Mergers and Acquisitions Dr. J.D. Han King’s College, University of Western Ontario

I. Two Latest Phenomena of Corporate Financing 1) Traditionally, debts in corporate financing have been more important than Equities. 2) The recent surge in Mergers and Acquisitions (M & A) has raised D/E ratio through LBOs.

Sources of External Corporate Financing in U. S. : * In Canada, equity financing has a larger share. Why?

II. Why is debt financing more important than equity financing? Firm’s view point -With tax (deductible interest expenses), cost of debt is lower than cost of equity -Equities are more vulnerable for hostile take- over Investor’s viewpoint -Debts are safer than equities in terms of “Principal-Agent Problem”.

1. Two major objectives of M & A: Improved Management: -A change in management and thus to an enhanced EFFINCIENCY -A just credible threat will wake up the stale management. Synergy

2. Target for M & A: How do you know whether a firm’s management is stale? Free Cash Flow Theory by Michael C. Jensen at HBS “Agency Cost of Free Cash Flow, Corporate Finance and Takeovers”, American Economic Review (1986)

* * Free Cash Flows as a Litmus Test Definition of FCF: Free Cash Flows = Cash Receipts - Cash Expenditures - Profitable (Constructive) Investment Opportunities Observation: FCF are the likely object of the Management’s abuse and the Principal-Agent Problem

*** Jensen’s FCF Theory in Reverse Gear Dictum “ The Larger the Free Cash Flow of a Firm, the More Severe the Principal-Agent Problem, and thus the Larger the Potential Benefits from M & A and Corporate Restructuring” Prediction We can also identify which firm is likely to be a target of M & A.

3. M & A and LBO: How does an Increased Indebtedness enhance Corporate Efficiency? 1) Debt contracts have a better monitoring and less moral hazards. 2) Reduced Equities increase - ROE - Management’s Financial Rewards -> “Incentive-Compatible”

*Numerical Example of an Increased Indebtedness enhancing Management’s Rewards Restructuring is “Leveraged” Buyout (of Shareholders) by Management Before Restructuring Debt-Equity Ratio = 0/1 = 0 CapitalProfits Equity 1Shareholders’ share$9,000 Equity 2Manager’s share$1,000 Total$10,000 *assume interest rate =10%; rate of returns on capital =100% After Restructuring Debt –Equity Ratio = 9 CapitalProfits DebtsShareholders’ share $9,000$ 900 Equity 2Manager’s share $1,000$9,100 Total$10,000 *Note: Manager’s profit share has increased by 810%.

4. Two Structural Changes as Prerequisites for a Surge of M & A Lowering Legal Barriers -Weakening of Anti-Trust Act(USA) Competition Act(Canada) Development of Financial Institutions, Market & Debt Instruments - Investment Banks, Securities Houses, Junk Bonds, (Debt-Equity) Swap, etc.

5. Who are the Big Players? Securities Firms Banks’ M & A Division of Investment Banking Department For instance - Morgan Stanley - Goldman Sachs - Salomon Smith Barney - Merrill Lynch - Donald Trump; Drexel Burnham, Campeu Co., T. Boone Pickens (Mesa Petrolium)

6. Pros and Cons of M& A 1) Pros: Advocate for M & A M & A enhances Efficiency of Corporate Management with synergy effect (evidence) Share price of Target Firm goes up by 30-50% before and after M & A Natural Part of Globalization Trend Strategy for Survival from International Competition

2) Criticism of M & A (1) Zero Sum Game for the entire economy: gains for shareholders come from someone’s loss a) Government Loss of Tax Revenues in LBO b) Wage Concessions after M & A c) Bond holders’ loss: Increased leverage - Increased Default Risk - Decreased Bond Price d) Consumers’ loss: Increased monopoly power - Higher price (2) Economic Frailty (= Bankruptcy risk + Increased Interdependency) (3) M & A could be costly: A High Transactions Cost

(3) A Costly M & A: “ Shark Repellants” -Setting up costly barriers against M & A Green Mail -bribe to a raider away Scorch Earth or Crow Jewel - make yourself unattractive Poison Pills - sell stock under market price in case of danger Golden Parachute - big severance package for leaving executives

IV. Canadian Context M & A will continue to increase M & A take on Globalization trends

Source: Crosbie & Company Inc. Historical Canadian Mergers & Acquisition Announcements Value in $ Billions Announcements 1,400 1,200 1, $210 $180 $150 $120 $90 $60 $30 0 Announcements

M & A at Canadian Cross-Border

M & A Resulting in Efficiency: CanadianCases

Classic Study Case of M & A – The Company’s objective is to build value for its investors through the acquisition of underperforming businesses( with a large amount of Free Cash Flow) financed largely with debts borrowed from third party lenders. Performances. - Acquired Celestica for C$750mm in October, 1996 which now has a market value of C$4.6 billion. - Onex announces a bid for Air Canada and Canadian Airlines during a time when the industry is struggling. 3. Case Studies Case Study I) Excellent Execution - Onex Corporation

Case Study - Excellent Execution - Onex Corporation Stock Price Performance September 29, September 30, /29/199404/20/199511/07/199505/29/199612/16/199607/08/199701/27/199808/17/199803/09/199909/27/1999 Onex Corp Sub Vtg Oct 1/96: Onex acquires Celestica for C$750mm Nov 13/96: ProSource completes IPO of US$48mm Oct 1/98: Onex announces SoftBank acquisition May 29/98: Onex sold ProSource Inc. to AmeriServe Food Distribution for C$123mm Jan 29/99: Onex announces LCS Industries acquisition Mar 11/99: Onex announces that it will sell 23% of its stake in Sky Chefs to LSG Mar 25/99: Onex announces C$1.5bn Telecom Fund with Telefonica May 11/99: Onex purchases American Buildings Aug 24/99: Onex announces bid for Air Canada and Canadian Airlines

Case Study 3 - High Yield Debt - Rogers Communications Stock Price Performance September 29, September 30, /29/199404/20/199511/07/199505/29/199612/16/199607/08/199701/27/199808/17/199803/09/199909/27/1999 Rogers Communications Inc Cl B Nov 11/95: Rogers Cablesystems announces two new high yield debt issues of US$150mm and US$125mm Jan 16/96: Issues US$100mm high yield debt Jan 25/96: Issues C$75mm high yield debt July 17/97: Two new high yield debt issues of US$330mm and C$165mm announced May 21/98: Rogers sells local telephone services to Metronet for C$1bn July 12/99: Microsoft makes C$600mm investment in Rogers; Aug 16/99: Completes sale of 33% interest of Rogers Cantel to AT&T Corp and BT PLC for C$1.4bn Sep 9/99: Rogers repurchases C$1.3bn in debt