chapter 23

23.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Chapter 23Chapter 23Mergers and Other Mergers and Other Forms of Corporate Forms of Corporate

RestructuringRestructuring


After Studying Chapter 23, After Studying Chapter 23, you should be able to:you should be able to:

1. Explain why a company might decide to engage in corporate restructuring.

2. Understand and calculate the impact on earnings and on market value of companies involved in mergers.

3. Describe what benefits, if any, accrue to acquiring company shareholders and to selling company shareholders.

4. Analyze a proposed merger as a capital budgeting problem. 5. Describe the merger process from its beginning to its conclusion. 6. Describe different ways to defend against an unwanted takeover. 7. Discuss strategic alliances and understand how outsourcing has

contributed to the formation of virtual corporations. 8. Explain what "divestiture" is and how it may be accomplished. 9. Understand what "going private" means and what factors may

motivate management to take a company private. 10. Explain what a leveraged buyout is and what risk it entails.


• Sources of Value• Strategic Acquisitions

Involving Common Stock• Acquisitions and Capital

Budgeting• Closing the Deal

Mergers and Other Forms of Mergers and Other Forms of Corporate RestructuringCorporate Restructuring


• Takeovers, Tender Offers, and Defenses

• Strategic Alliances• Divestiture• Ownership Restructuring• Leveraged Buyouts

Mergers and Other Forms of Mergers and Other Forms of Corporate RestructuringCorporate Restructuring


Any change in a company’s:1. Capital structure,2. Operations, or3. Ownershipthat is outside its ordinary course of business.

So where is the value comingfrom (why restructure)?

What is Corporate What is Corporate Restructuring?Restructuring?


• Sales enhancement and operating economies*

• Improved management• Information effect• Wealth transfers• Tax reasons• Leverage gains• Hubris hypothesis• Management’s personal agenda

* Will be discussed in more detail in the following two slides.

Why Engage in Why Engage in Corporate Restructuring?Corporate Restructuring?


• Sales enhancement Sales enhancement can occur because of market share gain, technological advancements to the product table, and filling a gap in the product line.

• Operating economies Operating economies can be achieved because of the elimination of duplicate facilities or operations and personnel.

• SynergySynergy – Economies realized in a merger where the performance of the combined firm exceeds that of its previously separate parts.

Sales Enhancement Sales Enhancement and Operating Economiesand Operating Economies


• Horizontal mergerHorizontal merger: best chance for economies

• Vertical mergerVertical merger: may lead to economies• Conglomerate mergerConglomerate merger: few operating

economies• DivestitureDivestiture: reverse synergy may occur

Economies of ScaleEconomies of Scale – The benefits of size in which the average unit cost falls as

volume increases.

Sales Enhancement Sales Enhancement and Operating Economiesand Operating Economies


• When the acquisition is done for common stock, a “ratio of exchange,” which denotes the relative weighting of the two companies with regard to certain key variables, results.

• A financial acquisition financial acquisition occurs when a buyout firm is motivated to purchase the company (usually to sell assets, cut costs, and manage the remainder more efficiently), but keeps it as a stand-alone entity.

Strategic Acquisition Strategic Acquisition – Occurs when one company acquires another as part of its overall

business strategy.

Strategic Acquisitions Strategic Acquisitions Involving Common StockInvolving Common Stock


Example Example – Company A will acquire Company B with shares of common stock.

Present earnings $20,000,000 $5,000,000Shares outstanding 5,000,000 2,000,000Earnings per share $4.00 $2.50Price per share $64.00 $30.00Price / earnings ratio 16 12

Company A Company B



Example Example – Company B has agreed on an offer of $35 in common stock of Company A.

Total earnings $25,000,000Shares outstanding* 6,093,750Earnings per share $4.10

Surviving Company A

Exchange ratio = $35 / $64 = 0.5468750.546875* New shares from exchange New shares from exchange = 0.5468750.546875 x 2,000,000

= 1,093,7501,093,750



• The shareholders of Company A will experience an increase in earnings per share because of the acquisition [$4.10 post-merger EPS versus $4.00 pre-merger EPS].

• The shareholders of Company B will experience a decrease in earnings per share because of the acquisition [.546875 x $4.10 = $2.24 post-merger EPS versus $2.50 pre-merger EPS].



• Surviving firm EPS will increase any time the P/E ratio “paid” for a firm is less than the pre-merger P/E ratio of the firm doing the acquiring. [Note: P/E ratio “paid” for Company B is $35/$2.50 = 14 versus pre-merger P/E ratio of 16 for Company A.]



Example Example – Company B has agreed on an offer of $45 in common stock of Company A.

Total earnings $25,000,000Shares outstanding* 6,406,250Earnings per share $3.90

Surviving Company A

Exchange ratio = $45 / $64 = 0.7031250.703125* New shares from exchange New shares from exchange = 0.7031250.703125 x 2,000,000

= 1,406,2501,406,250



• The shareholders of Company A will experience a decrease in earnings per share because of the acquisition [$3.90 post-merger EPS versus $4.00 pre-merger EPS].

• The shareholders of Company B will experience an increase in earnings per share because of the acquisition [0.703125 x $4.10 = $2.88 post-merger EPS versus $2.50 pre-merger EPS].



• Surviving firm EPS will decrease any time the P/E ratio “paid” for a firm is greater than the pre-merger P/E ratio of the firm doing the acquiring. [Note: P/E ratio “paid” for Company B is $45/$2.50 = 18 versus pre-merger P/E ratio of 16 for Company A.]



• Merger decisions should not be made without considering the long-term consequences.

• The possibility of future earnings growth may outweigh the immediate dilution of earnings.

With theWith themergermerger

Without theWithout themergermerger

Time in the Future (years)

Expe

cted

EPS

($)

Initially, EPS is less with the merger.Eventually, EPS is greater with the merger.

Equal

What About What About Earnings Per Share (EPS)?Earnings Per Share (EPS)?


• The above formula is the ratio of exchange of market price.

• If the ratio is less than or nearly equal to 1, the shareholders of the acquired firm are not likely to have a monetary incentive to accept the merger offer from the acquiring firm.

Market price per shareMarket price per shareof the acquiring companyof the acquiring company

Number of shares offered byNumber of shares offered bythe acquiring company for eachthe acquiring company for eachshare of the acquired companyshare of the acquired company

Market price per share of the acquired companyMarket price per share of the acquired company

X

Market Value ImpactMarket Value Impact


Example Example – Acquiring Company offers to acquire Bought Company with shares of

common stock at an exchange price of $40.

Present earnings $20,000,000 $6,000,000Shares outstanding 6,000,000 2,000,000Earnings per share $3.33 $3.00Price per share $60.00 $30.00Price / earnings ratio 18 10

Acquiring BoughtCompany Company



Exchange ratio Exchange ratio = $40 / $60 = .667Market price exchange ratio Market price exchange ratio = $60 x .667 / $30 = 1.33

Total earnings $26,000,000Shares outstanding* 7,333,333Earnings per share $3.55Price / earnings ratio 18Market price per share $63.90

Surviving Company

* New shares from exchange New shares from exchange = 0.6666670.666667 x 2,000,000 = 1,333,3331,333,333



• Notice that both earnings per share and market price per share have risen because of the acquisition. This is known as “bootstrapping.”

• The market price per share = (P/E) x (Earnings).• Therefore, the increase in the market price per share

is a function of an expected increase in earnings per share andand the P/E ratio NOTNOT declining.

• The apparent increase in the market price is driven by the assumption that the P/E ratio will not change and that each dollar of earnings from the acquired firm will be priced the same as the acquiring firm before the acquisition (a P/E ratio of 18).



• Target firms in a takeover receive an average premium of 30%.

• Evidence on buying firms is mixed. It is not clear that acquiring firm shareholders gain. Some mergers do have synergistic benefits.

BuyingBuyingcompaniescompanies

SellingSellingcompaniescompanies

TIME AROUND ANNOUNCEMENT(days)

Announcement date

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Empirical Evidence Empirical Evidence on Mergerson Mergers


• Idea is to rapidly build a larger and more valuable firm with the acquisition of small- and medium-sized firms (economies of scale).

• Provide sellers cash, stock, or cash and stock.• Owners of small firms likely stay on as managers.• If privately owned, a way to more rapidly grow towards

going through an initial public offering (see Slide 24).

Roll-Up Transactions Roll-Up Transactions – The combining of multiple small companies in the same industry to create one larger company.

Developments in Mergers Developments in Mergers and Acquisitionsand Acquisitions


• IPO funds are used to finance the acquisitions.

IPO Roll-Up IPO Roll-Up – An IPO of independent companies in the same industry that

merge into a single company concurrent with the stock offering.

An Initial Public Offering (IPO) is a company’s first offering of common stock

to the general public.

Developments in Mergers Developments in Mergers and Acquisitionsand Acquisitions


• An acquisition can be treated as a capital budgeting project. This requires an analysis of the free cash flows free cash flows of the prospective acquisition.

• Free cash flows Free cash flows are the cash flows that remain after we subtract from expected revenues any expected operating costs and the capital expenditures necessary to sustain, and hopefully improve, the cash flows.

• Free cash flows Free cash flows should consider any synergistic effects but be before any financial charges so that examination is made of marginal after-tax operating cash flows and net investment effects.

Acquisitions and Acquisitions and Capital BudgetingCapital Budgeting


AVERAGE FOR YEARS (in thousands) 1 – 5 6 – 10 11 – 15

Annual after-tax operatingAnnual after-tax operating cash flows from acquisitioncash flows from acquisition $2,000 $2,000 $1,800 $1,800 $1,400 $1,400Net investmentNet investment 600 600 300 300 — — Cash flow after taxesCash flow after taxes $1,400 $1,400 $1,500 $1,400$1,500 $1,400

16 – 20 21 – 25Annual after-tax operatingAnnual after-tax operating cash flows from acquisitioncash flows from acquisition $ 800 $ 800 $ 200$ 200Net investmentNet investment — — — — Cash flow after taxesCash flow after taxes $ 800 $ 800 $ 200$ 200

Cash Acquisition and Cash Acquisition and Capital Budgeting ExampleCapital Budgeting Example


• The appropriate discount rate for our example free free cash flows cash flows is the cost of capital for the acquired firm. Assume that this rate is 15% after taxes.

• The resulting present value of free cash flow free cash flow is $8,724,000$8,724,000. This represents the maximum acquisition price that the acquiring firm should be willing to pay, if we do not assume the acquired firm’s liabilities.

• If the acquisition price is less than (exceeds) the present value of $8,724,000$8,724,000, then the acquisition is expected to enhance (reduce) shareholder wealth over the long run.

Cash Acquisition and Cash Acquisition and Capital Budgeting ExampleCapital Budgeting Example


• Noncash payments and assumption of Noncash payments and assumption of liabilitiesliabilities

• Estimating cash flowsEstimating cash flows• Cash-flow approach versus earnings Cash-flow approach versus earnings

per share (EPS) approachper share (EPS) approach• Generally, the EPS approach examines the

acquisition on a short-run basis, while the cash-flow approach takes a more long-run view.

Other Acquisition and Other Acquisition and Capital Budgeting IssuesCapital Budgeting Issues


• Target is evaluated by the acquirer• Terms are agreed upon• Ratified by the respective boards• Approved by a majority (usually two-thirds) of

shareholders from both firms• Appropriate filing of paperwork• Possible consideration by The Antitrust Division

of the Department of Justice or the Federal Trade Commission

Consolidation Consolidation – The combination of two or more firms into an entirely new firm. The old firms cease to exist.

Closing the DealClosing the Deal


• TaxableTaxable – if payment is made by cash or with a debt instrument.

• Tax-FreeTax-Free – if payment made with voting preferred or common stock and the transaction has a “business purpose.” (Note: to be a tax-free transaction a few more technical requirements must be met that depend on whether the purchase is for assets or the common stock of the acquired firm.)

At the time of acquisition, for the selling firm or its shareholders, the transaction is:

Taxable or Taxable or Tax-Free TransactionTax-Free Transaction


Pooling of Interests (method) Pooling of Interests (method) – A method of accounting treatment for a merger based on the

net book value net book value of the acquired company’s assets. The balance sheets of the two

companies were simply combined.Eliminated as an option with SFAS 141.

Purchase (method) Purchase (method) – A method of accounting treatment for a merger based on the market market

price price paid for the acquired company.

Accounting TreatmentsAccounting Treatments


• SFAS 142 eliminated mandatory periodic amortization of goodwill for financial accounting purposes, but requires an impairment test (at least annually) to goodwill.

• Goodwill charges are generally deductible for “tax purposes” over 15 years for acquisitions occurring after August 10, 1993.

• An impairment to earnings is recognized when the book value of goodwill exceeds its market value by an amount that equals the difference.

Goodwill Goodwill – The intangible assets of the acquired firm arising from the acquiring firm paying more for them than their book value.

Accounting Accounting Treatment of GoodwillTreatment of Goodwill


• Allows the acquiring company to bypass the management of the company it wishes to acquire.

Tender Offer Tender Offer – An offer to buy current shareholders’ stock at a specified price, often

with the objective of gaining control of the company. The offer is often made by another

company and usually for more than the present market price.

Tender OffersTender Offers


• It is not possible to surprise another company with its acquisition because the SEC requires extensive disclosure.

• The tender offer is usually communicated through financial newspapers and direct mailings if shareholder lists can be obtained in a timely manner.

• A two-tier offer (next slide) may be made with the first tier receiving more favorable terms. This reduces the free-rider problem.

Tender OffersTender Offers


• Increases the likelihood of success in gaining control of the target firm.

• Benefits those who tender “early.”

Two-tier Tender OfferTwo-tier Tender Offer – Occurs when the bidder offers a superior first-tier price (e.g., higher amount or all cash) for a specified

maximum number (or percent) of shares and simultaneously offers to acquire the

remaining shares at a second-tier price.

Two-Tier Tender OfferTwo-Tier Tender Offer


• The company being bid for may use a number of The company being bid for may use a number of defensive tactics including:defensive tactics including:• (1) persuasion by management that the offer is not

in their best interests, (2) taking legal actions, (3) increasing the cash dividend or declaring a stock split to gain shareholder support, and (4) as a last resort, looking for a “friendly” company (i.e., white knight) to purchase them.

White Knight White Knight – A friendly acquirer who, at the invitation of a target company, purchases shares from the hostile bidder(s) or launches a friendly counter-bid in order to

frustrate the initial, unfriendly bidder(s).

Defensive TacticsDefensive Tactics


Shareholders’ Interest HypothesisShareholders’ Interest HypothesisThis theory implies that contests for corporate

control are dysfunctional and take management time away from profit-making activities.

Managerial Entrenchment Hypothesis Managerial Entrenchment Hypothesis This theory suggests that barriers are erected to protect management jobs and that such actions

work to the detriment of shareholders.

Motivation TheoriesMotivation Theories::

Antitakeover Amendments Antitakeover Amendments and Other Devicesand Other Devices


• Stagger the terms of the board of directors• Change the state of incorporation• Supermajority merger approval provision• Fair merger price provision• Leveraged recapitalization• Poison pill• Standstill agreement• Premium buy-back offer

Shark Repellent Shark Repellent – Defenses employed by a company to ward off potential takeover

bidders – the “sharks.”

Antitakeover Amendments Antitakeover Amendments and Other Devicesand Other Devices


• Empirical results are mixed in determining if antitakeover devices are in the best interests of shareholders.

• Standstill agreements and stock repurchases by a company from the owner of a large block of stocks (i.e., greenmail) appears to have a negative effect on shareholder wealth.

• For the most part, empirical evidence supports the management entrenchment hypothesismanagement entrenchment hypothesis because of the negative share price effect.

Empirical Evidence Empirical Evidence on Antitakeover Deviceson Antitakeover Devices


• Strategic alliances usually occur between (1) suppliers and their customers, (2) competitors in the same business, (3) non-competitors with complementary strengths.

• A joint venture joint venture is a business jointly owned and controlled by two or more independent firms. Each venture partner continues to exist as a separate firm, and the joint venture represents a new business enterprise.

Strategic Alliance Strategic Alliance – An agreement between two or more independent firms to cooperate in order to achieve some specific commercial objective.

Strategic AllianceStrategic Alliance


• LiquidationLiquidation – The sale of assets of a firm, either voluntarily or in bankruptcy.

• Sell-offSell-off – The sale of a division of a company, known as a partial sell-off, or the company as a whole, known as a voluntary liquidation.

Divestiture Divestiture – The divestment of a portion of the enterprise or the firm as a whole.

DivestitureDivestiture


• Spin-offSpin-off – A form of divestiture resulting in a subsidiary or division becoming an independent company. Ordinarily, shares in the new company are distributed to the parent company’s shareholders on a pro rata basis.

• Equity Carve-outEquity Carve-out – The public sale of stock in a subsidiary in which the parent usually retains majority control.

DivestitureDivestiture


• For liquidation of the entire company, shareholders of the liquidating company realize a +12 to +20% return.

• For partial sell-offs, shareholders selling the company realize a slight return (+2%). Shareholders buying also experience a slight gain.

• Shareholders gain around 5% for spin-offs.• Shareholders receive a modest +2% return for equity

carve-outs.• Divestiture results are consistent with the informational

effect as shown by the positive market responses to the divestiture announcements.

Empirical Evidence Empirical Evidence on Divestitureson Divestitures


• The most common transaction is paying shareholders cash and merging the company into a shell corporation owned by a private investor management group.

• Treated as an asset sale rather than a merger.

Going Private Going Private – Making a public company private through the repurchase of stock by current management and/or

outside private investors.

Ownership RestructuringOwnership Restructuring


• Elimination of costs associated with being a publicly held firm (e.g., registration, servicing of shareholders, and legal and administrative costs related to SEC regulations and reports).

• Reduces the focus of management on short-term numbers to long-term wealth building.

• Allows the realignment and improvement of management incentives to enhance wealth building by directly linking compensation to performance without having to answer to the public.

MotivationsMotivations::

Motivation and Empirical Motivation and Empirical Evidence for Going PrivateEvidence for Going Private


• Large transaction costs to investment bankers.

• Little liquidity to its owners.• A large portion of management wealth is

tied up in a single investment.Empirical EvidenceEmpirical Evidence::

• Shareholders realize gains (+12 to +22%) for cash offers in these transactions.

Motivations (Offsetting Arguments)Motivations (Offsetting Arguments)::

Motivation and Empirical Motivation and Empirical Evidence for Going PrivateEvidence for Going Private


• The debt is secured by the assets of the enterprise involved. Thus, this method is generally used with capital-intensive businesses.

• A management buyout management buyout is an LBO in which the pre-buyout management ends up with a substantial equity position.

Leverage Buyout (LBO) Leverage Buyout (LBO) – A primarily debt financed purchase of all the stock or assets of a company, subsidiary, or

division by an investor group.

Ownership RestructuringOwnership Restructuring


• The company has gone through a program of heavy capital expenditures (i.e., modern plant).

• There are subsidiary assets that can be sold without adversely impacting the core business, and the proceeds can be used to service the debt burden.

• Stable and predictable cash flows.• A proven and established market position.• Less cyclical product sales.• Experienced and quality management.

Common characteristics (not all necessary)Common characteristics (not all necessary)::

Common Characteristics For Common Characteristics For Desirable LBO CandidatesDesirable LBO Candidates

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