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.
After Studying Chapter 23,
you should be able to:
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.
Mergers and Other Forms
of Corporate Restructuring
• Sources of Value
• Strategic Acquisitions
Involving Common Stock
• Acquisitions and Capital
Budgeting
• Closing the Deal
Mergers and Other Forms
of Corporate Restructuring
• Takeovers, Tender Offers, and

Defenses
• Strategic Alliances
• Divestiture
• Ownership Restructuring
• Leveraged Buyouts
What is Corporate
Restructuring?
Any change in a company’s:
1. Capital structure,
2. Operations, or
3. Ownership
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
• Management’s personal agenda
* Will be discussed in more detail in the following two slides.

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
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 (see Slide 24).
Developments in Mergers
and Acquisitions
An Initial Public Offering (IPO) is a
company’s 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
23.25
cash flows and net investment effects.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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 $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
firm’s 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
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 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 company’s
assets. The balance sheets of the two
companies were simply combined.
Eliminated as an option with SFAS 141.
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
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.
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

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.
• 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 company’s 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.
Empirical Evidence
on Divestitures
• 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.
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.
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:
• 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 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.

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Chapter 23

Mergers and Other

• Takeovers, Tender Offers, and

So where is the value coming

• Sales enhancement and operating

* Will be discussed in more detail in the following two slides.

• Sales enhancement can occur because of

• 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

• Noncash payments and assumption

• Target is evaluated by the acquirer

Purchase (method) – A method of accounting

Pooling of Interests (method) – A method of

• Empirical results are mixed in determining if

Divestiture – The divestment of a portion

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