mergers and acquisitions

interpretation and evaluation of NPV method

• the cost depends on the payment method → cash or share exchange

• it is a useful framework for investment appraisal of M&A deals, but its reliability depends heavily on assumption

• small changes in estimated gains [e.g. from 5 mil. to 1 mil. in perpetuity] swing NPV from highly positive to negative

• this sensitivity exposes the method’s weaknesses → estimates of future synergy gains are subjective and error prone

• synergy is hard to quantify due to cultural integration, managerial alignment, and execution risk

• share exchange adds complexity - value of consideration depends on new share price and exchange ratio, affected by market reaction

incentives, bias, EMH → NPV

three reasons gain estimates might be flawed:

• estimation of gains is highly subjective and difficult due to:

  • integration challenges

  • uncertainty around cost savings or revenue synergies

• acquirer managers often inflate gains to:

  • justify the merger

  • convince shareholders or target firms

  • pursue personal benefits

• bias [hubris] also plays a role:

  • overconfidence in managerial ability to deliver synergies

  • leads to unintentional overestimation of value

• cost side may also be flawed → use of inflated market prices [especially during rumours] can overstate true cost

• efficient markets hypothesis:

  • market prices should reflect all known information

  • but in practice, rumours cause price drifts before announcements

  • using these distorted prices in NPV calculations leads to overpayment

• empirical evidence shows:

  • acquirer managers and target shareholders benefit most

  • acquirer shareholders often don’t → indicating gains are overestimated and costs are under judged

conclusion → the gains are likely to be overestimated due to managerial incentives and EMH imperfections. this undermines the reliability of NPV

NPV → motives for mergers

• synergy → combine operations to increase value [cost savings, market power, new markets

• bargain buying → acquire undervalued firms [inefficiently run, distressed]

• managerial motives:

  • empire building, power, status

  • more responsibility → higher pay

  • the ‘thrill of the chase‘ or hubris

• free cash flow theory → spend surplus cash on acquisitions to avoid returning it to shareholders

• this party pressures → investment banks, consultants, analysts may push deals for their own fees/interests

interpretation and evaluation of valuation method

valuation methods:

• maintainable earnings → uses average pst earnings and capitalises them

• dividend yield → values company based on expected dividends and required return

• net asset value [NAV] → based on assets - liabilities

• super profits → NAV + value of earnings above normal return

• berliner → average of NAV and earnings value

strengths;

• give a range of values to use in negotiations

• use different assumptions → income, assets, market expectations

weaknesses:

• all rely on subjective inputs [e.g. expected earnings, appropriate yield]

• historical data may not reflect future potential [especially with R&D heavy firms]

• market benchmarks [e.g. yields] may not apply to unique targets

• conflicts of interest and motives can skew inputs → e.g. low NAV to seem undervalued or high earnings to justify a bid

conclusion → use multiple methods together [e.g. berliner], but understand that valuation is as much an art as a science. the final price is always negotiated, not just calculated

incentives, bias, EMH → valuations method

managers of both acquirer and target have strong incentives to manipulate valuations:

• valuation methods depend on subjective inputs, which are prone to manipulation]

  • maintainable earnings, expected dividends, asset values can all be influenced

• acquirer incentives:

  • inflate valuation to justify high bids for strategic or ego driven reasons

  • delate valuation selectively to negotiate better deals

• target firm incentives:

  • inflate valuations to demand a larger premium

  • alternatively, deflate valuation as a defensive tactic [to avoid being bought]

• bias [hubris] affects both sides:

  • overconfidence in forecasts or performance potential

  • leads to unrealistic earnings or asset assumptions

• EMH concerns:

  • valuations using market prices may be distorted by rumours or insider trading

  • if a price includes speculation, it no longer reflects fundamental value

conclusion → even when using multiple valuation methods, the process is highly sensitive to incentive driven inputs and EMH failures

defence tactics

• pre-bid tactics:

  • placing shares in friendly hands [e.g. pension funds, employees]

  • strategic alliances or defensive investments

  • PR campaigns to boost firm image/value

• post-bid tactics:

  • lobbying stakeholders [unions, regulators] to oppose the bid

  • revising forecasts to boost share price and make bid less attractive

• other dubious tactics:

  • white knight - find a friendly acquirer

  • Crown Jewels - sell of key key assets to make the firm less attractive

  • golden parachutes - expensive exit packages to deter takeovers

these are used by the target to resist being bought, especially if they believe they’re undervalued or the deal isn’t in shareholders interest