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Chapter 16Chapter 16
Corporate Corporate RestructuringRestructuring
© 2000 South-Western College Publishing
BASIC DEFINITIONS, TERMINOLOGY, AND PROCEDURE
Merger Combination of businesses Acquisition under a single Consolidation controlling ownership
"Merger" loosely used for any combination
BUT
B Merges Into A A and B A Acquires B Consolidate A Takes Over B Into C
Figure 16-1 Basic Business Combinations
Size of combining companies does not determine the nature
of the combination.
TM 16-1
AAA
B BC
THE FRIENDLY MERGER THE FRIENDLY MERGER PROCEDUREPROCEDURE
Acquirer's management contacts target's management and proposes a deal
Target's management agrees and cooperates
TM 16-2 Slide 1 of 2
THE UNFRIENDLY OR HOSTILE PROCEDURE
Acquiring firm makes a tender offer to the target's shareholders
Offers a fixed price if accepted on enough shares to gain control
Meanwhile, target's management likely contests with defensive measures
Hostility is between the managements or boards of directors not the stockholders to whom the target is just an investment
Why Unfriendly Mergers Are UnfriendlyPrice too low
Managements of acquired companies lose power, often jobs
TM 16-2 Slide 2 of 2
ECONOMIC CLASSIFICATION OF MERGERSECONOMIC CLASSIFICATION OF MERGERS
Vertical Merger
A firm acquires its suppliers or customers
Horizontal Merger
Between firms in the same kind of business usually as competitors
Generally has the effect of reducing competition
Conglomerate Merger
Lines of business have nothing to do with one another
THE ANTITRUST LAWSTHE ANTITRUST LAWSThe U.S. is committed to a competitive economy
Mergers concentrate economic power, and can reduce competitiveness
Antitrust laws can prohibit mergers
Judgment by Justice Department
TM 16-3
THE REASONS BEHIND MERGERSTHE REASONS BEHIND MERGERSSynergies
Growth Internal growth vs. external
Diversification To Reduce RiskSimilar to portfolio diversification
Counterargument
Economies of Scale
Guaranteed Sources and Markets
Acquiring Assets Cheaply
TM 16-4 Slide 1 of 2
Tax Losses
Rich Inc. Poor Inc. Merged
EBT $2,000 ($1,000) $1,000
Tax (35%) 700 -0- 350
EAT $1,400 ($1,000) $ 650
Not allowed if merger is primarily for tax avoidance.
Ego and Empire
TM 16-4 Slide 2 of 2
THE HISTORY OF MERGER ACTIVITY IN THE UNITED STATESTHE HISTORY OF MERGER ACTIVITY IN THE UNITED STATES
Wave One, The Turn of the Century, 1897-1904
Profound effect on the structure of American industry
Largely horizontal and in primary industries
Transformed the country from a nation of small companies into
one of industrial giants
Small companies absorbed using unfair and violent tactics
Monopolistic abuses led to antitrust laws
Wave Two, The Roaring Twenties, 1916-1929
Horizontal mergers resulted in concentration into oligopolies
Wave Three, The Swinging Sixties, 1965-1969
Conglomerate mergers
Financial phenomena EPS - P/E
Little increase in concentration
Many now undone
TM 16-5 Slide 1 of 2
An Important Development During the 1970sAn Important Development During the 1970s
Prior to the 1970's reputable companies did not do hostile takeovers.
Changed in 1974 with the acquisition of ESB, the world's largest maker of batteries, by International Nickel Company (Canadian)
assisted by Morgan Stanley, a prestigious investment bank.
The hostile takeover became an
acceptable financial maneuver.
TM 16-5 Slide 2 of 2
Wave Four, Bigger and Bigger, 1981
Distinguishing characteristics of the current wave
of intense merger activity:
Size
Very large mergers involving leading firms are common
HostilityProportion of hostile actions has increased (still small),
especially at large end
The threat of hostile takeover now pervades corporate life
TM 16-6 Slide 1 of 2
RaidersFinanciers who mount hostile takeovers.
Defenses
A new field - Things the target of a hostile takeover
can do to avoid losing control
Advisors Investment bankers and lawyers instigate
much of the current merger activity
Financing Junk bonds developed by the now defunct investment bank of Drexel
Burnham Lambert were a source of financing for takeovers
TM 16-6 Slide 2 of 2
MERGER ANALYSIS AND THEMERGER ANALYSIS AND THE PRICE PREMIUM PRICE PREMIUM
What should an acquiring company be willing to pay
for a particular target?
A capital budgeting exercise based on a projection of cash flows the target will generate over the indefinite future
The Appropriate Discount Rate
The target's equity rate
The Value to the Acquirer and the per Share PriceNPV divided by shares of target's stock outstanding
TM 16-8 Slide 1 of 2
The Price PremiumPrice offered to the target's shareholders must always be higher than the
stock's market price to induce a majority to sell.
Excess over market is the premium.
A major issue is choosing a premium that's high enough to attract a majority of shares but no higher.
The Effect on Market PriceSince a premium is virtually always paid, market price increases rapidly
whenever a firm is in play.
Insider TradingIt is illegal to make a short term profit on price changes
that result from the merger.
TM 16-8 Slide 2 of 2
The Aldebron Motor Company is considering acquiring Arcturus Gear Works, Inc.
ARCTURUS GEAR WORKS, INC. ($M)
0 1 2 3
Revenue $1,500 $1,650 $1,815 $2,000
EAT 95 106 117 130
•Synergies will net $10M after tax per year
•Cash equal to depreciation will have to be reinvested to keep assets current
•60% of remaining cash from operations will be invested in growth opportunities
•Assume a 6% annual growth after the third year
•kRF = 8% kM = 13% bx = 1.8
•20 million shares outstanding, P0 = $19
How much is Arcturus worth?
TM 16-9 Slide 1 of 2
Solution: kX = kRF + (kM – kRF)bX
= 8% + (13% – 8%)1.8
= 17%
ARCTURUS GEAR WORKS, INC.
ESTIMATED CASH FLOWS ($M)
0 1 2 3
Revenue $1,500 $1,650 $1,815 $2,000
EAT (unmerged) 95 106 117 130
Synergies 10 10 10 10
EAT/Cash Flow
(merged) $ 105 $ 116 $ 127 $ 140
Reinvested
(60%) 63 70 76 84
Cash Flow
to Aldebron $ 42 $ 46 $ 51 $ 56
TM 16-9 Slide 2 of 2
Summarize later cash flows in a Terminal Value assumption.
Constant Growth (Gordon) Stock Valuation Model
P0 = D0(1+g) / (k – g)
Rewrite as: TV = C3(1+g) / (k – g)
= $56M (1.06) / (.17 – .06) = $540M
1 2 3
Oper Cash Flow $ 46 $ 51 $ 56
Terminal Value $540
Total $ 46 $ 51 $596
Then:
PV = $112M + $337M
PV = $449M
$449M / 20 million shares = $22.45 per share
Premium over market price:
($22.45 – $19.00) / $19.00 = 18.2%
332 (1.17)
$540M
(1.17)
$56M
(1.17)
$51M
1.17
$46M PV
TM 16-10 Slide 1 of 2
THE QUALITY OF THE ESTIMATETHE QUALITY OF THE ESTIMATE
Valuation process can be arbitrary, especially with respect to the terminal value calculation
It represents the time about which we know the least (the distant future), yet the TV accounts for two thirds of value
Suppose long term growth rate = 9%
Then TV is $763M with a present value of $476M
Total value is then
PV = $116M + $476M = $592M,
and maximum acquisition price is
$592M/20M = $29.60,
and premium is
($29.60 - $19.00)/$19.00 = 55.8%
TM 16-10 Slide 2 of 2
The Junk Bond MarketThe Junk Bond Market
In the 1980s, investment bankers helped raise debt money for acquisitions through low quality, high yield "junk bonds."
The Capital Structure Argument
To Justify High Premiums
More leverage can sometimes increase value.
TM 16-11
DEFENSIVE TACTICSDEFENSIVE TACTICSThings managements of target companies can do to prevent
or stop acquisitions
TACTICS AFTER A TAKEOVER IS UNDERWAYTACTICS AFTER A TAKEOVER IS UNDERWAYChallenge the Price
Price is too low because stock is temporarily undervalued
Raise Antitrust Issues
Approach Justice Department claiming merger is anticompetitive
Issue Debt and Repurchase Shares
Drives up stock price and weakens capital structure
Seek A White Knight Find an alternative acquirer with a better reputation
Greenmail Buy out potential acquirer above market price
TM 16-12 Slide 1 of 2
TACTICS IN ANTICIPATION OF A TAKEOVERTACTICS IN ANTICIPATION OF A TAKEOVERWritten Into Corporate Bylaws
Staggered Election of Directors
Delays acquirer's ability to take control
Require Approval by a Supermajority of Stockholders
Makes approval more difficult
Poison Pills
Make it prohibitively expensive for outsiders to take control Acquirer commits financial suicide by swallowing target along with its poison pill
Golden Parachutes
Exorbitant severance packages for senior management if fired after a takeover
Accelerated Debt Principal amounts due if taken over.
Share Rights Plans (SRP's) Current shareholders given right to buy shares in merged company at reduced price
TM 16-12 Slide 2 of 2
LEVERAGED BUYOUTS (LBOs)LEVERAGED BUYOUTS (LBOs)A publicly held company's stock purchased by investors
in a negotiated deal or a tender offer
Company becomes privately held
Investors are frequently the firm's management
Leverage is usually asset based
Very risky because of high debt and interest burden
LBO is a takeover but not a merger
PROXY FIGHTSPROXY FIGHTSProxy - a legal document giving one person the right to act
for another on a certain issue
Directors usually elected by proxy
Competing groups fight for seats on the board by soliciting proxies from stockholders
TM 16-13
DIVESTITURESDIVESTITURESReasons for Divestitures
CashStrategic Fit
Poor Performance
METHODS OF DIVESTING OPERATIONSMETHODS OF DIVESTING OPERATIONS
Sale for Cash and/or Securities
A friendly acquisition or an LBO
Spin-off Two parts of a firm are strategically incompatible,
but there's no desire to get rid of either
Set up operation as a separate corporation Give a share of new firm for every share of old firm held
Liquidation
Close business and sell off assetsUsually a last resort
TM 16-14
BANKRUPTCY AND THE RE-BANKRUPTCY AND THE RE-ORGANIZATION OF FAILED BUSINESSESORGANIZATION OF FAILED BUSINESSES
Economic failure - business is unable to provide an adequate return to its owners
An issue between a business and its owners
Commercial failure - a business can't pay its debts
Such a firm is insolventAn issue between a business and its creditors
A commercial failure faces bankruptcy
A commercial failure is usually economic failure as well
An economic failure may not involve commercial failure
TM 16-15 Slide 1 of 2
BANKRUPTCYBANKRUPTCYA legal proceeding which protects a failing firm from its creditors so it can stay in
business until a solution is worked out
The solution generally involves either:
A reorganization under the supervision and protection of the court, which involves a restructuring of debt and a plan to pay everyone off as fairly as
possible,
Or
A liquidation of the firm's assets to pay creditors.
A firm "comes out of bankruptcy" after a reorganization in which its creditors agree to a settlement of their claims.
Voluntary or Involuntary
The court may appoint a trustee to oversee operations
during bankruptcy proceedings.
TM 16-15 Slide 2 of 2
BANKRUPTCY PROCEDURESBANKRUPTCY PROCEDURES
ReorganizationBusiness plan under which firm can continue to operate and pay off its debts
Judged on fairness and feasibility
Fairness implies the priorities in the bankruptcy laws
A reorganization plan must be approved by bankruptcy court, creditors, and stockholders
Debt RestructuringThe heart of most reorganization plans is a restructuring of the
firm's debt to make payments easier.
Extension - More time to repay
Composition - Creditors settle for less
Conversion of debt into equity
LiquidationValue of assets is more than the operating value of firm
Sell off assets using the proceeds to pay off as many debts as possible
Can be administratively complex
TM 16-16 Slide 1 of 2
Distribution PrioritiesDistribution Priorities
All claimants are not equal in the eyes of the law
Secured Debt paid from sale of related assets
Priorities for Payment of General Claims 1. Administrative expenses of the bankruptcy proceedings.
2. Certain business expenses incurred after the bankruptcy petition is filed.
3. Unpaid wages up to $2,000 per employee.
4. Certain unpaid contributions to employee benefit plans.
5. Certain customer deposits up to $900 per individual.
6. Unpaid taxes.
7. Unsecured creditors.
8. Preferred stockholders.
9. Common stockholders.
TM 16-16 Slide 2 of 2