in the revenues for the merged firm from new products, increased prices, or
better distribution of existing products? Alternatively, are there cost savings
as a result of taking advantage of economies of scale, improved efficiency, or
a lower cost of capital for the target?
ā¢ What is the value of any performance improvements? Values can be estimat-
ed using multiples or discounted earnings/cash flow methods.
AT&Tā™s Pricing of NCR
AT&Tā™s $7.5 billion price for NCR represents a 120 percent premium to target stockhold-
ers (adjusted for market-wide changes during the merger negotiation period). This is cer-
tainly substantially higher than typical premiums during this period and in part reļ¬‚ects
opposition to the acquisition from NCRā™s management. AT&Tā™s initial offer for the ļ¬rm
was $85 per share. The ļ¬nal price, which was accepted by target management, was $110.
Mergers and Acquisitions
15-11 Part 3 Business Analysis and Valuation Applications
AT&Tā™s pricing of NCR also appears to be aggressive in terms of traditional forms of
valuation. At the time of the announcement of AT&Tā™s offer, the typical PE value for
ļ¬rms in the computer industry was 12.9 and NCRā™s PE was 11.5, yet AT&Tā™s ļ¬nal offer
valued NCR at 18 times current earnings. If these beneļ¬ts are realized immediately, the
total annual performance improvements from the acquisition for the new ļ¬rm is equiv-
alent to 50 percent of NCRā™s premerger earnings, a challenging target. Of course AT&Tā™s
management believed some of these beneļ¬ts would come from increased earnings from
its own operations.
The market reaction to acquisition announcements suggests that analysts believed that
AT&T overpaid for NCRā”AT&Tā™s stock price dropped by 13 percent (again adjusted for
market-wide changes), or $4.9 billion, during the negotiation period. Given the $3.7 bil-
lion premium that AT&T paid for NCR, this decline in AT&T equity implies that analysts
believed that AT&T would actually destroy value in NCR! Subsequent short-term ļ¬nancial
results for AT&Tā™s computer operations (which includes NCR) support the marketā™s skep-
ticism. NCRā™s 1991 earnings were $100 million (26 percent) below projections made to
AT&T. AT&Tā™s loss from computer operations in 1993 was $99 million (including a $190
million restructuring charge). For the ļ¬rst quarter of 1994 the ļ¬rm reported an operating
loss of $61 million (including another restructuring charge of $120 million).
NCR continued to show poor performance through 1995, with losses reportedly as
high as $2 million per day. Consequently, in 1995 AT&T announced that it would take a
$1.6 billion write-off of its NCR assets. In 1996 AT&T decided to reposition itself as a
communications services company. As part of the accompanying restructuring, it spun off
NCR to its shareholders. The newly listed NCR was valued at $3.5 billion, less than half
of the $7.5 billion that AT&T had paid for the company.
In summary, it appears from preliminary results and market assessments of the acqui-
sition that AT&T overpaid for NCR. Indeed, the market believed that AT&T would actu-
ally destroy NCRā™s value as an independent ļ¬rm, raising questions about the merits of
AT&Tā™s overall technology strategy.
Even if an acquisition is undertaken to create new economic value and is priced judi-
ciously, it may still destroy shareholder value if it is inappropriately ļ¬nanced. Several
ļ¬nancing options are available to acquirers, including issuing stock or warrants to target
stockholders, or acquiring target stock using surplus cash or proceeds from new debt.
The trade-offs between these options from the standpoint of target stockholders usually
hinge on their tax and transaction cost implications. For acquirers, they can affect the
ļ¬rmā™s capital structure and the ļ¬nancial reporting of the transaction and provide new in-
formation to investors.
As we discuss below, the ļ¬nancing preferences of target and acquiring stockholders
can diverge. Financing arrangements can therefore increase or reduce the attractiveness
of an acquisition from the standpoint of acquiring stockholders. As a result, a complete
608 Mergers and Acquisitions
Mergers and Acquisitions
analysis of an acquisition will include an examination of the implications of the ļ¬nanc-
ing arrangements for the acquirer.
Effect of Form of Financing on Target Stockholders
As noted above, the key ļ¬nancing considerations for target stockholders are the tax and
transaction cost implications of the acquirerā™s offer.
TAX EFFECTS OF DIFFERENT FORMS OF CONSIDERATION. Target stockholders
care about the after-tax value of any offer they receive for their shares. In the U.S., when-
ever target stockholders receive cash for their shares, they are required to pay capital
gains tax on the difference between the takeover offer price and their original purchase
price. Alternatively, if they receive shares in the acquirer as consideration and the acqui-
sition is undertaken as a tax-free reorganization, they can defer any taxes on the capital
gain until they sell the new shares.
U.S. tax laws appear to cause target stockholders to prefer a stock offer to a cash one.
This is certainly likely to be the case for a target founder who still has a signiļ¬cant stake
in the company. If the companyā™s stock price has appreciated over its life, the founder
will face a substantial capital gains tax on a cash offer and will therefore probably prefer
to receive stock in the acquiring ļ¬rm. However, cash and stock offers can be tax-neutral
for some groups of stockholders. For example, consider the tax implications for risk ar-
bitrageurs, who take a short-term position in a company that is a takeover candidate in
the hope that other bidders will emerge and increase the takeover price. They have no
intention of holding stock in the acquirer once the takeover is completed, and will pay
ordinary income tax on any short-term trading gain. Cash and stock offers therefore have
identical after-tax values for risk arbitrageurs. Similarly, tax-exempt institutions are
likely to be indifferent to whether an offer is in cash or stock.
TRANSACTION COSTS AND THE FORM OF FINANCING. Transaction costs are
another factor related to the form of ļ¬nancing that can be relevant to target stockholders.
Transaction costs are incurred when target stockholders sell any stock received as con-
sideration for their shares in the target. These costs will not be faced by target stockhold-
ers if the bidder offers them cash. Transaction costs are unlikely to be signiļ¬cant for
investors who intend to hold the acquirerā™s stock following a stock acquisition. However,
they may be relevant for investors who intend to sell, such as risk arbitrageurs.
Effect of Form of Financing on Acquiring Stockholders
For acquiring stockholders, the costs and beneļ¬ts of different ļ¬nancing options usually
depend on how the offer affects their ļ¬rmā™s capital structure, any information effects as-
sociated with different forms of ļ¬nancing, and the accounting methods of recording the
Mergers and Acquisitions
15-13 Part 3 Business Analysis and Valuation Applications
CAPITAL STRUCTURE EFFECTS OF FORM OF FINANCING.
where debt ļ¬nancing or surplus cash are the primary form of consideration for target
shares, the acquisition increases the ļ¬nancial leverage of the acquirer. This increase in
leverage may be part of the acquisition strategy, since one way an acquirer can add value
to an inefļ¬cient ļ¬rm is to lower its taxes by increasing interest tax shields. However, in
many acquisitions an increase in postacquisition leverage is a side effect of the method
of ļ¬nancing and not part of a deliberate tax-minimizing strategy. The increase in lever-
age can then potentially reduce shareholder value for the acquirer by increasing the risk
of ļ¬nancial distress.
To assess whether an acquisition leads an acquirer to have too much leverage, ļ¬nan-
cial analysts can assess the acquirerā™s ļ¬nancial risk following the proposed acquisition
by these methods:
ā¢ Assessing the pro forma financial risks for the acquirer under the proposed financ-
ing plan. Popular measures of financial risk include debt-to-equity and interest-
coverage ratios, as well as projections of cash flows available to meet debt repay-
ments. The ratios can be compared to similar performance metrics for the acquiring
and target firmsā™ industries. Do postmerger ratios indicate that the firmā™s probabil-
ity of financial distress has increased significantly?
ā¢ Examining whether there are important off-balance-sheet liabilities for the target
and/or acquirer which are not included in the pro forma ratio and cash flow analysis
of postacquisition financial risk.
ā¢ Determining whether the pro forma assets for the acquirer are largely intangible,
and therefore sensitive to financial distress. Measures of intangible assets include
such ratios as market to book equity and tangible assets to the market value of
INFORMATION PROBLEMS AND THE FORM OF FINANCING. As we discuss in
Chapter 16, information asymmetries between managers and external investors can
make managers reluctant to raise equity to ļ¬nance new projects. Managersā™ reluctance
arises from their fear that investors will interpret the decision as an indication that the
ļ¬rmā™s stock is overvalued. In the short term, this effect can lead managers to deviate
from the ļ¬rmā™s long-term optimal mix of debt and equity. As a result, acquirers are likely
to prefer to use internal funds or debt to ļ¬nance an acquisition, since these forms of con-
sideration are less likely to be interpreted negatively by investors.8
The information effects imply that ļ¬rms forced to use stock ļ¬nancing are likely to
face a stock price decline when investors learn of the method of ļ¬nancing.9 From the
viewpoint of ļ¬nancial analysts, the ļ¬nancing announcement may therefore provide
valuable news about the preacquisition value of the acquirer. However, it should have no
implications for analysis of whether the acquisition creates value for acquiring share-
holders, since the news reļ¬‚ected in the ļ¬nancing announcement is about the preacqui-
sition value of the acquirer and not about the postacquisition value of the target to the
610 Mergers and Acquisitions
Mergers and Acquisitions
A second information problem arises if the acquiring management does not have
good information about the target. Stock ļ¬nancing then provides a way for acquiring
stockholders to share the information risks with target shareholders. If the acquirer ļ¬nds
out after the acquisition that the value of the target is less than previously anticipated,
the accompanying decline in the acquirerā™s equity price will be partially borne by target
stockholders who continue to hold the acquirerā™s stock. In contrast, if the targetā™s shares
were acquired in a cash offer, any postacquisition loss would be fully borne by the
acquirerā™s original stockholders. The risk-sharing beneļ¬ts from using stock ļ¬nancing
appears to be widely recognized for acquisitions of private companies, where public in-
formation on the target is largely unavailable. In practice, it appears to be considered less
important for acquisitions of large public corporations.
FORM OF FINANCING AND POSTACQUISITION ACCOUNTING.
form of ļ¬nancing has an effect on the acquirerā™s ļ¬nancial statements following the ac-
quisition. Two methods of reporting for the acquisition are permitted under U.S. ac-
countingā”purchase and pooling of interests.10
Under the purchase method, the acquirer writes up the assets of the target to their
market value, and records the difference between the purchase price and the market
value of the targetā™s tangible net assets as goodwill. In the U.S. and most other countries,
goodwill is subsequently amortized to earnings over a period of from 5 to 40 years.
The pooling-of-interests method of accounting for mergers, which is rarely used out-
side the U.S., requires acquirers to show the targetā™s assets, liabilities, and equity at their
original book values. Thus, no goodwill is recorded, and subsequent earnings need not
be reduced by the amortization of goodwill.
An acquirerā™s decision on a method of ļ¬nancing an acquisition largely determines its
method of accounting for the transaction. A number of conditions must be satisļ¬ed for
an acquirer to use the pooling-of-interests method to account for an acquisition. If these
conditions are not satisļ¬ed, the acquirer is required to use purchase accounting. The
most signiļ¬cant of these conditions are that: (1) the acquirer issues voting common
shares (not cash) in exchange for substantially all of the voting common shares (at least
90 percent) of the acquired company; and (2) the acquisition occurs in a single trans-
Some managers seem to believe that there is a beneļ¬t to shareholders from using the
pooling-of-interests method for recording an acquisition. They argue that investors use
earnings to value a ļ¬rmā™s stock. Since the pooling-of-interests method leads to higher
earnings than the purchase method by avoiding amortization of goodwill (at least until
the asset is fully depleted), pooling must therefore lead to higher stock prices. However,
while the two methods do have different earnings implications for the ļ¬rm, they do not
lead to different cash ļ¬‚ows. They therefore do not alter the economic value of the ļ¬rm.11
Thus, for the ļ¬nancial analyst, the choice of ļ¬nancing largely determines the accounting
methods used to prepare an acquirerā™s pro forma balance sheets and income statements.
But these accounting effects are not relevant to the question of whether the acquisition
creates value for acquiring stockholders.
Mergers and Acquisitions
15-15 Part 3 Business Analysis and Valuation Applications
Key Analysis Questions
The form of ļ¬nancing has important tax and transaction cost implications for tar-
get stockholders. It can also have important capital structure, information, and
merger accounting implications for acquirers. From the perspective of the analyst,
the effect of any corporate tax beneļ¬ts from debt ļ¬nancing should already be re-
ļ¬‚ected in the valuation of the target. Information and accounting effects are not
relevant to the value of the acquisition. However, the analyst does need to consider
whether demands by target stockholders for consideration in cash lead the acquir-
er to have a postacquisition capital structure which increases the risk of ļ¬nancial
distress to a point that is detrimental for stockholders. Thus, part of the analystā™s
task is to determine how it affects the acquirerā™s capital structure and its risks of
ļ¬nancial distress by asking the following questions:
ā¢ What is the leverage for the newly created firm? How does this compare to
leverage for comparable firms in the industry?
ā¢ What are the projected future cash flows for the merged firm? Are these suf-
ficient to meet the firmā™s debt commitments? How much of a cushion does
the firm have if future cash flows are lower than expected? Is the firmā™s debt
level so high that it is likely to impair its ability to finance profitable future
investments if future cash flows are below expectations?
ā¢ Does management appear to be excessively concerned about financing the
acquisition in a way that ensures the pooling of interests method can be used
to account for the acquisition? If so, what are managementā™s motivations? Is
the firm failing to take advantage of interest tax shields to merely avoid future