MA_MCQ-2 (1)

Chapter 1: Introduction to
Mergers and Acquisitions

Chapter Summary and Learning Objectives
The purpose of this chapter is to provide students with an understanding of the underlying
dynamics of the M&A process. This includes developing a working knowledge of the relevant
vocabulary, the role of various participants in the M&A process, and the various factors affecting
M&A activity historically. The chapter also addresses why mergers and acquisitions take place
and the common reasons why M&As may fail to achieve expectations.
Chapter 1 Learning Objectives: Providing students with an understanding of
1. What corporate restructuring is and why it occurs;
2. Commonly used M&A vocabulary;
3. Key participants in the M&A process;
4. M&A as only one of a number of strategic options for increasing shareholder value;
5. Common motivations for M&A activity;
6. Historical mergers and acquisitions waves;
7. The Impact of M&A on shareholders and society; and
8. Commonly cited reasons for M&As frequent failure to meet expectations.
Learning Objective 1: Understanding what corporate restructuring is and why it occurs
Corporate Restructuring: This term is a catchall referring to a broad array of activities intended
to expand or contract a firm’s basic operations or fundamentally change its asset or financial
structure. It is often referred to as either operational or financial restructuring.
 Operational restructuring may include the following:
--Downsizing through layoffs or attrition the number of employees required to support

specific operations or closing of unprofitable or non-strategic operations;
--The partial or complete divestiture (i.e., sale) or spin-off (i.e., non-taxable transfer of a
subsidiary’s stock to parent company shareholders) of a product line or subsidiary; or
--Mergers or acquisitions to enhance the parent’s overall strategic position and long-term
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profitability
 Financial restructuring may include the following:
--Adding debt to lower the firm’s weighted average cost of capital;
--Adding debt to repurchase outstanding stock to reduce stock in the hands of shareholders
most likely to sell to an unwanted acquirer or to reward current shareholders by increasing
earnings per share and in turn the share price; or
--Leveraging the firm to distribute a special dividend to make the firm less attractive to
potential acquirers and to increase loyalty of existing shareholders.
Learning Objective 2: Understanding commonly used M&A vocabulary.
 Statutory Merger: Combination of two corporations in which only one corporation survives
in accordance with the statutes of the state in which the surviving firm is incorporated
 Subsidiary Merger: A merger of two companies resulting in the target company becoming a
subsidiary of the parent (e.g., EDS and GM)
 Consolidation: Two or more companies join to form a new company (e.g., Daimler-Benz
and Chrysler)
 Acquisition: Purchase of an entire company or a controlling interest in a company.
 Divestiture: The sale of all or substantially all of a company or product line to another party
for cash or securities
 LBO: The purchase of a company financed primarily by debt. The term is more often
applied to a firm going private financed primarily by debt.
 Management buyout: A leveraged buyout in which the managers of the firm to be taken
private are also equity investors.
 Holding company: A single company with investments in a number of other, often diverse,
operating companies
 Acquirer: A firm attempting to merge or acquire another company
 Target: The firm being solicited by the acquiring firm.
 Horizontal merger: Occurs when two firms in the same industry combine.
 Vertical merger: Mergers in which the two firms are in different stages of the value chain
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 Conglomerate mergers: Mergers between companies in largely unrelated industries.
 Friendly takeovers: The target’s management and board are receptive to being acquired and
recommend that the shareholders approve the transaction.
 Hostile takeover: Occurs when the initial offer was unsolicited by the target, the target was
not seeking a merger at the time it was approached, and the target’s management contested
the offer
 Takeover premium: The excess of the purchase price over the target’s current share price
Learning Objective 3: Understanding key participants in the M&A process
 Investment bankers: Often hired by acquiring and target firms, they provide their clients with
strategic and tactical advice and acquisition opportunities, screen potential buyers and sellers,
make initial contact with the seller or buyer, and provide valuation, negotiation, and deal
structuring support.
 Lawyers: Provide specialized legal expertise in such areas as M&As, tax, employee benefits,
real estate, antitrust, securities, environment, and intellectual property.
 Accountants: Provide advice on the optimal tax structure, on financial structuring, and on
performing due diligence.
 Proxy solicitors: Hired by dissident shareholders to compile lists of shareholders’ addresses

and to design strategies to educate shareholders and communicate why shareholders’ should
follow their recommendations. Solicitors may also be hired by boards to promote their
positions to shareholders.
 Public relations firms: Assist in developing consistent messages for communicating to the
various stakeholder groups of the firm.
 Institutional investors: Private and public pension funds, insurance firms, investment
companies, bank trust departments, and mutual funds who may seek to take either a passive
or activist role in how a firm is managed by how they vote their shares.
 Arbitrageurs: Investors who attempt to profit from small differences between the offer price
for a target firm and its actual share price
Learning Objective 4: Understanding that M&A is only one of a number of strategic

options for increasing shareholder value
Alternatives to M&A may include the following:
 Solo venture: “Going it alone” or “organic growth” by relying on a firm’s existing

managerial, operational, and financial resources.
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 Partnering: Utilizing the resources of others to implement a firm’s business strategy through
marketing/distribution alliances, joint ventures (i.e., usually more formal than an alliance),
licensing, franchising, and equity investments.
 Minority investments: Less than controlling interest investments made in other firms in an
effort to seek some strategic advantage.
 Asset swaps: Exchanging ownership in substantially similar assets (e.g., swapping groups of
customers in different geographic areas).
 Financial restructuring: See learning objective 1.
 Operational restructuring: See learning objective 1.
Learning Objective 5: Understanding common motivations for M&As
 Synergy: The increase in the shareholder value of combining two firms rather than operating
them independently
--Operating synergy: Gains in operating efficiency from either economies of scale and scope
and from improved managerial practices.
:
--Economies of scale: Fixed per unit costs decline as output increases
--Economies of scope: Producing multiple products or services with the same resources
--Financial: Lowering the cost of capital of the combined firms, reducing transaction-related
costs associated with issuing new securities, and better matching of opportunities with
internally generated funds.
 Diversification: Acquiring firms outside of a firm’s current primary lines of business
--Unrelated diversification: Acquiring firms whose products and markets are totally
different from those of the acquiring firm.
--Related diversification: Acquiring firms whose products differ from those of the acquirer or
whose markets differ from those of the acquirer but not both.
 Strategic realignment: The use of M&A to adjust rapidly to changes in a firm’s external
environment
--Technological change (CDs, cable satellite hook-ups, broadband)

--Deregulation (e.g., financial services and telecommunications)
 Hubris (managerial pride): Managers of the acquiring firm believe that their valuation of the
target firm is superior to the market’s, thus often leading to overpayment due to their
excessive optimism.
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 Buying undervalued assets (q-ratio): Acquiring firms whose market values are less than their
book values or replacement cost.
 Mismanagement (agency problems): Occurs when there is a difference between the interest
of incumbent management and the firm’s shareholders.
 Tax considerations: Acquiring a firm whose cumulative operating losses and tax credits and
the potential for writing acquired assets up to their market values enables the acquirer to
reduce its tax liability.
 Market power: Firms combine to improve their ability to set product prices at levels not
sustainable in a more competitive market.
 Managerialism: Managers who make poorly planned acquisitions to increase the size of the
acquiring firm and their own compensation.
Learning Objective 6: Understanding historical waves of mergers and acquisitions
 The First Wave: Horizontal Consolidation (1897-1904)

--Spurred by drive for efficiency, lax enforcement of anti-trust laws (Sherman Anti-
Trust Act), and westward migration and technological changes
--Resulted in increased concentration in primary metals, transportation, and mining
--Fraudulent financing and the stock market crash of 1904 ended this boom.
 The Second Wave: Increasing Concentration (1916-1929)

--Driven by entry of US into WWI and the post-war boom.
--Passage of Clayton Act which further defined what constituted monopolistic
practices along with the stock market crash of 1929 ended this wave.
 The Third Wave: The Conglomerate Era (1965-69)

--Emergence of Financial Engineering
 The Fourth Wave: The Retrenchment Era (1981-1989)

--Strategic U.S. buyers and foreign multinationals dominated the first half of the decade
--Second half dominated by financial buyers (Growth of junk bond market and the
emergence of Drexel Burnham as a market maker created liquidity)
--Wave ended with the bankruptcy of several LBOs and demise of Drexel Burnham.
 The Fifth Wave: Age of the Strategic Megamerger (1992-2000)
--Dollar volume of transactions reached record levels in each year between 1995 and
2000.
--Purchase prices reached record levels due to a soaring stock market, trend toward
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consolidation in many industries, technological innovation, and benign antitrust
policies.
--Wave ended with the collapse in global stock markets and worldwide recession.
 The Sixth Wave: Age of Cross Border Transactions and Horizontal Megamergers (2004 -
???)
--Propelled by low interest rates, buoyant equity markets, increasing synchronization
among world’s economies, globalization, and high commodity prices.
Learning Objective 7: Understanding the impact of M&A on shareholders and on society
 Success is elusive: Studies show that
--Around announcement dates, abnormal returns in mergers to target shareholders are

about 20% and 30-49% for tender offers; bidders’ shareholders earn 0 to slightly
negative returns
--50 – 80 percent of all mergers and acquisitions either fail to outperform their
industry peers or earn their cost of capital during the 3-5 years after closing.
 Experience helps
--72% of acquirers completing more than 6 acquisitions per year earn above industry
average returns versus 55% of those completing 1-5 transactions annually
 However, no evidence that alternatives to M&A, such as solo ventures or joint ventures, are
likely to be more successful on average in achieving participants’ expectations.
 In general, society benefits from M&A activity
--Increase in aggregate shareholder value (i.e., target plus acquirer) is more attributable to
improved operating efficiency than to market power (i.e., ability to raise prices).
--Little evidence that M&A activity results in increasing industrial concentration
Learning Objective 8: Understanding the most commonly cited reasons for M&As frequent
failure to meet expectations.
 Over-estimating synergy/over-payment
--Acquirers tend to overpay for growth firms based on their historical performance.
--Presumed synergies are frequently not achievable resulting in significant overpayment for
the target firm.
--Overpayment compounds challenges of achieving returns required by investors.
 Slow pace of integration
--Key employees and customers are lost doing periods of uncertainty associated with
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protracted periods of integration.
--Cost savings are not realized until much later than expected resulting in a lower present
value for such savings
 Poor strategy
--May be too complicated to execute

--May not satisfy customers’ highest priority needs.
Chapter 1 Study Test
True/False Questions:
1. A leveraged buyout involves the purchase of a company financed primarily by debt. True
or False
2. A merger is a combination of two firms in which only one firm’s identity survives. True
or False
3. In a consolidation, two or more firms combine to form a new company. True or False
4. A horizontal merger occurs between firms at different stages of the value chain. True or
False Vertical
5. The primary advantage of a holding company is the potential leverage that can
be achieved by gaining effective control of other companies’ assets at a lower overall
cost than would be required if the firm were to acquire 100% of the target’s outstanding
shares. True or False
6. Joint ventures are usually more profitable than mergers or acquisitions. True or False
7. A fairness opinion is a certification provided by a third party that guarantees that the
price paid for a specific company is fair. True or False
8. Arbitrageurs buy the stock and make a profit on the difference between the bid price and
the target’s current stock price if the deal is consummated. True or False
9. Empirical studies show that the share price of a target firm rarely rises in advance of the
announcement of a takeover attempt. True or False
10. Perceived synergy is rarely a motivation for M&A. True or False
11. Empirical studies show that unrelated diversification is an excellent way to increase
shareholder value. True or False less financial returns + higher cost
12. Tax considerations such as acquiring net operating loss carry forwards and investment tax
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not du tieu bieu because it is hindered by latter rules (VD in US)
credits are often excellent reasons to justify an acquisition. True of False
13. Market power is a motive for M&A in which the acquirer is seeking to gain market share
in order to get more control over its ability to set prices. True or False
14. M&A’s rarely pay off for target firm shareholders. True or False
15. Studies suggest that as many as 50% to 80% of M&A’s fail to meet expectations. True or
False
Multiple Choice Questions:
16. Which of the following are commonly cited reasons for M&As?
a. Synergy
b. Market power
c. Strategic realignment
d. All of the above
17. A merger is a combination of businesses in which

a. two businesses combine to form a new business.
b. the participants are necessarily comparable in size, competitive position,
profitability, and market capitalization.
c. one of the two firms becomes a wholly owned subsidiary of the other firm.
d. none of the above.
18. Vertical mergers are those in which the participants are

a. in the same industry.
b. in different industries
c. in different phases of the value chain.
d. none of the above. sell all or substantially all of a company or product line to another party for cash or
19. An employee stock ownership plan (ESOP) is a trust that

a. can be used as alternative to a divestiture.
b. can be used to purchase the shares of the owners of a privately held firm in a
leveraged buyout.
c. can be used as a means of placing a firm’s stock in “friendly” hands to help
dissuade an unwanted takeover attempt.
d. all of the above.
20. All of the following are common motives for a merger or acquisition except for
a. operating synergy
b. financial synergy
c. raising the cost of capital.
d. buying undervalued assets.
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Chapter 3: The Corporate Takeover Market:
Common Takeover Tactics, Takeover Defenses,
And Corporate Governance
The purpose of this chapter is to discuss the commonly used tactics to acquire a company in a hostile
takeover attempt and to evaluate the effectiveness of various takeover defenses in the context of corporate
governance. Corporate governance is defined as the interactions among shareholders, managers, boards of
directors, and outside auditors and analysts, as well as the laws, regulations and institutions that govern
their actions. Traditionally, the goal of good corporate governance has been viewed narrowly as the
protection of shareholder rights. More recently, the goal of corporate governance has been expanded to
include a broader array of corporate stakeholders including customers, employees, the government,
lenders, communities, regulators, and suppliers. Following a discussion of the factors affecting corporate
governance, the chapter is divided into two major sections: alternative takeover tactics and alternative
takeover defenses. Alternative takeover tactics are subdivided further into friendly and aggressive tactics.
Aggressive tactics include the bear hug, proxy contests, open-market operations, and tender offers.
Alternative takeover defenses are viewed in terms of two stages: prebid, those put in place before a bid is
made; and postbid, those put in place in response to a bid.
1. corporate governance and its role in protecting stakeholders in the firm;
2. factors external and internal to the firm affecting corporate governance;
3. common takeover tactics employed in the market for corporate control and when and
why they are used; and
4. common takeover defenses employed by target firms and when and why they are used;
Learning Objective 1: Corporate governance and its role in protecting stakeholders in the
firm
 Corporate governance is defined as the interactions among shareholders, managers, boards of

directors, and outside auditors and analysts, as well as the laws, regulations, and institutions
that govern their actions.
 The goal of corporate governance is to protect the rights of such corporate stakeholders as
shareholders, customers, employees, the government, lenders, communities, regulators, and
suppliers.
 If properly applied, corporate governance practices protect stakeholders’ from incompetent

or corrupt managers and indifferent boards by
--Aligning the incentives of managers with the goals of shareholders and other primary
stakeholders and
--Making the firm’s financial position sufficiently transparent to enable shareholders to
evaluate the performance of managers based on publicly available information
Learning Objective 2: Factors external and internal to the firm affecting corporate
governance
 Factors internal to the firm affecting the effectiveness of corporate governance include the
independence of the board, audit, and compensation committees; internal controls and
incentive systems; and anti-takeover defenses.
--Boards of directors must aggressively review the quality of recommendations received by

the CEO from corporate management, as well as oversee management, corporate strategy
and the company’s financial reports to shareholders.
--Internal controls and incentive systems include financial reporting, internal audits,
executive
compensation, personnel practices, and succession planning.
--Takeover defenses are obstacles put in place to forestall or eliminate a hostile takeover
bid.
 Factors external to the firm affecting the effectiveness of corporate governance include
government regulators, legislation (e.g., federal and state), the market for corporate control,
and institutional activism.
--Market for corporate control includes the threat of hostile takeovers and proxy contests.
--Legislation includes federal and state securities and antitrust laws, as well as insider trading
laws.
--Regulators include government agencies (e.g., SEC and DoJ), public exchanges (e.g.,
NYSE), and standards setting boards (e.g., FASB)
--Institutional activists frequently include public pension funds.
Learning Objective 3: Common takeover tactics employed in the market for corporate
control and when and why they are used
 Bear hugs represent the attempt by a bidder to limit the options of the target’s senior
management by making a formal acquisition proposal, usually involving a public
announcement, to the board of directors of the target.
 Purchasing target stock in advance of a formal bid to accumulate stock at a price lower than
the eventual offer price
 Street sweeps involve purchasing as much stock as possible as quickly as possible by seeking
out large blocks of target stock.
 Proxy contests consist of solicitation by a dissident shareholder of the votes of other
shareholders to change the composition of the board, affect management decisions, force the
payment of dividends or to buy back stock.
 Tender offers occur when the acquirer bypasses the target’s board and management and goes
directly to the target’s shareholders with an offer to purchase their shares.
Learning Objective 4: Common takeover defenses employed by target firms and when and
why they are used
 Poison pills represent a new class of stock issued by a company to its shareholders, which
have no value unless an investor acquires a specific percentage of the firm’s voting stock.
Once activated, shareholders may purchase additional shares at a discount from the firm’s
current common stock price.
 Shark repellants are specific types of takeover defenses (e.g., staggered boards and
cumulative voting rights) that are adopted by amending either a corporate charter or its
bylaws.
 Golden parachutes are employee severance arrangements, which are triggered whenever a
change in control takes place.
1. Successful corporate governance systems rely on aligning managerial incentives with

those of shareholders and on making financial statements “transparent” to the investors.
True and False
2. Boards of directors play a pivotal role in ensuring good corporate governance systems by
monitoring the day-to-day activities of management. True or False
3. We can be highly confident that a firm’s financial statements are accurate, if they were
compiled in accordance with generally accepted accounting principles. True or False
4. The threat of hostile takeovers is an important factor in promoting good governance

practices. True or False
5. Institutional activism has proven to be largely ineffective in promoting good government

practices. True or False
6. A friendly takeover is often pursued because it offers the potential of a lower overall
purchase price, but it increases the likelihood that post-closing integration will be
difficult.
True or False
7. Float represents the amount of stock of a firm that can be purchased most easily by a
potential bidder. Float tends to be largest for those firms that are performing above
investor expectations. True or False
8. To initiate the proxy process, the bidder may attempt to call a special stockholders’
meeting or may introduce a proposal to replace the target’s board at a regularly scheduled
shareholders’ meeting. True or False
9. A tender offer involving cash for stock is called an exchange offer. True or False
cash offer tender for securities
10. A casual pass is a commonly used takeover defense. True or False
11. Under a classified or staggered board system only a relatively small portion of the total
board of directors is up for re-election in any given year. True or False
12. In some states, shareholders may take action to add to the number of seats on the board,
to remove specific board members, or to elect new members without a special meeting.
All that is required is the written consent of shareholders. This is called consent
solicitation. True or False
13. It is illegal for a potential target firm to change its state of incorporation. True or False
14. Greenmail is relatively uncommon today because of changes in the tax law. True or False
15. ESOPs are rarely used as takeover defenses. True or False
16. Share buyback plans may have all of the following effects except for:
a. Reducing the amount of float
b. Lowering the target firm’s current earnings per share
c. Increasing the cost of the purchase to the bidding firm by boosting the share price
d. Making it easier for the bidder to complete the transaction by reducing the
number of shares outstanding.
17. Which of the following is not usually considered a takeover tactic?

a. A bear hug
b. A tender offer
c. A proxy contest
d. A poison pill
18. Which of the following is not usually considered a takeover defense?

a. A tender offer
b. A poison pill
c. A golden parachute
d. A staggered board
19. Which of the following factors affect corporate governance?

a. The Securities and Exchange Commission
b. Institutional activists
c. The threat of hostile takeovers
d. All of the above
20. Which of the following is not true about friendly takeovers?

a. They promote ease of post acquisition integration
b. They are often less expensive than hostile takeovers
c. Bidder and target management often reach agreement on key issues early in the
negotiation process
d. They generally do not require target shareholder approval
Answers to Test Questions
True/False 1. T
2. F
3. F
4. T
5. F
6. F
7. F
8. T
9. F
10. F
11. T
12. T
13. F
14. T
15. F
Multiple Choice 16. B
17. D
18. A
19. D
20. D
Chapter 4: Planning: Developing
Business and Acquisition Plans
Phases 1 and 2 of the Acquisition Process
The text envisions the acquisition process as consisting of an integrated and interactive ten-step
process consisting of planning and implementation stages. The planning stage, phases 1 and 2 of
the acquisition process, consists of the development of the business and the acquisition plans.
The implementation stage includes the search, screening, contacting the target, negotiation,
integration planning, closing, integration, and evaluation activities.
1. Developing a business plan from the acquirer’s perspective;
2. Selecting the appropriate implementation strategy; and
3. How to develop an acquisition plan.
Learning Objective 1: Developing a business plan from the acquirer’s perspective
 Key business planning concepts include the following:
--Business plans articulate a mission or vision for the firm and business strategy for realizing
that mission for the firm’s stakeholders
--Implementation strategies refer to the way in which the firm chooses to execute the
business
strategy (i.e., on its own or solo venture, through partnering, or through a merger or
acquisition)
 Key activities include the following:
--An external analysis to determine where and how to compete

--An internal analysis or self-assessment of how the firm stacks up against the competition in
terms of strengths and weaknesses
--A mission statement summarizing where and how the firm has chosen to compete, basic
operating beliefs, and management values
--Setting quantifiable objectives
--Selecting that business strategy from a range of reasonable options most likely to achieve
the firm’s objectives in an acceptable time period and level of risk.
--Implementation plan selection
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Learning Objective 2: Selecting the appropriate implementation strategy
 Alternative implementation strategies
--Solo venture
--Partnering (i.e., marketing/distribution alliances, joint venture, license, and franchise)
--Minority investments
--Acquire or merge
--Swap assets
 Selection criteria:
--Degree of control varies from total for a solo venture to minimal with a minority
investment
or being a minority partner
--Degree of risk varies from solo venture to partnerships in which risk is shared.
--Degree of speed may be greatest for an acquisition versus the other extreme of a solo
venture
--Use of cash may be highest for a solo venture or acquisition versus a minority investment
or
partnership
Learning Objective 3: How to develop an acquisition plan
 Assuming an acquisition is chosen to implement the business strategy, the firm should develop an
acquisition plan.
 The acquisition plan consists of the following elements:
--Plan objectives (support the realization of key business plan objectives)

--Timetable
--Resource/capability review
--Management’s preferences expressed in terms of boundaries or limitations
--Search plan
--Purchase price estimate
--Negotiation strategy
--Initial price determination
--Financing plan
--Integration plan (or “exit strategy” for financial buyers)
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1. An internal analysis of firm’s strengths and weaknesses is most informative if they are
compared to the firm’s primary competitors. True or False
2. Generic business strategies most often fall into one of the following three categories: cost
leadership, differentiation, and focus/niche. True or False
3. While commonly used as business objectives, financial returns and cash flow are
really a result of managing those factors which drive financial returns and cash flow such
as productivity and market share. True or False
4. Well thought-out plans require little updating. True or False
5. The desire for control is often the most important determinant of which implementation
strategy is selected. True or False
6. Market share is a common non-financial objective in business plans. True or False
7. Acquisition plan objectives should be quantifiable and supportive of business plan

objectives. True or False
8. Understanding the assumptions underlying a business plan is relatively unimportant.

True or False
9. Market share is usually a relatively unimportant determinant of a firm’s ability to achieve

a cost leadership position in an industry. True or False
10. Corporate diversification always involves a firm moving into a new market or product
line that is unrelated to the firm’s current products or markets. True or False
can have diver type: move into new related to current ones
11. The experience curve postulates that as the cumulative historical volume of a firm’s
output increases, costs per unit of output increase geometrically. True or False
12. Distribution channels refer to how a business chooses to distribute its products. True or
False
13. A firm’s market share relative to another firm’s may be a useful measure of its overall
operating efficiency compared to competitors. True or False
14. Market segmentation involves identifying customers with common needs and
characteristics. True or False
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15. An acquisition plan is a key element of any firm’s business plan. True or False.

16. Which of the following is generally not considered an example of a strategic control?
a. Incentive systems
b. Monitoring systems
c. Targeted market
d. Retention bonuses
17. Which one of the following is generally not considered a key element of a business plan?
a. External analysis
b. Internal analysis
c. Tolerance for goodwill
d. Functional strategies
18. Which of the following is generally not considered a common business strategy?
a. Cost leadership
b. Focus
c. Niche
d. Product life cycle
19. Which of the following is an important factor in determining profitability and cash flow in
an industry or market?
a. Potential competitors
b. Potential substitute products
c. Current customers
d. All of the above
20. Which one of the following is generally not considered a phase of the acquisition process?
a. Developing a business plan

b. Searching for the potential target
c. Post closing integration
d. Market segmentation

True/False 1. True
2. True
3. True
4. False
5. True
6. True
7. True
8. False
9. False
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10. False
11. False
12. True
13. True
14. True
15. False
Multiple Choice 16. C
17. C
18. D
19. D
20. D
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d. All of the above
c. Actual payment of retention bonuses
a. Conduct the search for a

potential target firm
c. Regulatory agencies
d. All of the above

Chapter 6: Integration:
Mergers, Acquisitions, and
Business Alliances
This chapter assumes that integration is the goal of the acquirer immediately after the transaction
closes. Slow or ineffective integration is one of the commonly cited reasons for mergers and
acquisitions failing to meet expectations. If done correctly, the integration process can help to
mitigate the loss of key employees, customers, and suppliers. The chapter identifies the most
important factors contributing to a successful integration effort and discusses ways in which
obstacles can be overcome during the integration process.
Chapter 6 Learning Objectives: To provide students with knowledge of
1. Factors critical to successfully integrating businesses;
2. Viewing integration as a process;
3. Developing communication plans;
4. Creating a new organization;
5. Developing staffing plans;
6. Functional integration;
7. Developing a new corporate culture; and
8. Mechanisms for integrating business alliances
Learning Objective 1: Factors critical to successfully integrating businesses
 Integrate as rapidly as is prudent. Plan carefully, but act quickly. Rapid integration enables
the combined firms to more readily realize projected synergies and minimizes the loss of key
employees, customers, and suppliers due to the uncertainty associated with a protracted
integration.
 Introduce project management: Integration should be managed as a fully coordinated project
with clearly stated objectives, supporting timetables, and individuals responsible for
achieving each objective.
 Communicate from the top of the organization. Tell stakeholders as much as you can as soon
as you can. Address the “me-issues.”
 Focus on customers: Stay in touch with customer needs as customer attrition immediately
following closely can escalate.
 Make the tough decision early. Decide on organizational structure, reporting relationships,
spans of control, people selection, roles and responsibilities, and workforce reductions as
early as possible during the integration phase.
 Focus on the critical issues. Prioritize objectives carefully and concentrate resources on
achieving those offering the greatest payoff first.
Learning Objective 2: Viewing integration as a process
 Integration planning: Planning should begin before closing when the buyer has greatest
leverage over the seller. Refine valuation, resolve transition issues such as payroll and benefit
processing immediately following closing and customer checks sent to the seller after
closing, and negotiate contract assurances.
 Developing communication plans: Plans should be developed for all major stakeholder
categories including: employees, customers, suppliers, investors, communities, and
regulators.
 Creating a new organization: Business needs drive organizational structure
 Developing staffing plans: Determine personnel requirements for the new organization;
determine resource availability, establish staffing plans and timetables; develop a
compensation strategy, and create supporting information systems.
 Functional integration: Revalidate due diligence data, conduct performance benchmarking,

and integrate functions.
 Building a new corporate culture: Identify cultural issues and integrate through shared goals,
standards, services, and space.
Learning Objective 3: Developing communication plans
 Employees: Address the “me issues” immediately.
 Customers: Undercommit and overdeliver.

 Suppliers: Develop long-term vendor relationships.
 Investors: Maintain shareholder loyalty by presenting a compelling vision of the future.
 Communities: Build strong, credible relationships.
Learning Objective 4: Creating a new organization
 Learn from the past. Building a new structure requires an understanding of past structures.
 Business needs drive structure. A well-structured organization should support the acceptance
of the culture desired for the new corporation.
 Integrating corporate structures. Balance need for control with need for flexibility.
 Integrating senior management. The management integration team that provides direction for
the overall integration effort should consist of senior managers from both the acquiring and
target organizations.
 Integrating middle management. Jobs should go to the most qualified from either the acquirer
or target firms.
Learning Objective 5: Developing staffing plans
 Identify staffing requirements based upon operational requirements.
 Determine the number of each type of employee required both inside and outside of the firm.
 Establish plans and timetables for filling the needed positions.
 Determine types of compensation plans needed to attract and retain needed personnel.
 If the two firms are to be wholly integrated, integrate compensation plans for both the
acquirer and target firms.
 Merge personnel information systems if the acquirer intends to merge the target into the
acquiring firm.
Learning Objective 6: Functional integration
 Due diligence data revalidation: Ensure that data collected during the initial due diligence is
accurate by revisiting those individuals or facilities not sufficiently covered during the initial
due diligence activity.
 Performance benchmarking: Benchmarking provides the data necessary to determine and
implement “best practices.”
 Integrate functions
--Manufacturing and operations

--Information technology
--Finance
--Sales
--Marketing
--Purchasing
--Research and development
--Human resources
Learning Objective 7: Developing a new corporate culture.
 Cultural issues differ by size and maturity of the size of company, the industry, and
geographic locations.
 Use cultural profiling to determine the extent to which the two organizations are alike or are
different.
 Techniques for integrating corporate cultures include the following:
--Create shared goals, which serve to drive different units to cooperate.

--Establishing shared standards enable the adoption of the “best practices” found in one unit
or function by another entity.
--Create shared services by centralizing selected services in support of multiple units.
--Share space by co-locating employees and managers.
Learning Objective 8: Mechanisms for Integrating Business Alliances
 Leadership: Provide clear direction, values, and behaviors to create a culture that focuses on
the alliances strategic objectives as its top priority.
 Teamwork and role clarification: Teamwork is the underpinning that makes alliances work.
 Coordination: In contrast to an acquisition, no one firm is in charge. Actions must be

carefully coordinated among participating parties.
 Policies and values: Employees need to understand how decisions are made, what the
priorities are, who will be held responsible, and how rewards will be determined.
 Consensus decision making: Make decisions with everyone having an opportunity to provide
input.
 Resource commitments: All parties to the alliance must live up to their resource pledges.
1. Rapid integration increases the likelihood of the merger achieving its goals by enabling
the realization of planned synergies sooner and by minimizing employee and customer
attrition. True or False
2. Customer attrition often escalates immediately following an acquisition. True or

False
3. The bulk of integration planning should wait until just before closing because of the huge
demands of negotiating. True or False
4. Agreements of purchase and sale rarely indicate how target firm employees will be paid
and how their benefit claims will be processed immediately following closing. True or
False
5. “Buyer reps and warranties provide the buyer with recourse to the seller if any of their
claims or promises are untrue. True or False
6. Sellers are often inclined to warrant the accuracy of their sales and profit projections.
True or False
7. Post closing integration organizations are difficult to assemble during a hostile takeover.
True or False
8. The post merger integration organization should consist of a management integration

team and a series of work teams, each of which focuses on implementing a specific
portion of the integration plan. True or False
9. Communication during the early stages of the integration process should be kept to a
minimum due to the potential for litigation if what is communicated is not likely to be
entirely implemented. True or False
10. Empirical studies show that a newly merged company can expect to lose on average at
least 5 to 10% of its existing customers because of the merger. True or False
11. Given the benefits of rapid integration, it is usually preferable to impose the acquirer’s
organizational structure on the target firm. True or False
12. It is best to staff positions in the new organization following a merger with employees of
the acquiring firm to ensure their loyalty. True or False
13. Performing additional due diligence after closing is redundant and expensive since the
acquirer had an opportunity to perform due diligence prior to closing. True or False
14. Encouraging an atmosphere of shared goals is a common way of integrating disparate

corporate cultures. True or False
15. Integrating alliances relies more on teamwork than on top-down direction. True or False
Multiple Choice:
16. All of the following are common integrating mechanisms for business alliances except
for
a. Team work
b. Top-down direction on a daily basis
c. Consensus decision making
d. Parties to alliance living up to their resource commitments
17. Which of the following are commonly used in integrating corporate cultures?
a. Shared goals
b. Shared standards
c. Shared services
d. All of the above
18. Corporate cultures are more likely to be significantly different if the acquirer and target
firms are in
a. The same industry

b. Different industries
c. In different countries
d. In different countries in different industries
19. Communication plans should be developed for which of the following stakeholder groups
prior to closing.
a. Employees
b. Customers
c. Suppliers
d. All of the above
20. All of the following are often considered transition issues except for
a. Ensuring continuity of payroll and benefit processing functions

b. How the seller should be reimbursed for products shipped by the seller before
closing but not paid for by the customer until after closing
c. How the buyer will be reimbursed by the seller for monies owed to suppliers for
product provided to the seller before closing but not billed until after closing
d. Non-compete agreements
True/False 1. True
2. True
3. False
4. False
5. True
6. False
7. True
8. True
9. False
10. True
11. False
12. False
13. False
14. True
15. True
Multiple Choice 16. B
17. D
18. D
19. D
20. D
Chapter 7: Merger and Acquisition Cash
Flow Valuation Basics
The purpose of this chapter is to provide an overview of the basics of valuing mergers and
acquisitions using discounted cash flow methods. The chapter provides an overview of
elementary finance concepts including measuring risk and return, the capital asset pricing model,
the effects of leverage on risk and return, and calculating present and future values of cash flow.
Cash flow defined by generally accepted accounting principles is re-defined by adjusting for
certain non-cash considerations to create cash flow definitions suitable for valuation. The
chapter concludes with a discussion of the valuation of non-operating assets such as excess cash
and marketable securities, investments in other firms, unutilized and pension fund assets, and
intangible assets.
1. How to analyze risk and return;
2. How to define valuation cash flows consistent with the cost of equity and weighted
average cost of capital and when they are applied;
3. Alternative discounted cash flow methods and under what conditions they are applied;
4. Determining growth rates and the sensitivity of terminal values to changes in

assumptions;
5. Valuation of non-operating assets and liabilities and adjustment of firm value.
Learning Objective 1: How to analyze risk and return;
 Cost of equity (ke): Minimum return required to induce investors to invest in equities of
comparable risk.
Capital asset pricing model: ke = Rf +  (Rm – Rf) + FSP
where Rf = risk free rate of return

 = beta
Rm = the expected rate of return on equities
Rm – Rf = 5.5% (i.e., its historical average since 1963)
FSP = firm size adjustment
 Cost of preferred stock (kpr): Preferred dividend divided by market value of preferred stock.
2
 Weighted Average Cost of capital (WACC): Minimum return required by investors to
purchase common and preferred equity and bonds of firms of comparable risk.
WACC = ke  __ E_ + i  (1 – t)  __D + kpr x PF___

(D+E+PF) (D+E+PF) (D+E+PF)
where E = the market value of common equity

D = the market value of debt
PF = the market value of preferred stock
t = the firm’s marginal tax rate.
i = nominal interest rate
 Risk consists of a diversifiable component (e.g., strikes, default, lawsuits, etc.) and a non-
diversifiable component (e.g., factors affecting all firms such as inflation, war, etc.).
 Beta Coefficient () is a measure of non-diversifiable risk (i.e., the extent to which a firm’s
(or asset’s) return changes due to a change in the market’s return).
 Effects of Leverage on Beta:
l = u (1 + (1 – t) D/E) and u = l / (1 + (1-t) D/E)
where l and u are leveraged and un-leveraged betas, respectively.
Learning Objective 2: How to define valuation cash flows consistent with the cost of equity
and weighted average cost of capital and when they are applied
 GAAP cash flows must be redefined to include cash flow available for common equity
investors and for both equity investors and lenders. To retain or attract equity investors, the
amount of cash flow available for investors must be sufficient to allow equity investors to
earn at least their cost of equity. To retain both or attract both equity investors and lenders,
the amount of cash flow available for both constituent groups must be sufficient to enable the
firm to earn its weighted average cost of capital.
 Free cash flow to equity investors (FCFE) or equity cash flow is cash flow remaining for
paying dividends to common equity investors after the firm satisfies all obligations including
debt payments, capital expenditures, changes in net working capital, and preferred dividend
payments.
a. FCFE = Net Income - (Gross Capital Expenditures – Depreciation)1 -  Net

Working Capital + New Debt Issues – Principal Repayments – Preferred
Dividends
 Free cash flow to the firm (FCFF) or enterprise cash flow is the cash flow available for
equity investors and lenders; it can be calculated in two ways:
3
a. By adding up cash flows to all of a firm’s claim holders
FCFF = FCFE + Interest Expense (1 – Tax Rate) + Principal Repayments – New

Debt Issues + Preferred Dividends or
= Net Income– (Gross Capital Expenditures – Depreciation) -  Net
Working Capital + Interest Expense (1 – Tax Rate)
Dividends (Note: The inclusion of the components of FCFE in this
equation result in the cancellation of New Debt Issues, Principal
Repayments, and Preferred Dividends.)
b. By adjusting earnings from operating earnings before interest and taxes (EBIT)2,3
FCFF = EBIT (1 – Tax Rate)4 - (Gross Capital Expenditures – Depreciation) -

 Net Working Capital
1
(Gross Capital Expenditures – Depreciation) represents that portion of capital spending that
cannot be financed out of internal cash flow (i.e., net income plus non-cash expenses such as
depreciation). Other non-cash expenses not directly related to capital expenditures that need to
be added back to net income include things such as goodwill expense.
2
Both 2a and 2b provide the same estimates of cash flow.
3
Differences between FCFE and FCFF are due to debt-related cash flow plus non-equity claims.
4
(1-t) x i represents the portion of interest paid to bondholders that is not recoverable by
shareholders as a result of the tax deductibility of interest. The effects of this tax saving are
already included in Net Income. Alternatively, EBIT(1-t) can be expressed as NI + i (1-t), since
NI = EBIT – i – (EBIT-i) x t = EBIT – i –EBIT x t – i x t = EBIT(1-t) –i (1-t) and EBIT(1-t) = NI
+ i (1-t).
Learning Objective 3: Alternative discounted cash flow methods and under what
conditions they are applied
 Zero Growth Model: Free cash flow is constant in perpetuity. The value of the firm
is the “capitalized” value of its annual cash flow.
a. P0 = FCFF0 / WACC, where FCFF0 is free cash flow to the firm and WACC is the
weighted average cost of capital.
b. P0 = FCFE0 / ke, where FCFE0 is free cash flow to equity investors and ke is the
cost of equity.
Example: Calculate the cost of capital and value of a firm whose capital structure consists only
of common equity of $40 million and debt of $60 million. Both equity and debt are expressed in
terms of their market values. The firm’s marginal tax rate is .4 and beta is 1.2. The corporate
bond rate is 6%, the Treasury bond rate is 4%, and the expected annual return on stocks is 9.5%.
Annual FCFF is expected to remain at $7 million indefinitely.
4
ke = .04 + 1.2 (.095 - .04) = .106 x 100 = 10.6%
WACC = .106 x (40/100) + .06 x (1-.4) x (60/100) = .042 + .022 = .064 x 100 = 6.4%
P0 = $7 / .064 = $109.4 million
 Constant Growth Model: Cash flow next year (i.e., the first year of the forecast period) is
expected to grow at a constant amount, i.e., FCFF1 = FCFF0 (1 + g).
a. P0 = FCFF1 / (WACC – g), where g is the expected rate of growth of FCFF1.
b. P0 = FCFE1 / (ke – g), note: FCFE1 = FCFE0 (1 + g)
Example: Constant growth model: Estimate the value of a firm (P0), whose cost of equity is 12%
and whose cash flow in the preceding year of $4 million is projected to grow 10% in the current
year and then at a constant 5% annual rate thereafter.
P0 = (4.0 x 1.1)(1.05) / (.12 - .05) = $66 million
 Variable Growth Model: Cash flow exhibits both a high and a stable or terminal growth
period. The growth rate and discount rates during the high growth period exceed the rates
during the terminal growth period.
Example: Variable growth model: Estimate the value of a firm’s equity (P0) whose cash flow is
projected to grow at a compound annual average growth rate of 15% for the next five years. The
current year’s cash flow is $3.00 million. The firm’s cost of capital during the high growth
period is 12%. The sustainable growth rate and cost of capital during the terminal period are 5%
and 8%, respectively. The market value of the firm’s current outstanding debt is $6 million.
P0 = 3.00 x 1.15 + 3.00 x 1.152 + 3.00 x 1.153 +

(1.12) (1.12)2 (1.12)3
3.00 x 1.154 + 3.00 x 1.155 + ((3.00 x (1.15)5 x 1.05)) / (.08 - .05)

(1.12)4 (1.12)5 (1.12)5
= 3.45 / 1.12 + 3.97 / 1.122 + 4.56 / 1.123 + 5.25 /1.124 + 6.03 /1.125 + 211.2/ 1.125
= 3.08 + 3.16 + 3.25 + 3.34 + 3.42 + 119.84
= $136.09
PV of equity = $136.09 – $6 = $130.09
Learning Objective 4: Determining growth rates and the sensitivity of terminal values to
changes in assumptions
 Key Premise: The value of the firm can be represented by the sum of the high growth
5
period(s) plus a stable growth period extending indefinitely into the future.
 Key Risk: Sensitivity of annual cash flows and terminal values to choice of assumptions
about the stable growth rate and the discount rate associated with each period.
 Stable Growth Rate: The firm’s growth rate that is expected to last forever is generally
equal to or less than the industry or overall economy’s growth rate. For multinational firms,
the growth rate is that of the world economy.
 Length of the High Growth Period: The greater the current growth rate of a firm’s cash
flow relative to the stable growth rate, the longer the high growth period.
 Adjusting the Discount Rate: Since risk and return are positively correlated, the discount
rate for the stable growth period should be reduced. The discount rate during the terminal
period often is assumed to equal the current industry average cost of equity or weighted
average cost of capital.
Learning Objective 5: Valuation of non-operating assets and liabilities and adjusting firm
value
 Non-operating assets include the following:
--Cash and marketable securities in excess of normal operating requirements.

--Investments in other firms
--Unutilized or underutilized assets such as patents, trademarks, or over-funded pension
plans.
 Non-operating liabilities include the following:
--Warranty claims
--Legal judgments
--Environmental liabilities
 Adjust the value of the firm’s equity for the present value of non-operating assets and
liabilities by adding their PV to the PV of the firm’s equity.
1. The capital asset pricing model relates the return required by shareholders to the risk free
rate of return, the risk premium on stocks, and to the firm’s diversifiable risk. True or
False
2. The weights associated with the cost of equity and debt, in calculating the firm’s
weighted average cost of capital, reflect the firm’s target capital structure. True or False
6
3 A beta reflecting the effects of both the increased volatility of earnings and the tax-shelter
effect of leverage is called an unlevered beta. True or False
FCFF 4. Enterprise cash flow is the cash flow available for common and preferred stockholders, as
well as lenders. True or False
5. Equity cash flow is the cash flow remaining for paying dividends to common equity
investors, buying back stock, or reinvesting in the firm after satisfying all of the firm’s
obligations. True or False
6. In applying discounted cash flow methods, enterprise cash flow is discounted by the
firm’s cost of equity. True or False
7 An important advantage of discounted cash flow methods is that they are relatively
insensitive to changes in estimates of the sustainable growth rate and discount rate. True
or False
8. The zero growth model is a special case of the constant growth valuation model. True or
False
9. The variable growth model consists of a high growth and a no growth period. True or
False
10. It is possible for the sustainable growth rate for a firm’s cash flow to exceed the overall
market growth rate indefinitely. True or False
11. The market value of a firm’s equity can be estimated by subtracting the book value of the
firm’s current debt from the present value of the firm’s enterprise cash flow. True or
False
12. Cash in excess of the firm’s operating requirements should be added to the value of the
firm’s equity in calculating the total value of the firm. True or False
13. If the terminal value accounts for a large percentage (75% or more) of the total PV, the
conventional 5-year projection of future cash flows should be extended to at least 10
years. True or False
14. In calculating the present value of a firm’s equity cash flows, the cash flows are
discounted by the firm’s cost of equity. True or False
15. In calculating the value of a firm, it is unnecessary to consider the value of a firm’s non-
operating assets and liabilities. True or False
7
16. All of the following are used in the calculation of the weighted average cost of capital
except for
a. Cost of equity
b. After-tax cost of interest
c. Book value of debt
d. Market value of equity
17. Enterprise cash flow reflects all of the following except for
a. Cash from operating activities

b. Cash from financing activities it pertains to how the company finances its operations
c. Cash from investing activities
d. After tax operating income
18. Which of the following should be added to the present value of a firm’s equity in
determining the total equity value of the firm?
a. Cash balances in excess of normal operating requirements

b. Surplus land
c. PV of unused patents
d. All of the above
19. Which of the following are not examples of non-operating assets?
a. Cash in excess of normal operating requirements

b. Finished goods inventories
c. Vacant land shown on the firm’s balance sheet
d. Unused patents
20. Which of the following is not included in calculating a firm’s cost of equity using the
Capital Asset Pricing Model?
a. Risk free rate of return

b. The firm’s beta
c. Return on all stocks
d. Book value of assets
Practice Problems:
21. The CEO of Buffalo Bob’s Chicken Wings is considering selling his firm. She estimates
that the firm’s current year equity cash flow is $4 million. She asks her CFO to create
several estimates of the firm’s value. Scenario 1 is to be based on a 4% annual growth
rate; the second scenario is to reflect a 6% annual growth rate for the next five years and
3% thereafter. The firm’s cost of equity for both scenarios is estimated to be 10%. What
is the value of the firm under scenario 1 and scenario 2?
8
22. The current dividend yield of the Standard & Poor 500 Index is 1.2%. The average
earnings of firms in the index are expected to grow at 5% annually into the foreseeable
future. What is the equity value of a firm whose equity cash flow was $3 million last
year and whose cash flow is expected to grow by 7% this year and 3% thereafter.
23. Sematech has achieved a dominant market position in its targeted market. Its huge
market share makes it unlikely that the firm can grow faster than the growth rate of the
overall market, which is expected to be 8% annually through the foreseeable future. Its
net income in 2013 was $15 million. Depreciation expense and capital expenditures were
$5 million and $10 million, respectively. The annual change in working capital was
minimal. The 10-year Treasury bond rate was 5% and the firm’s beta was estimated to
be 1.3. The historical risk premium on stocks over the risk free rate of return is 5.5%.
a. Calculate Sematech’s discount rate.

b. Calculate the firm’s free cash flow in 2013.
c. Estimate the value of Sematech at the end of 2013.
24. The present value of a firm’s operating cash flows is estimated to be $27 million. Cash in
excess of the firm’s normal operating requirements is $2 million. The present value of
future warranty claims is expected to be $3 million. What is the value of the firm?
25. A firm’s cost of equity and preferred stock are estimated to be 9.5% and 6.5%,
respectively. The firm’s cost of debt and marginal tax rate are 6% and 40%, respectively.
The market values of the firm’s common and preferred equity are $870 million and $120
million, respectively. The market value of the firm’s debt is $250 million. What is the
firm’s weighted average cost of capital?
26. Free cash flow to equity last year was $4 million. It is expected to grow by 20% in the
current year, at a 15% rate annually for the next five years, and then assume a more
normal 4% growth rate thereafter. The firm’s cost of equity is 10% during the high
growth period and then drops to 8% during the normal growth period. What is the
present value of the firm?
True/False 1. False
2. True
3. False
4. True
5. True
6. False
7. False
8. True
9. False
10. False
9
11. False
12. True
13. True
14. True
15. False
Multiple Choice 16. C
17. B
18. D
19. B
20. D
Answers to Practice Problems
21. PV (scenario 1) = (4 x 1.04) / (.10-.04) = 69.33
PV (scenario 2) = 4x1.06 + 4x1.062 + 4x1.063 + 4x1.064 + 4x1.065 +

1.10 1.102 1.103 1.104 1.105
(4x1.065x1.03/(.10-.03)
1.105
=3.85 + 3.71 + 3.58 + 3.45 + 3.32 + 48.91
=66.82
22. ke = d1/P0 + g = .012 + .05 = .062
PV = (3 x 1.07 x 1.03)/(.062 - .03) = $103.32 million
23. a. COE = .05 + 1.3(.055) = 12.15

a. FCFE = 15 + 5 –10 = 10
b. PV = 10 x 1.08/(.1215 -.08) = $260.24
24. $27 + $2 -$3 = $26 million
25. .095x(870/870+120+250) + .065 x (120/870+120+250) + .06x(1-.4)x(250/870+120+250)
= .0667 + .0063 + .0073 = .0803 x 100 = 8.03%
26. PV1-5 = $4 x 1.2 x 1.15 + $4 x 1.2 x (1.15)2 + $4 x 1.2 x (1.15)3 +

(1.10) (1.10)2 (1.10)3
$4 x 1.2 x (1.15)4 + $4 x 1.2 x (1.15)5

(1.10)4 (1.10)5
10
= $5.02 + $5,25 + $5.48 + $5.73 + $5.99
= $27.47
PV5 = (($4 x 1.2 x(1.15)5 x 1.04)) / (.08 - .04) = $155.86

(1.10)5
P0 = PV1-5 + PV5 = $27.47 + $155.86 = $183.33
11
Chapter 8: Relative, Asset-Oriented, and
Real Option Basics
Chapter 7 focused on applying discounted cash flow methods to value mergers and acquisitions.
The purpose of this chapter is to provide an overview of other commonly used valuation
methods. These include relative or market-based, asset-oriented, replacement cost, real options,
and weighted average methods.
1. Relative or market based methods of valuation including comparable companies,

comparable transactions, same or comparable industry; and PEG ratios.
2. Asset oriented approaches including tangible book value, liquidation value, and break-up
value;
3. Replacement cost method;
4. Weighted average valuation methodology; and
5. Real options methods.
Learning Objective 1: Relative or market based methods including comparable companies,

comparable transactions, same or comparable industry, and PEG ratios.
 Comparable companies’ multiples approach:
--Calculate market value of shareholders’ equity to before/after-tax earnings, cash flow,

revenue; and book value for companies with similar products and similar in size to the
acquisition target
--Multiply average of ratios for comparable companies by comparable data for the
acquisition target to obtain an estimated value for the target company
--Widely used in legal cases and by investment bankers in “fairness” opinions
--Primary limitations include the difficulty in obtaining truly comparable companies and
the potential for widely divergent ratios and values
--Project the target company’s “normal” earnings and revenue growth rate based on
historical or trend information. If a firm is at a “peak” or “trough” in its business cycle,
compute the average growth rate of prior “peak” and “trough” periods to obtain a more
“normal” growth rate. If the annual growth rate is highly variable, use a moving
average or regression analysis to “smooth” the historical data. Alternatively, project the
target’s earnings and revenue growth using stock analysts’ estimates.
--Comparable company valuations do not include a control premium. Consequently, the
valuation must be adjusted for the anticipated premium in order to estimate accurately
the actual purchase price.
 Comparable transactions’ multiples approach:
--Similar to comparable companies’ multiples approach. Multiples used to estimate the

value of the target company are based on purchase prices of comparable companies that
were recently acquired. Consequently, such valuations already include a control
premium.
--Most accurate whenever the transaction is truly comparable and very recent.
--In general, such transactions are rare.
 Same or comparable industry multiples’ approach:
--Multiply the target company’s earnings or revenue by the ratio of the market value of
shareholders’ equity to earnings or revenue for the target company’s industry or for a
comparable industry. The resulting valuation does not include a control premium.
--Primary advantages include the ease of calculation and application.
--Disadvantages include the presumption that industry multiples are actually comparable
and that analysts’ projections are unbiased.
 PEG ratios
--Used to adjust relative valuation methods for differences in growth rates among firms
--Calculated by dividing the firm’s price-to earnings ratio by the expected growth rate in
earnings
--Provides a convenient method for comparing firms with different growth rates
--Helpful in evaluating the potential market values of a number of different firms in the
same industry in selecting the most attractive acquisition target.
Learning Objective 2: Asset oriented approaches including tangible book value, liquidation
value, and break-up value
 Tangible book value or equity per share
--Generally do not mirror actual market values for manufacturing companies

--May be more accurate for distribution companies with high inventory turnover rates
--Widely used for valuing financial services companies where tangible book value is
primarily cash or liquid assets.
--Reserves and deferred taxes may be added to equity in the calculation of book value,
because they are theoretically a non-interest bearing loan from the IRS
 Liquidation value (Provides minimum value estimate)
--If sold in an orderly fashion, receivables typically can be sold for 80 to 90 percent of
2
book value. “Orderly fashion” is defined as 9 to 12 months
--Inventories might realize 80-90 percent of book value depending upon condition and
degree of obsolescence. More rapid liquidations might reduce the value of inventories
to 60 – 65 percent of book value. Note that these percentages are guidelines only and
the actual percentages vary widely by industry.
--Equipment will vary widely depending upon age and condition. Equipment with a zero
book value may have a significant market value
--Land can be a hidden source of value as it is frequently undervalued on GAAP balance
sheets
--Prepaid assets such as insurance premiums can sometimes be liquidated with a portion
of the premium recovered
 Break-up value
--A business is viewed as consisting of a series of independent operating units whose

income, cash flow, and balance sheet statements reflect intra-company sales, fully-
allocated costs, and operating liabilities specific to that business.
--After-tax cash flows or profits are valued using market-based multiples or discounted to
determine the operating unit’s current market value.
--The unit’s equity value is determined by deducting operating liabilities from its current
market value.
--The aggregate equity value of the business is determined by summing the equity value
of each independent operating unit less any unallocated liabilities and break-up costs
Learning Objective 3: Replacement cost method
 All operating assets of a business are assigned a value based on what it would cost to replace
them.
 Each asset is treated as if no additional value is created by operating the assets as part of
going concern. The “going concern” value is the difference between the market value and
book value of the firm.
 Each asset’s value is summed to determine the aggregate value of the business.
 This approach is of limited use if the firm is highly profitable (suggesting a high going
concern value) or if many of the firm’s assets are intangible.
Learning Objective 4: Weighted average valuation methodology
 Valuing the firm using an average or weighted average of several methodologies.
--Weights reflect the analyst’s relative confidence in the various methodologies.

--Valuations of multiples based on recent comparable transactions are frequently given
the greatest weight, followed by discounted cash flow calculations.
--Liquidation values are generally given the smallest weight as they represent the “worst”
3
case scenario.
Learning Objective 5: Real options methods
 Real options refer to management’s ability to adopt and later revise corporate investment
decisions.
 If we view a merger or acquisition as a single project, we should consider real options as part
of the M&A valuation process.
 Investment decisions, including M&As, often contain certain “embedded” options such as
the ability to expand, delay, or abandon the investment.
--Pre-closing options include a “toehold” strategy in which the acquirer makes a minority
investment in the target but defers making a controlling investment until a later date.
--Post-closing options include accelerating investment in an acquisition based on actual
performance exceeding expectations or divesting or liquidating the acquired company if
performance is disappointing.
 Adjusting NPV for the existence of real options:
--Develop a limited number of different scenarios with a specific probability of occurrence

associated with each scenario. Calculate the expected NPV based on the cash flows
associated with each weighted scenario.
--Alternatively, employ more rigorous techniques such as the Black Scholes Option
Valuation Method.
1. Relative valuation is often described as market-based, as it reflects the amounts investors

are willing to pay for each dollar of earnings, cash flow, sales, or book value. True or
False
2. The comparable companies’ method of valuation is widely used in “fairness opinion”

letters. True or False
3 In practice, it is relatively easy to find companies that are substantially similar to the
target in terms of markets served, product offering, degree of leverage, and size. True or
False
4. Relative valuation methods can be manipulated easily, because the methods do not
require a clear statement of assumptions with respect to risk, growth, or the timing or
magnitude of cash flows. True or False
4
ONLY comparable transactions
5 Comparable companies’ methods already reflect an acquisition premium. True or False
6 Comparable recent transactions do not require the addition of an acquisition premium.

True or False
7. An important limitation of the comparable industry method is the presumption that

industry multiples are actually comparable and that analysts’ projections are unbiased.
True or False
8. PEG ratios are applied to adjust similar firms with different earnings or cash flow growth
rates. True or False
9. Liquidation value generally provides an estimate of the minimum value of the firm. True
or False
10. The comparable recent transactions method of valuation is often considered the most
accurate of the various methods available. True or False
11. Empirical evidence suggests that forecasts of earnings and other value indicators are
better predictors of firm value than value indicators based on historical data. True or
False
12. Micro value drivers are those that directly influence specific functions within the
firm. True or False
13. The going concern value of a company may be defined as the firm’s value in excess of
the sum of the value of its parts. True or False
14. Real options refer to management’s ability to adopt and later revise corporate investment
decisions. True or False
15. Traditional DCF valuation methods adequately account for the value of real options. True
or False
16. Which of the following are generally considered real options?
a. Option to expand
b. Option to delay
c. Options to abandon
d. All of the above.
17. Which of the following are generally considered indicators of value in applying relative
methods?
5
a. After-tax earnings
b. Book value
c. Cash flow
d. All of the above
18. Which of the following valuation methods does not require the addition of a control
premium to determine the purchase price of a target firm?
a. Recent comparable transactions method

b. Comparable companies method
c. Tangible book value
d. Discounted cash flow method
19. Weaknesses of the comparable companies valuation method include all of the following
except for:
a. Truly comparable firms rarely exist

b. May be distorted because of current market psychology
c. Utilize market-based value indicators
d. Often reflects accounting based historical data
20. Which of the following is not generally considered a relative or market based valuation
method?
a. Discounted cash flow

b. Comparable companies
c. Recent comparable transactions
d. Liquidation value
Practice Problems:
21. As a result of a maturing product market, Passe Inc. projected future cash flows for the
next seven years of $(50), $15.0, $10.0, $6, $4, $2, and $.5. The sizeable negative cash
flows in the first year reflected anticipated weakness in the economy, R&D, and
marketing expenses. However, despite a recovery in the economy, demand for the firm’s
current products was expected to decline. Moreover, new competitors were expected to
take market share from the firm. However, Passe had a new patented technology which
offered the potential for introducing new products that could reinvigorate the firm’s
growth. Longview Inc. was considering acquiring Passe and viewed gaining the exclusive
right to the new technology as a call option to expand Passe’s current product offering.
Longview placed a value on the option of $40 million. Passe’s cost of capital was 10%,
compared to Longview’s 8%. What is the most Longview should pay for Passe?
22. Best’s Foods is seeking to acquire the Heinz Baking Company, whose book value is $34
million. A comparable bakery was recently acquired for $300 million, 20% more than
6
the book value of the firm. What was the book value of the recently acquired bakery?
How much should Best’s Foods expect to have to pay for the Heinz Baking Company?
23. Two potential acquisition candidates, AJAX and COMET, exhibit price to cash flow
ratios of 6 and 4, respectively. AJAX’s cash flows per share are expected to grow at a
12% annual rate and COMET’s at a more modest 10% rate. AJAX’s current cash flow
per share is $4, and COMET’s is $5 million. AJAX’s current share price is $28 and
Comet’s is $16. Which of the two firms is more attractive based on a ranking of their
PEG ratios as an acquisition target?
24. An analyst has estimated the value of Target Inc. using discounted cash flow at $56
million. The estimated values using the comparable company method and the recent
comparable transaction method are $47 and $51 million, respectively. The analyst is
twice as confident in the DCF approach as the alternative methods. What is the estimated
value of Target Inc. using the weighted average valuation method?
25. Limited Prospects Inc. is a holding company consisting of thee businesses, which show
little synergy across their operations. Each business has been valued as a standalone
operation including all debt issued by the holding company to finance their operations.
The after-tax values of the three units are $22, $56, and $81 million. The holding
company retained $14 million in debt and other expenses totaling $9 million.
Management decided that the breakup and sale of the individual units would result in the
greatest value to Limited Prospects shareholders. Investment banking and other
consulting fees associated with the breakup totaled $7 million. Non-operating assets,
consisting primarily of land held at the holding company level, have an estimated after-
tax value of $16 million. What is the breakup value of Limited Prospects Inc.?
True/False 1. True
2. True
3. False
4. True
5. False
6. True
7. True
8. True
9. True
10. True
11. True
12. True
13. True
14. True
15. False
Multiple Choice 16. D
17. D
7
18. A
19. C
20. A
Answers to Practice Problems
21. PV = $(50) + $15 + $10 + $6 + $4 + $2 + $.5

1.1 1.12 1.13 1.14 1.15 1.16 1.17
= $(45.5) + $12.4 + $7.51 + $4.10 + $2.48 + $1.13 +.$26
= $(17.62) million
Maximum price = $40 + $(17.62) = $22.38 million
22. Book value (BV) of the recently acquired bakery: 1.2 x BV = $300 or BV = $250 million
Best Foods should expect to pay 1.2 x $34 million = $40.8 million
23. AJAX: PEG Ratio: 6/12 = .5

Implied share price = .5 x 12 x $4 = $24
COMET: PEG Ratio: 4/10 = .40

Implied share price = .40 x 10 x $5 = $20
COMET is more attractive as an acquisition target since its current share price is $16 and
its implied value is $20; AJAX is currently selling for $28 while its implied value is $24.
Comet is undervalued and AJAX overvalued according to this valuation methodology.
24. P0 = 2w x $56 + w x $47 + w x $51 = .5 x $56 + .25 x $47 + .25 $51 = $52.5 million
Where w = weight or relative importance the analyst attributes to each valuation method
Note: 2w + w + w = 100 and w = .25
25. $22 + $56 + $81 + $16 - $14 -$7 -$9 = $145 million
8
Chapter 13: Financing Transactions:
Leveraged Buyout Structures
and Valuation
This chapter begins with a discussion of the evolution of LBOs (i.e., highly leveraged
transactions) in the context of the risks associated with alternative financing options from asset-
based or secured lending to pure cash flow–based lending. Subsequent sections discuss typical
LBO structures, the risks associated with poorly constructed deals, how to take a company
private, and how to develop viable exit strategies. Empirical studies of pre- and postbuyout
returns to shareholders also are reviewed. The chapter concludes with a discussion of how to
analyze and value LBO transactions and an example illustrating the methodology.
1. Characteristics of financial buyers
2. Alternative LBO /models
3. Advantages and disadvantages of LBOs as a deal structure;
4 Alternative financing options;
5. Common forms of LBO legal structures
6. Factors critical to the success of leveraged buyout transactions;
7. Pre-LBO returns to target company shareholders;
8. Post-buyout returns to LBO shareholders;
9. Analyzing and valuing LBOs; and
10. Developing LBO exit strategies.
Learning Objective 1: Characteristics of financial buyers

• Focus on ROE rather than ROA. Financial buyers emerged during the 1970s and unlike most
managers of publicly traded companies, who focus on ROA (including equity and debt) to
evaluate acquisitions, they focus on a narrow definition of returns involving only equity.
• Use OPM. By using other people’s money, financial buyers frequently offered a substantial
premium over the current public market value.
• Succeed through improved operational performance. Success came through improving the
performance of the acquired company by providing management incentives and leverage.
• Focus on targets having stable cash flow to meet debt service requirements. Typical targets
are in mature industries (e.g., retailing, textiles, food processing, apparel, and soft drinks),
Learning Objective 2: Alternative LBO Models
Classic LBO Model (Late 1970s and early 1980s)
• Debt normally 4 to 5 times equity. Debt amortized over no more than 10 years.
• Existing corporate management encouraged to participate.
• Complex capital structure:

--Senior bank debt (collateralized by the target’s assets) usually comprises over 60% of
total funds raised.
--Subordinated or senior unsecured debt referred to as mezzanine debt is provided by
insurance companies, pension funds, etc., and often carries PIK (payment in kind)
provisions giving more of the same security in lieu of interest payments if the firm is
unable to meet interest obligations. Mezzanine debt usually comprises about 26% of
total funds raised.
--Preferred stock provides about 5% of total funds raised.
--Common equity provides the balance of funds raised.
• Firm frequently taken public within seven years as tax benefits diminish.
Break-Up LBO Model (late 1980s)
• Same as classic LBO but debt serviced from operating cash flow/asset sales.
• Changes in the tax laws reduced popularity of this approach as asset sales immediately upon
closing of the transaction are no longer deemed tax-free. Previously, could buy stock in a
company, sell the assets and any gain on asset sales was offset by a mirrored reduction in the
value of the stock.
Strategic LBO Model (1990s)
2
• Exit strategy is via IPO.
• D/E ratios are lower so as not to depress EPS. Equity as a percent of debt increased to about
30% as compared to 5-10% in the late 1980s.
• Financial buyers provide the expertise to grow earnings. Previously, their expertise focused
on capital structure.
• Deals structured so that debt repayment not required until 10 years after the transaction to
reduce pressure on immediate performance improvement.
• Buy-out firms purchase a firm as a means for leveraged buy-outs of other firms in the same
industry.
LBOs in the New Millennium:
• The average size of LBOs has increased dramatically in recent years due to a world awash in
savings and the resulting cheap financing, as well as excess capacity in many industries
encouraging consolidation. The Sarbanes-Oxley Act of 2002 has also encouraged some firms
to go provide to escape the increased reporting requirements of the Act.
• The explosion in LBO activity has been accompanied by increased risk, as the average debt
burden of firms taken private has increased substantially.
• Western Europe has also witnessed an explosion in LBO activity, reflecting ongoing
liberalization in the European Union as well as cheap financing and industry consolidation
Learning Objective 3: Advantages and disadvantages of LBOs as a deal structure
• Advantages include the following:
--Management incentives,
--Tax savings from interest expense and depreciation from asset write-up,
--More efficient decision processes under private ownership,
--A potential improvement in operating performance, and
--Serving as a takeover defense by putting control in the hands of management.
• Disadvantages include the following:
--High fixed costs of debt,

--Vulnerability to business cycle fluctuations and competitor actions,
--Not appropriate for firms with high growth prospects or high business risk, and
--Potential difficulties in raising capital.
Learning Objective 4: Alternative financing options
• Asset-based or secured lending
3
• Cash flow or unsecured lending
• Junk bonds
--Junk bonds are non-rated debt. The quality of such bonds varies widely. Interest rates
usually 3-5 percentage points above the prime rate.
--Bridge or interim financing was obtained in LBO transactions to close the transaction
quickly because of the extended period of time needed to issue “junk” bonds. These high
yielding bonds represented permanent financing for the LBO.
--A series of defaults of over-leveraged firms in the late 1980s along with alleged insider
trading and fraud at such companies as Drexel Burnham, the primary market maker for
junk
bonds, caused this source of financing to dry up for LBOs. This factor and an ebullient
stock
market encouraged the development of the Strategic LBO.
--Junk bond financing is highly cyclical, tapering off as the economy goes into recession and
fears of increasing default rates escalate.
• Common and preferred stock (including payment in kind)
Learning Objective 5: Common forms of LBO legal structures
• Direct merger: One in which the seller receives cash for stock. The lender makes the loan to
the buyer once the appropriate security agreements are in place and the target’s stock has
been pledged against the loan.
• Subsidiary merger: One in which a new subsidiary of the acquirer is formed to merge with
the target.
• Fraudulent conveyance: The new company created by the LBO must be strong enough to
meet its obligations to current and future creditors. If the new firm is found by the courts to
have been inadequately capitalized, the lender could be stripped of its secured position in the
assets of the company and its claims on the assets could be subordinated to those of general
or unsecured creditors.
Learning Objective 6: Factors critical to the success of leveraged buyout transactions
• Knowing what to buy. Attractive target firms

--Should have unused borrowing capacity, tax shelter, and redundant assets
--Should have competent and motivated management
--Should compete in mature industries such as manufacturing, retailing, textiles, food
processing, apparel, and beverage.
--Could be an underperforming business within a larger firm.
4
• Not overpaying, especially in view of the burden of paying down the debt and its deleterious
impact on the competitiveness of the firm
• Improving operating performance. The discipline imposed by the need to satisfy debt service
requirements focuses management’s attention on maximizing operating cash flows.
Learning Objective 7: Pre-LBO returns to target firm shareholders
• Returns to target shareholders of LBOs can often exceed 40% on or about the announcement
date due to
--Anticipated improvement in efficiency and tax benefits
--Wealth transfer effects
--Superior knowledge of LBO investors who might include the target firm’s management
--More efficient decision making
Learning Objective 8: Postbuyout returns to LBO shareholders
• A number of studies suggest that postbuyout investors earn abnormally positive returns
• Such returns would imply that the increase in the target firm’s share price during the
announcement date does not fully reflect the benefits of the anticipated improvement in
operating performance and tax benefits.
• Often the postbuyout returns are due to the target firm being acquired following the
formation of the LBO
Learning Objective 9: Analyzing and valuing LBOs
• Decision rules: Determining if a deal makes sense: Using capital budgeting analysis
--From standpoint of all investors, if

PVFCFF  ID+E+PFD,
where D, E, & PFD are debt, equity and preferred stock, respectively
--From standpoint of equity investors, if
PVFCFE  IE
--Note that it is possible for the deal to make sense to equity investors but not to other
investors such as pre-LBO debt and preferred stockholders.
• Valuation using the variable risk method involves a five-step procedure;
--Step 1: Projecting annual cash flows (including any tax savings)

--Step 2: Projecting debt-to-equity ratios
5
--Step 3: Calculate terminal value
--Step 4: Adjust the discount rate to reflect changing risk and discount cash flows
and terminal value
--Step 5: Determine if NPV of cash flows is greater than or equal to one.
Alternatively, the adjusted present value method may be employed. This entails the
following:
--Step 1: Projecting annual cash flows and interest tax savings

--Step 2: Value target without tax savings
--Step 3: Estimate PV of tax savings
--Step 4: Add PV of firm without debt to PV of tax savings
--Step 5: Determine if NPV of cash flows is greater than or equal to one.
While computationally simpler than the variable risk method, the adjusted present value
method suggests that NPV always can be increased by taking on additional leverage, thereby
ignoring the potential for bankruptcy. APV ignores the effect of leverage on the discount
rate.
Learning Objective 10: Developing LBO exit strategies
• Investors are able to realize their return only after they have been able to cash out of the
business
• Common exit strategies include the following:
--Selling to a strategic buyer
--An initial public offering
--A leveraged recapitalization
--A sale to another buyout firm
1. A financial buyer is interested in acquiring a firm for purposes of integrating the business
into another firm to enhance the overall strategic value of the combined firms. True or
False
2. LBOs typically account for less than 5% of the total dollar volume of M&As in an
average year. True or False
6
3. LBOs in the 1990s typically involved a much higher percentage of equity in the capital
structure than during the 1980s. True or False
4. Under asset based lending, the borrower pledges certain assets as collateral. True or
False
5. Accounts receivable and inventory are common examples of a target firm’s assets used as
collateral in securing asset based loans. True or False
6. An example of a negative covenant is one in which the firm’s ability to pay dividends
without the lender’s permission is limited. True or False
7. Using target assets as collateral is the only way in which lenders are willing to finance a
leveraged buyout. True or False
8. Junk bonds are typically high yield bonds either rated by the credit rating agencies as
below investment grade or not rated at all. They are necessarily high risk bonds. True or
False
9. Junk bonds frequently exhibit an increasing default rate the longer they are outstanding.
True or False
10. Payment in kind preferred stock or debt is a type of equity or debt in which dividends and
interest are paid in the form of more preferred stock or debt. True or False
11. The key to a successful LBO is not to overpay for the acquisition. True or False
12. Divisions of large companies rarely make good candidates for LBOs. True or False
13. Postbuyout returns to LBO investors are often enhanced by the subsequent acquisition of
the LBO by a strategic buyer. True or False
14. Successful LBOs often rely heavily on management incentives to improve operating
performance. True or False
15. LBO structures are generally most appropriate for relatively small firms. True or False
Multiple Choice:
7
16. Which of the following is generally not considered a factor critical to the success of an
LBO?
a. Knowing what type of firm to buy

b. Not overpaying for the target firm
c. Improving operating performance
d. Large reinvestment requirements to sustain growth
17. Which of the following are common sources of financing for LBOs?
a. Asset based lending

b. Cash flow based lending
c. Junk bonds
d. All of the above
18. All of the following are often pledged as collateral for loans except for
a. Intangible assets such as goodwill

b. Accounts receivable
c. Fixed assets
d. Inventory
19. All of the following are examples of affirmative covenants except for
a. The borrowing firm must carry sufficient insurance to cover insurable business
risks
b. The borrower must maintain a minimum amount of net working capital
c. The borrower must retain key management personnel acceptable to the lending
institution.
d. The borrower is required to obtain the lender’s approval before certain assets can
be sold.
20. Which of the following are sometimes considered factors affecting returns to target
shareholders?
a. Anticipated improvement in efficiency

b. Tax benefits
c. More efficient decision making
d. All of the above
8
Mergers Test
Study online at https://quizlet.com/_4sjntp
A forward triangular merger involves the acquisition subsidiary
being merged with the target firm and the acquiring subsidiary True
surviving. True or False
The form of acquisition may consist of cash, common stock, debt,
or a combination of all three as payment to the target company False
shareholders. True or False
The form of payment may influence the choice of acquisition
True
vehicle and post-closing organization. True or False
Tax considerations rarely affect the amount and composition of
False
the purchase price. True or False
The corporate structure or some variation is the most commonly
True
used acquisition vehicle. True or False
If the acquirer is interested in integrating the target business
immediately following closing, the corporate or divisional structure
may be most desirable because the acquirer is most likely to be True
able to gain the greatest control by using this structure. True or
False
A divisional structure would also be most appropriate as a post-
closing organization if the form of payment were an earnout. True False
or False
Balance sheet adjustments are used primarily in purchases of
assets due to the potential for significant changes in the value
True
of working capital between the time the contract is signed and
closing. True or False
Earnouts are payments made prior to closing to provide an incen-
tive for the seller to cooperate with the buyer prior to closing. True False
or False
Stock purchases involve the exchange of the target's stock for
True
cash, debt, or the stock of the acquiring firm. True or False
Stock for stock or stock for assets transactions represent alterna-
True
tives to a merger. True or False
In a purchase of assets, the buyer retains the seller's net operating
False
losses and tax credits. True or False
In a merger, two corporations are combined and only one survives.
True
True or False
If the acquirer is interested in integrating the target business
immediately following closing, the corporate or divisional structure
may be most desirable, because the acquirer is most likely to be True
able to gain the greatest control by using this structure. True or
False
Real property may also be considered a form of payment. True or
True
False
Which of the following are common forms of payment in mergers
and acquisitions?
a. Cash D
b. Stock
c. Debt
d. All of the above
Which of the following is generally not a reason for conducting a
staged transaction?
a. To enable the completion of a technology or process by the D

target firm
b. The target may be waiting for an advance ruling of approval from
regulatory authorities before completing the transaction
1/6
Mergers Test
c. To minimize cultural conflicts
d. To rapidly integrate the target firm into the acquirer
Advantages of a purchase of assets to the buyer include all of the
following except for which of the following:
a. The buyer retains net operating losses and tax credits of the
selling firm
A
b. Buyers can select only target assets in which they are interested
c. Acquired assets may be revalued to market value at closing
d. Benefit plans for employees may be maintained or terminated at
the discretion of the acquirer in the absence of successor liability
clauses in the contracts
Advantages of a purchase of stock to the buyer include all of the
following except for which of the following:
a. The buyer is liable for all of the seller's liabilities on the balance
A
sheet, but it may avoid those not on the target's balance sheet.
b. All assets are transferred with the target's stock
c. Net operating losses and tax credits pass to the buyer
d. Provides for the continuity of customer and supplier contracts
Which of the following are commonly used to close a "gap" on the
purchase price
between the buyer and seller?
a. Balance sheet adjustments D
b. Earnouts
c. Rights, royalties, and fees
d. All of the above
A divestiture always results in a cash infusion to the parent. True
False
or False
If the after-tax value of a business is greater than the after-tax
value of the business as a continuing operation to the parent, it is False
always appropriate to divest the business. True or False
Timing has a major influence on the decision to sell a business.
True
True or False
A spin-off is a transaction in which a portion of a firm is sold to the
False
public. True or False
Subsidiary equity carve-outs are sometimes used to value the
True
subsidiary. True of False
An equity carveout is sometimes a prelude to a divestiture of the
True
operating unit. True or False
Tracking stocks are separate classes of common stock of the
True
parent corporation. True or False
Tracking stocks may create internal operating conflicts among the
True
parent's business units True or False
Parent firms with a high tax basis in a business may choose to
spin-off the unit as a tax-free distribution to shareholders rather
False
than sell the business and incur a substantial tax liability. True or
False
Divestitures and carveouts often provide cash to the parent, while
True
spin-offs do not. True or False
Parent firms that engage in divestitures are often highly diversified
in largely unrelated industries and have a desire to achieve greater True
focus to raise cash. True or False
The parent firm generally retains control of the business involved
True
in an equity carve-out. True or False
2/6
Mergers Test
Split-ups and spin-offs generally are taxable to shareholders. True
False
or False
Divestitures, spin-offs, equity carve-outs, split-ups, split-offs, and
bust-ups are commonly used strategies to exit businesses and to
True
redeploy corporate assets by returning cash or non-cash assets
through a special dividend to shareholders. True or False
In a public solicitation, a firm can announce publicly that it is
putting itself, a subsidiary, or a product line up for sale. Either
True
potential buyers contact the seller or the seller actively solicits bids
from potential buyers or both. True or False
Which of the following is generally not considered a strategy for
exiting a business?
a. A spin-off C
b. A divestiture
c. An acquisition
d. An equity carveout
Which of the following are common reasons for exiting a busi-
ness?
a. Regulatory concerns D
b. Changing corporate strategy or focus
c. Lack of fit
d. All of the above
A spin-off may create shareholder wealth for all of the following
reasons except for
a. Spin-offs are generally not taxable if properly structured
b. The spin-off's management and board is independent of the
C
former parent
c. The cost of capital of the spin-off is generally higher than when
it was part of the parent
d. The spin-off may be subsequently acquired by another firm
Which one of the following is generally not a reason for issuing
tracking stocks?
a. To give investors a "pure play" in a specific business owned by
the parent
B
b. To enhance the likelihood that the business will be acquired
c. To create an incentive for management receiving the stock
d. To raise capital for the parent or for the business for which the
tracking stock is created
Which of the following is not true of a spin-off?
a. Creates cash infusion for parent
b. Change in equity ownership of the spin-off D
c. New shares issued to the public
d. All of the above
A financial buyer is interested in acquiring a firm for purposes of
integrating the business into another firm to enhance the overall False
strategic value of the combined firms. True or False
Private equity, hedge funds, and venture capital funds, so-called
financial sponsors, play a pivotal role in the financing a wide range True
of investments globally. True or False
If the borrower defaults on the loan, the lender can seize and sell
True
the collateral to recover the value of the loan. True or False
Under asset based lending, the borrower pledges certain assets
True
as collateral. True or False
Accounts receivable and inventory are common examples of a
target firm's assets used as collateral in securing asset based True
loans. True or False
3/6
Mergers Test
An example of a negative covenant is one in which the firm's ability
to pay dividends without the lender's permission is limited. True or True
False
Using target assets as collateral is the only way in which lenders
False
are willing to finance a leveraged buyout. True or False
Junk bonds are typically high yield bonds either rated by the credit
rating agencies as below investment grade or not rated at all. They False
are necessarily high risk bonds. True or False
Junk bonds frequently exhibit an increasing default rate the longer
True
they are outstanding. True or False
Payment in kind preferred stock or debt is a type of equity or debt in
which dividends and interest are paid in the form of more preferred True
stock or debt. True or False
The key to a successful LBO is not to overpay for the acquisition.
True
True or False
Divisions of large companies rarely make good candidates for
False
LBOs. True or False
Private equity, hedge, and venture capital funds take money from
large institutions such as pension funds and endowments, borrow
True
additional cash, and buy private and public companies. True or
False
Successful LBOs often rely heavily on management incentives to
True
improve operating performance. True or False
While private equity firms accept funds from limited partners such
as institutional investors, the bulk of the equity funds comes from False
the general partner. True or False
Which of the following is generally not considered a factor critical
to the success of an LBO?
a. Knowing what type of firm to buy D

b. Not overpaying for the target firm
c. Improving operating performance
d. Large reinvestment requirements to sustain growth
17. Which of the following are common sources of financing for
LBOs?
a. Asset based lending D

b. Cash flow based lending
c. Junk bonds
d. All of the above
All of the following are often pledged as collateral for loans except
for
a. Intangible assets such as goodwill A

b. Accounts receivable
c. Fixed assets
d. Inventory
All of the following are examples of affirmative covenants except

for
a. The borrowing firm must carry sufficient insurance to cover

insurable business risks D
b. The borrower must maintain a minimum amount of net working
capital
c. The borrower must retain key management personnel accept-
able to the lending institution.
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Mergers Test
d. The borrower is required to obtain the lender's approval before
certain assets can be sold.
20. Which of the following are sometimes considered factors af-
fecting returns to target shareholders?
a. Anticipated improvement in efficiency D

b. Tax benefits
c. More efficient decision making
d. All of the above
Tax considerations can affect the amount, timing, and composition
True
of the purchase price. True or False
If a transaction is taxable, target shareholders will demand a
higher purchase price to offset the anticipated tax liability. True or True
False
Acquirers, whose stock is publicly traded, are increasingly vulner-
able to massive write offs of goodwill, often resulting from exces-
sive prices paid for target companies. This ever-present threat of
True
asset impairment may exert some discipline into the negotiating
process, affecting both the amount and timing of offer prices. True
or False
Tax considerations are always extremely important in M&A trans-
False
actions, particularly to acquirers. True or False
The use of anything other than the acquirer's stock to acquire sub-
stantially all of the target's stock renders the transaction taxable True
to the target firm's shareholders. True or False
Taxable transactions have been made somewhat more attractive
since 1993, when a change in the legislation allowed acquirers to
True
amortize intangible assets, including goodwill, over 15 years for
tax purposes. True or False
According to Section 338 of the U.S. tax code, a purchaser of 80%
or more of the stock of the target may elect to treat the acquisition True
as if it were an acquisition of the target's assets. True or False
Transactions may be partially taxable if the target shareholders
receive some nonequity consideration, such as cash or debt, in True
addition to the acquirer's stock. True or False
Net operating loss carry forwards are provisions in the tax laws
allowing firms to use NOLs generated in the past to offset future True
taxable income. True or False
Pooling of interests accounting is currently a popular form of
False
reporting business combinations. True or False
A forward triangular merger is the most commonly used form of
reorganization for tax-free asset acquisitions in which the form of True
payment is acquirer stock. True or False
The IRS generally views forward triangular cash mergers as a
purchase of target assets, since the acquiring subsidiary survives. True
True or False
A transaction generally will be considered taxable to the seller if
it involves the purchase of the target's stock (but not if it involves
False
a purchase of assets) for substantially all cash, notes, or some
other nonequity consideration. True or False
If a transaction involves a purchase of assets, the target compa-
ny's tax cost or basis in the acquired stock or assets is increased True
or "stepped up" to their fair market value. True of False
Which of the following is not true of a taxable transaction?
a. Acquiring firm steps up the basis for the acquired assets to their
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Mergers Test
fair market value
b. Immediate recognition of a gain by target shareholders
c. Net operating losses of the target are transferred to the acquir-
C
ing firm
d. The acquiring firm loses the target's net operating losses and
tax credits
Which phrase best completes the following statement. For fi-
nancial reporting purposes, an upward valuation of tangible and
intangible assets, other than goodwill,
a. Raises depreciation but lowers amortization expenses D

b. Lowers depreciation and amortization expenses
c. Increases operating and net income
d. Raises depreciation and amortization expenses, which lowers
operating and net income.
As a general rule, a transaction is tax-free to the target's share-
holders if:
a. The buyer uses cash to acquire the target's stock

B
b. The buyer uses mostly stock to acquire substantially all of the
target's stock or assets
c. The buyer uses cash to buy the target's assets
d. The buyer uses debt to buy the target's stock
Which of the following is not true of goodwill?
a. It must be amortized over 40 years.

b. It represents the excess of the purchase price over the net asset
value of acquired assets.
A
c. It must be written down if its net asset value falls below its
carrying value.
d. The loss of key customer contracts, patent protection expiration,
or the failure to achieve anticipated cost-saving synergies could
affect the value of goodwill on the firm's balance sheet.
Which of the following is not true of purchase accounting?
a. The acquiring firm records the target at the actual purchase

price.
b. Acquired assets and assumed liabilities are revalued to their fair
D
market value on the closing date.
c. The purchase price is first allocated to tangible and then to
intangible assets.
d. The excess of the purchase price over the target firm's net asset
value is ignored.
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Chapter 1: Introduction to

Mergers and Acquisitions

Chapter 1 Learning Objectives: Providing students with an understanding of

1. What corporate restructuring is and why it occurs;

2. Commonly used M&A vocabulary;

3. Key participants in the M&A process;

5. Common motivations for M&A activity;

6. Historical mergers and acquisitions waves;

7. The Impact of M&A on shareholders and society; and

8. Commonly cited reasons for M&As frequent failure to meet expectations.

Learning Objective 1: Understanding what corporate restructuring is and why it occurs

 Operational restructuring may include the following:

--Downsizing through layoffs or attrition the number of employees required to support

 Financial restructuring may include the following:

--Adding debt to lower the firm’s weighted average cost of capital;

Learning Objective 2: Understanding commonly used M&A vocabulary.

 Acquisition: Purchase of an entire company or a controlling interest in a company.

 Acquirer: A firm attempting to merge or acquire another company

 Target: The firm being solicited by the acquiring firm.

Learning Objective 3: Understanding key participants in the M&A process

 Proxy solicitors: Hired by dissident shareholders to compile lists of shareholders’ addresses

Learning Objective 4: Understanding that M&A is only one of a number of strategic

Alternatives to M&A may include the following:

 Solo venture: “Going it alone” or “organic growth” by relying on a firm’s existing

 Financial restructuring: See learning objective 1.

 Operational restructuring: See learning objective 1.

Learning Objective 5: Understanding common motivations for M&As

 Diversification: Acquiring firms outside of a firm’s current primary lines of business

--Technological change (CDs, cable satellite hook-ups, broadband)

Learning Objective 6: Understanding historical waves of mergers and acquisitions

 The First Wave: Horizontal Consolidation (1897-1904)

 The Second Wave: Increasing Concentration (1916-1929)

 The Third Wave: The Conglomerate Era (1965-69)

 The Fourth Wave: The Retrenchment Era (1981-1989)

 The Fifth Wave: Age of the Strategic Megamerger (1992-2000)

Learning Objective 7: Understanding the impact of M&A on shareholders and on society

 Success is elusive: Studies show that

--Around announcement dates, abnormal returns in mergers to target shareholders are

 In general, society benefits from M&A activity

 Slow pace of integration

--May be too complicated to execute

Chapter 1 Study Test

10. Perceived synergy is rarely a motivation for M&A. True or False

Multiple Choice Questions:

17. A merger is a combination of businesses in which

18. Vertical mergers are those in which the participants are

19. An employee stock ownership plan (ESOP) is a trust that

Chapter 3 Learning Objectives: Providing students with an understanding of

1. corporate governance and its role in protecting stakeholders in the firm;

2. factors external and internal to the firm affecting corporate governance;

 Corporate governance is defined as the interactions among shareholders, managers, boards of

 If properly applied, corporate governance practices protect stakeholders’ from incompetent

--Boards of directors must aggressively review the quality of recommendations received by

Chapter 3 Study Test

1. Successful corporate governance systems rely on aligning managerial incentives with

4. The threat of hostile takeovers is an important factor in promoting good governance

5. Institutional activism has proven to be largely ineffective in promoting good government

15. ESOPs are rarely used as takeover defenses. True or False

Multiple Choice Questions:

17. Which of the following is not usually considered a takeover tactic?

WACC = ke  __ E_ + i  (1 – t)  D + kpr x PF_