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Chapter 26 - Leasing

What is a Lease?
Why Lease?
Operating versus Financial Leases
Valuing Leases
When Do Leases Pay?

The Basics
A lease is a contractual agreement between a
lessee and lessor.
The agreement establishes that the lessee
has the right to use an asset and in return
must make periodic payments to the lessor.
The lessor is either the assets manufacturer
or an independent leasing company.
2

Buying versus Leasing


Buy

Lease

Firm U buys asset and uses asset;


financed by debt and equity.

Lessor buys asset, Firm U leases it.

Manufacturer
of asset

Manufacturer
of asset

Firm U
1.
2.

Lessor

Uses asset
Owns asset

Equity
shareholders

Creditors

1.

Owns asset

2. Does not use asset

Equity
shareholders

Lessee (Firm U)
1.

Uses asset

2. Does not own asset

Creditors
3

Reasons for Leasing


Good Reasons
Taxes may be reduced by leasing.
The lease contract may reduce certain types of
uncertainty.
Transactions costs can be higher for buying an
asset and financing it with debt or equity than for
leasing the asset.

Bad Reasons
Leasing and accounting income
100% financing
4

Operating Leases
Usually not fully amortized. This means that the
payments required under the terms of the lease
are not enough to recover the full cost of the
asset for the lessor.
Usually require the lessor to maintain and insure
the asset.
Lessee enjoys a cancellation option. This option
gives the lessee the right to cancel the lease
contract before the expiration date.
5

Financial (Capital) Leases


The exact opposite of an operating lease.
1. Do not provide for maintenance or service
by the lessor.
2. Financial leases are fully amortized.
3. The lessee usually has a right to renew the
lease at expiry.
4. Generally, financial leases cannot be
cancelled, i.e., the lessee must make all
payments or face the risk of bankruptcy.
6

Sale and Lease-Back


A particular type of financial lease.
Occurs when a company sells an asset it
already owns to another firm and immediately
leases it from them.
Two sets of cash flows occur:
The lessee receives cash today from the sale.
The lessee agrees to make periodic lease
payments, thereby retaining the use of the
asset.
7

Leveraged Leases
A leveraged lease is another type of financial lease.
A three-sided arrangement between the lessee, the
lessor, and lenders.
The lessor owns the asset and for a fee allows
the lessee to use the asset.
The lessor borrows to partially finance the asset.
The lenders typically use a nonrecourse loan.
This means that the lessor is not obligated to the
lender in case of a default by the lessee.
8

Leveraged Leases
Lessor buys asset, Firm U leases it.

Manufacturer
of asset

Lessor
1.

Owns asset

2. Does not use asset

Equity
shareholders

Lessor borrows from lender to


partially finance purchase
The lenders typically use a
nonrecourse loan. This
Lessee (Firm U) means that the lessor is not
1.
Uses asset
obligated to the lender in
2. Does not own asset case of a default by the
lessee
In the event of a default by
the lessor, the lender has a
first lien on the asset. Also
Creditors
the lease payments are
made directly to the lender
9
after a default.

Accounting and Leasing


In the old days, leases led to off-balance-sheet
financing.
In 1979, the Canadian Institute of Chartered
Accountants implemented new rules for lease
accounting according to which financial leases
must be capitalized.
Capital leases appear on the balance sheetthe
present value of the lease payments appears on
both sides.
10

Accounting and Leasing


Balance Sheet
Truck is purchased with debt
Truck
$100,000
Land
$100,000
Total Assets
$200,000

Debt
Equity
Total Debt & Equity

$100,000
$100,000
$200,000

Operating Lease
Truck
Land
Total Assets

$100,000
$100,000

Debt
Equity
Total Debt & Equity

$100,000
$100,000

Capital Lease
Assets leased
Land
Total Assets

$100,000
$100,000
$200,000

Obligations under capital lease


Equity
Total Debt & Equity

$100,000
$100,000
$200,000

11

Financial (Capital) Lease


A lease must be capitalized if any one of the following is
met:
The present value of the lease payments is at least
90-percent of the fair market value of the asset at the
start of the lease.
The lease transfers ownership of the property to the
lessee by the end of the term of the lease.
The lease term is 75-percent or more of the estimated
economic life of the asset.
The lessee can buy the asset at a bargain price at
expiry.
12

Taxes and Leases

The principal benefit of long-term leasing is tax


reduction.
Leasing allows the transfer of tax benefits from those
who need equipment but cannot take full advantage of
the tax benefits of ownership to a party who can.
If the CRA (Canada Revenue Agency) detects one or
more of the following, the lease will be disallowed.
1. The lessee automatically acquires title to the
property after payment of a specified amount in the
form of rentals.
2. The lessee is required to buy the property from the
lessor.
3. The lessee has the right during the lease to acquire
the property at a price less than fair market value.
13

Operating Lease
Example : Acme Limo has a client who will sign a lease for 7 years,
with lease payments due at the start of each year. The following
table shows the NPV of the limo if Acme purchases the new limo
for $75,000 and leases it for 7 years.
0
Initial cost
Maintenance, insurance, selling,
and administrative costs
Tax shield on costs
Depreciation tax shield
Total
NPV @ 7% = - $98.15
Break even rent(level)
Tax
Break even rent after-tax
NPV @ 7% = - $98.15

Year
3

-75
-12

-12

-12

-12

-12

-12

-12

4.2
0
-82.8

4.2
5.25
-2.55

4.2
8.4
0.6

4.2
5.04
-2.76

4.2
3.02
-4.78

4.2
3.02
-4.78

4.2
1.51
-6.29

26.18
-9.16
17.02

26.18
-9.16
17.02

26.18
-9.16
17.02

26.18
-9.16
17.02

26.18
-9.16
17.02

26.18
-9.16
17.02

26.18
-9.16
17.02
14

Financial Leases
Example : Greymare Bus Lines is considering a lease. Your
operating manager wants to buy a new bus for $100,000. The bus
has an 8 year life. The Bus Saleswoman says she will lease
Greymare the bus for 8 years at $16,900 per year, but Greymare
assumes all operating and maintenance costs.
Should Greymare Buy or Lease the bus?

Cash flow consequences of the lease contract to Greymare


0
Cost of new bus
Lost Depr tax shield
Lease payment
Tax shield of lease
Cash flow of lease

(7.00)
(16.90)
5.92
(17.98)

(11.20)
(16.90)
5.92
(22.18)

Year
3

(4.03)
(16.90)
5.92
(15.01)

(4.03)
(16.90)
5.92
(15.01)

(2.02)
(16.90)
5.92
(13.00)

(16.90)
5.92
(10.98)

100.00
(16.90)
5.92
89.02

(6.72)
(16.90)
5.92
(17.70)

15

Financial Leases
Example - cont
Greymare Bus Lines can borrow at 10%, thus the value of the lease should be discounted
at 6.5% or .10 x (1-.35). The result will tell us if Greymare should lease or buy the bus.

0
Cost of new bus
Lost Depr tax shield
Lease payment
Tax shield of lease
Cash flow of lease

(7.00)
(16.90)
5.92
(17.98)

(11.20)
(16.90)
5.92
(22.18)

Year
3

(4.03)
(16.90)
5.92
(15.01)

(4.03)
(16.90)
5.92
(15.01)

(2.02)
(16.90)
5.92
(13.00)

(16.90)
5.92
(10.98)

100.00
(16.90)
5.92
89.02

(6.72)
(16.90)
5.92
(17.70)

16

Financial Leases
Example A loan with same cash flows as lease

0
Amount borrowed
at year end
Interest paid @ 10%
Tax shield @ 35%
Interest paid after tax
Principal repaid
Net cash flow of
equivalent loan

Year
3

89.72

77.56
-8.97
3.14
-5.83
-12.15

60.42
-7.76
2.71
-5.04
-17.14

46.64
-6.04
2.11
-3.93
-13.78

34.66
-4.66
1.63
-3.03
-11.99

21.89
-3.47
1.21
-2.25
-12.76

10.31
-2.19
0.77
-1.42
-11.58

0.00
-1.03
0.36
-0.67
-10.31

89.72

-17.99

-22.19

-17.71

-15.02

-15.02

-13.00

-10.98

17

Financial Leases
Example - cont
The Greymare Bus Lines lease cash flows can also be treated as a
favorable financing alternative and valued using APV.

APV NPV of project NPV of lease


APV 3,000 700 $3,700
18

Financial Lease Benefits


Value of lease to lessor =

17.99
17.99 22
22.19
.19 17
17.71
.71 15
15.02
.02 13
13 10
10.98
.98
-89.02

-89.02 1.065
22
33
44
55
66

1.065
1.065
1.065
1.065
1.065
1.065 1.065
1.065 1.065 1.065 1.065
.70
.70 or
or $$700
700
Value of lease =
77

16
16.9
.9
100

100 (1.10)t t
t
t 00 (1.10)
100
10099
99.18
.18
.82
.82 or
or $$820
820
19

Example
Consider a firm, ClumZee Movers, that wishes to acquire
a delivery truck.
The truck is expected to reduce costs by $4,500 per year.
The truck costs $25,000 and has a useful life of five
years.
If the firm buys the truck, they will depreciate it straightline to zero.
They can lease it for five years from Tiger Leasing with an
annual lease payment of $6,250 paid at the end of the
year.
The firms borrowing rate is 7.70% and its marginal tax
rate is 34%.
20

Example Q1: continue


Suppose ClumZee movers is actually in the 25%
tax bracket and Tiger Leasing is in the 35% tax
bracket and a before tax borrowing rate of 7%. If
Tiger reduces the lease payment to $6,200, can
both firms have a positive NPV?

21

Summary

There are three ways to value a lease.


1. Use the real-world convention of discounting the
incremental after-tax cash flows at the lessors aftertax rate on secured debt.
2. Calculate the increase in debt capacity by
discounting the difference between the cash flows of
the purchase and the cash flows of the lease by the
after-tax interest rate. The increase in debt capacity
from a purchase is compared to the extra outflow at
year 0 from a purchase.
3. Use APV (APV = All-Equity Value + Financing NPV)
They all yield the same answer.
22

Practice Question 1
Calculate NPV for lessee and lessor
Cost of machine = $85,000
CCA rate = 30%
Operating costs = $ 10,000 per year maintenance
expense
Lease payments = $53,600 per year
Lessor provides maintenance as a part of the lease
contract.
Cost of debt (rD) = 15%
After-tax cost of debt, rD(1 TC) = 9%
TC = 40% (for both the lessee and the lessor)
23

Practice Question 2
A noncancellable lease contract lasts for 4 years with
payments of $37,000 at the end of each year. The lessee
pays maintenance expense under either the lease or buy
alternatives. If purchased, the $100,000 asset has a
CCA rate of 30%. The beforetax cost of debt is 10% and
the corporate tax rate is 40%. What is the value of the
lease to the lessee?
If the lease in problem were cancelable, how much must
the cancellation option be worth to make the lease
alternative better than the purchase alternative?

24

Chapter 26 - Hedging

Why Manage Risk?


Insurance
Forward and Futures Contracts
SWAPS
How to Set Up A Hedge

25

Risk Reduction
Why risk reduction does not add value
1. Hedging is a zero sum game
2. Investors do-it-yourself alternative

26

Risk Reduction
Risks to a business
1. Cash shortfalls
2. Financial distress
3. Agency costs

27

Insurance
Most businesses face the possibility of a
hazard that can bankrupt the company in
an instant.
Insurance companies have some
advantages in bearing risk.
The cost and risk of a loss due to a
hazard, however, can be shared by others
who share the same risk.
28

Insurance
Example
An offshore oil platform is valued at
$1 billion. Expert meteorologist
reports indicate that a 1 in 10,000
chance exists that the platform may
be destroyed by a storm over the
course of the next year.

How can the cost of this hazard


be shared?
29

Insurance
What do you expect the premium of an
insurance contract on this oil platform to
be?
Think of the following:
Administrative costs
Adverse selection
Moral hazard

30

Insurance Catastrophe Risk


The loss of an oil platform by a storm may be 1 in
10,000. The risk, however, is larger for an
insurance company since all the platforms in the
same area may be insured, thus if a storm
damages one it may damage all in the same area.
The result is a much larger risk to the insurer
Catastrophe Bonds - (CAT Bonds) Allow insurers
to transfer their risk to bond holders by selling
bonds whose cash flow payments depend on the
level of insurable losses NOT occurring.
31

Insurance What to Insure


Two Possibilities:
Most Common - buy insurance only for large
potential losses.
BP case buy insurance for small risks only.

32

Hedging with Forwards and Futures


Business has risk
Business Risk - variable costs
Financial Risk - Interest rate changes
Goal - Eliminate risk
HOW?
Hedging & Forward Contracts
33

Hedging with Forwards and Futures


Ex - Kellogg produces cereal. A major component and cost
factor is sugar.
Forecasted income & sales volume is set by using a fixed
selling price.
Changes in cost can impact these forecasts.
To fix your sugar costs, you would ideally like to purchase
all your sugar today, since you like todays price, and
made your forecasts based on it. But, you can not.
You can, however, sign a contract to purchase sugar at
various points in the future for a price negotiated today.
This contract is called a Futures Contract.
This technique of managing your sugar costs is called
Hedging.
34

Hedging with Forwards and Futures


1- Spot Contract - A contract for immediate sale &
delivery of an asset.
2- Forward Contract - A contract between two people for
the delivery of an asset at a negotiated price on a set
date in the future.
3- Futures Contract - A contract similar to a forward
contract, except there is an intermediary that creates a
standardized contract. Thus, the two parties do not
have to negotiate the terms of the contract.
The intermediary is the Commodity Clearing Corp
(CCC). The CCC guarantees all trades & provides a
secondary market for the speculation of Futures.
35

Types of Futures
Commodity Futures
-Sugar
-Corn
-OJ
-Wheat
-Soy beans -Pork bellies
Financial Futures
-Tbills
-Yen
-GNMA
-Stocks
-Eurodollars
Index Futures
-S&P 500
-Value Line Index
-Vanguard Index

36

Futures Contract Concepts

Not an actual sale


Always a winner & a loser (unlike stocks)
Settled every day. (Marked to Market)
Hedge - used to eliminate risk by locking in
prices
Speculation - used to gamble
Margin - not a sale - post partial amount

Futures and Spot Contracts


The basic relationship between futures prices and spot
prices for equity securities.

tt
F

S
(
1

y
)
Ft t S00(1 rf f y )
futures price
priceon
oncontract
contract of
of ttlength
length
FFt t futures

Today'ssspot
spot price
price
SS00 Today'
Riskfree
free rate
rate
rrf f Risk
Dividend yield
yield
yy Dividend

38

Futures and Spot Contracts


Example
The DAX spot price is 3,970.22. The interest rate is 3.5% and the
dividend yield on the DAX index is 2.0%. What is the expected price
of the 6 month DAX futures contract?

39

Futures and Spot Contracts


The basic relationship between futures prices and spot
prices for commodities.
sccy
cy))t t
FFt t SS00(1(1rrf f sc
futures price
priceon
oncontract
contractofof ttlength
length
FFt futures
t

Today' ssspot
spot price
price
SS00 Today'
Risk free
freerate
rate
rrf Risk
f

cyConvenienc
Convenienceeyield
yield
cy
scExperss
Experssstorage
storagecost
cost
sc

ncycy
cysc
scNet
NetConvenienc
Convenienceeyield
yield
ncy
40

Futures and Spot Contracts


Example
In July the spot price for coffee was $.7310 per pound. The interest
rate was 1.5% per (1.3% per 10 months). The 10 month futures
price was $0.8285? What is the net convenience yield?

41

Homemade Forward Rate Contracts


Suppose you know that you will receive $100m in
one year. You are worried that interest rates might
go down?
You can enter a FRA (forward rate agreement)
with a bank.

42

Swaps
Friendly Bancorp invested $50 M in debt carrying 8% fixed interest
rate and maturing in 5 years. Annual payments are $4m. However,
friendly Bancorp is predicting increases in interest rates, so it wants
a floating rate. Here is what it can do.

43

SWAPS
Birth 1981
Definition - An agreement between two
firms, in which each firm agrees to
exchange the interest rate characteristics
of two different financial instruments of
identical principal

How to Set a Hedge?


In practice, the commodity that a firm sells
is likely not identical to the one traded on
the exchange.
Delta measures the sensitivity of A to
changes in the value of B.
Duration is also used in setting hedge. (if
two assets have the exact duration, they
will be equally affected by change in
interest rates).
45

Ex - Settlement & Speculate


Example - You are speculating in Hog Futures. You think
that the Spot Price of hogs will rise in the future. Thus, you
go Long on 10 Hog Futures (1K is of $30,000 pound). If
the price drops .17 cents per pound ($.0017) what is total
change in your position?

Commodity Hedge
In June, farmer John Smith expects to harvest
10,000 bushels of corn during the month of
August. In June, the September corn futures are
selling for $2.94 per bushel (1K = 5,000
bushels). Farmer Smith wishes to lock in this
price (hedge).
Show the transactions if the Sept spot price
drops to $2.80.
Show the transactions if the Sept spot price
rises to $3.05.

Commodity Speculation
You have lived in NYC your whole life and are
independently wealthy. You think you know everything
there is to know about pork bellies (uncured bacon)
because your butler fixes it for you every morning.
Because you have decided to go on a diet, you think the
price will drop over the next few months. On the CME,
each PB K is 38,000 lbs. Today, you decide to short three
May Ks @ 44.00 cents per lbs. In Feb, the price rises to
48.5 cents and you decide to close your position. What is
your gain/loss?
If In Feb the price drops to 40.0 cents, what is your
gain/loss?

Margin
The amount (percentage) of a Futures
Contract Value that must be on deposit with a
broker.
Since a Futures Contract is not an actual
sale, you need only pay a fraction of the
asset value to open a position = margin.
CME margin requirements are 15%
Thus, you can control $100,000 of assets
with only $15,000.

Chapter 32 - Mergers

Sensible Motives for Mergers


Some Dubious Reasons for Mergers
Estimating Merger Gains and Costs
The Mechanics of a Merger
Takeover Battles and Tactics
Mergers and the Economy

50

The Basic Forms of Acquisitions


There are three basic legal procedures that one firm can
use to acquire another firm:
Merger (or consolidation)
Acquisition of Stock
Acquisition of Assets
Although these forms are different from a legal
standpoint, the financial press frequently does not
distinguish among them.
In our discussions, we use the term merger regardless of
the actual form of the acquisition.
51

Merger or Consolidation
A merger refers to the absorption of one firm by another.
The acquiring firm retains its name and identity, and
acquires all the assets and liabilities of the acquired firm.
After the merger, the acquired firm ceases to exist as a
separate entity.
A consolidation is the same as a merger except that an
entirely new firm is created. In a consolidation, both the
acquiring firm and the acquired firm terminate their
previous legal existence.

52

Acquisition of Stock
A firm can acquire another firm by purchasing target
firms voting stock in exchange for cash, shares of stock,
or other securities.
A tender offer is a public offer to buy shares made by
one firm directly to the shareholders of another firm.
If the shareholders choose to accept the offer, they
tender their shares by exchanging them for cash or
securities.
A tender offer is frequently contingent on the bidders
obtaining some percentage of the total voting shares.
If not enough shares are tendered, then the offer
might be withdrawn or reformulated.
53

Acquisition of Assets
One firm can acquire another by buying all of its assets.
A formal vote of the shareholders of the selling firm is
required.
Advantage of this approach: it avoids the potential
problem of having minority shareholders that may occur
in an acquisition of stock.
Disadvantage of this approach: it involves a costly legal
process of transferring title.

54

A Classification Scheme
Financial analysts typically classify acquisitions
into three types:
Horizontal acquisition: when the acquirer and
the target are in the same industry.
Vertical acquisition: when the acquirer and the
target are at different stages of the production
process; example: an airline company acquiring
a travel agency.
Conglomerate acquisition: the acquirer and the
target are not related to each other.
55

Recent Mergers in Canada


Date

Amount ($M) Target

Acquiring

June 2002

6,320

Bell Canada

BCE Inc.

Jan 2002

8,000

Canada Trust

TD Bank

Jan 2002

9,203

PanCanadian Energy

Alberta Energy

56

Sensible Reasons for Mergers


Economies of Scale
A larger firm may be able to reduce its per unit cost by
using excess capacity or spreading fixed costs across
more units.

Reduces costs

57

Sensible Reasons for Mergers


Combining Complementary Resources
Merging may results in each firm filling in the
missing pieces of their firm with pieces from
the other firm.
Firm A

Firm B
58

Sensible Reasons for Mergers


Mergers as a Use for Surplus Funds
If your firm is in a mature industry with few, if
any, positive NPV projects available, acquisition
may be the best use of your funds.

59

Source of Synergy from Acquisitions


Revenue Enhancement
Cost Reduction
Including replacement of ineffective managers.
Tax Gains
Net Operating Losses
Unused Debt Capacity
Incremental new investment required in working capital
and fixed assets

60

Dubious Reasons for Mergers


Diversification
Investors should not pay a premium for
diversification since they can do it
themselves.

61

Dubious Reasons for Mergers


The Bootstrap Game
Acquiring Firm has high P/E ratio
Selling firm has low P/E ratio (due to low
number of shares)
After merger, acquiring firm has short term
EPS rise
Long term, acquirer will have slower than
normal EPS growth due to share dilution.
62

Dubious Reasons for Mergers


The Bootstrap Game
World Enterprises
(before merger)
EPS
Price per share
P/E Ratio
Number of shares
Total earnings
Total market value
Current earnings
per dollar invested
in stock

$
$

$
$

2.00
40.00
20
100,000
200,000
4,000,000

World Enterprises
(after buying Muck
and Slurry)
Muck and Slurry
$
2.00 $
2.67
$
20.00 $
40.00
10
15
100,000
150,000
$
200,000 $
400,000
$
2,000,000 $
6,000,000

0.05 $

0.10 $

0.067
63

Dubious Reasons for Mergers


Earnings per
dollar invested
(log scale)

World Enterprises (after merger)


World Enterprises (before merger)
Muck & Slurry

.10
.067
.05
Now

Time
64

Lower Financing Costs


The combined company can borrow at lower
interest rates than either firm could separately.

That is what we would expect in well


functioning markets, but it does not increase
value for shareholders

65

Estimating Merger Gains


Questions
Is there an overall economic gain to the
merger?
Do the terms of the merger make the
company and its shareholders better off?

PV(AB) > PV(A) + PV(B)


66

Estimating Merger Gains

Gain PVAB ( PVA PVB ) PVAB


Cost Cash paid PVB
NPV ( A) gain cos t
PVAB (cash PVB )

67

Estimating Merger Gains


Example Two firms merge creating $25 million
in synergies. A pays B a sum of $65 million.

PVA $200
PVB $50
Gain PVAB $25
68

Estimating Merger Gains


Look at Incremental Economic Gain
Economic Gain = PV(increased earnings)

New cash flows from synergies


discount rate

69

Cash versus Common Stock Acquistion


Estimating Cost with Stock
Taxes
Cash acquisitions usually trigger taxes.
Stock acquisitions are usually tax-free.

Sharing Gains from the Merger


With a cash transaction, the target firm
shareholders are not entitled to any
downstream synergies.
70

The Tax Forms of Acquisitions


In a taxable acquisition (cash offer), the
shareholders of the target firm are
considered to have sold their shares, and
they will have capital gain/losses that will
be taxed.
In a tax-free acquisition, since the
acquisition is considered an exchange
instead of a sale, no capital gain or loss
occurs.
71

Tax Consequences of a Merger


In 1995 Seacorp (fully owned by Captain B) purchases a boat for $300,000.
In 2005, the boats book value is $150,000, but its market value is
$280,000. In 2005 Seacorp also holds $50,000 of marketable securities so
its market value is $330,000.
Suppose Baycorp acquires Seacorp for $330,000.

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Defensive Tactics
Target-firm managers frequently resist takeover
attempts.
It can start with press releases and mailings to
shareholders that present managements
viewpoint and escalate to legal action.
Management resistance may represent the pursuit
of self interest at the expense of shareholders.
Resistance may benefit shareholders in the end if
it results in a higher offer premium from the
bidding firm or another bidder.
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Takeover Defenses Terminology


White Knight - Friendly potential acquirer sought by the target
companys management. The white knight promises to maintain
the jobs of existing management and helps to threaten an
unwelcome suitor.
Shark Repellent - Amendments to a company charter made to
forestall takeover attempts.
Poison Pill - Measure taken by a target firm to avoid acquisition;
for example, the right for existing shareholders to buy additional
shares at an attractive price if a bidder acquires a large holding.
Golden parachutes - are compensation to outgoing target firm
management.
Crown jewels - are the major assets of the target. If the target
firm management is desperate enough, they will sell off the
crown jewels.
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The Control Block and Anti-Takeover


Legislation
If one individual or group owns 51-percent of a
companys stock, this control block makes a hostile
takeover virtually impossible.
Control blocks are typical in Canada, although they are
the exception in the United States.
In the US, however, anti-takeover legislation has
received wide attention.

75

Exclusionary Offers and Nonvoting Stock


The target firm makes a tender offer for its own
stock while excluding targeted shareholders.
An example:
In 1986, the Canadian Tire Dealers Association
offered to buy 49% of the companys voting
shares from the founding Billes family.
The offer was voided by the OSC, since it was
viewed as an illegal form of discrimination
against one group of shareholders.
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Going Private and LBOs


If the existing management buys the firm from
the shareholders and takes it private.
If it is financed with a lot of debt, it is a
leveraged buyout (LBO).
The extra debt provides a tax deduction for
the new owners, while at the same time
turning the previous managers into owners.
This reduces the agency costs of equity as
managers are now also owners.
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Abnormal Returns in Successful Canadian


Mergers

Mergers 1964--83
Going private
Transactions 1977--89
- Minority buyouts
- Non-controlling bidder

Target

Bidder

9%

3%

25%
27%
24%

NA
NA
NA

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Comparison of U.S. vs. Canadian Mergers


The evidence both in U.S. and Canada strongly
suggests that shareholders of successful target firms
achieve substantial gains from takeovers.
Shareholders of bidding firms earn significantly less from
takeovers. The balance is more even for Canadian
mergers than for U.S. ones.
One possible reason:
There is less competition among bidders in Canada.

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Divestitures
The basic idea is to increase corporate focus.
Divestiture can take three forms:
Sale of assets: usually for cash
Spinoff: parent company distributes shares of a
subsidiary to shareholders. Shareholders wind up
owning shares in two firms. Sometimes this is done
with a public IPO.
Issuance if tracking stock: a class of common stock
whose value is connected to the performance of a
particular segment of the parent company.
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Summary and Conclusions


The three legal forms of acquisition are
1. Merger and consolidation
2. Acquisition of stock
3. Acquisition of assets

M&A requires an understanding of


complicated tax and accounting rules.
The synergy from a merger is the value of
the combined firm less the value of the two
firms as separate entities.
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Summary and Conclusions


The possible synergies of an acquisition
come from the following:

Revenue enhancement
Cost reduction
Lower taxes
Lower cost of capital

The reduction in risk may actually help


existing bondholders at the expense of
shareholders.
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Practice Q1
Suppose Todd Trucking Company's stock is trading for $50 a share
while Hamilton Company's stock goes for $25 a share. The EPS of
Todd is $1 while the EPS of Hamilton is $2.50. Neither company has
debt in its current capital structure. Both companies have one million
shares of stock outstanding.
a. If Todd can acquire Hamilton for stock in an exchange based on
market value, what should be the postmerger EPS?
b. Suppose Todd pays a premium of 20% in excess of Hamilton's
current market value. How many shares of Todd must be given to
Hamilton's shareholders for each of their shares?
c. Based on your results in b, what will Todd's EPS be after it acquires
Hamilton?
d. If Hamilton were to acquire Todd by offering a 20% premium in
excess of Todd's current market price, how many shares of stock
would Hamilton have to offer, and what would be the effect on
Hamilton's EPS?
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Practice Q2
Susie's Pizza is analyzing the possible acquisition of Janet's Electric.
The projected cash flows to debt and equity expected from the
merger are as follows:
Year(s)
CF
1
150,000
2
170,000
3
200,000
4
200,000
5 on
6% growth per year
The current market price of Janet's debt is $800,000, the risk free rate
is 8%, the required return on the market is 12%, and the beta of the
firm being acquired is 1.5.
a. Determine the maximum price (NPV) Susie can afford to pay.
b. If Janet's current equity value is $1,100,000 and she demands a
30% premium, will the merger take place?
84