This would be expensive but if
managers could afford it they would have a higher say in running of
the business.

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Financial and strategic implications of

mergers and acquisitions:

If one entity acquires majority shareholding in another the

If 2 entities join together to submerge their separate entities into a

Results from the acquisition of one entity by another which is at a

Results when two entities in unrelated businesses

a) Increased market share/power

Why is Big Data so important?

a) Driving innovation by reducing time taken to answer key

The following reasons why entities merge are of questionable

Diversification, to reduce risk. While acquiring an entity in a different

2 or more companies coming together because one cannot

a) Operating economies= economies of scale, Economies of

b) Financial synergy= Diversification, diversification and

c) Other synergistic effects= surplus managerial talent,

a) Impact on acquiring companies’ shareholders:

The existence of synergy has been discussed above as a key

b) Impact on the target companies’ shareholders:

The acquiring company will often pay a premium to the

c) Impact on lenders/debt holders:

Debt is often repayable in the event of a change in control.

d) Impact on managers and staff=

Redundancies to avoid duplication of roles, thus managers

e) Impact on society as a whole=

Governments won’t allow takeovers which are not in the

a) The fit/ lack of fit syndrome= management styles or cultures

b) Lack of industrial or commercial fit= unexpected problems for

c) Lack of goal congruence

d) Cheap purchases= turnaround costs of a cheap company

e) Paying too much.

f) Failure to integrate effectively

g) Inability to manage change.

a) Differences in tax rates and double tax treaties=

OECD is an organization of developed countries whose main

b) Group loss relief=

Members of group companies may surrender losses to other

Also called retention tax. Is a government requirement for

Treated as a payment on account of the recipient’s final tax

a) Anti-competitive= creation of a new entity cannot have

Divestment= Reasons for divestment=

However, it may be that a business with many disparate parts

Diverting unwanted or less profitable parts.

Strategic change (focus on core activities)

A response to crisis (when cash is needed quickly)

Sell-offs or trade sale (sale of a party of an entity usually to a third

Spin-off or demerger (new entity created where shares are held by

Purchase of an existing business from the management team

Often management buyouts are carried out by the use of

Considerations before an MBO=

a) Do the current owners wish to sell?

Occurs when an investor, typically a private equity firm acquires a

Give funds for 5 to 10 years and expect a 25% return on their

a) Form of finance= Management will want to keep at least

c) The involvement of the institution (some require board

Role of private equity firms=

MBO’s considerations for financiers= key points for investors

a) What is actually for sale

b) Whether the activities are profitable and enjoy a

c) Whether the management is sufficiently strong

d) Where the price is sufficient and reasonable contribution is