Financial Management Slides Ch 23

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Chapter 23Chapter 23
Mergers and OtherMergers and Other
Forms of CorporateForms of Corporate
RestructuringRestructuring
Instructor: Ajab Khan Burki

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Mergers and Other Forms ofMergers and Other Forms of
Corporate RestructuringCorporate Restructuring
Sources of Value
Strategic Acquisitions
Involving Common Stock
Acquisitions and Capital
Budgeting
Closing the Deal

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Mergers and Other Forms ofMergers and Other Forms of
Corporate RestructuringCorporate Restructuring
Takeovers, Tender Offers, and
Defenses
Strategic Alliances
Divestiture
Ownership Restructuring
Leveraged Buyouts

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Why Engage inWhy Engage in
Corporate Restructuring?Corporate Restructuring?
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

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Sales EnhancementSales Enhancement
and Operating Economiesand Operating Economies
Sales enhancementSales enhancement can occur because of
market share gain, technological
advancements to the product table, and
filling a gap in the product line.
Operating economiesOperating economies can be achieved
because of the elimination of duplicate
facilities or operations and personnel.
SynergySynergy -- Economies realized in a merger
where the performance of the combined firm
exceeds that of its previously separate parts.

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Sales EnhancementSales Enhancement
and Operating Economiesand Operating Economies
Horizontal mergerHorizontal merger: best chance for economies
Vertical mergerVertical merger: may lead to economies
Conglomerate mergerConglomerate merger: few operating
economies
DivestitureDivestiture: reverse synergy may occur
Economies of ScaleEconomies of Scale -- The benefits of
size in which the average unit cost falls
as volume increases.

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Strategic AcquisitionsStrategic Acquisitions
Involving Common StockInvolving Common Stock
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 acquisitionfinancial 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 AcquisitionStrategic Acquisition -- Occurs when one
company acquires another as part of its overall
business strategy.

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ExampleExample -- Company A will acquire Company B
with shares of common stock.
Present earnings $20,000,000 $5,000,000
Shares outstanding 5,000,000 2,000,000
Earnings per share $4.00 $2.50
Price per share $64.00 $30.00
Price / earnings ratio 16 12
Company A Company B

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ExampleExample -- Company B has agreed on an offer
of $35 in common stock of Company A.
Total earnings $25,000,000
Shares outstanding* 6,093,750
Earnings per share $4.10
Surviving Company A
Exchange ratio = $35 / $64 = .546875.546875
* New shares from exchangeNew shares from exchange = .546875.546875 x 2,000,000
= 1,093,7501,093,750

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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 pre-
merger EPS].

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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 pre-
merger P/E ratio of 16 for Company A.]

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ExampleExample -- Company B has agreed on an offer
of $45 in common stock of Company A.
Surviving Company A
Exchange ratio = $45 / $64 = .703125.703125
= 1,406,2501,406,250

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The shareholders of Company A will
experience a decrease in earnings per share
because of the acquisition [$3.90 post-
merger 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].

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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 pre-
merger P/E ratio of 16 for Company A.]

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What AboutWhat About
Earnings Per Share (EPS)?Earnings Per Share (EPS)?
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.
With theWith the
mergermerger
Without theWithout the
mergermerger
Time in the Future (years)
ExpectedEPS($)
Initially, EPS is less with the merger.
Eventually, EPS is greater with the merger.
Equal

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Market Value ImpactMarket Value Impact
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 price per shareMarket price per share
of the acquiring companyof the acquiring company
Number of shares offered byNumber of shares offered by
the acquiring company for eachthe acquiring company for each
share of the acquired companyshare of the acquired company
Market price per share of the acquired companyMarket price per share of the acquired company
X

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ExampleExample -- Acquiring Company offers to
acquire Bought Company with shares of
common stock at an exchange price of $40.
Present earnings $20,000,000 $6,000,000
Shares outstanding 6,000,000 2,000,000
Earnings per share $3.33 $3.00
Price per share $60.00 $30.00
Price / earnings ratio 18 10
Acquiring Bought
Company Company

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Exchange ratioExchange ratio = $40 / $60 = .667
Market price exchange ratioMarket price exchange ratio = $60 x .667 / $30 = 1.33
Price / earnings ratio 18
Market price per share $63.90
Surviving Company
= 1,333,3331,333,333

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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 andand the P/E ratio NOTNOT 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).

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Empirical EvidenceEmpirical Evidence
on Mergerson Mergers
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.
BuyingBuying
companiescompanies
SellingSelling
companiescompanies
TIME AROUND ANNOUNCEMENT
(days)
Announcement date
0
-
+
CUMULATIVEAVERAGE
ABNORMALRETURN(%)

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Developments in MergersDevelopments in Mergers
and Acquisitionsand Acquisitions
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).
Roll-Up TransactionsRoll-Up Transactions – The combining of
multiple small companies in the same
industry to create one larger company.

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Developments in MergersDevelopments in Mergers
and Acquisitionsand Acquisitions
IPO funds are used to finance the
acquisitions.
IPO Roll-UpIPO Roll-Up – An IPO of independent
companies in the same industry that
merge into a single company concurrent
with the stock offering.
An Initial Public Offering (IPO) is a
company’s first offering of common stock
to the general public.

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Acquisitions andAcquisitions and
Capital BudgetingCapital Budgeting
An acquisition can be treated as a capital budgeting
project. This requires an analysis of the free cashfree cash
flowsflows of the prospective acquisition.
Free cash flowsFree 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 flowsFree 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.

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Cash Acquisition andCash Acquisition and
Capital Budgeting ExampleCapital Budgeting Example
AVERAGE FOR YEARS (in thousands)
1 - 5 6 - 10 11 - 15
Annual after-tax operatingAnnual after-tax operating
cash flows from acquisitioncash flows from acquisition $2,000$2,000 $1,800$1,800 $1,400$1,400
Net investmentNet investment 600600 300300 ------
Cash flow after taxesCash flow after taxes $1,400$1,400 $1,500 $1,400$1,500 $1,400
16 - 20 21 - 25
Annual after-tax operatingAnnual after-tax operating
cash flows from acquisitioncash flows from acquisition $ 800$ 800 $ 200$ 200
Net investmentNet investment ------ ------
Cash flow after taxesCash flow after taxes $ 800$ 800 $ 200$ 200

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Cash Acquisition andCash Acquisition and
Capital Budgeting ExampleCapital Budgeting Example
The appropriate discount rate for our example freefree
cash flowscash 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 flowfree cash flow is
$8,724,000$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$8,724,000, then the acquisition is
expected to enhance (reduce) shareholder wealth
over the long run.

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Other Acquisition andOther Acquisition and
Capital Budgeting IssuesCapital Budgeting Issues
Noncash payments and assumptionNoncash payments and assumption
of liabilitiesof liabilities
Estimating cash flowsEstimating cash flows
Cash-flow approach versus earningsCash-flow approach versus earnings
per share (EPS) approachper share (EPS) approach
Generally, the EPS approach examines the
acquisition on a short-run basis, while the cash-
flow approach takes a more long-run view.

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Closing the DealClosing the Deal
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
ConsolidationConsolidation -- The combination of two or more firms
into an entirely new firm. The old firms cease to exist.

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Taxable orTaxable or
Tax-Free TransactionTax-Free Transaction
TaxableTaxable -- if payment is made by cash or with a
debt instrument.
Tax-FreeTax-Free -- if payment made with voting
preferred or common stock and the transaction
has a “business purpose.” (Note: to be a tax-
free 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.)
At the time of acquisition, for the selling firm
or its shareholders, the transaction is:

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AlternativeAlternative
Accounting TreatmentsAccounting Treatments
Pooling of Interests (method)Pooling of Interests (method) -- A method of
accounting treatment for a merger based on
the net book valuenet book value of the acquired
company’s assets. The balance sheets of
the two companies are simply combined.
Purchase (method)Purchase (method) -- A method of accounting
treatment for a merger based on the marketmarket
priceprice paid for the acquired company.

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FASB and AlternativeFASB and Alternative
Accounting TreatmentsAccounting Treatments
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).
Pooling of InterestsPooling of Interests

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AccountingAccounting
Treatment of GoodwillTreatment of Goodwill
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.
GoodwillGoodwill -- The intangible assets of the
acquired firm arising from the acquiring firm
paying more for them than their book value.
Goodwill must be amortized.

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Tender OffersTender Offers
Allows the acquiring company to bypass
the management of the company it wishes
to acquire.
Tender OfferTender 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.

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Tender OffersTender Offers
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.

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Two-Tier Tender OfferTwo-Tier Tender Offer
Increases the likelihood of success
in gaining control of the target firm.
Benefits those who tender “early.”
Two-tier Tender OfferTwo-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.

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Defensive TacticsDefensive Tactics
The company being bid for may use a number ofThe company being bid for may use a number of
defensive tactics including: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 KnightWhite 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).

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Antitakeover AmendmentsAntitakeover Amendments
and Other Devicesand Other Devices
Shareholders’ Interest HypothesisShareholders’ Interest Hypothesis
This theory implies that contests for corporate
control are dysfunctional and take management
time away from profit-making activities.
Managerial Entrenchment HypothesisManagerial Entrenchment Hypothesis
This theory suggests that barriers are erected to
protect management jobs and that such actions
work to the detriment of shareholders.
Motivation TheoriesMotivation Theories::

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Antitakeover AmendmentsAntitakeover Amendments
and Other Devicesand Other Devices
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
Shark RepellentShark Repellent -- Defenses employed by a
company to ward off potential takeover
bidders -- the “sharks.”

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on Antitakeover Deviceson Antitakeover Devices
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 entrenchmentmanagement entrenchment
hypothesishypothesis because of the negative share
price effect.

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Strategic AllianceStrategic Alliance
Strategic alliances usually occur between (1)
suppliers and their customers, (2) competitors in
the same business, (3) non-competitors with
complementary strengths.
A joint venturejoint 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.
Strategic AllianceStrategic Alliance -- An agreement between two
or more independent firms to cooperate in order
to achieve some specific commercial objective.

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DivestitureDivestiture
LiquidationLiquidation -- The sale of assets of a firm,
either voluntarily or in bankruptcy.
Sell-offSell-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.
DivestitureDivestiture -- The divestment of a portion
of the enterprise or the firm as a whole.

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DivestitureDivestiture
Spin-offSpin-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-outEquity Carve-out -- The public sale of stock
in a subsidiary in which the parent usually
retains majority control.

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on Divestitureson Divestitures
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.

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Ownership RestructuringOwnership Restructuring
The most common transaction is paying
shareholders cash and merging the company
into a shell corporation owned by a private
investor management group.
Treated as an asset sale rather than a merger.
Going PrivateGoing Private -- Making a public
company private through the repurchase
of stock by current management and/or
outside private investors.

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Motivation and EmpiricalMotivation and Empirical
Evidence for Going PrivateEvidence for Going Private
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.
MotivationsMotivations::

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Motivation and EmpiricalMotivation and Empirical
Evidence for Going PrivateEvidence for Going Private
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 EvidenceEmpirical Evidence::
Shareholders realize gains (+12 to +22%)
for cash offers in these transactions.
Motivations (Offsetting Arguments)Motivations (Offsetting Arguments)::

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Ownership RestructuringOwnership Restructuring
The debt is secured by the assets of the enterprise
involved. Thus, this method is generally used with
capital-intensive businesses.
A management buyoutmanagement buyout is an LBO in which the pre-
buyout management ends up with a substantial
equity position.
Leverage Buyout (LBO)Leverage Buyout (LBO) -- A primarily
debt financed purchase of all the stock
or assets of a company, subsidiary, or
division by an investor group.

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Common Characteristics ForCommon Characteristics For
Desirable LBO CandidatesDesirable LBO Candidates
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.
Common characteristics (not all necessary)Common characteristics (not all necessary)::

Financial Management Slides Ch 23

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Financial Management Slides Ch 23