Chapter 23

Mergers and Other

Forms of Corporate
Restructuring
23-1

2001 Prentice-Hall, Inc.

Fundamentals of Financial Management, 11/e
Created by: Gregory A. Kuhlemeyer, Ph.D.
Carroll College, Waukesha, WI

Mergers and Other Forms of

Corporate Restructuring

23-2

Sources of Value
Strategic Acquisitions
Involving Common Stock
Acquisitions and Capital
Budgeting
Closing the Deal

Mergers and Other Forms of

Corporate Restructuring

23-3

Takeovers, Tender Offers, and

Defenses
Strategic Alliances
Divestiture
Ownership Restructuring
Leveraged Buyouts

Why Engage in
Corporate Restructuring?

23-4

Sales enhancement and operating

economies*
Improved management
Information effect
Wealth transfers
Tax reasons
Leverage gains
Hubris hypothesis
Managements personal agenda
* Will be discussed in more detail in Slides 23-5 and 23-6

Sales Enhancement
and Operating Economies

23-5

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.

23-6

Horizontal merger:
merger best chance for economies
Vertical merger:
merger may lead to economies
Conglomerate merger:
merger few operating
economies
Divestiture:
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.

23-7

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.

Strategic Acquisitions
Involving Common Stock
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
Earnings per share
Price per share
Price / earnings ratio
23-8

5,000,000 2,000,000
$4.00

$2.50

$64.00

$30.00

16

12

Strategic Acquisitions
Involving Common Stock
Example -- Company B has agreed on an offer
of $35 in common stock of Company A.
Total earnings

Surviving Company A
$25,000,000

Shares outstanding*
Earnings per share

6,093,750
$4.10

Exchange ratio = $35 / $64 = .546875

23-9

* New shares from exchange = .546875 x 2,000,000

= 1,093,750

Strategic Acquisitions
Involving Common Stock

The shareholders of Company A will

experience an increase in earnings per
share because of the acquisition [$4.10 postmerger 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 premerger EPS].

23-10

Strategic Acquisitions
Involving Common Stock

23-11

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 premerger P/E ratio of 16 for Company A.]

Strategic Acquisitions
Involving Common Stock
Example -- Company B has agreed on an offer
of $45 in common stock of Company A.
Total earnings

Surviving Company A
$25,000,000

Shares outstanding*
Earnings per share

6,406,250
$3.90

Exchange ratio = $45 / $64 = .703125

* New shares from exchange = .703125 x 2,000,000
= 1,406,250
23-12

Strategic Acquisitions
Involving Common Stock

23-13

The shareholders of Company A will

experience a decrease in earnings per share
because of the acquisition [$3.90 postmerger EPS versus $4.00 pre-merger EPS].
The shareholders of Company B will
experience an increase in earnings per
share because of the acquisition [.703125 x
$4.10 = $2.88 post-merger EPS versus $2.50
pre-merger EPS].

Strategic Acquisitions
Involving Common Stock

23-14

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 premerger P/E ratio of 16 for Company A.]

23-15

Merger decisions
should not be made
without considering
the long-term
consequences.
The possibility of
future earnings growth
may outweigh the
immediate dilution of
earnings.

Expected EPS ($)

What About
Earnings Per Share (EPS)?
With the
merger
Equal

Without the
merger
Time in the Future (years)

Initially, EPS is less with the merger.

Eventually, EPS is greater with the merger.

Market Value Impact

Market price per share
of the acquiring company

Number of shares offered by

the acquiring company for each
share of the acquired company

Market price per share of the acquired company

23-16

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.

Present earnings
Shares outstanding
Earnings per share
Price per share
Price / earnings ratio
23-17

Acquiring
Company
$20,000,000
6,000,000
$3.33
$60.00
18

Bought
Company
$6,000,000
2,000,000
$3.00
$30.00
10

Market Value Impact

Exchange ratio
= $40 / $60
= .667
Market price exchange ratio = $60 x .667 / $30 = 1.33
Surviving Company
Total earnings
$26,000,000
Shares outstanding*
7,333,333
Earnings per share
$3.55
Price / earnings ratio
18
Market price per share
$63.90
* New shares from exchange = .666667 x 2,000,000
= 1,333,333
23-18

Market Value Impact

23-19

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).

Target firms in a
takeover receive an
average premium of
30%.
Evidence on buying
firms is mixed. It is
not clear that
acquiring firm
shareholders gain.
Some mergers do
have synergistic
benefits.

23-20

CUMULATIVE AVERAGE
ABNORMAL RETURN (%)

Empirical Evidence
on Mergers
Selling
companies
+

Buying
companies

0
Announcement date

TIME AROUND ANNOUNCEMENT

(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 (see Slide 22).

23-21

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.

23-22

IPO funds are used to finance the

acquisitions.

Acquisitions and
Capital Budgeting

23-23

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)
1-5
6 - 10
11 - 15
Annual after-tax operating
cash flows from acquisition
Net investment
Cash flow after taxes

Annual after-tax operating

cash flows from acquisition
Net investment
Cash flow after taxes
23-24

$2,000
600
$1,400

$1,800
300
$1,500

16 - 20

21 - 25

$ 800
--$ 800

$ 200
--$ 200

$1,400
--$1,400

Cash Acquisition and

Capital Budgeting Example

23-25

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.
$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,
$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

23-26

Generally, the EPS approach examines the

acquisition on a short-run basis, while the cashflow 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.

23-27

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

Taxable or
Tax-Free Transaction
At the time of acquisition, for the selling firm
or its shareholders, the transaction is:

23-28

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 taxfree 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.)

Alternative
Accounting Treatments
Purchase (method) -- A method of accounting
treatment for a merger based on the market
price paid for the acquired company.
Pooling of Interests (method) -- A method of
accounting treatment for a merger based on
the net book value of the acquired
companys assets. The balance sheets of
the two companies are simply combined.
23-29

FASB and Alternative

Accounting Treatments
Pooling of Interests

23-30

Pooling of interests is largely a United States

phenomenon.
In 1999, FASB voted unanimously to
eliminate pooling of interests.
Likely to become effective in 2000 once a
final standard is issued (although still vocal
opposition to the accounting change).

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.
Goodwill must be amortized.

23-31

Goodwill cannot be amortized for more than

40 years for financial accounting
purposes.
Goodwill charges are generally deductible
for tax purposes over 15 years for
acquisitions occurring after August 10, 1993.

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.

23-32

Allows the acquiring company to bypass

the management of the company it wishes
to acquire.

Tender Offers

23-33

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 (Slide 34) 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.

23-34

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).
23-35

Antitakeover Amendments
and Other Devices
Motivation Theories:
Managerial Entrenchment Hypothesis
This theory suggests that barriers are erected to
protect management jobs and that such actions
work to the detriment of shareholders.
Shareholders Interest Hypothesis
This theory implies that contests for corporate
control are dysfunctional and take management
time away from profit-making activities.
23-36

Antitakeover Amendments
and Other Devices
Shark Repellent -- Defenses employed by a
company to ward off potential takeover
bidders -- the sharks.

23-37

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

23-38

Empirical results are mixed in determining if

antitakeover 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.

23-39

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.

23-40

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.

23-41

Empirical Evidence
on Divestitures

23-42

For liquidation of the entire company, shareholders of

the liquidating company realize a +12 to +20% return.
For partial sell-offs, shareholders selling the company
realize a slight return (+2%). Shareholders buying
also experience a slight gain.
Shareholders gain around 5% for spin-offs.
Shareholders receive a modest +2% return for equity
carve-outs.
Divestiture results are consistent with the
informational effect as shown by the positive market
responses to the divestiture announcements.

Ownership Restructuring
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.

23-43

Motivation and Empirical

Evidence for Going Private
Motivations:

23-44

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.

Motivation and Empirical

Evidence for Going Private
Motivations (Offsetting Arguments):

Large transaction costs to investment

bankers.
Little liquidity to its owners.
A large portion of management wealth is
tied up in a single investment.

Empirical Evidence:

23-45

Shareholders realize gains (+12 to +22%)

for cash offers in these transactions.

Ownership Restructuring
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 prebuyout management ends up with a substantial equity
position.

23-46

Common Characteristics For

Desirable LBO Candidates
Common characteristics (not all necessary):

23-47

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.