3-2Mergers and Other Forms ofMergers and Other Forms ofCorporate RestructuringCorporate RestructuringSources of ValueStrategic AcquisitionsInvolving Common StockAcquisitions and CapitalBudgetingClosing the Deal
3-3Mergers and Other Forms ofMergers and Other Forms ofCorporate RestructuringCorporate RestructuringTakeovers, Tender Offers, andDefensesStrategic AlliancesDivestitureOwnership RestructuringLeveraged Buyouts
3-4Why Engage inWhy Engage inCorporate Restructuring?Corporate Restructuring?Sales enhancement and operatingeconomies*Improved managementInformation effectWealth transfersTax reasonsLeverage gainsHubris hypothesisManagement’s personal agenda* Will be discussed in more detail in Slides 23-5 and 23-6
3-5Sales EnhancementSales Enhancementand Operating Economiesand Operating EconomiesSales enhancementSales enhancement can occur because ofmarket share gain, technologicaladvancements to the product table, andfilling a gap in the product line.Operating economiesOperating economies can be achievedbecause of the elimination of duplicatefacilities or operations and personnel.SynergySynergy -- Economies realized in a mergerwhere the performance of the combined firmexceeds that of its previously separate parts.
3-6Sales EnhancementSales Enhancementand Operating Economiesand Operating EconomiesHorizontal mergerHorizontal merger: best chance for economiesVertical mergerVertical merger: may lead to economiesConglomerate mergerConglomerate merger: few operatingeconomiesDivestitureDivestiture: reverse synergy may occurEconomies of ScaleEconomies of Scale -- The benefits ofsize in which the average unit cost fallsas volume increases.
3-7Strategic AcquisitionsStrategic AcquisitionsInvolving Common StockInvolving Common StockWhen the acquisition is done for common stock, a“ratio of exchange,” which denotes the relativeweighting of the two companies with regard tocertain key variables, results.A financial acquisitionfinancial acquisition occurs when a buyout firm ismotivated to purchase the company (usually to sellassets, cut costs, and manage the remainder moreefficiently), but keeps it as a stand-alone entity.Strategic AcquisitionStrategic Acquisition -- Occurs when onecompany acquires another as part of its overallbusiness strategy.
3-8Strategic AcquisitionsStrategic AcquisitionsInvolving Common StockInvolving Common StockExampleExample -- Company A will acquire Company Bwith 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 12Company A Company B
3-9Strategic AcquisitionsStrategic AcquisitionsInvolving Common StockInvolving Common StockExampleExample -- Company B has agreed on an offerof $35 in common stock of Company A.Total earnings $25,000,000Shares outstanding* 6,093,750Earnings per share $4.10Surviving Company AExchange ratio = $35 / $64 = .546875.546875* New shares from exchangeNew shares from exchange = .546875.546875 x 2,000,000= 1,093,7501,093,750
3-10Strategic AcquisitionsStrategic AcquisitionsInvolving Common StockInvolving Common StockThe shareholders of Company A willexperience an increase in earnings pershare because of the acquisition [$4.10 post-merger EPS versus $4.00 pre-merger EPS].The shareholders of Company B willexperience a decrease in earnings per sharebecause of the acquisition [.546875 x $4.10 =$2.24 post-merger EPS versus $2.50 pre-merger EPS].
3-11Strategic AcquisitionsStrategic AcquisitionsInvolving Common StockInvolving Common StockSurviving firm EPS will increase any time theP/E ratio “paid” for a firm is less than thepre-merger P/E ratio of the firm doing theacquiring. [Note: P/E ratio “paid” forCompany B is $35/$2.50 = 14 versus pre-merger P/E ratio of 16 for Company A.]
3-12Strategic AcquisitionsStrategic AcquisitionsInvolving Common StockInvolving Common StockExampleExample -- Company B has agreed on an offerof $45 in common stock of Company A.Total earnings $25,000,000Shares outstanding* 6,406,250Earnings per share $3.90Surviving Company AExchange ratio = $45 / $64 = .703125.703125* New shares from exchangeNew shares from exchange = .703125.703125 x 2,000,000= 1,406,2501,406,250
3-13Strategic AcquisitionsStrategic AcquisitionsInvolving Common StockInvolving Common StockThe shareholders of Company A willexperience a decrease in earnings per sharebecause of the acquisition [$3.90 post-merger EPS versus $4.00 pre-merger EPS].The shareholders of Company B willexperience an increase in earnings pershare because of the acquisition [.703125 x$4.10 = $2.88 post-merger EPS versus $2.50pre-merger EPS].
3-14Strategic AcquisitionsStrategic AcquisitionsInvolving Common StockInvolving Common StockSurviving firm EPS will decrease any timethe P/E ratio “paid” for a firm is greater thanthe pre-merger P/E ratio of the firm doing theacquiring. [Note: P/E ratio “paid” forCompany B is $45/$2.50 = 18 versus pre-merger P/E ratio of 16 for Company A.]
3-15What AboutWhat AboutEarnings Per Share (EPS)?Earnings Per Share (EPS)?Merger decisionsshould not be madewithout consideringthe long-termconsequences.The possibility offuture earnings growthmay outweigh theimmediate dilution ofearnings.With theWith themergermergerWithout theWithout themergermergerTime in the Future (years)ExpectedEPS($)Initially, EPS is less with the merger.Eventually, EPS is greater with the merger.Equal
3-16Market Value ImpactMarket Value ImpactThe above formula is the ratio of exchange ofmarket price.If the ratio is less than or nearly equal to 1, theshareholders of the acquired firm are not likely tohave a monetary incentive to accept the mergeroffer from the acquiring firm.Market price per shareMarket price per shareof the acquiring companyof the acquiring companyNumber of shares offered byNumber of shares offered bythe acquiring company for eachthe acquiring company for eachshare of the acquired companyshare of the acquired companyMarket price per share of the acquired companyMarket price per share of the acquired companyX
3-17Market Value ImpactMarket Value ImpactExampleExample -- Acquiring Company offers toacquire Bought Company with shares ofcommon 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 10Acquiring BoughtCompany Company
3-18Market Value ImpactMarket Value ImpactExchange ratioExchange ratio = $40 / $60 = .667Market price exchange ratioMarket price exchange ratio = $60 x .667 / $30 = 1.33Total earnings $26,000,000Shares outstanding* 7,333,333Earnings per share $3.55Price / earnings ratio 18Market price per share $63.90Surviving Company* New shares from exchangeNew shares from exchange = .666667.666667 x 2,000,000= 1,333,3331,333,333
3-19Market Value ImpactMarket Value ImpactNotice that both earnings per share and marketprice per share have risen because of theacquisition. This is known as “bootstrapping.”The market price per share = (P/E) x (Earnings).Therefore, the increase in the market price pershare is a function of an expected increase inearnings per share andand the P/E ratio NOTNOT declining.The apparent increase in the market price is drivenby the assumption that the P/E ratio will not changeand that each dollar of earnings from the acquiredfirm will be priced the same as the acquiring firmbefore the acquisition (a P/E ratio of 18).
3-20Empirical EvidenceEmpirical Evidenceon Mergerson MergersTarget firms in atakeover receive anaverage premium of30%.Evidence on buyingfirms is mixed. It isnot clear thatacquiring firmshareholders gain.Some mergers dohave synergisticbenefits.BuyingBuyingcompaniescompaniesSellingSellingcompaniescompaniesTIME AROUND ANNOUNCEMENT(days)Announcement date0-+CUMULATIVEAVERAGEABNORMALRETURN(%)
3-21Developments in MergersDevelopments in Mergersand Acquisitionsand AcquisitionsIdea is to rapidly build a larger and more valuable firmwith 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 growtowards going through an initial public offering (seeSlide 22).Roll-Up TransactionsRoll-Up Transactions – The combining ofmultiple small companies in the sameindustry to create one larger company.
3-22Developments in MergersDevelopments in Mergersand Acquisitionsand AcquisitionsIPO funds are used to finance theacquisitions.IPO Roll-UpIPO Roll-Up – An IPO of independentcompanies in the same industry thatmerge into a single company concurrentwith the stock offering.An Initial Public Offering (IPO) is acompany’s first offering of common stockto the general public.
3-23Acquisitions andAcquisitions andCapital BudgetingCapital BudgetingAn acquisition can be treated as a capital budgetingproject. This requires an analysis of the free cashfree cashflowsflows of the prospective acquisition.Free cash flowsFree cash flows are the cash flows that remain afterwe subtract from expected revenues any expectedoperating costs and the capital expendituresnecessary to sustain, and hopefully improve, thecash flows.Free cash flowsFree cash flows should consider any synergisticeffects but be before any financial charges so thatexamination is made of marginal after-tax operatingcash flows and net investment effects.
3-24Cash Acquisition andCash Acquisition andCapital Budgeting ExampleCapital Budgeting ExampleAVERAGE FOR YEARS (in thousands)1 - 5 6 - 10 11 - 15Annual after-tax operatingAnnual after-tax operatingcash flows from acquisitioncash flows from acquisition $2,000$2,000 $1,800$1,800 $1,400$1,400Net investmentNet investment 600600 300300 ------Cash flow after taxesCash flow after taxes $1,400$1,400 $1,500 $1,400$1,500 $1,40016 - 20 21 - 25Annual after-tax operatingAnnual after-tax operatingcash flows from acquisitioncash flows from acquisition $ 800$ 800 $ 200$ 200Net investmentNet investment ------ ------Cash flow after taxesCash flow after taxes $ 800$ 800 $ 200$ 200
3-25Cash Acquisition andCash Acquisition andCapital Budgeting ExampleCapital Budgeting ExampleThe appropriate discount rate for our example freefreecash flowscash flows is the cost of capital for the acquiredfirm. Assume that this rate is 15% after taxes.The resulting present value of free cash flowfree cash flow is$8,724,000$8,724,000. This represents the maximumacquisition price that the acquiring firm should bewilling to pay, if we do not assume the acquiredfirm’s liabilities.If the acquisition price is less than (exceeds) thepresent value of $8,724,000$8,724,000, then the acquisition isexpected to enhance (reduce) shareholder wealthover the long run.
3-26Other Acquisition andOther Acquisition andCapital Budgeting IssuesCapital Budgeting IssuesNoncash payments and assumptionNoncash payments and assumptionof liabilitiesof liabilitiesEstimating cash flowsEstimating cash flowsCash-flow approach versus earningsCash-flow approach versus earningsper share (EPS) approachper share (EPS) approachGenerally, the EPS approach examines theacquisition on a short-run basis, while the cash-flow approach takes a more long-run view.
3-27Closing the DealClosing the DealTarget is evaluated by the acquirerTerms are agreed uponRatified by the respective boardsApproved by a majority (usually two-thirds) ofshareholders from both firmsAppropriate filing of paperworkPossible consideration by The Antitrust Divisionof the Department of Justice or the Federal TradeCommissionConsolidationConsolidation -- The combination of two or more firmsinto an entirely new firm. The old firms cease to exist.
3-28Taxable orTaxable orTax-Free TransactionTax-Free TransactionTaxableTaxable -- if payment is made by cash or with adebt instrument.Tax-FreeTax-Free -- if payment made with votingpreferred or common stock and the transactionhas a “business purpose.” (Note: to be a tax-free transaction a few more technicalrequirements must be met that depend onwhether the purchase is for assets or thecommon stock of the acquired firm.)At the time of acquisition, for the selling firmor its shareholders, the transaction is:
3-29AlternativeAlternativeAccounting TreatmentsAccounting TreatmentsPooling of Interests (method)Pooling of Interests (method) -- A method ofaccounting treatment for a merger based onthe net book valuenet book value of the acquiredcompany’s assets. The balance sheets ofthe two companies are simply combined.Purchase (method)Purchase (method) -- A method of accountingtreatment for a merger based on the marketmarketpriceprice paid for the acquired company.
3-30FASB and AlternativeFASB and AlternativeAccounting TreatmentsAccounting TreatmentsPooling of interests is largely a United Statesphenomenon.In 1999, FASB voted unanimously toeliminate pooling of interests.Likely to become effective in 2000 once afinal standard is issued (although still vocalopposition to the accounting change).Pooling of InterestsPooling of Interests
3-31AccountingAccountingTreatment of GoodwillTreatment of GoodwillGoodwill cannot be amortized for more than40 years for “financial accountingpurposes.”Goodwill charges are generally deductiblefor “tax purposes” over 15 years foracquisitions occurring after August 10, 1993.GoodwillGoodwill -- The intangible assets of theacquired firm arising from the acquiring firmpaying more for them than their book value.Goodwill must be amortized.
3-32Tender OffersTender OffersAllows the acquiring company to bypassthe management of the company it wishesto acquire.Tender OfferTender Offer -- An offer to buy currentshareholders’ stock at a specified price, oftenwith the objective of gaining control of thecompany. The offer is often made by anothercompany and usually for more than the presentmarket price.
3-33Tender OffersTender OffersIt is not possible to surprise anothercompany with its acquisition because theSEC requires extensive disclosure.The tender offer is usually communicatedthrough financial newspapers and directmailings if shareholder lists can be obtainedin a timely manner.A two-tier offer (Slide 34) may be made withthe first tier receiving more favorable terms.This reduces the free-rider problem.
3-34Two-Tier Tender OfferTwo-Tier Tender OfferIncreases the likelihood of successin gaining control of the target firm.Benefits those who tender “early.”Two-tier Tender OfferTwo-tier Tender Offer – Occurs when thebidder offers a superior first-tier price (e.g.,higher amount or all cash) for a specifiedmaximum number (or percent) of shares andsimultaneously offers to acquire theremaining shares at a second-tier price.
3-35Defensive TacticsDefensive TacticsThe company being bid for may use a number ofThe company being bid for may use a number ofdefensive tactics including:defensive tactics including:(1) persuasion by management that the offer is notin their best interests, (2) taking legal actions, (3)increasing the cash dividend or declaring a stocksplit to gain shareholder support, and (4) as a lastresort, looking for a “friendly” company (i.e., whiteknight) to purchase them.White KnightWhite Knight -- A friendly acquirer who, at the invitationof a target company, purchases shares from the hostilebidder(s) or launches a friendly counter-bid in order tofrustrate the initial, unfriendly bidder(s).
3-36Antitakeover AmendmentsAntitakeover Amendmentsand Other Devicesand Other DevicesShareholders’ Interest HypothesisShareholders’ Interest HypothesisThis theory implies that contests for corporatecontrol are dysfunctional and take managementtime away from profit-making activities.Managerial Entrenchment HypothesisManagerial Entrenchment HypothesisThis theory suggests that barriers are erected toprotect management jobs and that such actionswork to the detriment of shareholders.Motivation TheoriesMotivation Theories::
3-37Antitakeover AmendmentsAntitakeover Amendmentsand Other Devicesand Other DevicesStagger the terms of the board of directorsChange the state of incorporationSupermajority merger approval provisionFair merger price provisionLeveraged recapitalizationPoison pillStandstill agreementPremium buy-back offerShark RepellentShark Repellent -- Defenses employed by acompany to ward off potential takeoverbidders -- the “sharks.”
3-38Empirical EvidenceEmpirical Evidenceon Antitakeover Deviceson Antitakeover DevicesEmpirical results are mixed in determining ifantitakeover devices are in the bestinterests of shareholders.Standstill agreements and stockrepurchases by a company from the ownerof a large block of stocks (i.e., greenmail)appears to have a negative effect onshareholder wealth.For the most part, empirical evidencesupports the management entrenchmentmanagement entrenchmenthypothesishypothesis because of the negative shareprice effect.
3-39Strategic AllianceStrategic AllianceStrategic alliances usually occur between (1)suppliers and their customers, (2) competitors inthe same business, (3) non-competitors withcomplementary strengths.A joint venturejoint venture is a business jointly owned andcontrolled by two or more independent firms. Eachventure partner continues to exist as a separatefirm, and the joint venture represents a newbusiness enterprise.Strategic AllianceStrategic Alliance -- An agreement between twoor more independent firms to cooperate in orderto achieve some specific commercial objective.
3-40DivestitureDivestitureLiquidationLiquidation -- The sale of assets of a firm,either voluntarily or in bankruptcy.Sell-offSell-off -- The sale of a division of acompany, known as a partial sell-off, orthe company as a whole, known as avoluntary liquidation.DivestitureDivestiture -- The divestment of a portionof the enterprise or the firm as a whole.
3-41DivestitureDivestitureSpin-offSpin-off -- A form of divestiture resulting ina subsidiary or division becoming anindependent company. Ordinarily, sharesin the new company are distributed to theparent company’s shareholders on a prorata basis.Equity Carve-outEquity Carve-out -- The public sale of stockin a subsidiary in which the parent usuallyretains majority control.
3-42Empirical EvidenceEmpirical Evidenceon Divestitureson DivestituresFor liquidation of the entire company, shareholders ofthe liquidating company realize a +12 to +20% return.For partial sell-offs, shareholders selling the companyrealize a slight return (+2%). Shareholders buyingalso experience a slight gain.Shareholders gain around 5% for spin-offs.Shareholders receive a modest +2% return for equitycarve-outs.Divestiture results are consistent with theinformational effect as shown by the positive marketresponses to the divestiture announcements.
3-43Ownership RestructuringOwnership RestructuringThe most common transaction is payingshareholders cash and merging the companyinto a shell corporation owned by a privateinvestor management group.Treated as an asset sale rather than a merger.Going PrivateGoing Private -- Making a publiccompany private through the repurchaseof stock by current management and/oroutside private investors.
3-44Motivation and EmpiricalMotivation and EmpiricalEvidence for Going PrivateEvidence for Going PrivateElimination of costs associated with being a publiclyheld firm (e.g., registration, servicing of shareholders,and legal and administrative costs related to SECregulations and reports).Reduces the focus of management on short-termnumbers to long-term wealth building.Allows the realignment and improvement ofmanagement incentives to enhance wealth building bydirectly linking compensation to performance withouthaving to answer to the public.MotivationsMotivations::
3-45Motivation and EmpiricalMotivation and EmpiricalEvidence for Going PrivateEvidence for Going PrivateLarge transaction costs to investmentbankers.Little liquidity to its owners.A large portion of management wealth istied 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)::
3-46Ownership RestructuringOwnership RestructuringThe debt is secured by the assets of the enterpriseinvolved. Thus, this method is generally used withcapital-intensive businesses.A management buyoutmanagement buyout is an LBO in which the pre-buyout management ends up with a substantialequity position.Leverage Buyout (LBO)Leverage Buyout (LBO) -- A primarilydebt financed purchase of all the stockor assets of a company, subsidiary, ordivision by an investor group.
3-47Common Characteristics ForCommon Characteristics ForDesirable LBO CandidatesDesirable LBO CandidatesThe company has gone through a program of heavycapital expenditures (i.e., modern plant).There are subsidiary assets that can be sold withoutadversely impacting the core business, and theproceeds 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)::