© 2004 by Nelson, a division of Thomson Canada Limited Chapter 20: Corporate Restructuring Contemporary Financial Management

© 2004 by Nelson, a division of Thomson Canada Limited 2 Introduction  This chapter focuses on forms of corporate restructuring, including external expansion (mergers) and business failure (bankruptcy).

© 2004 by Nelson, a division of Thomson Canada Limited 3 Types of Combinations  Merger (or Acquisition) Vertical Horizontal Conglomerate Geographic market Product extension Pure  Consolidation Holding company Joint venture

© 2004 by Nelson, a division of Thomson Canada Limited 4 Leveraged Buyout (LBO)  Buyer borrows most of the purchase price  Purchased assets used as collateral  Buyers frequently are the managers  Anticipated cash flows to service debt  Reasonable ROI  Sell assets to pay off debt

© 2004 by Nelson, a division of Thomson Canada Limited 5 Types of Mergers  Share Purchase Acquiring company buys the stock of the target company. Assumes liabilities of the acquired firm

© 2004 by Nelson, a division of Thomson Canada Limited 6 Types of Mergers  Asset Purchase Acquiring company buys assets of target company NO assumption of liabilities

© 2004 by Nelson, a division of Thomson Canada Limited 7 Types of Mergers  Tender Offer/Hostile Takeover Purchase the common stock of the target company Offering price is greater than the market price Induce shareholders to sell

© 2004 by Nelson, a division of Thomson Canada Limited 8 What Happens After a Merger?  Divestitures Part of the company sold for cash Spin-off Equity carve-out  Restructurings Operational Financial

© 2004 by Nelson, a division of Thomson Canada Limited 9 Popularity of Restructuring  Failure of internal control mechanisms Unproductive investment Organizational inefficiencies  Large active investors  Available financing  Long economic expansion Increased revenues Increased asset values

© 2004 by Nelson, a division of Thomson Canada Limited 10 Anti-Takeover Measures  Staggering board  Golden parachutes  Supermajority rule  Poison pills  White knight  Standstill agreement  “Pacman” defense  Litigation  Asset/Liability restructuring

© 2004 by Nelson, a division of Thomson Canada Limited 11 Boardmail  Institutional investors use it to fight anti-takeover devices  Requires the board of directors to adopt weaker anti-takeover measures  In exchange for voting support from institutional owners  Vote in sympathetic board members

© 2004 by Nelson, a division of Thomson Canada Limited 12 Why Firms Seek External Growth  Less Expensive  Achieve economies of scale  Vertical merger  Rapid growth  Diversification  Tax-loss carryforward

© 2004 by Nelson, a division of Thomson Canada Limited 13 Taxes on Mergers  Cash or debt securities Gains are usually taxable at the time of the merger  Equity securities Usually tax-free

© 2004 by Nelson, a division of Thomson Canada Limited 14 Accounting for Mergers  Section 1581 of the CICA handbook requires that all business combinations after 2001 be accounted for under the purchase method. Total value paid recorded on books Tangible assets at fair market value Excess as goodwill Must be amortized Deducted from net income after taxes

© 2004 by Nelson, a division of Thomson Canada Limited 15 Valuation of a Merger Candidate  Comparative P/E Ratio Method Examines prices and P/E ratios of similar companies  Adjusted Book Value Method Determine market value of the company’s assets  Discounted Cash Flow Method Uses capital budgeting techniques to find the Present value of the free cash flows

© 2004 by Nelson, a division of Thomson Canada Limited 16 EPS of the Surviving Company EPS c = Earnings per share (combined companies) EAT 1 = Earnings after taxes (acquiring company) EAT 2 = Earnings after taxes (target company) EAT 1,2 = Synergistic earnings from merger NS 1 = Shares outstanding (acquiring company) NS 2 = Shares outstanding (target company) ER = Exchange ratio Post-merger common share price and P/E ratio determined by the financial markets

© 2004 by Nelson, a division of Thomson Canada Limited 17 Business Failure  Two federal laws govern business failure: The Bankruptcy and Insolvency Act (BA) Companies’ Creditors Arrangement Act (CCAA)

© 2004 by Nelson, a division of Thomson Canada Limited 18 Failures  Technically insolvent Unable to meet current obligations  Legally insolvent Assets are less than liabilities  Bankrupt Unable to pay debts Files for protection under federal bankruptcy laws

© 2004 by Nelson, a division of Thomson Canada Limited 19 Reasons Why Firms Fail  Business risk Industry downturns Over expansion Inadequate sales Increased competition Technological change

© 2004 by Nelson, a division of Thomson Canada Limited 20 Reasons Why Firms Fail  Financial risk Excessive leverage Too much short-term debt Poor management of accounts receivable Poor management of accounts payable Incompetent management

© 2004 by Nelson, a division of Thomson Canada Limited 21 Alternatives for Failing Businesses Resolve its Difficulties (informally) Declare Bankruptcy (formally)

© 2004 by Nelson, a division of Thomson Canada Limited 22 Reorganization Vs Liquidation  Legal bankruptcy proceedings focus on whether the failing firm should be reorganized or liquidated  Reorganize if going-concern value exceeds its liquidation value  Liquidate if liquidation value is more than its going-concern value

© 2004 by Nelson, a division of Thomson Canada Limited 23 Alternatives for Cash Flow Problems  Negotiate accounts payable deferrals  Restructure debt Extension Composition  Sell off assets Real estate/operating divisions  Sale and leaseback  Creditors’ committee  Assignment

© 2004 by Nelson, a division of Thomson Canada Limited 24 Failure under Bankruptcy Laws  Voluntary petition Debtor company files for bankruptcy.  Involuntary petition Unsecured creditors file the claim for bankruptcy asserting that the debtor company is not paying its present debts as they come due.

© 2004 by Nelson, a division of Thomson Canada Limited 25 Priorities  Administration expenses  Wages owed six months prior to bankruptcy (maximum $2000)  Municipal taxes owed within 2 years preceding bankruptcy  Rent for preceding 3-month period  General/unsecured claims, including taxes due the Crown  Preferred shareholders  Common share holders

© 2004 by Nelson, a division of Thomson Canada Limited 26 Major Points  Mergers and acquisitions are a method of growing more quickly than through internal growth.  Firms must use the Purchase Method of accounting for acquisitions.  A leveraged buyout allows a buyer to acquire a target using mainly debt financing.  Failing firms are said to be insolvent.  A failing firm may be liquidated or reorganized.