Chapter 23
Mergers and Other
Forms of Corporate
Restructuring
23-1
© 2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e
Created by: Gregory A. Kuhlemeyer, Ph.D.
Carroll College, Waukesha, WI
Mergers and Other Forms
of Corporate Restructuring
 Sources
of Value
 Strategic Acquisitions
Involving Common Stock
 Acquisitions and Capital
Budgeting
 Closing the Deal
23-2
Mergers and Other Forms
of Corporate Restructuring
 Takeovers,
Tender Offers, and
Defenses
 Strategic Alliances
 Divestiture
 Ownership Restructuring
 Leveraged Buyouts
23-3
Why Engage in
Corporate Restructuring?








23-4
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 Slides 23-5 and 23-6
Sales Enhancement
and Operating Economies



23-5
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 can be achieved
because of the elimination of duplicate
facilities or operations and personnel.
Synergy -- Economies realized in a merger
where the performance of the combined firm
exceeds that of its previously separate parts.
Sales Enhancement
and Operating Economies
Economies of Scale -- The benefits of size
in which the average unit cost falls as
volume increases.




23-6
Horizontal merger: best chance for economies
Vertical merger: may lead to economies
Conglomerate merger: few operating
economies
Divestiture: reverse synergy may occur
Strategic Acquisitions
Involving Common Stock
Strategic Acquisition -- Occurs when one
company acquires another as part of its overall
business strategy.


23-7
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 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 Acquisitions
Involving Common Stock
Example -- Company A will acquire Company B
with shares of common stock.
Company A
$20,000,000
Company B
$5,000,000
Shares outstanding
5,000,000
2,000,000
Earnings per share
$4.00
$2.50
$64.00
$30.00
16
12
Present earnings
Price per share
Price / earnings ratio
23-8
Strategic Acquisitions
Involving Common Stock
Example -- Company B has agreed on an offer
of $35 in common stock of Company A.
Total earnings
Surviving Company A
$25,000,000
Shares outstanding*
Earnings per share
6,093,750
$4.10
Exchange ratio = $35 / $64 = .546875
23-9
* New shares from exchange = .546875 x 2,000,000
= 1,093,750
Strategic Acquisitions
Involving Common Stock

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 premerger EPS].
23-10
Strategic Acquisitions
Involving Common Stock

23-11
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 premerger P/E ratio of 16 for Company A.]
Strategic Acquisitions
Involving Common Stock
Example -- Company B has agreed on an offer
of $45 in common stock of Company A.
Total earnings
Surviving Company A
$25,000,000
Shares outstanding*
Earnings per share
6,406,250
$3.90
Exchange ratio = $45 / $64 = .703125
23-12
* New shares from exchange = .703125 x 2,000,000
= 1,406,250
Strategic Acquisitions
Involving Common Stock


23-13
The shareholders of Company A will
experience a decrease in earnings per share
because of the acquisition [$3.90 postmerger EPS versus $4.00 pre-merger EPS].
The shareholders of Company B will
experience an increase in earnings per
share because of the acquisition [.703125 x
$4.10 = $2.88 post-merger EPS versus $2.50
pre-merger EPS].
Strategic Acquisitions
Involving Common Stock

23-14
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/$2.50 = 18 versus premerger P/E ratio of 16 for Company A.]


23-15
Merger decisions
should not be made
without considering
the long-term
consequences.
The possibility of
future earnings growth
may outweigh the
immediate dilution of
earnings.
Expected EPS ($)
What About
Earnings Per Share (EPS)?
With the
merger
Equal
Without the
merger
Time in the Future (years)
Initially, EPS is less with the merger.
Eventually, EPS is greater with the merger.
Market Value Impact
Market price per share
of the acquiring company
X
Number of shares offered by
the acquiring company for each
share of the acquired company
Market price per share of the acquired company


23-16
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 Value Impact
Example -- Acquiring Company offers to
acquire Bought Company with shares of
common stock at an exchange price of $40.
Present earnings
Shares outstanding
Earnings per share
Price per share
Price / earnings ratio
23-17
Acquiring
Company
$20,000,000
6,000,000
$3.33
$60.00
18
Bought
Company
$6,000,000
2,000,000
$3.00
$30.00
10
Market Value Impact
Exchange ratio
= $40 / $60
= .667
Market price exchange ratio = $60 x .667 / $30 = 1.33
Surviving Company
Total earnings
$26,000,000
Shares outstanding*
7,333,333
Earnings per share
$3.55
Price / earnings ratio
18
Market price per share
$63.90
23-18
* New shares from exchange = .666667 x 2,000,000
= 1,333,333
Market Value Impact




23-19
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 and the P/E ratio NOT 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.
23-20
CUMULATIVE AVERAGE
ABNORMAL RETURN (%)
Empirical Evidence
on Mergers
Selling
companies
+
Buying
companies
0
Announcement date
TIME AROUND ANNOUNCEMENT
(days)
Developments in Mergers
and Acquisitions
Roll-Up Transactions – The combining of
multiple small companies in the same
industry to create one larger company.

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 22).
23-21
Developments in Mergers
and Acquisitions
An Initial Public Offering (IPO) is a
company’s first offering of common stock
to the general public.
IPO Roll-Up – An IPO of independent
companies in the same industry that
merge into a single company concurrent
with the stock offering.
 IPO
funds are used to finance the
acquisitions.
23-22
Acquisitions and
Capital Budgeting



23-23
An acquisition can be treated as a capital budgeting
project. This requires an analysis of the free cash
flows of the prospective acquisition.
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 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.
Cash Acquisition and
Capital Budgeting Example
AVERAGE FOR YEARS (in thousands)
1-5
6 - 10
11 - 15
Annual after-tax operating
cash flows from acquisition
Net investment
Cash flow after taxes
Annual after-tax operating
cash flows from acquisition
Net investment
Cash flow after taxes
23-24
$2,000
600
$1,400
$1,800
300
$1,500
16 - 20
21 - 25
$ 800
--$ 800
$ 200
--$ 200
$1,400
--$1,400
Cash Acquisition and
Capital Budgeting Example



23-25
The appropriate discount rate for our example free
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 is
$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, then the acquisition is
expected to enhance (reduce) shareholder wealth
over the long run.
Other Acquisition and
Capital Budgeting Issues

Noncash payments and assumption
of liabilities

Estimating cash flows

Cash-flow approach versus earnings
per share (EPS) approach
 Generally,
the EPS approach examines the
acquisition on a short-run basis, while the cashflow approach takes a more long-run view.
23-26
Closing the Deal
Consolidation -- The combination of two or more firms
into an entirely new firm. The old firms cease to exist.

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
23-27
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
Taxable or
Tax-Free Transaction
At the time of acquisition, for the selling firm
or its shareholders, the transaction is:


23-28
Taxable -- if payment is made by cash or with a
debt instrument.
Tax-Free -- if payment made with voting
preferred or common stock and the transaction
has a “business purpose.” (Note: to be a taxfree 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.)
Alternative
Accounting Treatments
Purchase (method) -- A method of accounting
treatment for a merger based on the market
price paid for the acquired company.
Pooling of Interests (method) -- A method of
accounting treatment for a merger based on
the net book value of the acquired
company’s assets. The balance sheets of
the two companies are simply combined.
23-29
FASB and Alternative
Accounting Treatments
Pooling of Interests



23-30
Pooling of interests is largely a United States
phenomenon.
In 1999, FASB voted unanimously to
eliminate pooling of interests.
Likely to become effective in 2000 once a
final standard is issued (although still vocal
opposition to the accounting change).
Accounting
Treatment of Goodwill
Goodwill -- The intangible assets of the
acquired firm arising from the acquiring firm
paying more for them than their book value.
Goodwill must be amortized.


23-31
Goodwill cannot be amortized for more than
40 years for “financial accounting
purposes.”
Goodwill charges are generally deductible
for “tax purposes” over 15 years for
acquisitions occurring after August 10, 1993.
Tender Offers
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.

23-32
Allows the acquiring company to bypass
the management of the company it wishes
to acquire.
Tender Offers



23-33
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 (Slide 34) may be made with
the first tier receiving more favorable terms.
This reduces the free-rider problem.
Two-Tier Tender Offer
Two-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.


23-34
Increases the likelihood of success
in gaining control of the target firm.
Benefits those who tender “early.”
Defensive Tactics
The company being bid for may use a number of
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 -- 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).

23-35
Antitakeover Amendments
and Other Devices
Motivation Theories:
Managerial Entrenchment Hypothesis
This theory suggests that barriers are erected to
protect management jobs and that such actions
work to the detriment of shareholders.
Shareholders’ Interest Hypothesis
This theory implies that contests for corporate
control are dysfunctional and take management
time away from profit-making activities.
23-36
Antitakeover Amendments
and Other Devices
Shark Repellent -- Defenses employed by a
company to ward off potential takeover
bidders -- the “sharks.”


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




23-37
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
Empirical Evidence
on Antitakeover Devices



23-38
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
hypothesis because of the negative share
price effect.
Strategic Alliance
Strategic Alliance -- An agreement between two
or more independent firms to cooperate in order
to achieve some specific commercial objective.


23-39
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 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.
Divestiture
Divestiture -- The divestment of a portion
of the enterprise or the firm as a whole.
23-40

Liquidation -- The sale of assets of a firm,
either voluntarily or in bankruptcy.

Sell-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

Spin-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-out -- The public sale of stock
in a subsidiary in which the parent usually
retains majority control.
23-41
Empirical Evidence
on Divestitures





23-42
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.
Ownership Restructuring
Going Private -- Making a public
company private through the repurchase
of stock by current management and/or
outside private investors.
 The
most common transaction is paying
shareholders cash and merging the company
into a shell corporation owned by a private
investor management group.
 Treated
23-43
as an asset sale rather than a merger.
Motivation and Empirical
Evidence for Going Private
Motivations:



23-44
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.
Motivation and Empirical
Evidence for Going Private
Motivations (Offsetting Arguments):
 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 Evidence:

23-45
Shareholders realize gains (+12 to +22%)
for cash offers in these transactions.
Ownership Restructuring
Leverage Buyout (LBO) -- A primarily
debt financed purchase of all the stock
or assets of a company, subsidiary, or
division by an investor group.

The debt is secured by the assets of the enterprise
involved. Thus, this method is generally used with
capital-intensive businesses.

A management buyout is an LBO in which the prebuyout management ends up with a substantial
equity position.
23-46
Common Characteristics For
Desirable LBO Candidates
Common characteristics (not all necessary):






23-47
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.