chapter 19 corporate restructuring 1ce lecture 050930

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Chapt

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Slides Developed by:

Terry FegartySeneca College

© 2006 by Nelson, a division of Thomson Canada Limited 2

Chapter 19 – Outline (1)

• Corporate Restructuring • Mergers and Acquisitions

Why Unfriendly Mergers are Unfriendly Economic Classification of Business Combinations The Role of Investment Dealers Competition and Mergers The Reasons Behind Mergers Holding Companies The History of Merger Activity in Canada and the

United States



Merger Analysis Merger Analysis and the Price Premium The Price Premium Terminal Value Assumption Paying for the Acquisition—The Junk Bond Market Defensive Tactics Types of Poison Pills

• Other Kinds of Takeovers—LBOs and Proxy Fights Leveraged Buyouts (LBO) Proxy Fights



• Divestitures• Bankruptcy and the Reorganization of Failed

businesses Failure and Insolvency Bankruptcy—Concept and Objectives Bankruptcy Procedures—Reorganization,

Restructuring, Liquidation Reorganization Debt Restructuring Liquidation Distribution Priorities


Corporate Restructuring

• Ways in which companies are reorganizedinclude: Changes in capital structure Changes in ownership Mergers Divestitures Changes to asset structure Changes in methods of doing business Business failure and bankruptcy


Mergers and Acquisitions

• Merger—combination of two or more businesses in which: All but one legally cease to exist Combined organization continues under name of

surviving firm

• Acquisition (AKA: takeover)— merger in which continuing firm acquires the shares of another (the takeover target)

• Consolidation—all combining firms dissolve and new firm with new name is formed


Figure 19.1: Basic Business Combinations



• Relationships Consolidation implies the firms combined

willingly In acquisition one firm acquires other, in

either a friendly or hostile takeover• Shareholders

Majority must approve business combination Be willing to give up their shares for offered

price (cash and/or shares in continuing company)



• Friendly Merger Procedure Target's board of directors and management

approves of the deal and cooperates with acquiring company

Negotiation occurs until agreement is reached

Proposal submitted to shareholders for vote• Percentage required for approval depends on

corporate charter and legal regulations



• Unfriendly Procedure Target's management resists and may take

defensive measures to stop the deal Acquiring firm makes tender offer to

target's shareholders• Special offer to buy shares for fixed price

contingent upon obtaining enough shares to gain control


Why Unfriendly Mergers are Unfriendly

• Target's management may resist takeover because Acquiring firm doesn't offer high enough price

for firm's shares Acquiring firm's management may lose

power, influence or jobs


Economic Classification of Business Combinations • Vertical Merger

When firm acquires one of its suppliers or customers

• Horizontal Merger Merging firms are competitors (reduces

competition)• Conglomerate Merger

Merging firms are not in same lines of business


The Role of Investment Dealers

• Act as advisors to acquiring companies Establishing value of target company Raising money to pay for target’s shares

• Advise reluctant targets on defensive measures


Competition and Mergers

• Canada committed to maintaining competitive economy Opportunity to compete Fair dealing for consumers

• Competition laws enacted in 1889 and afterwards prohibit certain activities that can reduce competitive nature of economy

• Mergers have the potential to increase concentration (reduce competition) Competition Act limits freedom of companies to

merge


The Reasons Behind Mergers

• Synergies• Growth• Diversification to Reduce Risk• Economies of Scale• Guaranteed Sources and Markets• Acquiring Assets Cheaply• Tax Losses• Ego and Empire



• Synergies When performance as combined entity expected to

be better than performance as separate entities• Whole is more than the sum of its parts

Usually cost-saving opportunities In practice, hard to find and difficult to implement

• Growth Internal growth occurs when firms sell more in

current businesses External growth occurs when a firm acquires a rival

• Much faster than internal growth



• Diversification to Reduce Risk Collection of diverse businesses generally less risky

than company with only single line of business Variations of different business lines tend to offset

each other Combined performance more steady

• Economies of Scale Combined company in horizontal merger may

operate at lower cost level than individual organizations



• Guaranteed Sources and Markets Vertical mergers can lock in firm's sources of critical

supplies or create captive markets

• Acquiring Assets Cheaply Firm may acquire assets more cheaply by buying

firm that already owns the assets then by buying assets individually

• When shares of target firm depressed

• Tax Losses Acquiring firm with tax loss can offset taxes on

acquirer's earnings


Tax Losses

Consider the following possible combination of Rich Inc. and Poor Inc.

Operating independently Rich pays $700 in taxes while Poor pays nothing, for a combined total of $700. However, the merged companies pay a combined tax of only $350.

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$650($1,000)$1,400EAT

350-0-700Tax (35%)

$1,000($1,000)$2,000EBT

MergedPoor Inc.Rich Inc.



• Ego and Empire Powerful people at top of organization may be

building up their empire Executive pay depends on size of organization May mean the acquiring firm pays too high a price

for the target


Holding Companies

• Holding company—corporation that owns other corporations called subsidiaries Known as the parent of the subsidiaries

• Typical organization for a conglomerate merger


Holding Companies

• Advantages When controlling firm would like to keep business

operations separate• Failure of one subsidiary doesn't affect parent or other

subsidiaries

Possible to control subsidiary without owning (and paying for) all of its shares• Ownership of 25% virtually guarantees control• 10% may effectively control widely held firm

• But, can not benefit from synergies


The History of Merger Activity in Canada and the United States

• Wave 1: The Turn of the Century, 1897-1904 Horizontal mergers in primary industries (mining,

transportation, etc.) Large firms absorbing small ones, sometimes unfair

or violent

• Wave 2: The Roaring Twenties, 1916-1929 Ended with stock market crash of 1929 Mergers tended to be horizontal and led to

oligopolies (ex; automobile industry)


The History of Merger Activity in Canada and the United States

• Wave 3: The Swinging Sixties, 1965-1969 Companies acquired firms in non-related industries

(conglomerate mergers) Often driven by stock market issues rather than

operating concerns• To raise share price

• An Important Development During the 1970s Prior to 1970s hostile takeovers unusual However, in 1970s hostile takeovers viewed as

acceptable


The History of Merger Activity in Canada and the United States • Wave 4: Bigger and Bigger, 1981 - ?

Mergers in the 1980s and onward characterized by: •Size—very large mergers more common•Hostility—threat of hostile takeover pervades

corporate life•Corporate raiders—financiers who mount hostile

takeovers•Defenses—strategies to combat hostile takeovers•Advisors—Investment dealers and lawyers

initiate mergers and advise companies involved•Financing—the junk bond market helped spur the

financing for mergers


Merger Analysis

• What price should acquiring company be willing to pay for target firm? Merger analysis attempts to answer

question• Capital budgeting exercise

• Forecast future cash flows of target company• Choose appropriate discount rate• Calculate NPV


Merger Analysis

• Estimating Merger Cash Flows Should be straightforward (with two exceptions)

• Provide for synergies expected• Provide for new investment required for expected growth

Difficult in practice• Subject to usual uncertainties and biases • Also, acquiring firm does not have easy access to all of

target's information about past or about future prospects • In friendly merger, target tries to bump up price so

information shared tends to be biased optimistically• In unfriendly merger, target does not share information

• Tendency is for acquirer to overstate value of target


Merger Analysis

• The Appropriate Discount Rate An acquisition is an equity transaction

• Should be valued using cost of equity for target company

• Risk of the project is that of target company

• The Value to the Acquirer and the Per-Share Price Calculate NPV of target Determine per-share value

• Divide NPV by the number of outstanding shares for target Represents maximum acquirer should be willing to

pay


Example 19.1: Merger Analysis

Q: Alpha Corp. is analyzing whether or not it should acquire Beta Corp. Alpha has determined that the appropriate interest rate for the analysis is 12%. Beta has 12,000 shares outstanding. Its estimated cash flows including synergies over the next three years ($000):

Year 1 2 3Cash flow $200 $220 $250

Alpha’s management is fairly conservative and feels the acquisition should be justified by cash flows projected over no more than three years. Management believes projections beyond that are too risky to be considered reliable. What is the maximum Alpha should pay for a share of Beta?

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Example 19.1: Merger Analysis

A: The present value of Beta’s positive cash flows: Year Cash Flow PVF12,n Present Value

1 $200,000 .8929 $178,5802 220,000 .7972 175,3843 250,000 .7118 177,950

$531,914

The maximum Alpha should pay for all of Beta’s shares is $531,914. At that price, Alpha would be indifferent to the acquisition.Dividing by the number of shares outstanding gives the maximum per share price Alpha should be willing to pay.

Maximum acquisition price = $531,914/12,000 = $44.33

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Merger Analysis and the Price Premium• The Price Premium

Price offered to target’s shareholders generally higher than shares' market price• Whether merger is friendly or unfriendly• To induce majority of shareholders to sell to them

at once• Offering price exceeds current market price by

price premium• Major issue: determining proper price premium--don't

want it to be too high

• Value of target to acquiring company must be equal or greater than price offered


The Price Premium

• Price premiums create speculative opportunity Shares in target will increase in price (generally)

once the firm becomes in play Thus, acquiring firms keep merger negotiations

secret

• Illegal for insiders to make short-term profits on price movements from acquisitions Include company executives and investment dealers

• Some investors follow a strategy of buying shares in companies they expect to become takeover targets, to benefit from price increase


Terminal Value Assumption• Conservative acquirer will base target’s value on

forecast cash flows for limited number of years (<10?)• Aggressive acquirer willing to value target based on

longer-term forecasts• Forecasts stream of cash flows that goes on indefinitely.

Tends to strongly favour doing the acquisition. Creates the terminal value problem

• Terminal value calculation is arbitrary, but accounts for much of valuation. Small changes in long-term forecast can make huge differences in total value

• Hard to believe company can be worth so much more than its market value

• Good judgment called for to avoid basing multimillion dollar deal on too high a price.


Example 19.2: Terminal Value Assumption

Q: The Aldebron Motor Company is considering acquiring Arcturus Gear Works, Inc. and has made a three-year projection of the firm's financial statements, including the following revenue and earnings estimate. Period 0 is the current year and not part of the forecast. Figures are in million of dollars.

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13011710695EAT

$2,000$1,815$1,650$1,500Revenue

3210

Year



Q: Synergies will net $10 million after tax per year. Cash equal to amortization will be reinvested to keep Arcturus's plant operating efficiently, and 60% of the remaining cash generated by operations will be invested in growth opportunities. Assume a 6% annual growth in all of the target's figures after the third year.

Currently 90-day Treasury bills are yielding 8% and an average share returns 13%. Arcturus's beta is 1.8 and it has 20 million shares outstanding, which closed at $19 a share yesterday.

How much should Aldebron be willing to pay for Arcturus's shares? Discuss the quality of the estimate.

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A: Discount rate using the CAPM approach

kx = kRF + (kM – kRF)bx = 8% + (13% - 8%)1.8 = 17%

Estimated cash flows for the next three years

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$56$51$46$42Cash flow to Aldebron

84767063Reinvested (60%)

$140$127$116$106EAT/cash flow (merged)*

10101010Synergies

13011710695EAT (unmerged)

$2,000$1,815$1,650$1,500Revenue

3210

Year



A: Present value of the terminal value at year three

Present value of three years of cash flows and terminal value

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3C (1+g) $56M(1.06)TV = = = $540M

k-g .17-.06

$372$37$39Present Value

$596$51$46Total

540Terminal Value

$56$51$46Operating cash flow

321

Year Notice how large the terminal

value is compared to the operating cash

flows

Sum = $449



A: Since Arcturus has 20 million outstanding shares, Aldebron should consider paying a maximum of about ($449 / 20 =) $22.45 per share for Arcturus.

If the shares are currently selling for $19, this represents an 18.2% premium over market price.

NOTE: If the constant growth assumption were changed from 6% to 9%, the maximum acquisition price rises to $29.40 per share.

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Paying for the Acquisition—The Junk Bond Market• Acquiring firm pays shareholders or target firm

either one or a combination of: Cash Shares in the acquiring firm Debt of the acquiring firm

• Acquiring firm needs to either have cash or be able to raise it Use services of investment dealer Junk bond market began in 1980s and helped firms

to finance mergers • Low quality bonds that pay high yields• Firms that issue them are risky


Merger Analysis and the Price Premium • The Capital Structure Argument to Justify High

Premiums If acquirer uses debt to raise cash to buy out a target's

shareholders• Usually results in a more leveraged firm

If the increased leverage results in higher firm value, use of debt may be justified

• The Effect of Paying Too Much Acquiring firm that pays too much transfers value from its

shareholders to target’s shareholders• If the money raised by borrowing, combined firm must pay

principal and interest on debt • May perform poorly or fail


Defensive Tactics

• Strategies for management of target firm to prevent firm from being acquired

• Tactics After a Takeover is Under Way Challenge the price—management attempts to

convince shareholders that price offered is too low Claim a violation of Competition Act—hope

Competition Bureau will intervene and prevent merger

Issue debt and repurchase shares—tends to drive up price of shares

• Makes price offered by acquirer less attractive• Increased leverage makes capital structure less desirable


Defensive Tactics

Seek a white knight—find alternative acquirer with better reputation for treating management of acquired firms

Greenmail—buy back shares from a minority group of shareholders (a group expected to acquire a controlling interest in the firm) at inflated price


Defensive Tactics

• Tactics in Anticipation of a Takeover (Written into corporation’s charter and bylaws) Staggered Election of Directors— will take more time

for a controlling interest to take control of board Approval by a supermajority—mergers requiring

approval by a supermajority (two-thirds +) makes taking control of company more difficult

Poison pills—legal devices making it prohibitively expensive for outsiders to take control of company without approval of management

• Examples: golden parachutes, accelerated debt, share rights plans


Types of Poison Pills

• Golden parachutes—exorbitant severance packages for target's management

• Accelerated debt—requires the principal amounts be paid immediately if the firm is taken over

• Share rights plans (SRPs)—current shareholders given rights to buy shares in merged company at a greatly reduced price after a takeover


Leveraged Buyouts (LBO)

• Public company's shares bought by group of investors Often company’s senior management Company is no longer publicly traded but is now a

private or closely held firm Majority of money for share purchase raised by

borrowing secured by firm's assets (leveraged buyout)

• Tend to be very risky due to high debt burden However company attempts to pay down the debt

load quickly by selling off divisions or assets


Proxy Fights

• When corporations elect boards of directors, management usually solicits shareholders for their proxies (rights to vote) Generally no opposition occurs and shareholders

willingly grant their proxies

• However, proxy fights occur when opposing groups solicit shareholders' proxies Winning group gets control of board and company


Divestitures

• A company decides to get rid of particular business operation Reasons for divestitures

• Cash—a firm needs cash so it sells operation to generate cash

• Firm may do this after LBO or takeover to reduce debt

• Poor performance of operation

• Strategic fit—a division may not fit into firm's long-term plans


Divestitures

Methods of Divesting Companies• Sale for cash and securities

• Spin-off—operation is divested as separate corporation and shareholders in original company given shares of new firm

• Liquidation—divested business is closed down and its assets sold


Failure and Insolvency

• Economic failure—firm unable to provide adequate return to shareholders (return on equity)

• Commercial failure—business can’t pay debts (insolvent) Technically insolvent—can't meet short-term

obligations Legally insolvent—firm's liabilities exceed assets

• A business can be economic failure but not commercial failure


Failure and Insolvency

• Two federal laws govern commercial failure:

The Bankruptcy and Insolvency Act (BA) Companies’ Creditors Arrangement Act

(CCAA)


Bankruptcy—Concept and Objectives • Bankruptcy—federal legal proceeding designed to

keep single creditor from seizing firm's assets for itself and preventing other creditors from a claim

• Firm isn’t bankrupt until action is filed in court• Bankruptcy court protects insolvent firm from its

creditors and determines whether firm should remain running or shut down If firm is insolvent due to business gone bad

• Best to shut company down before it loses more money• Salvage assets to pay off debt

If a firm is insolvent due to too much debt but is in survivable situation

• Firm may be able to make good on its debt if given enough time and conditions are changed


Bankruptcy—Concept and Objectives• Insolvent company worth more as a going

concern than value of assets Court orders a reorganization Debt restructured and plan developed to pay

creditors as fairly as possible

• Insolvent company in situation deemed unrecoverable Court orders liquidation Assets sold under the court's supervision

• Proceeds used to pay creditors according to priority


Bankruptcy Procedures—Reorganization, Restructuring, Liquidation • A bankruptcy petition can be initiated by either

the insolvent company (voluntary) or its creditors (involuntary)

• A firm in bankruptcy is usually allowed to continue operations Protected from creditors until bankruptcy resolved However, to guard against unethical acts, court may

appoint trustee to oversee operations


Reorganization • A reorganization—plan under which an insolvent firm continues

to operate while attempting to pay off debts

• Management and shareholders support a reorganization over liquidation If liquidation occurs management has no job and shareholders

usually receive nothing

• Once bankruptcy petition filed, firm has up to 6 months to file plan

• Reorganization plans judged based on fairness and feasibility Fairness—claims are satisfied based on priorities set by law Feasibility—the likelihood that the plan will actually occur

• Plan must be approved by the bankruptcy court as well as the firm's creditors and shareholders


Debt Restructuring

• Debt restructuring—concessions that lower insolvent firm's debt payments so it can continue operating Central to reorganization plan

• Can be accomplished in two ways: Extension—creditors agree to extend the time the

firm has to repay its debts• Deferrals of interest and principal

Composition—creditors agree to settle for less than full amount owed

• Creditors have incentive to compromise because if firm fails, they are unlikely to receive as much as they would otherwise


Debt Restructuring

• Debt-to-equity conversions are common method of restructuring debt Creditors give up debt claims in return for

shares in company• Reduces debt burden on firm• Eases cash flow problems

If firm survives the equity may be worth more in long run than debt given up


Example 19.3: Debt Restructuring

Q: The Adcock Company has 50,000 common shares outstanding at a book value of $40, pays 10% interest on its debt, and is in the following financial situation

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($300)Cash flow

(100)Principal repayment

200Amortization

($400)NI

---Tax

$8,000Total capital($400)EBT

2,000Equity600Interest

$6,000Debt$200EBIT

CapitalIncome and Cash Flow

Although the company has positive EBIT, it doesn't earn

enough to pay its interest let alone repay principal on schedule.

Without help it will fail shortly. Devise a composition involving a

debt for equity conversion that will keep the firm afloat.


Debt Restructuring—Example

A: Suppose the creditors are willing to convert $3 million in debt to equity at the $40 book value of the existing shares. Would require the firm to issue 75,000 new shares, resulting in the following:

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$50Cash flow

(50)Principal Repayment

200Amortization

($100)NI

---Tax

$8,000Total capital($100)EBT

5,000Equity300Interest

$3,000Debt$200EBIT

CapitalIncome and Cash Flow

The company now has a slightly positive cash flow and can at least theoretically continue in

business indefinitely. However, creditors now own a controlling

interest in the firm.


Liquidation

• Liquidation—closing bankrupt firm and selling its assets to pay debts

• A trustee attempts to recover any unauthorized transfers out of firm When bankruptcy is anticipated assets are frequently

removed• Illegal because these assets should be used to satisfy

creditors' claims

• Trustee then supervises the sale of the assets and pools the funds so that creditors' claims can be satisfied The trustee then distributes the funds


Distribution Priorities

• Distribution follows an order of priority set forth by the Bankruptcy and Insolvency Act

• The priority rile states that some claimants are ahead of others in the order of payoff

• Priority rule payoffs Secured debt—debt that is guaranteed by a specific

asset• These creditors are paid when the specified assets are sold—

remaining funds are placed into the pool of funds to pay remaining claimants


Distribution Priorities

• Priority payoffs after secured claims Administrative expenses of bankruptcy proceedings Certain business expenses incurred after bankruptcy

petition is filed Unpaid wages—up to $2,000 per employee Certain unpaid contributions to employee benefit

plans Certain customer deposits and claims—up to $900

per person Unpaid taxes Unsecured creditors Preferred shareholders Common shareholders

chapter 19 corporate restructuring 1ce lecture 050930

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