Chapter 26 - Leasing
•
•
•
•
•
What is a Lease?
Why Lease?
Operating versus Financial Leases
Valuing Leases
When Do Leases Pay?
1
The Basics
– A lease is a contractual agreement between a
lessee and lessor.
– The agreement establishes that the lessee
has the right to use an asset and in return
must make periodic payments to the lessor.
– The lessor is either the asset’s manufacturer
or an independent leasing company.
2
Buying versus Leasing
Buy
Lease
Firm U buys asset and uses asset;
financed by debt and equity.
Lessor buys asset, Firm U leases it.
Manufacturer
of asset
Manufacturer
of asset
Firm U
1.
2.
Lessor
Uses asset
Owns asset
Equity
shareholders
Creditors
1.
Owns asset
2. Does not use asset
Equity
shareholders
Lessee (Firm U)
1.
Uses asset
2. Does not own asset
Creditors
3
Reasons for Leasing
• Good Reasons
– Taxes may be reduced by leasing.
– The lease contract may reduce certain types
of uncertainty.
– Transactions costs can be higher for buying
an asset and financing it with debt or equity
than for leasing the asset.
• Bad Reasons
– Leasing and accounting income
– 100% financing
4
Operating Leases
• Usually not fully amortized. This means that the
payments required under the terms of the lease
are not enough to recover the full cost of the
asset for the lessor.
• Usually require the lessor to maintain and insure
the asset.
• Lessee enjoys a cancellation option. This option
gives the lessee the right to cancel the lease
contract before the expiration date.
5
Financial (Capital) Leases
The exact opposite of an operating lease.
1. Do not provide for maintenance or service
by the lessor.
2. Financial leases are fully amortized.
3. The lessee usually has a right to renew the
lease at expiry.
4. Generally, financial leases cannot be
cancelled, i.e., the lessee must make all
payments or face the risk of bankruptcy.
6
Sale and Lease-Back
• A particular type of financial lease.
• Occurs when a company sells an asset it
already owns to another firm and immediately
leases it from them.
• Two sets of cash flows occur:
– The lessee receives cash today from the sale.
– The lessee agrees to make periodic lease
payments, thereby retaining the use of the
asset.
7
Leveraged Leases
• A leveraged lease is another type of financial
lease.
• A three-sided arrangement between the lessee,
the lessor, and lenders.
– The lessor owns the asset and for a fee
allows the lessee to use the asset.
– The lessor borrows to partially finance the
asset.
– The lenders typically use a nonrecourse loan.
This means that the lessor is not obligated to
the lender in case of a default by the lessee. 8
Leveraged Leases
Lessor buys asset, Firm U leases it.
Manufacturer
of asset
Lessor
1.
Owns asset
2. Does not use asset
Equity
shareholders
Lessor borrows from lender to
partially finance purchase
The lenders typically use a
nonrecourse loan. This
Lessee (Firm U) means that the lessor is not
1. Uses asset
obligated to the lender in
2. Does not own asset case of a default by the
lessee
In the event of a default by
the lessor, the lender has a
first lien on the asset. Also
Creditors
the lease payments are
made directly to the lender
9
after a default.
Accounting and Leasing
• In the old days, leases led to off-balance-sheet
financing.
• In 1979, the Canadian Institute of Chartered
Accountants implemented new rules for lease
accounting according to which financial leases
must be “capitalized.”
• Capital leases appear on the balance sheet—
the present value of the lease payments
appears on both sides.
10
Accounting and Leasing
Balance Sheet
Truck is purchased with debt
Truck
$100,000
Land
$100,000
Total Assets
$200,000
Debt
Equity
Total Debt & Equity
$100,000
$100,000
$200,000
Operating Lease
Truck
Land
Total Assets
$100,000
$100,000
Debt
Equity
Total Debt & Equity
$100,000
$100,000
Capital Lease
Assets leased
Land
Total Assets
$100,000
$100,000
$200,000
Obligations under capital lease
Equity
Total Debt & Equity
$100,000
$100,000
$200,000
11
Financial (Capital) Lease
A lease must be capitalized if any one of the following is
met:
– The present value of the lease payments is at least
90-percent of the fair market value of the asset at the
start of the lease.
– The lease transfers ownership of the property to the
lessee by the end of the term of the lease.
– The lease term is 75-percent or more of the estimated
economic life of the asset.
– The lessee can buy the asset at a bargain price at
expiry.
12
Taxes and Leases
•
•
•
The principal benefit of long-term leasing is tax
reduction.
Leasing allows the transfer of tax benefits from those
who need equipment but cannot take full advantage of
the tax benefits of ownership to a party who can.
If the CRA (Canada Revenue Agency) detects one or
more of the following, the lease will be disallowed.
1. The lessee automatically acquires title to the
property after payment of a specified amount in the
form of rentals.
2. The lessee is required to buy the property from the
lessor.
3. The lessee has the right during the lease to
acquire the property at a price less than fair market
13
value.
Operating Lease
Example : Acme Limo has a client who will sign a lease for 7 years,
with lease payments due at the start of each year. The following
table shows the NPV of the limo if Acme purchases the new limo
for $75,000 and leases it for 7 years.
0
Initial cost
Maintenance, insurance, selling,
and administrative costs
Tax shield on costs
Depreciation tax shield
Total
NPV @ 7% = - $98.15
Break even rent(level)
Tax
Break even rent after-tax
NPV @ 7% = - $98.15
1
Year
3
2
4
5
6
-75
-12
-12
-12
-12
-12
-12
-12
4.2
0
-82.8
4.2
5.25
-2.55
4.2
8.4
0.6
4.2
5.04
-2.76
4.2
3.02
-4.78
4.2
3.02
-4.78
4.2
1.51
-6.29
26.18
-9.16
17.02
26.18
-9.16
17.02
26.18
-9.16
17.02
26.18
-9.16
17.02
26.18
-9.16
17.02
26.18
-9.16
17.02
26.18
-9.16
17.02
14
Financial Leases
Example : Greymare Bus Lines is considering a lease. Your
operating manager wants to buy a new bus for $100,000. The bus
has an 8 year life. The Bus Saleswoman says she will lease
Greymare the bus for 8 years at $16,900 per year, but Greymare
assumes all operating and maintenance costs.
Should Greymare Buy or Lease the bus?
Cash flow consequences of the lease contract to Greymare
0
Cost of new bus
Lost Depr tax shield
Lease payment
Tax shield of lease
Cash flow of lease
1
2
(7.00)
(16.90)
5.92
(17.98)
(11.20)
(16.90)
5.92
(22.18)
Year
3
4
5
6
7
(4.03)
(16.90)
5.92
(15.01)
(4.03)
(16.90)
5.92
(15.01)
(2.02)
(16.90)
5.92
(13.00)
(16.90)
5.92
(10.98)
100.00
(16.90)
5.92
89.02
(6.72)
(16.90)
5.92
(17.70)
15
Financial Leases
Example - cont
Greymare Bus Lines can borrow at 10%, thus
the value of the lease should be discounted at
6.5% or .10 x (1-.35). The result will tell us if
Greymare should lease or buy the bus.
0
Cost of new bus
Lost Depr tax shield
Lease payment
Tax shield of lease
Cash flow of lease
1
2
(7.00)
(16.90)
5.92
(17.98)
(11.20)
(16.90)
5.92
(22.18)
Year
3
4
5
6
7
(4.03)
(16.90)
5.92
(15.01)
(4.03)
(16.90)
5.92
(15.01)
(2.02)
(16.90)
5.92
(13.00)
(16.90)
5.92
(10.98)
100.00
(16.90)
5.92
89.02
(6.72)
(16.90)
5.92
(17.70)
16
Financial Leases
Example – A loan with same cash flows as
lease
0
Amount borrowed
at year end
Interest paid @ 10%
Tax shield @ 35%
Interest paid after tax
Principal repaid
Net cash flow of
equivalent loan
1
2
Year
3
4
5
6
7
89.72
77.56
-8.97
3.14
-5.83
-12.15
60.42
-7.76
2.71
-5.04
-17.14
46.64
-6.04
2.11
-3.93
-13.78
34.66
-4.66
1.63
-3.03
-11.99
21.89
-3.47
1.21
-2.25
-12.76
10.31
-2.19
0.77
-1.42
-11.58
0.00
-1.03
0.36
-0.67
-10.31
89.72
-17.99
-22.19
-17.71
-15.02
-15.02
-13.00
-10.98
17
Financial Leases
Example - cont
The Greymare Bus Lines lease cash flows can
also be treated as a favorable financing
alternative and valued using APV.
APV  NPV of project  NPV of lease
APV  3,000  700  $3,700
18
Financial Lease Benefits
Value of lease to lessor =
17.99
22.19
17.71
15.02
13
10.98
 -89.02 





2
3
4
5
1.065 1.065 1.065 1.065 1.065 1.0656
 .70 or $700
Value of lease =
7
16.9
 100  
t
(
1
.
10
)
t 0
 100  99.18
 .82 or $820
19
Example
• Consider a firm, ClumZee Movers, that wishes to acquire
a delivery truck.
• The truck is expected to reduce costs by $4,500 per
year.
• The truck costs $25,000 and has a useful life of five
years.
• If the firm buys the truck, they will depreciate it straightline to zero.
• They can lease it for five years from Tiger Leasing with
an annual lease payment of $6,250 paid at the end of
the year.
• The firm’s borrowing rate is 7.70% and its marginal tax
20
rate is 34%.
Example Q1: continue
Suppose ClumZee movers is actually in the 25%
tax bracket and Tiger Leasing is in the 35% tax
bracket and a before tax borrowing rate of 7%. If
Tiger reduces the lease payment to $6,200, can
both firms have a positive NPV?
21
Summary
•
•
There are three ways to value a lease.
1. Use the real-world convention of discounting the
incremental after-tax cash flows at the lessor’s aftertax rate on secured debt.
2. Calculate the increase in debt capacity by
discounting the difference between the cash flows of
the purchase and the cash flows of the lease by the
after-tax interest rate. The increase in debt capacity
from a purchase is compared to the extra outflow at
year 0 from a purchase.
3. Use APV (APV = All-Equity Value + Financing NPV)
They all yield the same answer.
22
Practice Question 1
Calculate NPV for lessee and lessor
• Cost of machine = $85,000
• CCA rate = 30%
• Operating costs = $ 10,000 per year maintenance
expense
• Lease payments = $53,600 per year
• Lessor provides maintenance as a part of the lease
contract.
• Cost of debt (rD) = 15%
• After-tax cost of debt, rD(1 -TC) = 9%
• TC = 40% (for both the lessee and the lessor)
23
Practice Question 2
• A noncancellable lease contract lasts for 4 years with
payments of $37,000 at the end of each year. The lessee
pays maintenance expense under either the lease or buy
alternatives. If purchased, the $100,000 asset has a
CCA rate of 30%. The before-tax cost of debt is 10% and
the corporate tax rate is 40%. What is the value of the
lease to the lessee?
• If the lease in problem were cancelable, how much must
the cancellation option be worth to make the lease
alternative better than the purchase alternative?
24
Chapter 26 - Hedging
•
•
•
•
•
Why Manage Risk?
Insurance
Forward and Futures Contracts
SWAPS
How to Set Up A Hedge
25
Risk Reduction
Why risk reduction does not add value
1. Hedging is a zero sum game
2. Investors’ do-it-yourself alternative
26
Risk Reduction
Risks to a business
1. Cash shortfalls
2. Financial distress
3. Agency costs
27
Insurance
• Most businesses face the possibility of a
hazard that can bankrupt the company in
an instant.
• Insurance companies have some
advantages in bearing risk.
• The cost and risk of a loss due to a
hazard, however, can be shared by others
who share the same risk.
28
Insurance
Example
An offshore oil platform is valued
at $1 billion. Expert meteorologist
reports indicate that a 1 in 10,000
chance exists that the platform
may be destroyed by a storm over
the course of the next year.
How can the cost of this hazard
be shared?
29
Insurance
What do you expect the premium of an
insurance contract on this oil platform to
be?
Think of the following:
– Administrative costs
– Adverse selection
– Moral hazard
30
Insurance – Catastrophe Risk
• The loss of an oil platform by a storm may be 1
in 10,000. The risk, however, is larger for an
insurance company since all the platforms in the
same area may be insured, thus if a storm
damages one it may damage all in the same
area. The result is a much larger risk to the
insurer
• Catastrophe Bonds - (CAT Bonds) Allow
insurers to transfer their risk to bond holders by
selling bonds whose cash flow payments
depend on the level of insurable losses NOT 31
occurring.
Insurance – What to Insure
Two Possibilities:
• Most Common - buy insurance only for large
potential losses.
• BP case – buy insurance for small risks only.
32
Hedging with Forwards and Futures
Business has risk
Business Risk - variable costs
Financial Risk - Interest rate changes
Goal - Eliminate risk
HOW?
Hedging & Forward Contracts
33
Hedging with Forwards and Futures
Ex - Kellogg produces cereal. A major component and
cost factor is sugar.
• Forecasted income & sales volume is set by using a
fixed selling price.
• Changes in cost can impact these forecasts.
• To fix your sugar costs, you would ideally like to
purchase all your sugar today, since you like today’s
price, and made your forecasts based on it. But, you
can not.
• You can, however, sign a contract to purchase sugar at
various points in the future for a price negotiated today.
• This contract is called a “Futures Contract.”
• This technique of managing your sugar costs is called
“Hedging.”
34
Hedging with Forwards and Futures
1- Spot Contract - A contract for immediate sale &
delivery of an asset.
2- Forward Contract - A contract between two people for
the delivery of an asset at a negotiated price on a set
date in the future.
3- Futures Contract - A contract similar to a forward
contract, except there is an intermediary that creates a
standardized contract. Thus, the two parties do not
have to negotiate the terms of the contract.
The intermediary is the Commodity Clearing Corp
(CCC). The CCC guarantees all trades & “provides” a
secondary market for the speculation of Futures.
35
Types of Futures
Commodity Futures
-Sugar
-Corn
-OJ
-Wheat
-Soy beans -Pork bellies
Financial Futures
-Tbills
-Yen
-GNMA
-Stocks
-Eurodollars
Index Futures
-S&P 500
-Value Line Index
-Vanguard Index
36
Futures Contract Concepts
•
•
•
•
Not an actual sale
Always a winner & a loser (unlike stocks)
“Settled” every day. (Marked to Market)
Hedge - used to eliminate risk by locking in
prices
• Speculation - used to gamble
• Margin - not a sale - post partial amount
Futures and Spot Contracts
The basic relationship between futures prices and spot
prices for equity securities.
Ft  S0 (1  rf  y )t
Ft  futures price on contract of t length
S0  Today' s spot price
rf  Risk free rate
y  Dividend yield
38
Futures and Spot Contracts
Example
The DAX spot price is 3,970.22. The interest rate is 3.5% and the
dividend yield on the DAX index is 2.0%. What is the expected price
of the 6 month DAX futures contract?
39
Futures and Spot Contracts
The basic relationship between futures prices and spot
prices for commodities.
Ft  S 0 (1  rf  sc  cy ) t
Ft  futures price on contract of t length
S 0  Today' s spot price
rf  Risk free rate
cy  Convenience yield
sc  Experss storage cost
ncy  cy  sc  Net Convenience yield
40
Futures and Spot Contracts
Example
In July the spot price for coffee was $.7310 per pound. The interest
rate was 1.5% per (1.3% per 10 months). The 10 month futures
price was $0.8285? What is the net convenience yield?
41
Homemade Forward Rate Contracts
Suppose you know that you will receive $100m in
one year. You are worried that interest rates might
go down?
You can enter a FRA (forward rate agreement)
with a bank.
Borrow for 1 year at 10%
Lend for 2 years at 12%
Net cash flow
Year 0
+90.91
-90.91
0
Year 1
-100
-100
Year 2
114.04
114.04
42
Swaps
Friendly Bancorp invested $50 M in debt carrying 8% fixed interest
rate and maturing in 5 years. Annual payments are $4m. However,
friendly Bancorp is predicting increases in interest rates, so it wants
a floating rate. Here is what it can do.
Year
1. Borrow $66.67 at 6%
fixed rate
2. Lend $66.67 at LIBOR
floating rate
Net cash flow
0
1
2
3
4
5
66.67
-4
-4
-4
-4
-70.67
-66.67
.05x66.67
0
-4
.05x66.67
Standard fixed-tofloating swap
0
-4
.05x66.67
LIBOR4x66.67
LIBOR1 x66.67 LIBOR2x66.67 LIBOR3x66.67
+66.67
-4
-4
-4
-4
LIBOR1x66.67 LIBOR2x66.67 LIBOR3x66.67 LIBOR4x66.67
-4
-4
-4
-4
LIBOR1x66.67 LIBOR2x66.67 LIBOR3x66.67 LIBOR4x66.67
43
SWAPS
Birth 1981
Definition - An agreement between two
firms, in which each firm agrees to
exchange the “interest rate characteristics”
of two different financial instruments of
identical principal
How to Set a Hedge?
• In practice, the commodity that a firm sells
is likely not identical to the one traded on
the exchange.
• Delta measures the sensitivity of A to
changes in the value of B.
• Duration is also used in setting hedge. (if
two assets have the exact duration, they
will be equally affected by change in
interest rates).
45
Ex - Settlement & Speculate
Example - You are speculating in Hog Futures. You think
that the Spot Price of hogs will rise in the future. Thus, you
go Long on 10 Hog Futures (1K is of $30,000 pound). If
the price drops .17 cents per pound ($.0017) what is total
change in your position?
Commodity Hedge
In June, farmer John Smith expects to harvest
10,000 bushels of corn during the month of
August. In June, the September corn futures are
selling for $2.94 per bushel (1K = 5,000
bushels). Farmer Smith wishes to lock in this
price (hedge).
Show the transactions if the Sept spot price
drops to $2.80.
Show the transactions if the Sept spot price
rises to $3.05.
Commodity Speculation
You have lived in NYC your whole life and are
independently wealthy. You think you know everything
there is to know about pork bellies (uncured bacon)
because your butler fixes it for you every morning.
Because you have decided to go on a diet, you think the
price will drop over the next few months. On the CME,
each PB K is 38,000 lbs. Today, you decide to short three
May Ks @ 44.00 cents per lbs. In Feb, the price rises to
48.5 cents and you decide to close your position. What is
your gain/loss?
If In Feb the price drops to 40.0 cents, what is your
gain/loss?
Margin
• The amount (percentage) of a Futures
Contract Value that must be on deposit
with a broker.
• Since a Futures Contract is not an actual
sale, you need only pay a fraction of the
asset value to open a position = margin.
• CME margin requirements are 15%
• Thus, you can control $100,000 of assets
with only $15,000.
Chapter 32 - Mergers
•
•
•
•
•
•
Sensible Motives for Mergers
Some Dubious Reasons for Mergers
Estimating Merger Gains and Costs
The Mechanics of a Merger
Takeover Battles and Tactics
Mergers and the Economy
50
The Basic Forms of Acquisitions
• There are three basic legal procedures that one firm can
use to acquire another firm:
– Merger (or consolidation)
– Acquisition of Stock
– Acquisition of Assets
• Although these forms are different from a legal
standpoint, the financial press frequently does not
distinguish among them.
• In our discussions, we use the term merger regardless of
the actual form of the acquisition.
51
Merger or Consolidation
• A merger refers to the absorption of one firm by another.
The acquiring firm retains its name and identity, and
acquires all the assets and liabilities of the acquired firm.
After the merger, the acquired firm ceases to exist as a
separate entity.
• A consolidation is the same as a merger except that an
entirely new firm is created. In a consolidation, both the
acquiring firm and the acquired firm terminate their
previous legal existence.
52
Acquisition of Stock
• A firm can acquire another firm by purchasing target
firm’s voting stock in exchange for cash, shares of stock,
or other securities.
• A tender offer is a public offer to buy shares made by
one firm directly to the shareholders of another firm.
– If the shareholders choose to accept the offer, they
tender their shares by exchanging them for cash or
securities.
– A tender offer is frequently contingent on the bidder’s
obtaining some percentage of the total voting shares.
– If not enough shares are tendered, then the offer
might be withdrawn or reformulated.
53
Acquisition of Assets
• One firm can acquire another by buying all of its assets.
• A formal vote of the shareholders of the selling firm is
required.
• Advantage of this approach: it avoids the potential
problem of having minority shareholders that may occur
in an acquisition of stock.
• Disadvantage of this approach: it involves a costly legal
process of transferring title.
54
A Classification Scheme
Financial analysts typically classify acquisitions
into three types:
– Horizontal acquisition: when the acquirer and
the target are in the same industry.
– Vertical acquisition: when the acquirer and the
target are at different stages of the production
process; example: an airline company
acquiring a travel agency.
– Conglomerate acquisition: the acquirer and
the target are not related to each other.
55
Recent Mergers in Canada
Date
Amount ($M) Target
Acquiring
June 2002
6,320
Bell Canada
BCE Inc.
Jan 2002
8,000
Canada Trust
TD Bank
Jan 2002
9,203
PanCanadian Energy
Alberta Energy
56
Sensible Reasons for Mergers
Economies of Scale
A larger firm may be able to reduce its per unit cost by
using excess capacity or spreading fixed costs across
more units.
Reduces costs
$
$
$
57
Sensible Reasons for Mergers
Combining Complementary Resources
Merging may results in each firm filling in
the “missing pieces” of their firm with
pieces from the other firm.
Firm A
Firm B
58
Sensible Reasons for Mergers
Mergers as a Use for Surplus Funds
If your firm is in a mature industry with few, if
any, positive NPV projects available, acquisition
may be the best use of your funds.
59
Source of Synergy from Acquisitions
• Revenue Enhancement
• Cost Reduction
– Including replacement of ineffective managers.
• Tax Gains
– Net Operating Losses
– Unused Debt Capacity
• Incremental new investment required in working capital
and fixed assets
60
Dubious Reasons for Mergers
• Diversification
– Investors should not pay a premium for
diversification since they can do it themselves.
61
Dubious Reasons for Mergers
The Bootstrap Game
Acquiring Firm has high P/E ratio
Selling firm has low P/E ratio (due to low
number of shares)
After merger, acquiring firm has short term
EPS rise
Long term, acquirer will have slower than
normal EPS growth due to share dilution.
62
Dubious Reasons for Mergers
The Bootstrap Game
World Enterprises
(before merger)
EPS
Price per share
P/E Ratio
Number of shares
Total earnings
Total market value
Current earnings
per dollar invested
in stock
$
$
$
$
$
2.00
40.00
20
100,000
200,000
4,000,000
World Enterprises
(after buying Muck
and Slurry)
Muck and Slurry
$
2.00 $
2.67
$
20.00 $
40.00
10
15
100,000
150,000
$
200,000 $
400,000
$
2,000,000 $
6,000,000
0.05 $
0.10 $
0.067
63
Dubious Reasons for Mergers
Earnings per
dollar invested
(log scale)
World Enterprises (after merger)
World Enterprises (before merger)
Muck & Slurry
.10
.067
.05
Now
Time
64
Lower Financing Costs
The combined company can borrow at lower
interest rates than either firm could separately.
That is what we would expect in well
functioning markets, but it does not increase
value for shareholders
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Estimating Merger Gains
• Questions
– Is there an overall economic gain to the
merger?
– Do the terms of the merger make the
company and its shareholders better off?
PV(AB) > PV(A) + PV(B)
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Estimating Merger Gains
Gain  PVAB  ( PVA  PVB )  PVAB
Cost  Cash paid  PVB
NPV ( A)  gain  cos t
 PVAB  (cash  PVB )
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Estimating Merger Gains
Example – Two firms merge creating $25 million
in synergies. A pays B a sum of $65 million.
PVA  $200
PVB  $50
Gain  PVAB  $25
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Estimating Merger Gains
Look at Incremental Economic Gain
Economic Gain = PV(increased earnings)
=
New cash flows from synergies
discount rate
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Cash versus Common Stock Acquistion
• Estimating Cost with Stock
• Taxes
– Cash acquisitions usually trigger taxes.
– Stock acquisitions are usually tax-free.
• Sharing Gains from the Merger
– With a cash transaction, the target firm
shareholders are not entitled to any
downstream synergies.
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The Tax Forms of Acquisitions
• In a taxable acquisition (cash offer), the
shareholders of the target firm are
considered to have sold their shares, and
they will have capital gain/losses that will
be taxed.
• In a tax-free acquisition, since the
acquisition is considered an exchange
instead of a sale, no capital gain or loss
occurs.
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Tax Consequences of a Merger
In 1995 Seacorp (fully owned by Captain B) purchases a boat for $300,000.
In 2005, the boat’s book value is $150,000, but its market value is
$280,000. In 2005 Seacorp also holds $50,000 of marketable securities so
its market value is $330,000.
Suppose Baycorp acquires Seacorp for $330,000.
Taxable Merger
Tax-free Merger
Captain B must recognize a
Capital gain can be deferred
Impact on Captain B $30000 capital gain and recapture until Captain B sells the Baycorp
depreciation $130,000.
shares.
Impact on baycorp
Boat is revalued at $280000. Tax
depreciation increases to
Boat's value remains at $150000,
$280000/10=$28000 per year
and tax depreciation continues
(assuming 10 years of remaining
at $15000 per year.
life)
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Defensive Tactics
• Target-firm managers frequently resist takeover
attempts.
• It can start with press releases and mailings to
shareholders that present management’s
viewpoint and escalate to legal action.
• Management resistance may represent the
pursuit of self interest at the expense of
shareholders.
• Resistance may benefit shareholders in the end
if it results in a higher offer premium from the
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bidding firm or another bidder.
Takeover Defenses Terminology
White Knight - Friendly potential acquirer sought by the
target company’s management. The white knight
promises to maintain the jobs of existing management
and helps to threaten an unwelcome suitor.
Shark Repellent - Amendments to a company charter
made to forestall takeover attempts.
Poison Pill - Measure taken by a target firm to avoid
acquisition; for example, the right for existing
shareholders to buy additional shares at an attractive
price if a bidder acquires a large holding.
Golden parachutes - are compensation to outgoing target
firm management.
Crown jewels - are the major assets of the target. If the
target firm management is desperate enough, they will
sell off the crown jewels.
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The Control Block and Anti-Takeover
Legislation
• If one individual or group owns 51-percent of a
company’s stock, this control block makes a hostile
takeover virtually impossible.
• Control blocks are typical in Canada, although they are
the exception in the United States.
• In the US, however, anti-takeover legislation has
received wide attention.
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Exclusionary Offers and Nonvoting Stock
The target firm makes a tender offer for its own
stock while excluding targeted shareholders.
An example:
– In 1986, the Canadian Tire Dealers
Association offered to buy 49% of the
company’s voting shares from the founding
Billes family.
– The offer was voided by the OSC, since it was
viewed as an illegal form of discrimination
against one group of shareholders.
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Going Private and LBOs
• If the existing management buys the firm
from the shareholders and takes it private.
• If it is financed with a lot of debt, it is a
leveraged buyout (LBO).
• The extra debt provides a tax deduction
for the new owners, while at the same time
turning the previous managers into
owners.
• This reduces the agency costs of equity as
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managers are now also owners.
Abnormal Returns in Successful Canadian
Mergers
Mergers 1964--83
Going private
Transactions 1977--89
- Minority buyouts
- Non-controlling bidder
Target
Bidder
9%
3%
25%
27%
24%
NA
NA
NA
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Comparison of U.S. vs. Canadian Mergers
• The evidence both in U.S. and Canada strongly
suggests that shareholders of successful target firms
achieve substantial gains from takeovers.
• Shareholders of bidding firms earn significantly less from
takeovers. The balance is more even for Canadian
mergers than for U.S. ones.
One possible reason:
– There is less competition among bidders in Canada.
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Divestitures
• The basic idea is to increase corporate focus.
• Divestiture can take three forms:
– Sale of assets: usually for cash
– Spinoff: parent company distributes shares of a
subsidiary to shareholders. Shareholders wind up
owning shares in two firms. Sometimes this is done
with a public IPO.
– Issuance if tracking stock: a class of common stock
whose value is connected to the performance of a
particular segment of the parent company.
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Summary and Conclusions
• The three legal forms of acquisition are
1. Merger and consolidation
2. Acquisition of stock
3. Acquisition of assets
• M&A requires an understanding of
complicated tax and accounting rules.
• The synergy from a merger is the value of
the combined firm less the value of the
two firms as separate entities.
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Summary and Conclusions
• The possible synergies of an acquisition
come from the following:
–
–
–
–
Revenue enhancement
Cost reduction
Lower taxes
Lower cost of capital
• The reduction in risk may actually help
existing bondholders at the expense of
shareholders.
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Practice Q1
Suppose Todd Trucking Company's stock is trading for $50 a share
while Hamilton Company's stock goes for $25 a share. The EPS of
Todd is $1 while the EPS of Hamilton is $2.50. Neither company has
debt in its current capital structure. Both companies have one million
shares of stock outstanding.
a. If Todd can acquire Hamilton for stock in an exchange based on
market value, what should be the post-merger EPS?
b. Suppose Todd pays a premium of 20% in excess of Hamilton's
current market value. How many shares of Todd must be given to
Hamilton's shareholders for each of their shares?
c. Based on your results in b, what will Todd's EPS be after it acquires
Hamilton?
d. If Hamilton were to acquire Todd by offering a 20% premium in
excess of Todd's current market price, how many shares of stock
would Hamilton have to offer, and what would be the effect on
Hamilton's EPS?
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Practice Q2
Susie's Pizza is analyzing the possible acquisition of Janet's Electric.
The projected cash flows to debt and equity expected from the
merger are as follows:
Year(s)
CF
1
150,000
2
170,000
3
200,000
4
200,000
5 on
6% growth per year
The current market price of Janet's debt is $800,000, the risk-free rate
is 8%, the required return on the market is 12%, and the beta of the
firm being acquired is 1.5.
a. Determine the maximum price (NPV) Susie can afford to pay.
b. If Janet's current equity value is $1,100,000 and she demands a 30%
premium, will the merger take place?
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