Level II Review Corporate Finance

Mergers and Acquisitions 

Posted by Joseph Hogue, CFA 

Study session nine in the Level II CFA Program curriculum includes two readings (28-29) on Corporate Finance.
Corporate Governance is the attempt to manage the agency problem between shareholders and management. The two primary objectives are to minimize conflicts of interest between the two groups and to ensure that assets are being used productively and efficiently.
The material is almost strictly conceptual and can be some easy points. Look for lists as well as any advantages/limitations of differing policies or methods.
The three main forms of business are pretty basic and anyone working in the corporate/financial environment should have a level of understanding. The differences on which you should focus are those in the liability, regulatory environment, and ability to raise capital. In sole proprietorships and partnerships, liability is unlimited and it is difficult to raise capital but there are few regulations. Contrast this with the corporation; where liability is limited only to invested capital, it is relatively easy to raise capital through equity or debt, and there can be many legal regulations.
Most of the material focuses on the board of directors, so understand their responsibilities and the best practices. Best practices for independence state that:

At least 75% of the board should be independent
The Chairman should be independent, and not the CEO
Annual elections of the board enable shareholders to change management quickly
There should be an annual self-assessment by the board
The audit, nomination, and compensation committees should be made up of independent members
The independent members should meet regularly and have the funds available to hire outside counsel
Understand the manager-shareholder conflicts as well as those evolving between directors and shareholders.


Increasing the size of the company may improve job security, salary and ego at the expense of profitability
Managers may invest in risky projects to increase the value of stock options which have a limited downside risk if the project is not profitable. Conversely, managers could become too risk-averse to protect their wealth and job.
Managers may grant themselves excessive compensation or try to control the board for their own interests

Directors may identify more closely with managers due to personal or business relationships
There may be cross-directorships where managers serve on the boards of companies of their own board members
Directors may have familial or business agreements with the company which would be jeopardized by confronting management

Mergers and Acquisitions is also mostly conceptual with only a couple of secondary formulas to calculate pre- and post-firm value. Again, the list material like takeover defenses is the most testable.
The three types of mergers are horizontal (same line of business), vertical (businesses in different stages of the production/product cycle) and conglomerate (businesses in unrelated product lines). Much like other parts of the corporate finance material, you should understand the basic vocabulary in the section. It is of secondary (or tertiary) importance on the CFA exams but you will definitely see it at some point in your career as an analyst.
Be able to do the calculation for bootstrapping earnings. The bootstrap effect occurs when the shares of the acquirer trade at a higher P/E than that of the target. Fewer total shares after the merger but the same earnings increases the post-merger EPS.
Understand the differences behind a stock purchase versus an asset purchase of a company.

Shareholder approval is not required if less than 50% of assets are being sold whereas approval is needed in a stock-purchase.
The target company pays taxes on capital gains in an asset purchase while target company shareholders pay cap gains taxes in a share sale
The acquirer does not assume target liabilities in an asset sale
Asset sales can be done more quickly and easily
*Note: Do not confuse the stock-sale/asset-sale material with the method of payment material. Targets can be paid for with cash, stock or a mix of both.

Pre-takeover defenses

Poison pills and puts are board-voted bylaws that gives the company the right to grant additional shares to existing shareholders in the case of a takeover. This can dilute the ownership of an acquiring company and give them less power
Golden parachutes grant management excessive compensation, increasing expenses, in the event of a takeover
Staggered board voting does not allow shareholders to change board members quickly and may delay a takeover
Restricted voting rights keep large share owners from taking control
Post-takeover defenses

Just say no is explicitly turning down an offer
Litigation – filing a lawsuit to stop or delay a takeover
Greenmail – the target company buys its shares back from the acquirer at a premium
Crown jewel is where the target sells off a particularly strong subsidiary or asset, making the resulting company less valuable
Pac man- is where the target may try to take the acquirer over. This technique is limited because it negates the ability to use any other defenses if it does not work
White knight and white squire- is where the acquirer finds another company (presumably more friendly) to buy part or all of the company.

Remember the basic dates and ideas behind the major legislation: Sherman Antitrust (1890), Clayton Antitrust (1914), Celler-Kefauver (1950), and Hart-Scott-Rodino (1976).
Be able to calculate the HHI and understand the three concentration levels.
Understand the differences and basic reasoning behind divestitures: equity carve-outs, spin-offs, split-offs, and liquidations.
Study session 10 in the Level II CFA Program curriculum begins the material on equity valuation. The topic represents the single biggest percentage of your Level II CFA Program score at 20% to 30% and some fairly difficult concepts.

‘til next time, happy studyin’
Joseph Hogue, CFA

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