Start with the value of an all equity firm Sources of potential increases or decreases in value PV of tax shields PV of other benefits or costs of leverage PV of benefits or costs of control changes PV of benefits or costs from M&As Exchange offer mechanics Provides one or more classes of securities, right or option to exchange part or all of holdings for different class of securities of firm Terms of offer involve new securities of greater market value than pre-exchange offer announcement market value to induce security holders to accept offer

1. Financial Restructuring

2. Value of the Firm
• Start with the value of an all equity firm
• Sources of potential increases or
decreases in value
– PV of tax shields
– PV of other benefits or costs of leverage
– PV of benefits or costs of control changes
– PV of benefits or costs from M&As

3. – PV of benefits or costs of changes in
strategies, policies, operations,
organization structure (restructuring)
– PV of costs of financial distress

4. Leverage and Leveraged
Recapitalizations
• Value enhancement of capital structure
decisions
– Acquisition of other firms
• Debt as a source of funding for acquisition activity
• Takeover of firm to capture unused tax benefits of
debt
– Defense against being acquired by others
• Increase debt level to make firm less attractive
• Use debt to reorganize management control of firm

5. • Effects of the use of leveraged recaps
– Leveraged recap mechanism
• Relatively large issue of debt
• Payment of relatively large cash dividend to
nonmanagement shareholders
• Share repurchases
• Increase in share ownership by management
• Has been proposed as an alternative to merger
when pooling is abolished, to avoid goodwill
write-offs of purchase accounting

6. – Leverage recap characteristics
• Book leverage measured by total debt to total
capitalization increases from 20% to about 70%
• Management ownership share increases from
9% to 24% on average
– Market response to announcement of
leveraged recap — defensive
• Defensive leveraged recap — action taken in
response to actual takeovers or indications of
likely takeover bid
• Both positive and negative returns

7. – Market response to announcement of
leveraged recap — proactive
• Cumulative positive abnormal return of about
30%
• Return to bondholders of positive 5%
• Action is a part of a longer-run program of
improving the performance of the firm

8. • Subsequent performance
– High rate of financial distress
– Main factors influencing post-performance
• Macroeconomic and industry conditions
• Whether defensive or proactive
• Whether operating improvements were
achieved
– Positive disciplinary role of debt

9. • Role of leveraged recaps
– Leveraged recap more likely to succeed if
• Part of a strategic plan to improve performance of
firm in relation to changing environments
• Success depends heavily on programs to improve
performance
– Takeover defense
• Succeed by returning cash to shareholders
• Shareowners continue to hold equity stubs
• May discourage outside bidders — scorched-earth
policy
• High percentage of firms which adopt leveraged
recaps are subsequently acquired

10. Dual-Class Recapitalizations
• Dual-class recapitalization (DCR)
mechanism
– Second class of common stock has limited
voting rights and a preferential claim to cash
flows
• Class A shares — one vote per share but higher
dividend rate than other class
• Class B shares — cast multiple votes such as 3,
5, or 10 per share but dividend rate is lower than
other class

11. – New class may be created by distributing
limited voting shares pro rata to current
shareholders
– Some patterns
• Officers and directors have 55-65% of common
stock voting rights
• Officers and directors have claim on about 25%
of total cash flows
– In substantial number of cases of DCR,
controlled group represents founding
families or their descendants

12. • Reasons for dual-class recapitalizations
– Management can solidify control to carry
out long-run programs
• Avoid pressure for good short-term results
• Operations are relatively complex and difficult
to evaluate managerial performance
– Managers are compensated when plans
come to fruition
– Negative — managers can entrench their
position against takeover or being replaced

13. • Market response to dual-class recaps
– Shareholder wealth not adversely affected
by adoption of DCR
• Positive abnormal returns of over 6% for 90-day
period preceding announcement of DCR
• Positive significant abnormal performance of 1%
for event window of two or three days
surrounding announcement
• Negative but not significant cumulative stock
price reaction over time period from
announcement to approval at shareholder
meeting

14. – Dual-class shares and takeover bids
• When firm taken over, holder of superior voting
right shares received differentially higher
payment
• Fewer firms with dual-class stock experienced
takeover bids
• Superior shares sell at a premium mainly
because they receive more in takeover

15. • Post-transaction performance
– DCR uses higher percentage of cash flows for capital
expenditures than LBO firms
– Large proportion of DCR firms issue equity following
recap
– DCR achieves significantly higher industry-adjusted
operating income to sales ratio
– LBO firms outperform in terms of size of improvement
and performance
– Substantial increased management equity stake in
LBOs; DCR firms' insiders already held 43.1% of
common equity before transaction
– DCR firms have relatively lower leverage policies and
do not alter them as a consequence of the transaction

16. • LBOs often used as an antitakeover transaction
• Takeover rumors or bids preceded DCRs in
only 3 of 97 firms in sample
• DCR firms' insider seeks to consolidate control
to carry through growth plan, sacrificing current
dividend income for possible larger long-term
gain

17. Exchange Offers
• Exchange offer mechanics
– Provides one or more classes of securities,
right or option to exchange part or all of
holdings for different class of securities of
firm
– Terms of offer involve new securities of
greater market value than pre-exchange
offer announcement market value to
induce security holders to accept offer

18. – Maximum number of securities that may be
exchanged are usually specified
– Many exchange offers contingent upon
acceptance of minimum number of
securities to be exchanged
– Average life of offer is about seven weeks
but frequently extended; initial
announcement precedes beginning of
exchange offer by nine months

19. • Tax aspects of exchange offers
– When firm redeems debt at price below
issue price, difference treated as ordinary
corporate income
– Debt redeemed at price above issue price,
difference treated as ordinary loss
– Stock tendered for debt, stockholders incur
capital gain tax liability
– Debt for common stock exchange likely to
occur when stock selling at relatively low
prices — shareholders incur little or no
capital gain liability