Corporate Restructuring

Financial Aspects
DR. SHUBHRA

Corporate Restructuring
Corporate restructuring implies activities related to expansion/
contraction of a firms operations or changes in its assets or financial or
ownership structure.
The most common forms of corporate restructuring are
mergers/amalgamations and acquisitions/takeovers, financial
restructuring, divestitures/demergers and buyouts.
Mergers
While a merger is a combination of two or more firms in which the resulting firm
maintains the identity of one of the firms only, an amalgamation involves the
combination of two or more firms to form a new firm. In the case of
merger/absorption, the firm that has been acquired/absorbed is known as the
target firm and the firm that acquires is known as the acquiring firm. There are
three types of mergers:
1) Horizontal,
2) Vertical and
3) Conglomerate.
Horizontal merger is a merger when two or more
firms dealing in similar lines of activity combine
together.
Vertical merger is a merger that involves two or more
stages of production/distribution that are usually
separate.
Conglomerate merger is a merger in which firms
engaged in different unrelated activities combine
together.
Economics of Merger
The major economic advantages of a merger are:
1) Economies of scale,
2) Synergy,
3) Fast growth,
4) Tax benefits and
5) Diversification.
Synergy takes place as the combined value of the merged firm is likely to be greater than
the sum of individual business entities.
The combined value = value of acquiring firm, V
A
+ value of target firm, V
t
+ value of
synergy, V
AT
. (1)
In ascertaining the gains from the merger, costs associated with acquisition should be
taken into account. Therefore, the net gain from the merger is equal to the difference
between the value of synergy and costs:
Net gain = V
AT
costs (2)
Financial Framework
The financial framework of merger covers three inter-
related aspects:
1) Determining the firms value,
2) Financing techniques in merger and
3) Analysis of the merger as a capital budgeting decision.
The alternative approaches to value a firm are
1) Book value,
2) Appraisal value,
3) Market value and
4) Earnings per share (EPS).
Earning Per Share : According to this approach, the value of a
prospective acquisition is considered to be a function of the impact
of the merger on the earnings per share (EPS).
Example 1
Company A is contemplating the purchase of Company B. Company A has 2,00,000
shares outstanding with Rs 25 market value per share while Company B has 1,00,000
shares selling at Rs 18.75. The EPS are Rs 3.125 for Company A and Rs 2.5 for
Company B. Assuming that the two managements have agreed that the shareholders
of Company B are to receive Company As shares in exchange for their shares (i) in
proportion to the relative earnings per share of the two firms or (ii) 0.9 share of
Company A for one share of Company B (share exchange ratio of 0.9: 1), illustrate the
impact of merger on the EPSc (earnings per share of the combined firm). Also,
compute the EPS after merger on the assumption that the anticipated growth rate in
earnings is 8 per cent for Company A and 14 per cent for Company B.
Financing Techniques in Mergers
The alternative methods of financing mergers/payment to the acquired company
are:
1) Ordinary share financing,
2) Debt and preference share financing,
3) Convertible securities,
4) Deferred payment plan and
5) Tender offers.
Ordinary Share Financing When a company is considering the use of common
(ordinary) shares to finance a merger, the relative price-earnings (P/E) ratios of two
firms are an important consideration. For instance, for a firm having a high P/E ratio,
ordinary shares represent an ideal method for financing mergers and acquisitions.
Similarly, ordinary shares are more advantageous for both companies when the firm
to be acquired has a low P/E ratio. This fact is illustrated in Table 4
TABLE 4 Effect of Merger on Firm As EPS and MPS
(a) Pre-merger Situation:
Firm A Firm B
Earnings after taxes (EAT) (Rs) 5,00,000 2,50,000
Number of shares outstanding (N) 1,00,000 50,000
EPS (EAT N) (Rs) 5 5
Price-earnings (P/E) ratio (times) 10 4
Market price per share, MPS (EPS P/E ratio) (Rs) 50 20
Total market value of the firm (N MPS) or (EAT P/E ratio) (Rs) 50,00,000 10,00,000
(b) Post-merger Situation:
Assuming share exchange ratio as
1: 2.5* 1:1
EATc of combined firm (Rs) 7,50,000 7,50,000
Number of shares outstanding after additional shares issued 1,20,000 1,50,000
EPSc (EATc N) (Rs) 6.25 5
P/Ec ratio (times) 10 10
MPSc (Rs) 62.50 50
Total market value (Rs) 75,00,000 75,00,000
* Based on current market price per share
The exchange ratio eventually negotiated/agreed upon
would determine the extent of merger gains to be
shared between the shareholders of the two firms. This
ratio would depend on the relative bargaining position
of the two firms and the market reaction of the merger
move.
TABLE 5 Apportionment of Merger Gains Between the Shareholders of Firms A and B
(1)Total market value of the merged firm
Less: Market value of the pre-merged firms:
Firm A
Firm B
Total merger gains
(2)(a)Apportionment of gains (assuming share exchange
ratio of 2.5:1)
Firm A:
Post-merger market value (1,00,000 shares Rs 62.50)
Less: Pre-merger market value
Gains for shareholders of Firm A
Firm B:
Post-merger market value (20,000 shares Rs 62.50)
Less: Pre-merger market value
Gains for shareholders of Firm B
(b) Assuming share exchange ratio of 1:1
Firm A:
Post-merger market value (1,00,000 shares Rs 50)
Less: Pre-merger market value
Gains for shareholders of Firm A
Firm B:
Post-merger market value (50,000 shares Rs 50)
Less: Pre-merger market value
Gains for shareholders of Firm B


Rs 50,00,000
10,00,000
Rs 75,00,000


60,00,000
15,00,000


62,50,000
50,00,000
12,50,000

12,50,000
10,00,000
2,50,000


50,00,000
50,00,000
NIL

25,00,000
10,00,000
15,00,000
TABLE 6 Determination of Tolerable Share Exchange Ratio for shareholders of Firms,
Based on Total Gain Accruing to Shareholders of Firm A
(a) Total market value of the merged firm (Combined earnings, Rs 7,50,000
P/E ratio, 10 times)
Rs 75,00,000

(b) Less: Pre-merger or minimum post-merger value acceptable to
shareholders of Firm B
10,00,000
(c) Post-merger market value of Firm A (a b) 65,00,000
(d) Divided by the Number of equity shares outstanding in Firm A 1,00,000
(e) Desired post-merger MPS (Rs 65 lakh/1 lakh shares) Rs 65
(f) Number of equity issues required to be issued in Firm A to have MPS of
Rs 65 and to have post-merger value of Rs 10 lakh of Firm B, that is,
(Rs 10 lakh/Rs 65)


15,385
(g) Existing number of equity shares outstanding of Firm B 50,000
(h) Share exchange ratio (g)/(h) i.e. 50,000/15,385 For every 3.25 shares of
Firm B, 1 share in Firm A will be issued

1 : 3.25
The extent of merger gains to be shared between the shareholders of the
acquiring firm and the target firm depends on the exchange ratio. The ratio
depends on the relative bargaining position of the two firms and the market
reaction of the merger move. Normally, the exchange ratio is such in which the
merger gains accrue to the shareholders of both firms.
Debt and Preference Shares Financing
In an attempt to tailor a security to the requirements of investors who seek
dividend/ interest income in contrast to capital appreciation/growth, convertible
debentures and preference shares might be used to finance mergers. The use of
such sources of financing has several advantages.
1) Potential earning dilution may be partially minimised by issuing a
convertible security.
2) A convertible issue might serve the income objectives of the shareholders
of the target firm without changing the dividend policy of the acquiring
firm.
3) Convertible security represents a possible way of lowering the voting
power of the target company.
4) Convertible security may appear more attractive to the acquired firm as it
combines the protection of fixed security with the growth potential of
ordinary shares.
Deferred Payment Plan is a plan for payment to shareholders of target firm in merger that
is linked to the earnings of the firm. There could be various types of deferred payments
plans. The arrangement eventually agreed upon would depend on the imagination of the
management of the two firms involved. One of the often used plans, for this purpose is
the base-period earnout. Under this plan, the shareholders of the target firm are to receive
additional shares for a specified number of future years, if the firm is able to improve its
earnings vis--vis the earnings of the base period (the earnings in the previous year
before the acquisition). The basis for determining the required number of shares to be
issued is as per Equation 3.
(Excess earnings x P/E ratio) / Share price of acquiring firm (3)
Tender Offer is a method to acquire control in another firm through bidding. The major
advantages of acquisition through tender offer include: (i) If the offer is not blocked, say
in friendly takeover, it may be less expensive than the normal route of acquiring a
company. This is so because it permits control by purchasing a smaller proportion of the
firms shares and (ii) The fairness of the purchase price is not questionable as each
shareholder individually agrees to part with his shares at the negotiated price.
Merger as a Capital Budgeting Decision
Merger as a capital budgeting decision involves the valuation of the target firm in terms of its
potentials to generate incremental future free cash flows (FCFF) to the acquiring firm. These cash
flows are then to be discounted at an appropriate rate that reflects the riskiness of the target
firms business. The cost of acquisition is deducted from the present value of FCFF. The merger
proposal is financially viable in case the NPV is positive. The finance manager can use sensitivity
analysis to have a range of NPV values within which the acquisition price may vary.
(i) Determination of Incremental Projected Free Cash Flows to The Firm (FCFF) These FCFF
should be attributable to the acquisition of the business of the target firm. Format 1 contains
constituent items of such cash flows.
FORMAT 1 Determination of FCFF
After-tax operating earnings
Plus: Non-cash expenses, such as depreciation and amortisation
Less: Investment in long-term assets
Less: Investment in net working capital
Note: All the financial inputs should be on incremental basis.
(ii) Determination of Terminal Value
(a) When FCFF are likely to be constant till infinity:
TV = FCFF
T + 1
/K
0
(4)
Where FCFF
T + 1
refers to the expected FCFF in the first year after the explicit forecast period.
(b) When FCFF are likely to grow (g) at a constant rate:
TV = FCFF
T
(1 + g)/ (K
0
g) (5)
(c) When FCFF are likely to decline at a constant rate:
TV = FCFF
T
(1 g)/ (K
0
+ g) (6)
(iii) Determination of Appropriate Discount Rate/Cost of Capital In the event of the risk complexion
of the target firm matching with the acquired firm (say in the case of horizontal merger and firms
having virtually identical debt-equity ratio), the acquiring firm can use its own weighted average
cost of capital (k
0
) as discount rate. In case the risk complexion of the acquired firm is different,
the appropriate discount rate is to be computed reflecting the riskiness of the projected FCFF of
the target firm.
(iv) Determination of Present Value of FCFF The present value of FCFF during the explicit forecast
period [as per step (i)] and of terminal value [as per step (ii)] is determined by using appropriate
discount rate [as per step (iii)].
(v) Determination of Cost of Acquisition The cost of acquisition is determined as per Format 2.
FORMAT 2 Cost of Acquisition
Payment to equity shareholders (Number of equity shares issued in acquiring company Market price
of equity share)
Plus: Payment to preference shareholders
Plus: Payment to debenture-holders
Plus: Payment of other external liabilities (say creditors)
Plus: Obligations assumed to be paid in future
Plus: Dissolution expenses (to be paid by acquiring firm)
Plus: Unrecorded/contingent liability
Less: Cash proceeds from sale of assets of target firm (not to be used in
business after acquisition)
Example 2 The Hypothetical Limited wants to acquire Target Ltd. The balance
sheet of Target Ltd. as on March 31 (current year) has the following assets and
liabilities:
(Rs lakh)
Liabilities Amount Assets Amount
Equity share capital
(4 lakh shares of Rs. 100 each) Rs 400 Cash Rs 10
Retained earnings 100 Debtors 65
10.50% Debentures 200 Inventories 135
Creditors and other liabilities 160 Plant and
Equipment
650
860 860
Additional information:
(i) The shareholders of Target Ltd. will get 1.5 share in Hypothetical Ltd. for every 2
shares; the shares of the Hypothetical Ltd. would be issued at its current market
price of Rs 180 per share. The debenture-holders will get 11% debentures of the
same amount. The external liabilities are expected to be settled at Rs 150 lakh.
Dissolution expenses of Rs 15 lakh are to be met by the acquiring company.
(ii) The following are projected incremental free cash flows (FCFF) expected from
acquisition for 6 years (Rs lakh):
Year-end 1
2
3
4
5
6
Rs 150
200
260
300
220
120
(iii) The free cash-flow of Target limited is expected to grow at 3 per cent per annum,
after 6 years.
(iv) Given the risk complexion of Target limited, cost of capital relevant for Target
limited cash flows has been decided at 13 per cent.
(v) There is unrecorded liability of Rs 20 lakh.
Advise the company regarding financial feasibility of the acquisition
Solution
TABLE 7 Financial Evaluation of Merger Decision
(i) Cost of Acquisition (t = 0) (Rs lakh)
Share capital (3,00,000 shares Rs 180)
11% Debentures
Settlement of external liabilities
Unrecorded liability
Dissolution expenses of Target firm

Rs 540
200
150
20
15
925
(ii) PV of Free Cash Inflows (years = 1 6) (Rs lakh)
Year-end FCFF PV factor
(0.13)
Total PV
1 Rs 150 0.885 Rs 132.75
2 200 0.783 156.60
3 260 0.693 180.18
4 300 0.613 183.90
5 220 0.543 119.46
6 120 0.480 57.60
830.49
(iii) PV of FCFF After the Forecast Period (Referred to as Terminal Value, TV)
TV6 = FCFF6 (1 + g)/(k
0
g)
= Rs 120 lakh (1.03)/(0.13 0.03) = Rs 123.6/0.1 = Rs 1,236 lakh
PV of TV = Rs 1,236 lakh 0.480 = Rs 593.28 lakh
(iv) Determination of Net Present Value
PV of Free cash flows (years 1 6) Rs 830.49 lakh
PV of Free cash flows subsequent to year 6 593.28
Total PV of benefits/FCFF 1,423.77
Less: Cost of acquisition 925.00
Net present value 498.77
Recommendation As the NPV is positive, acquisition of Target limited is
financially viable.
Example 3 Would your decision for acquiring Target limited (in Example 2)
change, if FCFF after the forecast period are assumed to be (a) constant and (b)
decline by 10 per cent per annum after 6 years.
Solution
TABLE 8 Determination of NPV, When FCFF are Constant after year-6 (Rs lakh)
PV of FCFF (years 1 6) Rs 830.49
PV of FCFF (subsequent to year 6) 443.08*
Total PV of benefits 1,273.57
Less: Cost of acquisition 925.00
Net present value 348.57
* Determination of PV related to TV:
TV = FCFF
6
/k
0
= Rs 120 lakh/0.13 = Rs 923.08 lakh
PV = Rs 923.08 lakh 0.480 = 443.08 lakh
TABLE 9 Determination of NPV when FCFF are Expected to Decline at 10 per
cent after year 6 (Rs lakh)
PV of FCFF (years 1 6) Rs 830.49
PV of FCFF (subsequent to year 6) 225.39*
Total PV of benefits 1,055.88
Less: Cost of acquisition 925.00
Net present value 130.88
* Determination of PV related to TV:
TV = FCFF
6
(1 g)/(k
0
+ g) = Rs 108 lakh/(0.13 + 0.10) = Rs 469.57 lakh
PV = Rs 469.57 lakh 0.480 = Rs 225.39
Recommendation Since the NPV is positive in both the situations, the merger
proposal continues to be financially viable.
Adjusted Present Value (APV) Approach
Adjusted Present Value a variant of DCF, is value of the target
company if it were entirely financed by equity plus the value of the
impact of debt financing in terms of the tax benefits as well as
bankruptcy cost.
The APV based valuation has its genesis in the Modigliani-Miller (MM)
propositions on capital structure, according to which in a world of no
taxes, the valuation of the firm (the sum of equity and debt) is
independent of capital structure (change in debt/equity proportion).
In other words, the capital structure can affect the valuation only
through taxes and other market imperfections and distortions.
Example 4 For the facts in Example 2, compute the value of Target Limited based on the
APV approach, given the cost of unlevered equity as 16 per cent, perpetual debentures
and a corporate tax rate of 35 per cent. Ignore bankruptcy costs. Also estimate the NPV.
Solution
TABLE 10 (i) PV of FCFF, Discounted at Unlevered Cost of Equity (ku)
Year-end FCFF PV factor (0.16) Total PV
1 Rs 150 0.862 Rs 129.30
2 200 0.743 148.60
3 260 0.641 166.66
4 300 0.552 165.60
5 220 0.476 104.72
6 120 0.410 49.20
764.08
(ii) PV of FCFF After the Forecast Period/Terminal Value (Rs lakh)
TV6 = FCFF
6
(1 + g)/(k
u
g)
= Rs 120 lakh (1.03)/(0.16 0.03) = Rs 950.77 lakh
PV of TV = Rs 950.77 lakh 0.410 = Rs 389.82 lakh
(iii) PV of Tax Savings Due to Interest (Rs lakh)
Amount of Debt (11% Debentures) Rs 200
Amount of interest (Rs 200 lakh 0.11) 22
Tax savings (Rs 22 lakh per year 0.35 tax rate) 7.7
Present value of tax shield (Rs 7.7 lakh/0.11) 70.0
TABLE 11 (iv) Adjusted Present Value and NPV of Target Limited (Rs lakh)
(i) PV of FCFF (years 1 6) Rs 764.08
(ii) PV of terminal value 389.82
(iii) PV of tax shield 70.00
Total adjusted present value 1223.90
Less: Cost of acquisition 925.00
Net present value 298.90