Chapter 20 McGraw-Hill/Irwin Mergers and Acquisitions and Financial Distress Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. 1 Introduction • Mergers and acquisitions – Firms combine • Assets • Liabilities • Equity 20-2 Mergers & Acquisitions • Merger — two firms combine to form one larger firm • Acquisition — one firm purchases another • Consolidation — newly-created firm absorbs bidder and target 20-3 Horizontal Mergers • A horizontal merger is the combination of two firms in the same industry • Market extension merger (also horizontal) combines two firms that sell the same product in different markets 20-4 Vertical Merger • Combines a firm with a supplier or distributor – Avoids fixed costs – Eliminates contracting, payment collection, communication, advertising and coordination costs – Improves inventory planning 20-5 Conglomerate Merger • Two companies merge that have no related products or markets – Popular in 1960s and 1970s, but dismantled in the 1980s and 1990s due to poor performance 20-6 Product Extension Merger • Firms merge that sell different, but somewhat related products • A cross between horizontal and conglomerate mergers 20-7 Revenue Enhancement • Acquisition of firm in growing area may enhance revenues • The acquiring firm’s revenues may become more stable • Acquisition of new markets 20-8 Cost Reduction • Economies of scale – Reduce or eliminate redundancies in firm – Cost of producing goods falls as size of firm increases 20-9 Economies of Scale in Mergers 20-10 Long-Term Effect of Economies of Scale 20-11 Cost Reduction • Economies of Scope – Refers to merged firms’ abilities to generate synergistic cost savings due to inter-relationship among products and “jointness” in cost of producing them 20-12 X-Efficiencies • Not directly due to economies of scope or scale • Due to superior management as result of replacing old, inefficient managers 20-13 Tax Considerations • Tax gains from an acquisition can result from – Net operating losses – Unused debt capacity – Surplus funds 20-14 Lowering the Cost of Capital • A merger can lower a firm’s cost of capital – Cost of issuing securities declines – Diversification due to merger reduces debt risk of merged firm, resulting in a lower interest rate 20-15 Managers’ Personal Incentives • Managers’ personal wishes may drive merger rather than sound economic basis – Not favorable for the merged firm and can cause stock price and shareholder’s wealth to decline 20-16 Valuing a Merger • Net present value (NPV) or discounted cash flow (DCF) method is most accurate method for valuing a merger – Forecasted cash flows discounted to PV based on merged firm’s weighted average cost of capital (WACC) 20-17 Financial Distress • Economic Failure • The return on a firm’s assets is less than the firm’s cost of capital • Business Failure – The most extreme type of distress – Firm is no longer in business • Technical Insolvency – A firm’s operating cash flows are not sufficient to pay its liabilities as they come due 20-18 Firm-Specific Causes of Financial Distress • • • • Excess financial leverage Highly volatile earnings stream Poor management Loss of key players on which production or management depended 20-19 Market-Specific Causes of Financial Distress • Business cycle fluctuations • High interest rates 20-20 Informal Resolutions of Financial Distress • Debt agreement restructuring • Liquidation of firm’s assets 20-21 Restructuring a Firm’s Debt Agreements • Appropriate if financial distress is judged to be temporary • Creditors and firm restructure debt agreements in a workout 20-22 Informal Liquidation of a Firm’s Assets • Termination of the firm as a going concern • Assets sold; proceeds pay off the firm’s creditors • Assignment passes liquidation of the firm’s assets to third-party assignee or trustee 20-23 Federal Bankruptcy Laws • Creditors can force the firm into bankruptcy if informal restructure agreement not reached • Firm can voluntarily file for bankruptcy 20-24 Bankruptcy Reform Act of 1978 • Chapter 11 – Firm in temporary financial distress can continue operating while creditors’ claims settled • Chapter 7 – Generally used if reorganization under Chapter 11 not feasible 20-25 Reorganization Procedures in Bankruptcy • Reorganization petition filed • Federal judge reviews petition – Firm submits reorganization plan within 120 days – Court appoints creditor committees 20-26 Liquidation Procedures in Bankruptcy • Bankruptcy for firms too distressed to reorganize via Chapter 7 • Trustee protects the creditors’ interests • Priority of claims followed 20-27 Predicting Bankruptcy • Broad types of credit scoring models – Linear discriminant models – Linear probability models – Logit models 20-28