Mergers and Other Forms of Corporate Restructuring

Chapter 23
Mergers and Other Forms of

Corporate Restructuring
23.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
OBJECTIVES
1. Explain why a company might decide to engage in corporate
restructuring.
2. Understand and calculate the impact on earnings and on market
value of companies involved in mergers.
3. Describe what benefits, if any, accrue to acquiring company
shareholders and to selling company shareholders.
4. Analyze a proposed merger as a capital budgeting problem.
5. Describe the merger process from its beginning to its conclusion.
6. Describe different ways to defend against an unwanted takeover.
7. Discuss strategic alliances and understand how outsourcing has
contributed to the formation of virtual corporations.
8. Explain what "divestiture" is and how it may be accomplished.
9. Understand what "going private" means and what factors may
motivate management to take a company private.
10. Explain what a leveraged buyout is and what risk it entails.
Outline
Sources of Value
Strategic Acquisitions Involving Common Stock
Acquisitions and Capital Budgeting
Closing the Deal
Takeovers, Tender Offers, and Defenses
Strategic Alliances
Divestiture
Ownership Restructuring
Leveraged Buyouts
More precise meaning:

* re-arrangement of the firms business at corporate level.
But it might refer to any change in a companys:
1. Ownership,
2. Capital structure,
3. Operations,
that is outside its ordinary course of business.
So where is the value coming

from (why restructure)?
Why Engage in
Corporate Restructuring?
Sales enhancement and operating economies

Improved management
Information effect
Wealth transfers
Tax reasons
Leverage gains
Hubris hypothesis
Managements personal agenda
Sales Enhancement
and Operating Economies
Sales enhancement can occur because of market

share gain, technological advancements to the
product table, and filling a gap in the product line.
Operating economies can be achieved because of
the elimination of duplicate facilities or operations
and personnel.
Synergy Economies realized in a merger where
the performance of the combined firm exceeds
that of its previously separate parts.
Sales Enhancement
and Operating Economies
Economies of Scale The benefits of size
in which the average unit cost falls as
volume increases.
Horizontal merger: best chance for economies
Vertical merger: may lead to economies
Conglomerate merger: few operating economies
Divestiture: reverse synergy may occur
Strategic Acquisitions
Involving Common Stock
Strategic Acquisition Occurs when one
company acquires another as part of its overall
business strategy.
When the acquisition is done for common stock, a ratio of
exchange, which denotes the relative weighting of the two
companies with regard to certain key variables, results.
A financial acquisition occurs when a buyout firm is
motivated to purchase the company (usually to sell assets,
cut costs, and manage the remainder more efficiently), but
keeps it as a stand-alone entity.
Example Company A will acquire Company B
with shares of common stock.
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
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
Exchange ratio = $35 / $64 = 0.546875
* New shares from exchange = 0.546875 x 2,000,000
= 1,093,750
The shareholders of Company A will

experience an increase in earnings per share
because of the acquisition [$4.10 post-merger
EPS versus $4.00 pre-merger EPS].
The shareholders of Company B will
experience a decrease in earnings per share
because of the acquisition [.546875 x $4.10 =
$2.24 post-merger EPS versus $2.50 pre-
merger EPS].
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.]
Example Company B has agreed on an offer
of $45 in common stock of Company A.
Surviving Company A
Exchange ratio = $45 / $64 = 0.703125

= 1,406,250
The shareholders of Company A will

experience a decrease in earnings per share
because of the acquisition [$3.90 post-
merger EPS versus $4.00 pre-merger EPS].
The shareholders of Company B will
experience an increase in earnings per
share because of the acquisition [0.703125 x
$4.10 = $2.88 post-merger EPS versus $2.50
pre-merger EPS].
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/$2.50 = 18 versus pre-
merger P/E ratio of 16 for Company A.]
What About
Earnings Per Share (EPS)?
Merger decisions
should not be made With the
Expected EPS ($)

without considering merger
the long-term
consequences. Equal
The possibility of
future earnings growth Without the
may outweigh the merger
immediate dilution of
earnings. Time in the Future (years)
Initially, EPS is less with the merger.
Eventually, EPS is greater with the merger.
Market Value Impact
Number of shares offered by
Market price per share
X the acquiring company for each
of the acquiring company
share of the acquired company
Market price per share of the acquired company
The above formula is the ratio of exchange of

market price.
If the ratio is less than or nearly equal to 1, the
shareholders of the acquired firm are not likely to
have a monetary incentive to accept the merger
offer from the acquiring firm.
Market Value Impact
Example Acquiring Company offers to
acquire Bought Company with shares of
common stock at an exchange price of $40.
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
Market Value Impact
Exchange ratio = $40 / $60 = .667
Market price exchange ratio = $60 x .667 / $30 = 1.33
Surviving Company
Price / earnings ratio 18
Market price per share $63.90
= 1,333,333
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).
Empirical Evidence on
Mergers
Target firms in a
takeover receive an Selling
ABNORMAL RETURN (%)

CUMULATIVE AVERAGE
average premium of companies
30%.
Evidence on buying +
Buying
firms is mixed. It is companies
not clear that 0
acquiring firm
shareholders gain.
Some mergers do Announcement date
have synergistic TIME AROUND ANNOUNCEMENT
benefits. (days)
Developments in Mergers
and Acquisitions
Roll-Up Transactions The combining of
multiple small companies in the same
industry to create one larger company.
Idea is to rapidly build a larger and more valuable firm
with the acquisition of small- and medium-sized firms
(economies of scale).
Provide sellers cash, stock, or cash and stock.
Owners of small firms likely stay on as managers.
If privately owned, a way to more rapidly grow towards
going through an initial public offering.
Developments in Mergers
and Acquisitions
An Initial Public Offering (IPO) is a
companys first offering of common stock
to the general public.
IPO Roll-Up An IPO of independent

companies in the same industry that
merge into a single company concurrent
with the stock offering.
IPO funds are used to finance the
acquisitions.
Acquisitions and Capital
Budgeting
An acquisition can be treated as a capital budgeting
project. This requires an analysis of the free cash flows of
the prospective acquisition.
Free cash flows are the cash flows that remain after we
subtract from expected revenues any expected operating
costs and the capital expenditures necessary to sustain,
and hopefully improve, the cash flows.
Free cash flows should consider any synergistic effects but
be before any financial charges so that examination is
made of marginal after-tax operating cash flows and net
investment effects.
Cash Acquisition and
Capital Budgeting Example
AVERAGE FOR YEARS (in thousands)
15 6 10 11 15
Annual after-tax operating
cash flows from acquisition $2,000 $1,800 $1,400
Net investment 600 300
Cash flow after taxes $1,400 $1,500 $1,400
16 20 21 25
Annual after-tax operating
cash flows from acquisition $ 800 $ 200
Net investment
Cash flow after taxes $ 800 $ 200
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. This represents the maximum acquisition
price that the acquiring firm should be willing to pay, if
we do not assume the acquired firms liabilities.
If the acquisition price is less than (exceeds) the present

value of $8,724,000, then the acquisition is expected to
enhance (reduce) shareholder wealth over the long run.
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.
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
(in Indonesia: KPPU).
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.)
Accounting
Treatment of Goodwill
Goodwill The intangible assets of the
acquired firm arising from the acquiring firm
paying more for them than their book value.
SFAS 142 eliminated mandatory periodic amortization of
goodwill for financial accounting purposes, but requires an
impairment test (at least annually) to goodwill.
Goodwill charges are generally deductible for tax purposes
over 15 years for acquisitions occurring after August 10,
1993.
An impairment to earnings is recognized when the book value
of goodwill exceeds its market value by an amount that equals
the difference.
Tender Offers
Tender Offer An offer to buy current
shareholders stock at a specified price, often
with the objective of gaining control of the
company. The offer is often made by another
company and usually for more than the present
market price.
Allows the acquiring company to bypass
the management of the company it wishes
to acquire.
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.
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.
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).
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
Empirical Evidence
on Antitakeover Devices
Empirical results are mixed in determining if

anti takeover 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.
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.
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.
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 companys 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.
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.
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.
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.
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.

Mergers and Other Forms of Corporate Restructuring

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Chapter 23

Mergers and Other Forms of

More precise meaning:

But it might refer to any change in a companys:

that is outside its ordinary course of business.

So where is the value coming

Sales enhancement and operating economies

Sales enhancement can occur because of market

The shareholders of Company A will

Surviving firm EPS will increase any time

Exchange ratio = $45 / $64 = 0.703125

The shareholders of Company A will

Surviving firm EPS will decrease any time

Expected EPS ($)

The above formula is the ratio of exchange of

ABNORMAL RETURN (%)

IPO Roll-Up An IPO of independent

The resulting present value of free cash flow is

If the acquisition price is less than (exceeds) the present

Noncash payments and assumption of

Target is evaluated by the acquirer

Empirical results are mixed in determining if

Divestiture The divestment of a portion

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