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Mergers and Other Forms of Corporate Restructuring Mergers and Other Forms of Corporate Restructuring
Mergers and Other Forms of Corporate Restructuring Mergers and Other Forms of Corporate Restructuring
Mergers and
and Other
Other
Forms
Forms of
of Corporate
Corporate
Restructuring
Restructuring
After studying Chapter 23,
you should be able to:
Explain why a company might decide to engage in corporate
restructuring.
Understand and calculate the impact on earnings and on market value
of companies involved in mergers.
Describe what benefits, if any, accrue to acquiring company
shareholders and to selling company shareholders.
Analyze a proposed merger as a capital budgeting problem.
Describe the merger process from its beginning to its conclusion.
Describe different ways to defend against an unwanted takeover.
Discuss strategic alliances and understand how outsourcing has
contributed to the formation of virtual corporations.
Explain what “divestiture” is and how it may be accomplished.
Understand what "going private" means and what factors may motivate
management to take a company private.
Explain what a leveraged buyout is and what risk it entails.
Mergers and Other Forms of
Corporate Restructuring
Sources of Value
Strategic Acquisitions
Involving Common Stock
Acquisitions and Capital
Budgeting
Closing the Deal
Mergers and Other Forms of
Corporate Restructuring
Company A Company B
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
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Strategic Acquisitions
Involving Common Stock
Example -- Company B has agreed on an offer
of $35 in common stock of Company A.
Surviving Company A
Total earnings $25,000,000
Shares outstanding* 6,093,750
Earnings per share $4.10
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Strategic Acquisitions
Involving Common Stock
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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Strategic Acquisitions
Involving Common Stock
Example -- Company B has agreed on an offer
of $45 in common stock of Company A.
Surviving Company A
Total earnings $25,000,000
Shares outstanding* 6,406,250
Earnings per share $3.90
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Strategic Acquisitions
Involving Common Stock
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 About
Earnings Per Share (EPS)?
Merger decisions
should not be made With the
Acquiring Bought
Company Company
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
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Market Value Impact
Exchange ratio = $40 / $60 = .667
Market price exchange ratio = $60 x .667 / $30 = 1.33
Surviving Company
Total earnings $26,000,000
Shares outstanding* 7,333,333
Earnings per share $3.55
Price / earnings ratio 18
Market price per share $63.90
* New shares from exchange = .666667 x 2,000,000
= 1,333,333
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Market Value Impact
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 and the P/E ratio NOT 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 Evidence
on Mergers
Target firms in a
takeover receive an Selling
16 - 20 21 - 25
Annual after-tax operating
cash flows from acquisition $ 800 $ 200
Net investment --- ---
Cash flow after taxes $ 800 $ 200
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Cash Acquisition and
Capital Budgeting Example
The appropriate discount rate for our example free
cash 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 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 and
Capital Budgeting Issues
Noncash payments and assumption
of liabilities
Estimating cash flows
Cash-flow approach versus earnings
per 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 Deal
Consolidation -- The combination of two or more firms
into an entirely new firm. The old firms cease to exist.
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
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Taxable or
Tax-Free Transaction
At the time of acquisition, for the selling firm
or its shareholders, the transaction is:
Taxable -- if payment is made by cash or with a
debt instrument.
Tax-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.)
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Accounting Treatments
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Tender 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 (next slide) may be made
with the first tier receiving more favorable
terms. This reduces the free-rider problem.
4
Two-Tier Tender Offer
Two-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.
Increases the likelihood of success
in gaining control of the target firm.
Benefits those who tender “early.”
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Defensive Tactics
The company being bid for may use a number of
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 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 Amendments
and Other Devices
Motivation Theories:
Managerial Entrenchment Hypothesis
This theory suggests that barriers are erected to
protect management jobs and that such actions
work to the detriment of shareholders.
Shareholders’ Interest Hypothesis
This theory implies that contests for corporate
control are dysfunctional and take management
time away from profit-making activities.
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Antitakeover Amendments
and Other Devices
Shark Repellent -- Defenses employed by a
company to ward off potential takeover
bidders -- the “sharks.”
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
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Empirical Evidence
on 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 entrenchment
hypothesis because of the negative share
price effect.
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Strategic Alliance
Strategic Alliance -- An agreement between two
or more independent firms to cooperate in order
to achieve some specific commercial objective.
Strategic alliances usually occur between (1) suppliers
and their customers, (2) competitors in the same
business, (3) non-competitors with complementary
strengths.
A joint 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.
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Divestiture
Divestiture -- The divestment of a portion
of the enterprise or the firm as a whole.
Liquidation -- The sale of assets of a firm,
either voluntarily or in bankruptcy.
Sell-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.
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Divestiture
Spin-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-out -- The public sale of stock
in a subsidiary in which the parent usually
retains majority control.
2
Empirical Evidence
on 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.
3
Ownership Restructuring
Going Private -- Making a public
company private through the repurchase
of stock by current management and/or
outside private investors.
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.
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Motivation and Empirical
Evidence for Going Private
Motivations:
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.
5
Motivation and Empirical
Evidence for Going Private
Motivations (Offsetting Arguments):
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 Evidence:
Shareholders realize gains (+12 to +22%)
for cash offers in these transactions.
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Ownership Restructuring
Leverage Buyout (LBO) -- A primarily
debt financed purchase of all the stock
or assets of a company, subsidiary, or
division by an investor group.
The debt is secured by the assets of the enterprise
involved. Thus, this method is generally used with
capital-intensive businesses.
A management buyout is an LBO in which the pre-
buyout management ends up with a substantial
equity position.
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Common Characteristics For
Desirable LBO Candidates
Common characteristics (not all necessary) :
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.
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