Chapter 19 Corporate Restructuring 1ce Lecture 050930

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Chapte
Corporate Restructuring
Slides Developed by:
Terry Fegarty Seneca College
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
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2006 by Nelson, a division of Thomson Canada Limited

Merger Analysis Merger Analysis and the Price Premium The Price Premium Terminal Value Assumption Paying for the AcquisitionThe Junk Bond Market Defensive Tactics Types of Poison Pills Other Kinds of TakeoversLBOs and Proxy Fights Leveraged Buyouts (LBO) Proxy Fights
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Divestitures Bankruptcy and the Reorganization of Failed businesses
Failure and Insolvency BankruptcyConcept and Objectives Bankruptcy ProceduresReorganization, Restructuring, Liquidation Reorganization Debt Restructuring Liquidation Distribution Priorities
Corporate Restructuring
Ways in which companies are reorganized include:
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

Mergercombination 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) Consolidationall 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
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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
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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
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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
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The Role of Investment Dealers

Act as advisors to acquiring companies
Establishing value of target company Raising money to pay for targets shares
Advise reluctant targets on defensive measures
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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
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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
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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
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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
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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
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Tax Losses
Consider the following possible combination of Rich Inc. and Poor Inc.
Rich Inc. Example

EBT Tax (35%) $2,000 700
Poor Inc.
($1,000) -0-
Merged
$1,000 350
EAT
$1,400
($1,000)
$650
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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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
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Holding Companies
Holding companycorporation that owns other corporations called subsidiaries
Known as the parent of the subsidiaries
Typical organization for a conglomerate merger
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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

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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)
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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
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Wave 4: Bigger and Bigger, 1981 - ?
Mergers in the 1980s and onward characterized by: Sizevery large mergers more common Hostilitythreat of hostile takeover pervades corporate life Corporate raidersfinanciers who mount hostile takeovers Defensesstrategies to combat hostile takeovers AdvisorsInvestment dealers and lawyers initiate mergers and advise companies involved Financingthe junk bond market helped spur the financing for mergers
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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
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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
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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

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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): Example Year Cash flow 1 $200 2 $220 3 $250
Alphas 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
Example
A: The present value of Betas positive cash flows: Year Cash Flow PVF12,n Present Value 1 $200,000 .8929 $178,580 2 220,000 .7972 175,384 3 250,000 .7118 177,950 $531,914 The maximum Alpha should pay for all of Betas 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 targets 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
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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
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Terminal Value Assumption

Conservative acquirer will base targets 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.
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Example 19.2:
Example
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. Year 0 Revenue EAT $1,500 95 1 $1,650 106 2 $1,815 117 3 $2,000 130
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Example 19.2:
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.
Example
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Example 19.2:
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 Year
Example
0 Revenue EAT (unmerged) Synergies $1,500 95 10
1 $1,650 106 10
2 $1,815 117 10
3 $2,000 130 10
EAT/cash flow (merged)*

Reinvested (60%) Cash flow to Aldebron
$106
63 $42
$116
70 $46
$127
76 $51
$140
84 $56
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Example 19.2:
A: Present value of the terminal value at year three

TV = C3 (1+g) $56M(1.06) = = $540M k-g .17-.06
Present value of three years of cash flows and terminal value
Example
Year
1 Operating cash flow Terminal Value Total Present Value $46 $39 $51 $37 $46 2 $51 3 $56 540 $596 $372
Notice how large the terminal value is compared to the operating cash flows
Sum = $449
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Example 19.2:
A: Since Arcturus has 20 million outstanding shares, Aldebron should consider paying a maximum of about ($449 / 20 =) $22.45 per share for Arcturus. Example 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 AcquisitionThe 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
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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 targets shareholders If the money raised by borrowing, combined firm must pay principal and interest on debt May perform poorly or fail
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Defensive Tactics
Strategies for management of target firm to prevent firm from being acquired Tactics After a Takeover is Under Way
Challenge the pricemanagement attempts to convince shareholders that price offered is too low Claim a violation of Competition Acthope Competition Bureau will intervene and prevent merger Issue debt and repurchase sharestends to drive up price of shares
Makes price offered by acquirer less attractive Increased leverage makes capital structure less desirable
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Defensive Tactics
Seek a white knightfind alternative acquirer with better reputation for treating management of acquired firms Greenmailbuy back shares from a minority group of shareholders (a group expected to acquire a controlling interest in the firm) at inflated price
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Defensive Tactics
Tactics in Anticipation of a Takeover
(Written into corporations charter and bylaws) Staggered Election of Directors will take more time for a controlling interest to take control of board Approval by a supermajoritymergers requiring approval by a supermajority (two-thirds +) makes taking control of company more difficult Poison pillslegal devices making it prohibitively expensive for outsiders to take control of company without approval of management
Examples: golden parachutes, accelerated debt, share rights plans
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Types of Poison Pills

Golden parachutesexorbitant severance packages for target's management Accelerated debtrequires 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
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Leveraged Buyouts (LBO)

Public company's shares bought by group of investors
Often companys 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
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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
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Divestitures
A company decides to get rid of particular business operation
Reasons for divestitures
Casha 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 fita division may not fit into firm's long-term plans
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Divestitures
Methods of Divesting Companies
Sale for cash and securities Spin-offoperation is divested as separate corporation and shareholders in original company given shares of new firm
Liquidationdivested business is closed down and its assets sold
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Failure and Insolvency

Economic failurefirm unable to provide adequate return to shareholders (return on equity) Commercial failurebusiness cant pay debts (insolvent)
Technically insolventcan't meet short-term obligations Legally insolventfirm's liabilities exceed assets
A business can be economic failure but not commercial failure

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Failure and Insolvency

Two federal laws govern commercial failure:
The Bankruptcy and Insolvency Act (BA) Companies Creditors Arrangement Act (CCAA)
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BankruptcyConcept and Objectives

Bankruptcyfederal legal proceeding designed to keep single creditor from seizing firm's assets for itself and preventing other creditors from a claim Firm isnt 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
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BankruptcyConcept 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
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Bankruptcy ProceduresReorganization, 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
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Reorganization
A reorganizationplan 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 Fairnessclaims are satisfied based on priorities set by law Feasibilitythe likelihood that the plan will actually occur Plan must be approved by the bankruptcy court as well as the firm's creditors and shareholders
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Debt Restructuring
Debt restructuringconcessions that lower insolvent firm's debt payments so it can continue operating Can be accomplished in two ways:
Deferrals of interest and principal
Central to reorganization plan
Extensioncreditors agree to extend the time the firm has to repay its debts Compositioncreditors 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
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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
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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
Income and Cash Flow EBIT $200 600 ($400) --($400) 200 (100) ($300) Debt Equity Total capital Capital $6,000 2,000 $8,000
Example
Interest EBT Tax NI Amortization Principal repayment 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.
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Debt RestructuringExample
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:
Income and Cash Flow Capital
Example
EBIT
Interest EBT Tax NI Amortization
$200
300 ($100) --($100) 200
Debt
Equity Total capital
$3,000
5,000 $8,000
Principal Repayment
Cash flow
(50)
$50
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.
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Liquidation
Liquidationclosing 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
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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 debtdebt 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
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Distribution Priorities
Priority payoffs after secured claims
Administrative expenses of bankruptcy proceedings Certain business expenses incurred after bankruptcy petition is filed Unpaid wagesup to $2,000 per employee Certain unpaid contributions to employee benefit plans Certain customer deposits and claimsup to $900 per person Unpaid taxes Unsecured creditors Preferred shareholders Common shareholders
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Slides Developed by:

Terry Fegarty Seneca College

Chapter 19 Outline (1)

2006 by Nelson, a division of Thomson Canada Limited

Chapter 19 Outline (2)

2006 by Nelson, a division of Thomson Canada Limited

Chapter 19 Outline (3)

Mergers and Acquisitions

Basic Business Combinations

2006 by Nelson, a division of Thomson Canada Limited

Mergers and Acquisitions

Mergers and Acquisitions

2006 by Nelson, a division of Thomson Canada Limited

Mergers and Acquisitions

2006 by Nelson, a division of Thomson Canada Limited

Why Unfriendly Mergers are Unfriendly

2006 by Nelson, a division of Thomson Canada Limited

Economic Classification of Business Combinations

2006 by Nelson, a division of Thomson Canada Limited

The Role of Investment Dealers

Advise reluctant targets on defensive measures

2006 by Nelson, a division of Thomson Canada Limited

Competition and Mergers

The Reasons Behind Mergers

The Reasons Behind Mergers

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

The Reasons Behind Mergers

The Reasons Behind Mergers

Acquiring Assets Cheaply

Rich Inc. Example

2006 by Nelson, a division of Thomson Canada Limited

The Reasons Behind Mergers

2006 by Nelson, a division of Thomson Canada Limited

Typical organization for a conglomerate merger

2006 by Nelson, a division of Thomson Canada Limited

But, can not benefit from synergies

The History of Merger Activity in Canada and the United States

Wave 2: The Roaring Twenties, 1916-1929

2006 by Nelson, a division of Thomson Canada Limited

The History of Merger Activity in Canada and the United States

An Important Development During the 1970s

The History of Merger Activity in Canada and the United States

2006 by Nelson, a division of Thomson Canada Limited

2006 by Nelson, a division of Thomson Canada Limited

The Value to the Acquirer and the Per-Share Price

Represents maximum acquirer should be willing to pay

2006 by Nelson, a division of Thomson Canada Limited

2006 by Nelson, a division of Thomson Canada Limited

Merger Analysis and the Price Premium

The Price Premium

Terminal Value Assumption

Terminal Value Assumption

2006 by Nelson, a division of Thomson Canada Limited

Terminal Value Assumption

2006 by Nelson, a division of Thomson Canada Limited

Terminal Value Assumption

0 Revenue EAT (unmerged) Synergies $1,500 95 10

EAT/cash flow (merged)*

2006 by Nelson, a division of Thomson Canada Limited

Terminal Value Assumption

A: Present value of the terminal value at year three

Present value of three years of cash flows and terminal value

2006 by Nelson, a division of Thomson Canada Limited