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Corporate Restructuring:
Combinations and Divestitures
CHAPTER ORIENTATION
Corporate restructuring comes through combining assets (mergers and acquisitions) and
uncombining assets (divestitures). This chapter examines how mergers and acquisitions can
create shareholder wealth and the methods used to value a potential merger candidate. Firms
may also increase shareholder wealth by divesting themselves of some portion of its current
operations. This chapter discusses the different divestiture options available to a firm.
CHAPTER OUTLINE
I.
II.
Internally, through the acquisition of specific assets which are financed by the
retention of earnings and/or external financing, or
B.
There have been five identifiable time periods where the number and amount of
mergers and acquisitions were particularly accentuated.
A.
End of the 19th century and beginning of the 20th century. During this time,
many industries were merged. The resulting firms had enormous economic
power. Example firms include U.S. Steel, American Tobacco, and Standard
Oil.
B.
The decade of the 1920s. This merger wave was closely related to the
creation of oligopolies (industries dominated by a few firms), such as IBM,
General Foods, and Allied Chemical. During this time, the developments in
transportation, communications, and merchandising fostered the growth.
53
C.
III.
Between the 1950s and the 1970s. No longer permitted by the Federal Trade
Commission to acquire firms in their own industry, companies actively began
acquiring companies outside their own industries. The bringing together of
these dissimilar firms into one corporate entity came to be known as the
conglomerate.
1.
2.
D.
E.
The 1990s. During the 90s the financial services and telecommunication
industries went through a period of consolidation resulting in some of the
largest mergers ever recorded.
Why mergers create value. For a merger to create wealth it has to provide
shareholders with something they get for free by merely holding the individual shares
of the two firms. Such benefits might include:
A.
B.
C.
The release of free cash flows to the owners: A merger can create wealth by
allowing the new management to distribute the free cash flow out to the
shareholders, thus allowing them to earn a higher return on these cash flows
than would have been earned by the firm.
D.
54
IV.
E.
Unused debt potential: Assuming the acquired firm has unused debt capacity,
a new management can increase debt financing, and reap the tax benefits
associated with the increased debt.
F.
G.
H.
Increased market power: The merger of two firms can result in an increase in
the market or monopoly power of the two firms. While this can result in
increased wealth, it may also be illegal.
I.
J.
The value of a firm depends not only on its earnings capabilities but also on
the operating and financial characteristics of the acquired firm. To determine
an acceptable price of a corporation, a number of factors must be carefully
evaluated. The final objective of this valuation process is to maximize the
stockholders' wealth (stock price) of both firms.
B.
The book value of a firm's net worth is the depreciated value of the
company's assets less its outstanding liabilities. Book value alone is not
a significant measure of the worth of a company but should be used as
a starting point to be compared with other analyses.
2.
b.
c.
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V.
3.
The "chop shop" approach to valuation attempts to identify multiindustry companies that are undervalued and would be worth more if
separated into their parts. As such, this approach encompasses the
idea of attempting to buy assets below their replacement cost.
4.
Divestitures
A.
B.
A successful divestiture allows the firm's assets to be used more efficiently, and
therefore, be assigned a higher value by the market forces.
C.
2.
3.
4.
5.
56
ANSWERS TO
END-OF-CHAPTER QUESTIONS
23-1.
Clearly, for a merger to create wealth it would have to provide shareholders with
something they could not get for free by merely holding the individual shares of the
two firms. Restating the question: What benefits are there to shareholders from
mergers and acquisitions? Potential benefits would include the following:
a.
b.
c.
d.
57
e.
Some firms simply do not exhaust their debt capacity. If a firm with unused
debt potential is acquired, the new management can then increase debt
financing, and reap the tax benefits associated with the increased debt.
f.
It may be possible to create wealth by combining cash-rich bidders and cashpoor targets, with wealth being created as a result of the positive NPV
projects taken by the merged firm that the cash-poor firm would have passed
up.
g.
h.
The merger of two firms can result in an increase in the market or monopoly
power of the two firms. While this can result in increased wealth, it may
also be illegal.
i.
Firm diversification, when the earnings from the two firms are less than
perfectly positively correlated, can reduce the chance of bankruptcy. Since
costs are associated with bankruptcy, reduction of the chance of bankruptcy
has a very real value to it.
23-2.
The basic function of book value is to establish the costs as set forth by accounting
principles, not to determine value. These costs may bear little relationship to the
value of the organization or to its ability to produce earnings.
23-3.
(2)
(3)
23-4.
23-5.
The NPV, or free cash flow valuation model, is familiar to us, since it merely
involves finding the present value of cash flows, as we did in our studies in capital
budgeting. Using the cash-flow approach to merger valuation requires that we
estimate the incremental net cash flows available to the bidding firm as a result of
the merger or acquisition. The present value of these cash flows will then be
determined, and this will be the maximum amount that should be paid for the target
firm. The initial outlay can then be subtracted out to calculate the net present value
from the merger. While this is very similar to what was proposed when we
examined the capital budgeting problem, there are differences, particularly when
estimating the initial outlay.
58
23-6.
(2)
(3)
(4)
Going private. Going private results when a company whose stock is traded
publicly is purchased by a small group of investors, and the stock is no
longer bought and sold on a public exchange.
(5)
SOLUTIONS TO
END-OF-CHAPTER PROBLEMS
Solutions to Problem Set A
23-1A.
Capital-toSales
1.0
0.9
1.2
Capital-toAssets
0.8
0.8
1.0
59
Segment
Sales
3,500
2,000
6,500
Segment
Sales
1,000
1,500
8,500
Theoretical
Values
$3,500
1,800
7,800
$13,100
Theoretical
Values
$ 800
1,200
8,500
$10,500
Business
Segment
Capital-toOperating Income
Sunglasses distribution
Reading glasses distribution
Technical products
Total Value
Segment
Sales
8.0
10.0
7.0
Theoretical
Values
350
250
1,200
$2,800
2,500
8,400
$13,700
$12,433
Year
Sales
Cost of goods sold
Admin. & selling costs
Depreciation
Earnings before taxes
Taxes (34%)
Earnings after taxes
Depreciation
Capital expenditures
Free cash flows
2004
$200.00
120.00
15.00
10.00
$55.00
18.70
$36.30
10.00
12.00
$34.30
2005
$225.00
135.00
20.00
15.00
$55.00
18.70
$36.30
15.00
13.00
$38.30
2006
$240.00
144.00
27.00
17.00
$52.00
17.68
$34.32
17.00
15.00
$36.32
2007
$250.00
150.00
28.00
20.00
$52.00
17.68
$34.32
20.00
17.00
$37.32
Beyond
2007
$275.00
165.00
30.00
24.00
$56.00
19.04
$36.96
24.00
20.00
$40.96
$28.96
$23.88
$21.34
$156.13*
$260.14
290.00
-$29.86
*=
$40.96
/(1+.15)4=$156.13
.
15
60
23-3A.
Year
Sales
Cost of Goods
Sold
Admin.& selling
Depreciation
Earnings before tax
Taxes (34%)
Earnings after tax.
Depreciation
Capital expenditures
Free Cash Flows
2004
$300.00
180.00
2005
$335.00
201.00
2006
$370.00
222.00
2007
$400.00
240.00
Beyond
2007
$425.00
255.00
40.00
25.00
$55.00
18.70
$36.30
25.00
30.00
$31.30
50.00
30.00
$54.00
18.36
35.64
30.00
37.00
$28.64
58.00
35.00
$55.00
18.70
$36.30
35.00
45.00
$26.30
62.00
38.00
$60.00
20.40
$39.60
38.00
48.00
$29.60
65.00
40.00
$65.00
22.10
$42.90
40.00
50.00
$32.90
$16.35
$113.56*
$195.02
180.00
$21.28
$16.85
$15.02
*=
$32.90
/(1+.16)4=$113.56
.16
61
Capital-toSales
0.75
1.10
1.00
Segment
Sales
$1,500
800
2,000
Theoretical
Values
$1,125
880
2,000
$4,005
Business
Segment
Consumer wholesale
Specialty services
Retirement centers
Total value
Capital-toAssets
0.60
0.90
0.60
Segment
Assets
$750
700
3,000
Theoretical
Values
$450
630
1,800
$2,880
Segment
Income
$100
150
600
Theoretical
Values
$1,000
1,050
3,600
$5,650
$4,178
Business
Capital-toSegment
Operating Income
Consumer wholesale
10.00
Specialty services
7.00
Retirement centers
6.00
Total value
Average theoretical value
23-2B
Capital-toSales
0.8
1.2
1.2
Segment
Sales
2,200
1,000
3,500
Theoretical
Values
1,760
1,200
4,200
$7,160
Capital-toAssets
Segment
Assets
Theoretical
Values
1.0
0.9
1.1
Capital-toOperating Income
Sunglasses distribution
Reading glasses distribution
Technical products
Total Value
Average Theoretical Value
8.0
10.0
12.0
62
600
700
5,000
Segment
Income
200
150
500
600
630
5,500
$6,730
Theoretical
Values
1,600
1,500
6,000
$9,100
$7,663
23-3B.
2004
$260.00
130.00
25.00
15.00
$90.00
30.60
$59.40
15.00
22.00
$52.40
2005
$265.00
132.50
25.00
17.00
$90.50
30.77
$59.73
17.00
18.00
$58.73
2006
$280.00
140.00
25.00
18.00
$97.00
32.98
$64.02
18.00
18.00
$64.02
2007
$290.00
145.00
30.00
23.00
$92.00
31.28
$60.72
23.00
20.00
$63.72
$300.00
150.00
30.00
30.00
$90.00
30.60
$59.40
30.00
22.00
$67.40
$41.82
*=
$67.40
/(1+.185)4=$184.76
.
185
63
$38.47
$32.32 $184.76*
$341.59
300.00
$41.59
2004
$200.00
140.00
30.00
18.00
$12.00
4.08
$7.92
18.00
20.00
$5.92
2005
$220.00
154.00
35.00
20.00
$11.00
3.74
$7.26
20.00
22.00
$5.26
2006
$245.00
171.50
38.00
22.00
$13.50
4.59
$8.91
22.00
25.00
$5.91
$3.65
$3.42
Beyond
2007
2007
$275.00 $300..00
192.50
210.00
40.00
45.00
25.00
30.00
$17.50
$15.00
5.95
5.10
$11.55
$9.90
25.00
30.00
28.00
30.00
$8.55
$9.90
$4.12 $23.87**
$39.99
37.00
$2.99
**=
$9.90
/(1+.20)4=$23.87
.
20
64