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Introduction to Business
Combinations and the
Conceptual Framework
Learning
Learning Objectives
Objectives
1. Describe
2. Identify
3. Identify
4. Identify
5. Distinguish
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1-3
acquisition.
Learning
Learning Objectives
Objectives
6.
7.
8.
9.
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1-4
Introduction
Introduction
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1-5
Introduction
Introduction
The IASB proposed the following definition of
control of an entity:
A reporting entity controls another entity when
the reporting entity has the power to direct the
activities of that other entity to generate returns
for the reporting entity
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1-6
Introduction
Introduction
On December 4, 2007, FASB released two new
standards,
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1-7
Introduction
Introduction
The new standard (141R) re-defines a business
combination
combination as a transaction or other event in
which an acquiring entity obtains control of one
or more businesses.
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1-8
Nature
Nature of
of the
the Combination
Combination
Business Combination occurs when the operations of
two or more companies are brought under common
control.
A business combination may be:
Friendly - the boards of directors of the potential
combining companies negotiate mutually agreeable terms
of a proposed combination.
Unfriendly (hostile) - the board of directors of a
company targeted for acquisition resists the
combination.
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1-9
Nature
Nature of
of the
the Combination
Combination
- In case, unfriendly position, a formal tender
offer enables the acquiring firm to deal with
individual shareholders.
-The
Nature
Nature of
of the
the Combination
Combination
Defense Tactics
Resistance often involves various moves by the
target firm as the following:
1.Poison pill: Issuing stock rights to existing
Nature
Nature of
of the
the Combination
Combination
Defense Tactics
4. Pac-man defense: Attempting an unfriendly takeover
of the would-be acquiring company.
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1-12
Nature
Nature of
of the
the Combination
Combination
Review Question
The defense tactic that involves purchasing shares held
by the would-be acquiring company at a price
substantially in excess of their fair value is called
a. poison pill.
b. pac-man defense.
c. greenmail.
d. white knight.
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1-13
Business
Business Combinations:
Combinations: Why?
Why? Why
Why Not?
Not?
A company may expand in two ways:
1.Internal expansion
By engaging in product development
1.External expansion
By acquiring one or more other firms.
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1-14
Business
Business Combinations:
Combinations: Why?
Why? Why
Why Not?
Not?
Advantages of External Expansion
1. Rapid expansion
2. Operating synergies ()
- Combinations with an existing company provides the
acquirer with an establishing operating unit, regular
supplier, productive facilities and distribution channels.
- The combination may be Vertical (a merger between a
supplier and a customer) or Horizontal (a merger between
competitors).
3. International marketplace
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1-15
Business
Business Combinations:
Combinations: Why?
Why? Why
Why Not?
Not?
Advantages of External Expansion
4.Financial synergy \
Business combinations are sometimes entered to benefit
from the tax laws in different countries. Because tax
laws vary from year to year and from country to country.
5.Diversification \
To achieve more protection from the competitors.
6.Divestitures
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Business
Business Combinations:
Combinations: Historical
Historical Perspective
Perspective
Three distinct periods
In the United States there have been three distinct periods
characterized by many business mergers, consolidations and
other forms of combinations:
1.1880 through 1904, huge holding companies, or trusts,
were created to establish monopoly control over certain
industries (horizontal integration).
2.1905 through 1930, to bolster the war effort, the
government encouraged business combinations to obtain
greater standardization of materials and parts and to
discourage price competition (vertical integration).
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1-17
Business
Business Combinations:
Combinations: Historical
Historical Perspective
Perspective
Three distinct periods
3. 1945 to the present, many of the mergers that occurred
from the 1950s through the 1970s were conglomerate
mergers (to diversify business risk)
In contrast, the 1980s were characterized by a
relaxation in antitrust enforcement and by the
emergence of high-yield junk bonds to finance
acquisitions.
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Terminology
Terminology and
and Types
Types of
of Combinations
Combinations
An
An asset
asset and
and aa stock
stock acquisition
acquisition
What Is Acquired?
Net assets of S Company
(Assets and Liabilities)
Common Stock
of S Company
Figure 1-1
3. Stock
4. Combination of
above
Terminology
Terminology and
and Types
Types of
of Combinations
Combinations
Notes:
-In
-In
The
Terminology
Terminology and
and Types
Types of
of Combinations
Combinations
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Statutory merger
Statutory consolidation
Stock acquisition
Statutory Merger
A Company
B Company
A Company
Statutory Consolidation
A Company
B Company
C Company
Financial
Statements of
B Company
Consolidated
Financial
Statements of
A Company and
B Company
Terminology
Terminology and
and Types
Types of
of Combinations
Combinations
Review Question
When a new corporation is formed to acquire two or
more other corporations and the acquired
corporations cease to exist as separate legal
entities, the result is a statutory
a. acquisition.
b. combination.
c. consolidation.
d. merger
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Takeover
Takeover Premiums
Premiums
Takeover Premium the excess of the amount offered or
agreed upon in an acquisition over the prior stock price
of the acquired firm.
Possible reasons for the premiums:
Stock prices of acquirer may be at a level which makes
it attractive to issue stock in the acquisition.
Credit may be generous for mergers and acquisitions.
Bidders may believe target firm is worth more than its
current market value.
Acquirer may believe growth by acquisitions is essential
and competition necessitates a premium.
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Possible
.
.
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Avoiding
Avoiding the
the Pitfalls
Pitfalls Before
Before the
the Deal
Deal
The factors to beware of include the following:
1.
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2.
3.
Avoiding
Avoiding the
the Pitfalls
Pitfalls Before
Before the
the Deal
Deal
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1-30
4.
5.
Avoiding
Avoiding the
the Pitfalls
Pitfalls Before
Before the
the Deal
Deal
Review Question
When an acquiring company exercises due diligence in
attempting a business combination, it should:
a. be skeptical about accepting the target companys
stated percentages
b. analyze the target company for assumed liabilities as
well as assets
c. look for nonrecurring items such as changes in
estimates
d. all the above
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Determining
Determining Price
Price and
and Method
Method of
of Payment
Payment
in
in Business
Business Combinations
Combinations
-When a business combination is effected through
open-market acquisition of stock, no problems arise
related to determine price or method of payment (the
price is determined by the normal functioning of the stock market,
and payment is generally in cash).
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Determining
Determining Price
Price and
and Method
Method of
of Payment
Payment
in
in Business
Business Combinations
Combinations
To determine an equitable price for each company and of the
resulting exchange ratio requires:
Evaluate net assets of each company (that is by assessing
for example: the expected collectability of accounts
receivable, current replacement cost for inventories and
some fixed assets such as goodwill and the current value of
long term liabilities).
Evaluate expected contribution of each company to the
future earnings of the new entity.
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Determining
Determining Price
Price and
and Method
Method of
of Payment
Payment
Excess Earnings Approach to Estimate Goodwill
1. Identify a normal rate of return on assets for firms
similar to the company being targeted.
2. Apply the rate of return (step 1) to the net assets of
the target to approximate normal earnings.
3. Estimate the expected future earnings of the target.
(Exclude any nonrecurring gains or losses).
4. Subtract the normal earnings (step 2) from the
expected target earnings (step 3). The difference is
excess earnings.
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Determining
Determining Price
Price and
and Method
Method of
of Payment
Payment
Excess Earnings Approach to Estimate Goodwill
5. Compute estimated goodwill from excess earnings.
Determining
Determining Price
Price and
and Method
Method of
of Payment
Payment
Review Question
A potential offering price for a company is computed by
adding the estimated goodwill to the
a. book value of the companys net assets.
b. book value of the companys identifiable assets.
c. fair value of the companys net assets.
d. fair value of the companys identifiable net assets.
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A.
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B.H
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Determining
Determining Price
Price and
and Method
Method of
of Payment
Payment
Exercise 1-1: Plantation Homes Company is considering the
acquisition of Condominiums, Inc. early in 2008. To assess
the amount it might be willing to pay, Plantation Homes
makes the following computations and assumptions.
A. Condominiums, Inc. has identifiable assets with a total fair
value of $15,000,000 and liabilities of $8,800,000. The assets
include office equipment with a fair value approximating book
value, buildings with a fair value 30% higher than book value,
and land with a fair value 75% higher than book value. The
remaining lives of the assets are deemed to be approximately
equal to those used by Condominiums, Inc.
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LO 7 Estimating goodwill.
LO 7 Estimating goodwill.
LO 7 Estimating goodwill.
Determining
Determining Price
Price and
and Method
Method of
of Payment
Payment
Exercise 1-1: (Part A)
15%
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8,800,000
Fair value of net assets
LO 7 Estimating goodwill.
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LO 7 Estimating goodwill.
LO 7 Estimating goodwill.
$ 98,667
25%
= $394,668
Estimated
Goodwill
LO 7 Estimating goodwill.
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LO 7 Estimating goodwill.
Part B
Excess earnings of target (same a Part A)
PV factor (ordinary annuity, 3 years, 15%)
Estimated goodwill
Fair value of net assets
Implied offering price
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$
x
$
98,667
2.28323
225,279
6,200,000
$ 6,425,279
LO 7 Estimating goodwill.
Alternative
Alternative Concepts
Concepts of
of Consolidated
Consolidated
Financial
Financial Statements
Statements
Non-controlling Interest
Under the economic entity concept, a noncontrolling
interest is part of the ownership equity. Thus it has the
same general nature and is accounted in the same way as
the controlling interest (i.e., component of owners
equity).
Under the parent company concept, the nature and
classification are unclear, the consolidated financial
statement are viewed as those of the parent company,
therefor, the noncontrolling interest is similar to a
liability. Consequently, the parent company concept
supports reporting the noncontrolling interest below
liabilities.
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$ 91000
Liabilities
$ 115000
Total liabilities
$ 206000
owners equity:
Non-controlling interest
$ 500000
Controlling interest
$ 1000000
1500000
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Accounts payable
$ 91000
Noncontrolling interest
$ 500000
Total liabilities
$ 591000
Stockholders equity
$1000000
Controlling interest
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Alternative
Alternative Concepts
Concepts
Review Question
According to the economic unit concept, the primary
purpose of consolidated financial statements is to
provide information that is relevant to
a. majority stockholders.
b. minority stockholders.
c. creditors.
d. both majority and minority stockholders.
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Conceptual
Conceptual
Figure 1-2
Conceptual
Framework for
Financial
Accounting and
Reporting by
(FASB)
SFAC
Nos. 1 & 2
Objectives:
Provide Information:
1. Usefulness in
investment and credit decisions
2. Usefulness in future cash flows
3. About enterprise resources, claims
to resources, and changes
SFAC No. 2
Qualitative
Characteristics
1. Relevance
2. Reliability
3. Comparability
4. Consistency
Also:Usefulness,Understandability
Framework
Framework
SFAC No. 6
(replaced SFAC No. 3)
Elements of Financial
Statements
Provides definitions
of key components
of financial statements
PRINCIPLES
Recognition
and Measurement
Objectives
Fundamental
Operational
1. Historical
Assumptions
Principlescost
Constraints
1. Economic entity 2. 1.
Historical
cost
1. Cost-benefit
Revenue
recognition
2. Going concern
2. Revenue recognition
2. Materiality
3. Matching
3. Monetary unit
3. Matching
3. Industry practice
4.
Full
disclosure
4. Periodicity
4. Full disclosure
4. Conservatism
SFAC No. 7: Using future cash flows & present values in accounting measures
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Copyright
Copyright
Copyright 2011 John Wiley & Sons, Inc. All rights reserved.
Reproduction or translation of this work beyond that permitted
in Section 117 of the 1976 United States Copyright Act
without the express written permission of the copyright owner
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caused by the use of these programs or from the use of the
information contained herein.
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