19
Slides Developed by:
Terry Fegarty
Seneca College

• Corporate Restructuring
• Mergers and Acquisitions
 Why Unfriendly Mergers are Unfriendly
 Economic Classification of Business Combinations
 The Role of Investment Dealers
 Competition and Mergers
 The Reasons Behind Mergers
 Holding Companies
 The History of Merger Activity in Canada and the
United States
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 Merger Analysis
 Merger Analysis and the Price Premium
 The Price Premium
 Terminal Value Assumption
 Paying for the Acquisition—The Junk Bond Market
 Defensive Tactics
 Types of Poison Pills
• Other Kinds of Takeovers—LBOs and Proxy Fights
 Leveraged Buyouts (LBO)
 Proxy Fights
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• Divestitures
• Bankruptcy and the Reorganization of Failed businesses
 Failure and Insolvency
 Bankruptcy—Concept and Objectives
 Bankruptcy Procedures—Reorganization,
Restructuring, Liquidation
 Reorganization
 Debt Restructuring
 Liquidation
 Distribution Priorities
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• Ways in which companies are reorganized include:
 Changes in capital structure
 Changes in ownership
 Mergers
 Divestitures
 Changes to asset structure
 Changes in methods of doing business
 Business failure and bankruptcy
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• Merger —combination of two or more businesses in which:
 All but one legally cease to exist
 Combined organization continues under name of surviving firm
• Acquisition (AKA: takeover )— merger in which continuing firm acquires the shares of another (the takeover target )
• Consolidation —all combining firms dissolve and new firm with new name is formed
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Figure 19.1:
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• Relationships
 Consolidation implies the firms combined willingly
 In acquisition one firm acquires other, in either a friendly or hostile takeover
• Shareholders
 Majority must approve business combination
 Be willing to give up their shares for offered price (cash and/or shares in continuing company)
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• Friendly Merger Procedure
 Target's board of directors and management approves of the deal and cooperates with acquiring company
 Negotiation occurs until agreement is reached
 Proposal submitted to shareholders for vote
• Percentage required for approval depends on corporate charter and legal regulations
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• Unfriendly Procedure
 Target's management resists and may take defensive measures to stop the deal
 Acquiring firm makes tender offer to target's shareholders
• Special offer to buy shares for fixed price contingent upon obtaining enough shares to gain control
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• Target's management may resist takeover because
 Acquiring firm doesn't offer high enough price for firm's shares
 Acquiring firm's management may lose power, influence or jobs
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• Vertical Merger
 When firm acquires one of its suppliers or customers
• Horizontal Merger
 Merging firms are competitors (reduces competition)
• Conglomerate Merger
 Merging firms are not in same lines of business
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• Act as advisors to acquiring companies
 Establishing value of target company
 Raising money to pay for target’s shares
• Advise reluctant targets on defensive measures
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• Canada committed to maintaining competitive economy
 Opportunity to compete
 Fair dealing for consumers
• Competition laws enacted in 1889 and afterwards prohibit certain activities that can reduce competitive nature of economy
• Mergers have the potential to increase concentration (reduce competition)
 Competition Act limits freedom of companies to merge
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• Synergies
• Growth
• Diversification to Reduce Risk
• Economies of Scale
• Guaranteed Sources and Markets
• Acquiring Assets Cheaply
• Tax Losses
• Ego and Empire
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• Synergies
 When performance as combined entity expected to be better than performance as separate entities
• Whole is more than the sum of its parts
 Usually cost-saving opportunities
 In practice, hard to find and difficult to implement
• Growth
 Internal growth occurs when firms sell more in current businesses
 External growth occurs when a firm acquires a rival
• Much faster than internal growth
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• Diversification to Reduce Risk
 Collection of diverse businesses generally less risky than company with only single line of business
 Variations of different business lines tend to offset each other
 Combined performance more steady
• Economies of Scale
 Combined company in horizontal merger may operate at lower cost level than individual organizations
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• Guaranteed Sources and Markets
 Vertical mergers can lock in firm's sources of critical supplies or create captive markets
• Acquiring Assets Cheaply
 Firm may acquire assets more cheaply by buying firm that already owns the assets then by buying assets individually
• When shares of target firm depressed
• Tax Losses
 Acquiring firm with tax loss can offset taxes on acquirer's earnings
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Consider the following possible combination of Rich Inc. and Poor Inc.
EBT
Tax (35%)
EAT
Rich Inc.
$2,000
700
$1,400
Poor Inc
.
($1,000)
-0-
($1,000
)
Merged
$1,000
350
$650
Operating independently Rich pays $700 in taxes while
Poor pays nothing, for a combined total of $700.
However, the merged companies pay a combined tax of only $350.
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• Ego and Empire
 Powerful people at top of organization may be building up their empire
 Executive pay depends on size of organization
 May mean the acquiring firm pays too high a price for the target
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• Holding company—corporation that owns other corporations called subsidiaries
 Known as the parent of the subsidiaries
• Typical organization for a conglomerate merger
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• Advantages
 When controlling firm would like to keep business operations separate
• Failure of one subsidiary doesn't affect parent or other subsidiaries
 Possible to control subsidiary without owning
(and paying for) all of its shares
• Ownership of 25% virtually guarantees control
• 10% may effectively control widely held firm
• But , can not benefit from synergies
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• Wave 1: The Turn of the Century, 1897-1904
 Horizontal mergers in primary industries (mining, transportation, etc.)
 Large firms absorbing small ones, sometimes unfair or violent
• Wave 2: The Roaring Twenties, 1916-1929
 Ended with stock market crash of 1929
 Mergers tended to be horizontal and led to oligopolies (ex; automobile industry)
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• Wave 3: The Swinging Sixties, 1965-1969
 Companies acquired firms in non-related industries
(conglomerate mergers)
 Often driven by stock market issues rather than operating concerns
• To raise share price
• An Important Development During the 1970s
 Prior to 1970s hostile takeovers unusual
 However, in 1970s hostile takeovers viewed as acceptable
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• Wave 4: Bigger and Bigger, 1981 - ?
 Mergers in the 1980s and onward characterized by:
• Size —very large mergers more common
• Hostility —threat of hostile takeover pervades corporate life
• Corporate raiders —financiers who mount hostile takeovers
• Defenses —strategies to combat hostile takeovers
• Advisors —Investment dealers and lawyers initiate mergers and advise companies involved
• Financing —the junk bond market helped spur the financing for mergers
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• What price should acquiring company be willing to pay for target firm?
 Merger analysis attempts to answer question
• Capital budgeting exercise
• Forecast future cash flows of target company
• Choose appropriate discount rate
• Calculate NPV
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• Estimating Merger Cash Flows
 Should be straightforward (with two exceptions)
• Provide for synergies expected
• Provide for new investment required for expected growth
 Difficult in practice
• Subject to usual uncertainties and biases
• Also, acquiring firm does not have easy access to all of target's information about past or about future prospects
• In friendly merger, target tries to bump up price so information shared tends to be biased optimistically
• In unfriendly merger, target does not share information
• Tendency is for acquirer to overstate value of target
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• The Appropriate Discount Rate
 An acquisition is an equity transaction
• Should be valued using cost of equity for target company
• Risk of the project is that of target company
• The Value to the Acquirer and the Per-Share
Price
 Calculate NPV of target
 Determine per-share value
• Divide NPV by the number of outstanding shares for target
 Represents maximum acquirer should be willing to pay
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Example 19.1:
Q: Alpha Corp. is analyzing whether or not it should acquire Beta Corp.
Alpha has determined that the appropriate interest rate for the analysis is 12%. Beta has 12,000 shares outstanding. Its estimated cash flows including synergies over the next three years ($000):
Year 1 2 3
Cash flow $200 $220 $250
Alpha’s management is fairly conservative and feels the acquisition should be justified by cash flows projected over no more than three years. Management believes projections beyond that are too risky to be considered reliable. What is the maximum Alpha should pay for a share of Beta?
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Example 19.1:
A: The present value of Beta’s positive cash flows:
Year Cash Flow PVF12,n
1 $200,000 .8929
2
3
220,000
250,000
.7972
Present Value
$178,580
175,384
.7118 177,950
$531,914
The maximum Alpha should pay for all of Beta’s shares is $531,914. At that price, Alpha would be indifferent to the acquisition.
Dividing by the number of shares outstanding gives the maximum per share price Alpha should be willing to pay.
Maximum acquisition price = $531,914/12,000 = $44.33
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• The Price Premium
 Price offered to target’s shareholders generally higher than shares' market price
• Whether merger is friendly or unfriendly
• To induce majority of shareholders to sell to them at once
• Offering price exceeds current market price by price premium
• Major issue: determining proper price premium--don't want it to be too high
• Value of target to acquiring company must be equal or greater than price offered
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• Price premiums create speculative opportunity
 Shares in target will increase in price (generally) once the firm becomes in play
 Thus, acquiring firms keep merger negotiations secret
• Illegal for insiders to make short-term profits on price movements from acquisitions
 Include company executives and investment dealers
• Some investors follow a strategy of buying shares in companies they expect to become takeover targets, to benefit from price increase
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• Conservative acquirer will base target’s value on forecast cash flows for limited number of years (<10?)
• Aggressive acquirer willing to value target based on longer-term forecasts
• Forecasts stream of cash flows that goes on indefinitely. Tends to strongly favour doing the acquisition. Creates the terminal value problem
• Terminal value calculation is arbitrary , but accounts for much of valuation. Small changes in long-term forecast can make huge differences in total value
• Hard to believe company can be worth so much more than its market value
• Good judgment called for to avoid basing multimillion dollar deal on too high a price.
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Example 19.2:
Q : The Aldebron Motor Company is considering acquiring Arcturus
Gear Works, Inc. and has made a three-year projection of the firm's financial statements, including the following revenue and earnings estimate. Period 0 is the current year and not part of the forecast. Figures are in million of dollars.
Revenu e
EAT
0
$1,500
95
1
$1,650
Year
2
$1,815
106 117
3
$2,000
130
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Example 19.2:
Q : Synergies will net $10 million after tax per year. Cash equal to amortization will be reinvested to keep Arcturus's plant operating efficiently, and 60% of the remaining cash generated by operations will be invested in growth opportunities.
Assume a 6% annual growth in all of the target's figures after the third year.
Currently 90-day Treasury bills are yielding 8% and an average share returns 13%. Arcturus's beta is 1.8 and it has 20 million shares outstanding, which closed at $19 a share yesterday.
How much should Aldebron be willing to pay for Arcturus's shares?
Discuss the quality of the estimate.
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Example 19.2:
A:  Discount rate using the CAPM approach k x
= k
RF
+ ( k
M
– k
RF
)b x = 8% + (13% - 8%)1.8 = 17%
 Estimated cash flows for the next three years
Year
0 1
Revenue
$1,500 $1,650
2
$1,815
EAT (unmerged)
Synergies
EAT/cash flow (merged)*
Reinvested (60%)
Cash flow to Aldebron
95
10
$106
63
$42
106
10
$116
70
$46
117
10
$127
76
$51
3
$2,000
130
10
$140
84
$56
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Example 19.2:
A:  Present value of the terminal value at year three
TV =
C (1+g) $56M(1.06)
3 = k-g .17-.06
= $540M
 Present value of three years of cash flows and terminal value
Operating cash flow
Terminal Value
Total
Present Value
1
$46
$46
$39
Year
2
$51
$51
$37
3
$56
540
$596
$372
Notice how large the terminal value is compared to the operating cash flows
Sum = $449
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Example 19.2:
A: Since Arcturus has 20 million outstanding shares, Aldebron should consider paying a maximum of about ($449 / 20 =)
$22.45 per share for Arcturus.
If the shares are currently selling for $19, this represents an
18.2% premium over market price.
NOTE: If the constant growth assumption were changed from
6% to 9%, the maximum acquisition price rises to $29.40 per share.
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• Acquiring firm pays shareholders or target firm either one or a combination of:
 Cash
 Shares in the acquiring firm
 Debt of the acquiring firm
• Acquiring firm needs to either have cash or be able to raise it
 Use services of investment dealer
 Junk bond market began in 1980s and helped firms to finance mergers
• Low quality bonds that pay high yields
• Firms that issue them are risky
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• The Capital Structure Argument to Justify High
Premiums
 If acquirer uses debt to raise cash to buy out a target's shareholders
• Usually results in a more leveraged firm
 If the increased leverage results in higher firm value, use of debt may be justified
• The Effect of Paying Too Much
 Acquiring firm that pays too much transfers value from its shareholders to target’s shareholders
• If the money raised by borrowing, combined firm must pay principal and interest on debt
• May perform poorly or fail
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• Strategies for management of target firm to prevent firm from being acquired
• Tactics After a Takeover is Under Way
 Challenge the price —management attempts to convince shareholders that price offered is too low
 Claim a violation of Competition Act —hope
Competition Bureau will intervene and prevent merger
 Issue debt and repurchase shares—tends to drive up price of shares
• Makes price offered by acquirer less attractive
• Increased leverage makes capital structure less desirable
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 Seek a white knight —find alternative acquirer with better reputation for treating management of acquired firms
 Greenmail —buy back shares from a minority group of shareholders (a group expected to acquire a controlling interest in the firm) at inflated price
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• Tactics in Anticipation of a Takeover
 (Written into corporation’s charter and bylaws)
 Staggered Election of Directors— will take more time for a controlling interest to take control of board
 Approval by a supermajority—mergers requiring approval by a supermajority (two-thirds +) makes taking control of company more difficult
 Poison pills —legal devices making it prohibitively expensive for outsiders to take control of company without approval of management
• Examples: golden parachutes, accelerated debt, share rights plans
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• Golden parachutes —exorbitant severance packages for target's management
• Accelerated debt —requires the principal amounts be paid immediately if the firm is taken over
• Share rights plans (SRPs) —current shareholders given rights to buy shares in merged company at a greatly reduced price after a takeover
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• Public company's shares bought by group of investors
 Often company’s senior management
 Company is no longer publicly traded but is now a private or closely held firm
 Majority of money for share purchase raised by borrowing secured by firm's assets ( leveraged buyout )
• Tend to be very risky due to high debt burden
 However company attempts to pay down the debt load quickly by selling off divisions or assets
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• When corporations elect boards of directors, management usually solicits shareholders for their proxies (rights to vote)
 Generally no opposition occurs and shareholders willingly grant their proxies
• However, proxy fights occur when opposing groups solicit shareholders' proxies
 Winning group gets control of board and company
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• A company decides to get rid of particular business operation
 Reasons for divestitures
• Cash—a firm needs cash so it sells operation to generate cash
• Firm may do this after LBO or takeover to reduce debt
• Poor performance of operation
• Strategic fit—a division may not fit into firm's long-term plans
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 Methods of Divesting Companies
• Sale for cash and securities
• Spin-off—operation is divested as separate corporation and shareholders in original company given shares of new firm
• Liquidation—divested business is closed down and its assets sold
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• Economic failure —firm unable to provide adequate return to shareholders (return on equity)
• Commercial failure —business can’t pay debts (insolvent)
 Technically insolvent—can't meet short-term obligations
 Legally insolvent—firm's liabilities exceed assets
• A business can be economic failure but not commercial failure
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• Two federal laws govern commercial failure:
 The Bankruptcy and Insolvency Act (BA)
 Companies’ Creditors Arrangement Act
(CCAA)
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• Bankruptcy —federal legal proceeding designed to keep single creditor from seizing firm's assets for itself and preventing other creditors from a claim
• Firm isn’t bankrupt until action is filed in court
• Bankruptcy court protects insolvent firm from its creditors and determines whether firm should remain running or shut down
 If firm is insolvent due to business gone bad
• Best to shut company down before it loses more money
• Salvage assets to pay off debt
 If a firm is insolvent due to too much debt but is in survivable situation
• Firm may be able to make good on its debt if given enough time and conditions are changed
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• Insolvent company worth more as a going concern than value of assets
 Court orders a reorganization
 Debt restructured and plan developed to pay creditors as fairly as possible
• Insolvent company in situation deemed unrecoverable
 Court orders liquidation
 Assets sold under the court's supervision
• Proceeds used to pay creditors according to priority
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• A bankruptcy petition can be initiated by either the insolvent company ( voluntary ) or its creditors ( involuntary )
• A firm in bankruptcy is usually allowed to continue operations
 Protected from creditors until bankruptcy resolved
 However, to guard against unethical acts, court may appoint trustee to oversee operations
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• A reorganization— plan under which an insolvent firm continues to operate while attempting to pay off debts
• Management and shareholders support a reorganization over liquidation
 If liquidation occurs management has no job and shareholders usually receive nothing
• Once bankruptcy petition filed, firm has up to 6 months to file plan
• Reorganization plans judged based on fairness and feasibility
 Fairness —claims are satisfied based on priorities set by law
 Feasibility —the likelihood that the plan will actually occur
• Plan must be approved by the bankruptcy court as well as the firm's creditors and shareholders
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• Debt restructuring —concessions that lower insolvent firm's debt payments so it can continue operating
 Central to reorganization plan
• Can be accomplished in two ways:
 Extension —creditors agree to extend the time the firm has to repay its debts
• Deferrals of interest and principal
 Composition —creditors agree to settle for less than full amount owed
• Creditors have incentive to compromise because if firm fails, they are unlikely to receive as much as they would otherwise
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• Debt-to-equity conversions are common method of restructuring debt
 Creditors give up debt claims in return for shares in company
• Reduces debt burden on firm
• Eases cash flow problems
 If firm survives the equity may be worth more in long run than debt given up
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Example 19.3:
Q: The Adcock Company has 50,000 common shares outstanding at a book value of $40, pays 10% interest on its debt, and is in the following financial situation
Capital Income and Cash Flow
EBIT
Interest
EBT
Tax
NI
Amortization
Principal repayment
Cash flow
$200
600
($400)
---
($400)
200
(100)
($300)
Debt
Equity
Total capital
$6,000
2,000
$8,000
Although the company has positive EBIT, it doesn't earn enough to pay its interest let alone repay principal on schedule.
Without help it will fail shortly.
Devise a composition involving a debt for equity conversion that will keep the firm afloat.
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A: Suppose the creditors are willing to convert $3 million in debt to equity at the $40 book value of the existing shares. Would require the firm to issue 75,000 new shares, resulting in the following:
EBIT
Interest
EBT
Tax
NI
Income and Cash Flow
$200
300
($100)
---
($100)
Amortization
Principal Repayment
Cash flow
200
(50)
$50
Capital
Debt
Equity
Total capital
$3,000
5,000
$8,000
The company now has a slightly positive cash flow and can at least theoretically continue in business indefinitely. However, creditors now own a controlling interest in the firm .
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• Liquidation —closing bankrupt firm and selling its assets to pay debts
• A trustee attempts to recover any unauthorized transfers out of firm
 When bankruptcy is anticipated assets are frequently removed
• Illegal because these assets should be used to satisfy creditors' claims
• Trustee then supervises the sale of the assets and pools the funds so that creditors' claims can be satisfied
 The trustee then distributes the funds
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• Distribution follows an order of priority set forth by the Bankruptcy and Insolvency Act
• The priority rile states that some claimants are ahead of others in the order of payoff
• Priority rule payoffs
 Secured debt—debt that is guaranteed by a specific asset
• These creditors are paid when the specified assets are sold— remaining funds are placed into the pool of funds to pay remaining claimants
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• Priority payoffs after secured claims
 Administrative expenses of bankruptcy proceedings
 Certain business expenses incurred after bankruptcy petition is filed
 Unpaid wages—up to $2,000 per employee
 Certain unpaid contributions to employee benefit plans
 Certain customer deposits and claims—up to $900 per person
 Unpaid taxes
 Unsecured creditors
 Preferred shareholders
 Common shareholders
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