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Chapter 20:Corporate Restructuring

Contemporary Financial Management

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Introduction

This chapter focuses on forms of corporate restructuring, including external expansion (mergers) and business failure (bankruptcy).

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Types of Combinations

Merger (or Acquisition) Vertical Horizontal Conglomerate

• Geographic market• Product extension• Pure

Consolidation Holding company Joint venture

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Leveraged Buyout (LBO)

Buyer borrows most of the purchase price

Purchased assets used as collateral

Buyers frequently are the managers

Anticipated cash flows to service debt

Reasonable ROI

Sell assets to pay off debt

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Types of Mergers

Share Purchase

Acquiring company buys the stock of the target company.

Assumes liabilities of the acquired firm

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Types of Mergers

Asset Purchase

Acquiring company buys assets of target company

NO assumption of liabilities

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Types of Mergers

Tender Offer/Hostile Takeover

Purchase the common stock of the target company

Offering price is greater than the market price• Induce shareholders to sell

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What Happens After a Merger?

Divestitures Part of the company sold for cash Spin-off Equity carve-out

Restructurings Operational Financial

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Popularity of Restructuring

Failure of internal control mechanisms Unproductive investment Organizational inefficiencies

Large active investors

Available financing

Long economic expansion Increased revenues Increased asset values

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Anti-Takeover Measures

Staggering board

Golden parachutes

Supermajority rule

Poison pills

White knight

Standstill agreement

“Pacman” defense

Litigation

Asset/Liability

restructuring

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Boardmail

Institutional investors use it to fight anti-takeover devices

Requires the board of directors to adopt weaker anti-takeover measures

In exchange for voting support from institutional owners

Vote in sympathetic board members

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Why Firms Seek External Growth

Less Expensive

Achieve economies of scale

Vertical merger

Rapid growth

Diversification

Tax-loss carryforward

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Taxes on Mergers

Cash or debt securities Gains are usually taxable at the time of the

merger

Equity securities Usually tax-free

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Accounting for Mergers

Section 1581 of the CICA handbook requires that all business combinations after 2001 be accounted for under the purchase method.

Total value paid recorded on books Tangible assets at fair market value Excess as goodwill

• Must be amortized• Deducted from net income after taxes

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Valuation of a Merger Candidate

Comparative P/E Ratio Method Examines prices and P/E ratios of similar

companies

Adjusted Book Value Method Determine market value of the company’s

assets

Discounted Cash Flow Method Uses capital budgeting techniques to find the

Present value of the free cash flows

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EPS of the Surviving Company

EPSc = Earnings per share (combined companies)EAT1 = Earnings after taxes (acquiring company)EAT2 = Earnings after taxes (target company)EAT1,2 = Synergistic earnings from mergerNS1 = Shares outstanding (acquiring company)NS2 = Shares outstanding (target company)ER = Exchange ratio

Post-merger common share price and P/E ratio determined by the financial markets

1 2 1,2

C1 2

EAT + EAT + EATEPS =

NS + NS ER

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Business Failure

Two federal laws govern business failure:

The Bankruptcy and Insolvency Act (BA) Companies’ Creditors Arrangement Act (CCAA)

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Failures

Technically insolvent Unable to meet current obligations

Legally insolvent Assets are less than liabilities

Bankrupt Unable to pay debts Files for protection under federal bankruptcy

laws

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Reasons Why Firms Fail

Business risk

Industry downturns Over expansion Inadequate sales Increased competition Technological change

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Reasons Why Firms Fail

Financial risk

Excessive leverage Too much short-term debt Poor management of accounts receivable Poor management of accounts payable Incompetent management

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Alternatives for Failing Businesses

Resolve itsDifficulties(informally) Declare

Bankruptcy(formally)

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Reorganization Vs Liquidation

Legal bankruptcy proceedings focus on whether the failing firm should be reorganized or liquidated

Reorganize if going-concern value exceeds its liquidation value

Liquidate if liquidation value is more than its going-concern value

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Alternatives for Cash Flow Problems

Negotiate accounts payable deferrals

Restructure debt Extension Composition

Sell off assets Real estate/operating divisions

Sale and leaseback

Creditors’ committee

Assignment

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Failure under Bankruptcy Laws

Voluntary petition Debtor company files for bankruptcy.

Involuntary petition Unsecured creditors file the claim for

bankruptcy asserting that the debtor company is not paying its present debts as they come due.

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Priorities

Administration expenses Wages owed six months prior to bankruptcy

(maximum $2000) Municipal taxes owed within 2 years preceding

bankruptcy Rent for preceding 3-month period General/unsecured claims, including taxes due the

Crown Preferred shareholders Common share holders

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Major Points

Mergers and acquisitions are a method of growing more quickly than through internal growth.

Firms must use the Purchase Method of accounting for acquisitions.

A leveraged buyout allows a buyer to acquire a target using mainly debt financing.

Failing firms are said to be insolvent.

A failing firm may be liquidated or reorganized.