Unit-4 Corporate Restructuring - Advance Finance.pptx

Unit-4:
Corporate
Restructuring
Prepared by : Prof. Ravi Raval
B.Tech CSBS Sem VI
2CSBSPE6105 : Advance Finance

Contents
1. Mergers and Acquisitions- Types of
Mergers
2. Evaluation of Merger Proposal
3. Takeover
4. Amalgamation
5. Leverage buy-out
6. Management buy-out
7. Corporate Failure and Liquidation.
Reference: Chap 31 & 32 of Principles of
Corporate Finance by Richard A. Brealey, Stewart
C. Myers, Franklin Allen (Page # 792-827)
2

• A merger adds value only if the two companies are worth more together than apart.
1) Horizontal mergers, that is, combinations of two firms in the same line of business.
• Two recent headline-grabbing examples are Pfizer’s acquisition of Wyeth and Bank of America’s
acquisition of Merrill Lynch.
Mergers and Acquisitions- Types of Mergers
3

2) A vertical merger involves companies at different stages of production. The
buyer expands back toward the source of raw materials or forward in the
direction of the ultimate consumer.
• An example of a vertical merger is the 2008 acquisition of Tele Atlas by its fellow Dutch firm,
TomTom. TomTom, the world’s largest maker of car navigation devices, plans to use Tele Atlas’s
digital map data to provide real-time updates to its sat-nav systems.
• Other recent vertical mergers include that between Google and Double-Click and the proposed
tie-up between Live Nation and Ticketmaster.
3) A conglomerate merger involves companies in unrelated lines of businesses.
• The principal mergers of the 1960s and 1970s were mostly conglomerate. Conglomerates are
much less popular now, at least in the United States and other developed economies. Much of
the action in the 1980s and 1990s has come from breaking up the conglomerates that had been
formed 10 to 20 years earlier.
4

• This was the case for AOL, which spent a record-
breaking $156 billion to acquire Time Warner. The aim
was to create a company that could offer consumers a
comprehensive package of media and information
products. It didn’t work
• Even more embarrassing (on a smaller scale) was the
acquisition of Apex One, a sporting apparel company,
by Converse Inc. The purchase was made on May 18,
1995. Apex One was closed down on August 11, after
Converse failed to produce new designs quickly enough
to satisfy retailers. Converse lost an investment of over
$40 million in 85 days.
5

 Reason?
• Many mergers that seem to make economic sense fail because managers cannot handle the
complex task of integrating two firms with different production processes, accounting methods,
and corporate cultures
• most businesses depends on human assets—managers, skilled workers, scientists, and
engineers will resign (unhappy with new role).
 Sensible Motives of Merger:
1) Economies of Scale: intended to reduce cost and achieve economies of scale.
• For example, when Bank of New York and Mellon Financial Corporation merged in 2007,
management forecasted annual cost savings of $700 million or over 8% of the current combined
costs. They anticipated that the merger would allow the two companies to share services and
technology, and would permit a reduction in staff from 40,000 to about 36,000.
2) Economies of vertical integration: Some companies try to gain control over the production
process by expanding back toward the output of the raw material or forward to the ultimate
consumer. One way to achieve this is to merge with a supplier or a customer.
6

• Think of an airline that does not own any planes. If it schedules a flight from Boston to San
Francisco, it sells tickets and then rents a plane for that flight from a separate company. This
strategy might work on a small scale, but it would be an administrative nightmare for a major
carrier, which would have to coordinate hundreds of rental agreements daily. In view of these
difficulties, it is not surprising that all major airlines have integrated backward, away from the
consumer, by buying and flying airplanes rather than simply patronizing rent-a-plane companies
3) Complementary Resources: Many small firms are acquired by large ones that can provide the
missing ingredients necessary for the small firms’ success. The small firm may have a unique
product but lack the engineering and sales organization required to produce and market it on a
large scale. The firm could develop engineering and sales talent from scratch, but it may be
quicker and cheaper to merge with a firm that already has ample talent. The two firms have
complementary resources —each has what the other needs—and so it may make sense for
them to merge. Also, the merger may open up opportunities that neither firm would pursue
otherwise.
7

• In recent years many of the major pharmaceutical firms have faced the loss of patent protection
on their more profitable products and have not had an offsetting pipeline of promising new
compounds. This has prompted an increasing number of acquisitions of biotech firms. For
example, in 2008 Eli Lilly acquired ImClone Systems. Lilly paid $6.5 billion for ImClone, a
premium of some 50% over the company’s earlier market value. But Lilly’s CEO claimed that the
acquisition would “broaden Lilly’s portfolio of marketed cancer therapies and boost Lilly’s
oncology pipeline with up to three promising targeted therapies in Phase III in 2009.” At the
same time ImClone obtained the resources necessary to bring its products to market.
4) Surplus Funds: Here’s another argument for mergers: Suppose that your firm is in a mature
industry. It is generating a substantial amount of cash, but it has few profitable investment
opportunities. Ideally such a firm should distribute the surplus cash to shareholders by
increasing its dividend payment or repurchasing stock. Unfortunately, energetic managers are
often reluctant to adopt a policy of shrinking their firm in this way. If the firm is not willing to
purchase its own shares, it can instead purchase another company’s shares. Firms with a
surplus of cash and a shortage of good investment opportunities often turn to mergers
financed by cash as a way of redeploying their capital. Some firms have excess cash and do not
pay it out to stockholders or redeploy it by wise acquisitions. Such firms often find themselves
targeted for takeover by other firms that propose to redeploy the cash for them. (example of
cash-rich oil companies in 1980s during the oil price slump)
8

5) Eliminating Inefficiencies: Cash is not the only asset that can be wasted by poor management.
There are always firms with unexploited opportunities to cut costs and increase sales and
earnings. Such firms are natural candidates for acquisition by other firms with better
management. In some instances “better management” may simply mean the determination to
force painful cuts or realign the company’s operations. Notice that the motive for such
acquisitions has nothing to do with benefits from combining two firms. Acquisition is simply
the mechanism by which a new management team replaces the old one.
6) Industry Consolidation: The biggest opportunities to improve efficiency seem to come in
industries with too many firms and too much capacity. These conditions seem to trigger a
wave of mergers and acquisitions, which then force companies to cut capacity and
employment and release capital for reinvestment elsewhere in the economy. For example,
when U.S. defense budgets fell after the end of the Cold War, a round of consolidating
takeovers followed in the defense industry. The consolidation was inevitable, but the takeovers
accelerated it.
9

 Dubious Motives of Merger:
1) Diversification: What about diversification as an end in itself? It is obvious that diversification reduces risk. Isn’t
that a gain from merging? The trouble with this argument is that diversification is easier and cheaper for the
stockholder than for the corporation. There is little evidence that investors pay a premium for diversified firms; in
fact, discounts are more common.
2) Increasing earnings per share: The Bootstrap game Some acquisitions that offer no evident economic
gains nevertheless produce several years of rising earnings per share. To see how this can happen, let us look at
the acquisition of Muck and Slurry by the well-known conglomerate World Enterprises.
The market value of World Enterprises after the merger should be equal to the sum of the separate values of the two
firms (line 6).
10

 Dubious Motives of Merger:
Total earnings double as a result of the merger (line 5), but the number of shares increases by only 50%. Earnings per
share rise from $2.00 to $2.67. We call this the bootstrap effect because there is no real gain created by the merger
and no increase in the two firms’ combined value.
3) Lower financing costs: You often hear it said that a merged firm is able to borrow more cheaply than its
separate units could. In part this is true. There are significant economies of scale in making new issues. Therefore,
if firms can make fewer, larger security issues by merging, there are genuine savings.
But when people say that borrowing costs are lower for the merged firm, they usually mean something more
than lower issue costs. They mean that when two firms merge, the combined company can borrow at lower
interest rates than either firm could separately. This, of course, is exactly what we should expect in a well-
functioning bond market. While the two firms are separate, they do not guarantee each other’s debt; if one fails,
the bondholder cannot ask the other for money. But after the merger each enterprise effectively does guarantee
the other’s debt; if one part of the business fails, the bondholders can still take their money out of the other part.
Because these mutual guarantees make the debt less risky, lenders demand a lower interest rate.
11

 Economical gain: only if the two firms are worth more together than apart.
Gain = PVAB – (PVA + PVB) = ΔPVAB
 Acquiring Cost: Cost = cash paid - PVB
 Net present value of merger: The net present value to A of a merger with B is measured by the
difference between the gain and the cost
NPV = gain – cost
= ΔPVAB – (cash – PVB)
• When you estimate the benefit, you concentrate on whether there are any gains to be made from the merger.
When you estimate cost, you are concerned with the division of these gains between the two companies.
 Example: Firm A has a value of $200 million, and B has a value of $50 million. Merging the two would
allow cost savings with a present value of $25 million. This is the gain from the merger. Thus,
PVA = $200 PVB = $50
Gain = ΔPVAB = +$25
PVAB = $275 million
Suppose that B is bought for cash, say, for $65 million. The cost of the merger is
Cost = cash paid – PVB
= 65 – 50 = $15 Million
Evaluation of merger proposal
12

• Note that the stockholders of firm B—the people on the other side of the transaction—are ahead by $15 million.
Their gain is your cost. They have captured $15 million of the $25 million merger gain. Thus when we write down
the NPV of the merger from A’s viewpoint, we are really calculating the part of the gain that A’s stockholders get to
keep. The NPV to A’s stockholders equals the overall gain from the merger less that part of the gain captured by B’s
stockholders:
NPV = 25 - 15 = +$10 million
• Just as a check, let’s confirm that A’s stockholders really come out $10 million ahead. They start with a firm worth
PV A $200 million. They end up with a firm worth $275 million and then have to pay out $65 million to B’s
stockholders. 9 Thus their net gain is:
NPV = wealth with merger - wealth without merger
= (PVAB – cash) - PVA
= ($275 - $65) - $200 = +$10 million
• The announcement will cause the value of B’s stock to rise from $50 million to $65 million, a 30%
increase.
• If investors share management’s assessment of the merger gains, the market value of A’s stock will
increase by $10 million, only a 5% increase.
13

• An acquiring firm should pursue a merger only if it creates some real economic values which may arise
from any source such as better and ensured supply of raw materials, better access to capital market,
better and intensive distribution network, greater market share, tax benefits etc.
• The financial evaluation of a target candidate, therefore, includes the determination of the total
consideration as well as the form of payment, i.e., in cash or securities of the acquiring firm.
 Merger Evaluation methods
1) Valuation based on assets: The worth of the target firm, no doubt, depends upon the tangible and intangible
assets of the firm
The value of a firm may be defined as:- Value of all assets – External Liabilities = Net Assets
• The assets of firm may be valued on the basis of the book values or realizable values
• In this case, the values of various assets given in the latest balance sheet of the firm are taken as worth of the assets
• From the total of the book values of all the assets, the amount of external liabilities is deducted to find out the net
worth of the firm.
• The net worth may be divided by the number of equity shares to find out the value per share of the target firm.
14

2) Valuation based on earnings:
• In the earnings based valuation, the PAT (Profit after taxes) is multiplied by the Price – Earnings ratio to find out the
value.
Market price per share = EPS * PE RATIO
• The earnings based valuation can also be made in terms of earnings yield as follows:-
Earnings yield = EPS / MPS * 100
Earnings valuation may also be found by capitalizing the total earnings of the firm as follows:-
Value = Earnings/ capitalization rate * 100
3) Market value approach:
• This approach is based on the actual market price of securities settled between the buyer and seller.
• The price of a security in the free market will be its most appropriate value.
• Market price is affected by the factors like demand and supply and position of money market.
• Market value is a device which can be readily applied at any time.
4) Earnings per share:
• According to this approach, the value of a prospective merger or acquisition is a function of the impact of
merger/acquisition on the earnings per share.
• As the market price per share is a function (product) of EPS and Price- Earnings Ratio, the future EPS will have an
impact on the market value of the firm.
15

5) Share exchange ratio:
• The share exchange ratio is the number of shares that the acquiring firm is willing to issue for each share of the
target firm.
• The exchange ratio determines the way the synergy is distributed between the shareholders of the merged and the
merging company.
• The swap ratio also determines the control that each group of shareholders will have over the combined firm.
• Based on Earnings Per Share(EPS)
Share Exchange Ratio = EPS of the target firm / EPS of the Acquiring firm
• Based on Market Price (MP)
Share Exchange Ratio = MP of the target firm’s share / MP of the Acquiring firm’s share
• Based on Book Value (BV)
Share Exchange Ratio = BV of share of the target firm / BV of share of the Acquiring firm
6) Other Methods:
a) Economic Value Added: EVA is based upon the concept of economic return which refers to excess of after tax
return on capital employed over the cost of capital employed.
b) Market Value Added: MVA is another concept used to measure the performance and as a measure of value
of a firm. MVA is determined by measuring the total amount of funds that have been invested in the
company (based on cash flows) and comparing with the current market value of the securities of the
company.
16

• Proxy Contest: When a group of investors believes that the board and its management should be replaced,
they can launch a proxy contest at the next annual meeting. A proxy is the right to vote another
shareholder’s shares. In a proxy contest, the dissident shareholders attempt to obtain enough proxies to
elect their own slate to the board of directors. Once the new board is in control, management can be
replaced and company policy changed. A proxy fight is therefore a direct contest for control of the
corporation. Many proxy fights are initiated by major shareholders who consider the firm poorly managed.
In other cases a fight may be a prelude to the merger of two firms. The proponent of the merger may
believe that a new board will better appreciate the advantages of combining the two firms.
• The alternative to a proxy fight is for the would-be acquirer to make a tender offer directly to the
shareholders. If the offer is successful, the new owner is free to make any management changes. The
management of the target firm may advise its shareholders to accept the offer, or it may fight the bid in the
hope that the acquirer will either raise its offer or throw in the towel.
• In the United States the rules for tender offers are set largely by the Williams Act of 1968 and by state laws.
The courts act as a referee to see that contests are conducted fairly. The problem in setting these rules is
that it is unclear who requires protection. Should the management of the target firm be given more
weapons to defend itself against unwelcome predators? Or should it simply be encouraged to sit the game
out? Or should it be obliged to conduct an auction to obtain the highest price for its shareholders? And
what about would-be acquirers? Should they be forced to reveal their intentions at an early stage, or would
that allow other firms to piggyback on their good ideas by entering bids of their own?
Takeover
17

• An amalgamation is the combination of two or more companies into an entirely new entity. Amalgamations
are distinct from acquisitions in that none of the companies involved in the transaction survives as a legal
entity. Instead, a completely new entity, with the combined assets and liabilities of the former companies,
is born.
• Amalgamations typically happen between two (or more) companies that are engaged in the same line of
business or that share some similarity in their operations. Usually, the process involves a larger entity, called
a "transferee" company, absorbing one or more smaller "transferor" companies before the creation of the
new entity.
• The terms of an amalgamation are finalized by the board of directors of each company involved. The plan is
prepared and submitted to regulators for approval. In India, for example, that authority resides in the High
Court and Securities and Exchange Board of India (SEBI).
• Once approved, the new company officially becomes a legal entity and can issue shares of stock in its own
name.
Amalgamation
18
Advantages Disadvantages
Can improve competitiveness Can concentrate too much power into a monopolistic company
May reduce taxes May lead to job losses
Increases economies of scale Increases the new company's debt load
Has potential to increase shareholder value
Diversifies the business
Example of Amalgamation: In April 2022, the telecom giant AT&T and the television
entertainment company Discovery, Inc. announced that they had finalized a deal to
combine AT&T's WarnerMedia business unit with Discovery. That month, a new
entity known as Warner Bros. Discovery Inc. began trading on the Nasdaq stock
exchange under the symbol WBD

• Leveraged buyouts (LBOs) differ from ordinary
acquisitions in two immediately obvious ways.
 First, a large fraction of the purchase price is
financed by debt. Some, if not all, of this debt is
junk, that is, below investment-grade.
 Second, the company goes private and its shares
no longer trade on the open market. Equity
financing for LBOs comes from private equity
investment partnerships. When a buyout is led
by existing management, the transaction is called
a management buyout or MBO.
Leverage buy-out
19

• LBOs and Leveraged Restructurings
The financial characteristics of LBOs and leveraged restructurings are similar. The three main
characteristics of LBOs are:
1. High debt. The debt is not intended to be permanent. It is designed to be paid down. The
requirement to generate cash for debt service is intended to curb wasteful investment and force
improvements in operating efficiency. Of course, this solution only makes sense in the case of
companies that are generating lots of cash and have few investment opportunities.
2. Incentives. Managers are given a greater stake in the business via stock options or direct
ownership of shares.
3. Private ownership. The LBO goes private. It is owned by a partnership of private investors who
monitor performance and can act right away if something goes awry. But private ownership is not
intended to be permanent. The most successful LBOs go public again as soon as debt has been
paid down sufficiently and improvements in operating performance have been demonstrated.
Leverage buy-out
20

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