B5 – Corporate Restructuring

CMA Part 2: Section B

Topics in Section B
1. Risk and return
2. Long-term financial management
3. Raising capital
4. Working capital management
5. Corporate restructuring
6. International finance

Topics in B5
1) Business Combinations
2) Takeover Defenses
3) Divestitures
4) DCF Valuation
Corporate Restructuring

Relates to the future form of the business.

• Mergers and acquisitions.
• Defenses that may be used by a company that is the target of an unwanted combination bid.
• Divestitures, the opposite of business combinations when a company is broken into multiple
entities.

Mergers and Acquisitions A business combination

An additional important way a company can accomplish expansion.

Merger
Two or more companies come together in some manner
to form a larger company.

Is executed under the provisions of applicable state laws.

The boards of directors of the companies involved

approve a plan for the exchange of
voting common stock of one of the corporations (the survivor)
for all the outstanding voting common stock of the other corporation(s).

In exchange for the outstanding voting common stock of the other

company, the survivor issues its common stock to their stockholders at an
agreed-upon exchange rate.

The survivor does not own the outstanding common stock of the
liquidated corporations, because that stock no longer exists.

Acquisitions
One company purchases another company.

Can take place by

1) the acquiring company purchasing a majority of the common shares of
the acquired company,
or
2) the acquiring company purchasing all of the assets of the acquired
company.

Common Stock Acquisitions

A means to accomplish hostile takeovers

One corporation (the investor) offers to purchase

from the present stockholders a controlling interest
in the voting common stock of another corporation (the investee).

Proxy Contest or Proxy Fight

A form that a shareholder uses to give his or her voting rights
to another person.

One means of taking over a company without negotiations

 If the tender offer results in another company’s acquiring a controlling
interest in the target’s voting common stock, the target becomes affiliated
with the acquiring company as a subsidiary, but it is not dissolved or
liquidated and it remains a separate legal entity.

Asset Acquisitions
A buyer may acquire from an enterprise all or part of either the gross
assets or the net assets of the other enterprise.

Unlike the other forms of business combinations,

the buyer in an acquisition of assets can determine which liabilities of the
seller it will assume.

The selling enterprise may continue its existence as a separate entity

(minus the assets or net assets sold), or it may be liquidated by its seller
following the sale.

It does not become an affiliate of the acquiring company.

Horizontal and Vertical M&As

1. Between firms in the same line of business –horizontal mergers
2. Between companies who are at different stages of production and distribution – vertical mergers.
• In a forward vertical merger, the acquiring company expands forward toward the ultimate consumer.
• In a backward vertical merger, the acquiring company expands backward toward the source of its
raw materials.
3. Between companies in unrelated lines of business – conglomerate mergers.

Reasons for Business Combinations

1. Economies of scale
2. Complementary resources
3. Sales enhancement or increased technological capabilities
4. Management improvements
5. Tax benefits
6. Diversification
7. Lower financing costs
Exercises

1. Question ID: ICMA 18.P2.012 (Topic: Business Combinations)

Firm A is considering acquiring Firm B for $2,000,000. Firm A has a value of
$4,000,000 and Firm B has a value of $1,000,000 prior to the merger. The merged
firm will have a combined value of $7,000,000. The synergy of the merger is
 A. $1,000,000.
 B. ($1,000,000).
 C. $2,000,000.
 D. ($2,000,000).

2. Question ID: CMA 689 1.9 (Topic: Business Combinations)

A sound justification for a firm’s repurchase of its own stock, such as treasury
stock, is to
 A. lower the debt to equity ratio of the firm.
 B. increase the firm’s total assets.
 C. meet the stock needs of a potential merger.
 D. reduce the idle cash and increase marketable securities.

3. Question ID: HTB 2.1.110 (Topic: Business Combinations)

Ogden Enterprises is a holding company for several successful retail businesses
including bookstores, pharmacies, and gourmet food shops. Ogden has excess
cash and long-range plans to acquire businesses outside the retail industry.
The company is currently considering the acquisition of G-Tech Inc., a company
involved in the research and development of genetically engineered
pharmaceuticals. G-Tech was founded four years ago and received its initial
financing from a venture capital group. G-Tech recently submitted its first new
drug application to the U.S. Food and Drug Administration and is readying a
second application for submission; however, it will be several years before either
of these products can be marketed.
The venture capital group would like to sell the company but does not believe a
public offering would do well. G-Tech is in need of cash and close monitoring to
improve its operational efficiency. G-Tech is most likely to be an attractive
investment to Ogden because of:
 A. Financial synergy, strategic realignment, and tax considerations.
 B. Differential efficiency, undervaluation, and operating synergy.
 C. Strategic realignment, financial synergy, and market power.
 D. Operating synergy, tax considerations, and market power.

4. Question ID: CIA 593 IV.59 (Topic: Business Combinations)

If a company is experiencing cash flow problems, it will most likely attempt a
reorganization involving
 A. Replacing some of the common stock outstanding with preferred stock.
 B. Replacing some of the common stock outstanding with debt.
 C. Replacing some of the debt outstanding with preferred stock.
 D. Replacing some of the debt outstanding with common stock.
Takeovers and Defenses Against Takeovers

Takeovers What Any business combination such as the mergers and acquisitions
particularly the tender offer.

Involves a change in control from one set of shareholders to another.

Takeover Defenses Pre-offer defenses + Post-offer defenses

Pre-offer Defenses
1. Changing the company charter
2. Staggered election of board members
3. Supermajority merger approval provisions
4. Fair merger price provision
5. Golden parachutes
6. Poison pills
7. Poison put
8. Voting rights plan

Post-Offer Defenses
5. Issuing new stock
6. Pacman defense (or reverse tender)
7. White knight defense
8. Leveraged recapitalization or restructuring
9. Crown jewel transfer

Exercises

10. Question ID: CMA 1296 1.26 (Topic: Takeover Defenses)

An example of a “poison pill,” a form of takeover defense, is
 A. An agreement to buy back from the hostile raider a large block of stock
at a premium.
 B. The act of substantially increasing a company’s debt.
 C. The selling off of profitable units in an attempt to dissuade the hostile
corporate raider.
 D. The issuance of rights that allow shareholders to purchase stock in the
proposed merged company at a substantial discount.
Corporate Divestitures and Ownership Restructuring

Corporate Divestitures What ? liquidate the company or part of it

Why? Sometimes in order to create value for shareholders

Methods ? 1. Voluntary Corporate Liquidation

Occurs because the firm’s assets
are more valuable to shareholders in liquidation
than the PV of the expected cash flows from those assets.

11. Partial Sell-off of Assets

Sale of part of a company to another company
Usually to enhance shareholder value
for both the purchasing firm and the selling firm.

12. Spin-Off
Similar to a partial sell-off
The business unit is not sold for cash or securities.
Instead,
common stock in the spun-off segment
is distributed to shareholders on a pro rata basis.

Example:
A shareholder owns 1% of the outstanding common stock of
Company A when Company A spins off its Division One as a
separate company, Company B.

Company B has authorized 2,000,000 common shares to be issued

in the spinoff.

In the spinoff the shareholder who owns 1% of Company A’s

common shares will receive 1% of Company B’s outstanding
shares, or 20,000 shares.

13. Equity Carve-outs

Involve the divestiture of a part of the company (like spin-offs)
BUT
The shares in the new company
are not given to existing shareholders of the parent
but rather are sold in an initial public offering.

The parent company usually sells only part of the stock

in the carved-out new company
while retaining majority control.

14. Tracking Stock

Stock issued that is tied to
the performance of a particular company division.
= > does not involve a corporate divestiture.

15. Going Private

 Changing publicly-owned company into privately-owned.

A group of investors purchases all the stock from the shareholders

and takes the company private.

Usually the purchase is for cash,

but it may employ borrowings, as in a leveraged buyout.

16. Leveraged Buyout

A method of financing the purchase of a company or a segment of
a company using very little equity.

Is considered because a company wants to divest itself of a

division, and that division’s managers want to take over the
ownership.

The main characteristics of a leveraged buyout are:

• The purchase is a cash purchase;
but a large proportion of the cash offered
is financed with large amounts of debt.
• The company or segment being purchased is the borrower,
and its assets are the collateral for the debt that finances the
purchase.
• A company needs to have stable cash flows, little debt, and
assets with market values high enough that they can be used as
collateral for the borrowings.

The Effect of Divestiture on Shareholder Value Generally = ? enhance shareholder wealth

When the entire company is liquidated voluntarily, shareholders usually receive large gains.
Shareholders of a company that purchases a sold-off segment from another company also usually have small
gains, usually because the division is more valuable to the buyer than to the seller.
Exercises

17. Question ID: ICMA 19.P2.087 (Topic: Divestitures)

A corporation would receive cash if it enters into a(n)
 A. reverse stock split program.
 B. spin-off divestiture.
 C. stock repurchase program.
 D. equity carve-out divestiture.

18. Question ID: ICMA 13.P2.034 (Topic: Divestitures)

BigCo, a large conglomerate, has a division that has developed a new and highly
promising technology. BigCo would like to retain control of this division, but also
raise additional capital to support the further development of this technology.
BigCo also realizes this promising technology is different than its usual business
lines and will require a new management style and incentive program to attract
and maintain talent. Which one of the following would best allow BigCo to
achieve these objectives?
 A. A management buy-out of the division.
 B. Sale of the division to another firm.
 C. An equity carve-out of the division.
 D. A spin-off of the division.

19. Question ID: ICMA 1603.P2.007 (Topic: Divestitures)

A publicly-traded company is planning to divest its Division A for $100 million.
Private investors have pooled their capital of $10 million and plan to finance the
balance of $90 million via debt financing with Division A’s assets as collateral.
The new owners plan to give the new management a bigger stake in the company
by providing stock options. They also redesigned performance measures and
incentive schemes for employees to minimize inefficiencies and bureaucracy.
This scenario most closely describes a
 A. leveraged recapitalization.
 B. management buyout.
 C. leveraged buyout.
 D. management recapitalization.

20. Question ID: HTB 2.1.111 (Topic: Divestitures)

A parent company sold a subsidiary to a group of managers of the subsidiary. The
purchasing group invested $1 million and borrowed $49 million against the assets
of the subsidiary. This is an example of a:
 A. Liquidation
 B. Joint venture
 C. Leveraged buyout
 D. Spin-off

21. Question ID: HTB 2.1.112 (Topic: Divestitures)

A large U.S. company recently set up a new corporation based on the assets from
one of its divisions. The stock of the new corporation was titled to the
stockholders of the original firm. This change is an example of a:
 A. Holding company
 B. Synergistic merger
 C. Merger
 D. Divestiture

22. Question ID: ICMAF 032 (Topic: Divestitures)

All of the following transactions could be classified as divestitures except the
sale
 A. of an operating division to a group of managers in a leveraged buyout.
 B. and leaseback of equipment.
 C. of an operating division to another firm in exchange for cash and
preferred stock.
 D. of assets in a geographical location for cash with the buyer also
assuming any liabilities.

23. Question ID: HTB 2.1.113 (Topic: Divestitures)

Clover Inc. recently sold a portion of the firm via an offering of shares in the new
entity to public investors. This type of sell-off is classified as a(n):
 A. Spin-off
 B. Leveraged cash-out
 C. Equity carve-out
 D. Liquidation
Discounted Cash Flow Method or Income Approach of Valuing a Business

What ?? involves determining the present value of the future cash flows
of the company to be valued.

The value of the company is

the present value of the expected future FREE cash flows generated by it,
discounted at the required rate of return.

Free Cash Flow What? Cash flow before interest but after taxes and after capital expenditures.

Calculation ? If all we have is Earnings Before Interest and Taxes (EBIT)

then we start with that, adjusted for taxes.
EBIT x (1 − tax rate)
− (Capital Expenditures − Depreciation)
+/− Change in Non-Cash Working Capital
= Free Cash Flow

Stages of Forecasting Often in two stages.

Stage 1 - Detailed annual forecasts of financial statement items
up to some horizon date, or some future date.

Stage 2 - Forecasts beyond the horizon date to infinity,

using a single growth rate forecast for all years
beyond the horizon date.

Required Rate of Return What? The discount rate used in calculating

the present value of the future cash flows

It should be the cost of common equity of the acquired firm

in order to reflect the riskiness of the acquired firm’s cash flows.

Determined ? The cost of equity of the firm to be acquired

can be approximated by the Capital Asset Pricing Model (CAPM).

Reflects risk

Higher higher discount rate is used for more risky things

PV of in Perpetuity Cash Flows

Expected Free Cash Flow for the Next Year
Cost of Capital − Expected Growth Rate

Example:

Assimilated Stores, Inc. is considering acquiring Takeover Target, Inc.

Takeover Target has been growing rapidly, and its growth is expected to continue for the next 5 years.
After that, its growth is expected to slow down to a more stable long-term rate, beginning with Year 6.
Takeover Target has the following estimated incremental future earnings and investments (in $millions) for the
next 5 years.
The projections below assume a 17% growth rate per year in free cash flow for years 1 through 5.
Yr. 1 Yr. 2 Yr. 3 Yr. 4 Yr. 5
Assets 75.0 87.6 101.6 117.0 137.3
Sales 250.0 300.0 360.0 425.0 500.0
After-tax earnings: EBIT (1- t) 18.0 20.0 22.0 29.0 34.0
Less: Investments (Cap. Exp.- Deprec.) 12.6 13.7 14.6 20.4 23.9
Free Cash Flow 5.4 6.3 7.4 8.6 10.1

It is expected that free cash flow will grow by 10.5% each year beginning with Year 6.

If Takeover Target’s cost of equity capital is 15%, what is the value of the business?

Step 1 - Discount the expected Free Cash Flows for Years 1 through 5 back to the present (Year 0)
using Takeover Target’s cost of equity capital of 15%
to calculate the present value of the near-term cash flows.

$5.4 + $6.3 + $7.4 + $8.6 + $10.1 =

1.15 1.152 1.153 1.154 1.155
$4.70 + $4.76 + $4.87 + $4.92 + $5.02 = $24.27 mln

Step 2 - Determine the horizon value

(the present value as of the end of Year 5 of the cash flows for Years 6 and following).

Pretend that Year 6 is Year 1 and the end of Year 5 is Year 0.

Calculate the present value of the Free Cash Flow for Years 6 and following as of the end of
Year 5, using the Gordon Growth Model, the 15% required rate of return, and the annual growth
rate of 10.5%.

The projected value for free cash flow is the “next year’s” free cash flow amount, which is the
year 5 free cash flow of 10.1 × 1.105, or 11.16.

Horizon Value (H) = 11.16 = $248.0 million

0.15 − 0.105

Step 3 - Discount this $248.0 million horizon value at the end of Year 5 back to the present, to Year 0 u
sing 15% as the discount rate:
248.0 = $123.30 million
1.155

Step 4 - Calculate an estimated gross value for the business by summing the $24.27 million present value
of the near-term cash flows calculated in Step 1 and the $123.30 million present value of the
horizon value calculated in Step 3:

$24.27 million + $123.30 million = $147.57 million

Step 5 - If the acquiring company is assuming liabilities of the acquired company,

the liabilities being assumed should be adjusted to market value and subtracted from the
estimated gross value of the business to arrive at the maximum price to pay for the business.
Any price up to this net amount should result in a worthwhile investment.

For example, if Assimilated Stores is assuming $20 million in liabilities for Takeover Target, the maximum
price Assimilated should pay is $147.57 million minus $20 million, or $127.57 million.
Doing this same process at 25% required rate if return provides a valuation of $44.19 million, instead of
the $147.57 value at a required rate of return of 15%.
Exercises

1. Question ID: ICMA 10Q.2.049 (Topic: Discounted Cash Flow Valuation)

The Gamma Company is a national chain of drug stores in the U.S., but has
decided it needs more stores in the Northeast. It is considering buying a regional
chain in the U.S. from Theta Corporation, a worldwide conglomerate. Gamma
needs to determine the value of the regional chain, so they can make an offer to
Theta.
Gamma has gathered the following data:
 The regional chain’s net income for the year which just ended is $3,500,000.
 The regional chain’s free cash flow for the year just ended is $4,500,000.
 The regional chain’s growth rate for the first 3 years under Gamma is 6%.
 The regional chain’s growth rate for years after year 3 is 3%.
 Gamma’s required rate of return is 9%.
Which one of the following is closest to the maximum amount Gamma should
pay for the regional chain?
 A. $81 million
 B. $84 million
 C. $105 million
 D. $65 million

4. Question ID: ICMA 1603.P2.063 (Topic: Discounted Cash Flow Valuation)

The common stock of a beverage company has a current market price of $34. The
beverage company is estimated to earn $2 per share in the next year. The
average price/earnings ratio of companies in the beverage industry is 15. Using
the price/earnings ratio as the comparable valuation method, the beverage
company’s stock is
 A. $4 overvalued.
 B. $4 undervalued.
 C. $2 undervalued.
 D. $2 overvalued.

6. Question ID: ICMA 1603.P2.027 (Topic: Discounted Cash Flow Valuation)

Clear Displays Inc. manufactures display screens for mobile devices and is
looking to expand their business through acquisition. Clear Displays has a
weighted average cost of capital of 10%. They are evaluating the opportunity to
acquire one of their competitors, Bright Screens Inc. Cash flows for Bright
Screens are forecasted to be $110,000 in each of the next four years, and net
income for Bright Screens is forecasted to be $90,000 in each of the next four
years. The projected terminal value for Bright Screens at the end of that four-year
period is $1,250,000. Utilizing the discounted cash flow method, the valuation for
Bright Screens is expected to be
 A. $1,139,050.
 B. $1,535,300.
 C. $1,202,450.
  D. $1,598,700.

2. Question ID: CMA 695 1.5 (Topic: Discounted Cash Flow Valuation)
If a firm is to be purchased entirely for cash, which of the following items would
the purchaser consider?
I. The incremental future after-tax cash flow from operations
II. Cash paid to the seller's shareholders
III. The present value of the seller's liabilities
 A. I and III.
 B. I.
 C. I and II.
 D. I, II, and III.

3. Question ID: CIA 592 IV.48 (Topic: Discounted Cash Flow Valuation)
The maximum acquisition value of an inefficiently run corporation is the
discounted net present value of the
 A. Current market value of the firm.
 B. Current net profits.
 C. Current earnings before interest and taxes (EBIT).
 D. Expected future cash flow.

5. Question ID: ICMA 13.P2.070 (Topic: Discounted Cash Flow Valuation)

A publicly-traded corporation in an industry with an average price/earnings ratio
of 20 has the following summary financial results.
Sales $1,000,000
Expenses 500,000
Operating income $ 500,000
Taxes 300,000
Net income $ 200,000

Assets $2,500,000
Liabilities $1,000,000
Shareholders' equity $1,500,000
A competitor wishes to make a bid to acquire the stock of the company. What is
the current market value?
 A. $4,000,000.
 B. $10,000,000.
 C. $20,000,000.
 D. $1,500,000.