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Corporate Financial Management II (#2, 3)

Corporate Financial Management II 2

Mergers & AcquisitionsAcquisition = (Big and Complex)

Capital Budgeting Project

Substantiation of Merger (Net Advantage to Merging):

NAM = [VAB - (VA+VB)] - PB - Expenses

Valuation: DCF and Comparative Analysis Methods; Break-up Valuation

Chapter 21

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Valid Reasons for MergersSynergy: Value of the whole exceeds

sum of the parts. Could arise from:Operating economiesFinancial economiesDifferential management efficiencyTaxes (use of accumulated losses)

Break-up value: Assets would be more valuable if broken up and sold to other companies.

Corporate Financial Management II 4

Questionable Reasons for MergersDiversification.

Purchase of assets at below replacement cost (or “cheap” refinancing).

Acquire other firms to increase size, thus making it more difficult to be acquired.

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Do Mergers Really Create Value?According to empirical evidence,

acquisitions do create value as a result of economies of scale, other synergies, and/or better management.

Shareholders of target firms reap most of the benefits, that is, the final price is close to full value (i.e. PB > NAM).

Target management can always say no.

Competing bidders often push up prices.

Corporate Financial Management II 6

Hostile and Friendly MergersFriendly merger - Supported by

managements of both firms.Hostile merger - Target firm’s

management resists the merger; Acquirer must go directly to the target firm’s stockholders, try to get 51% to tender their shares, or get proxies.

Often, mergers that start out hostile end up as friendly, when offer price is raised.

Corporate Financial Management II 7

Defensive TacticsChanging by-laws (staggered election

of directors, supermajority voting)Legal (filing on antitrust or other issues)Unloading cash (acquisitions, stock

repurchase, investments, leveraging)Capital-related (issue rights, special

classes of stock, friendly shareholder)Tactical (counter tender, poison pills)

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Forms of TransactionMerger or Consolidation

Combination of balance sheetsHas to be approved by both companies

Purchase of StockOpen market or tender offer

Purchase of AssetsBy-passes minority shareholders and

avoids hidden liabilitiesTends to be complicated and costly

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Accounting for MergersPooling of interests:

Assumes a merger among equals.New balance sheet is merely the sum of

the two existing balance sheets.No income statement effects other than

summing the two income statements.Purchase:

Assets of the acquired firm are “written up” to reflect purchase price if it is greater than the net asset value => Goodwill is created.

Goodwill amortized and expensed over time, reducing future reported earnings.

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Merger ValuationComparative Methods

Merger PremiumEarnings (Cash Flow, EBIT) MultiplesBook Value MultiplesPrice per Unit of Resource (natural

resources, customers...)DCF Valuation

Prepare pro-forma statements forecasting incremental cash flows expected to result from merger.

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Financial DistressFirm cannot meet obligations (this

can mean repayment, covenant or rating) =>

1) Try to renegotiate terms of loan

2) Find cash (refinance loan, sell assets)

3) File for bankrupcy

Reorganization,

Liquidation.

Chapters 22

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Causes of DistressManagementExternal Economic FactorsStructural Financial and Operating

FactorsOperational, Regulatory, Legal Risks

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Early Detection of DistressWho cares to know?

Management, ShareholdersLenders, BondholdersOther Stakeholders (business

partners, sometimes regulators...)Tools: Credit Analysis, Multiple Discri-

minant Analysis, Agency Ratings, Market Developments, Business News

Corporate Financial Management II 14

Reorganization Outs. BankrupcyUsually cheaper than in bankrupcy:

Issue new securities for existing securities, or

Modify the terms of outstanding securities (maturity, covenants), or

Repurchase a specific issue.Reporting, reputation, benefits.Use incentives (eg. holdout problem).

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International FinanceEarlier, most companies acted just in

their home markets.

Today, a number of companies are multinational (i.e. operating in two or more countries).

Others trade with foreign companies, use foreign currencies etc.

Chapters 17

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Why Firms Expand InternationallyTo seek new markets.

To seek new supplies of raw materials.

To gain new technologies.

To gain production efficiencies.

To avoid political and regulatory obstacles.

To reduce risk by diversification.

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Main DistinctionsCurrency differences

Economic and legal differences

Language differences

Cultural differences

Government roles

Political risk

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Asset Based FinancingWith traditional financing, investors

look to the entire cash flow of the firm for a return on their investment.

Asset-based financing limits this to cash flows from a specific pool of assets (recourse or nonrecourse).

Lease Financing, Project Financing, Limited Partnership Financing...

Chapter 18

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LeasingThe lessee uses the asset and makes

the lease, or rental, payments.The lessor owns the asset and

receives the rental payments.The lease decision is a financing

decision for the lessee and an investment decision for the lessor.

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Lease TypesOperating Lease

Normally short-term and cancelable; maintenance included

Financial LeaseNormally long-term and

noncancelable; no maintenanceSale and LeasebackCombination, Leveraged, Synthetic...

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Economic ImpactLeasing is a substitute for debt. As

such, leasing uses up a firm’s debt capacity.

Net Advantage to Leasing facilitates comparasion with borrow and buy

Corporate Financial Management II 22

Leasing HighlightsIn a perfect environment, leasing is zero-

sum. Why, then, is it so popular?Provision of maintenance services.Risk reduction for the lessee (project life,

resid. value, oper. risk, obsolence) -Portfolio risk reduction enables lessor to better bear these risks.

Cost of borrowing, altern. financing.Bankrupcy considerations.By-passing debt covenants, disclosure.

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Working Capital ManagementNet Working Capital = Current Assets -

Current LiabilitiesEstablishing Working Capital Policy:

Level of each current asset;How current assets are financed.

Day-to-day control of:Cash,Inventory,Receivables,Short-term liabilities.

Cash Conversion Cycle

Chapter 16

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Liquidity ManagementTradeoff between maintaining adequate

liquidity, and profitability. Cash earns no interest, so why hold it?

Transactions: Must have some cash to pay current bills.

Precaution (“Safety stock”): Mitigated by credit lines and marketable securities.

Compensating balances: For loans and/or services provided.

Speculation: To take advantage of bargains, take discounts, etc. (May be solved by credit line, marketable securities).

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WC Management Toolbox Have sufficient cash on hand to meet the needs,

but not one dollar more. Increase forecast accuracy, centralize processing; Synchronize inflows and outflows; Hold securities, negotiate lines of credit instead of

holding cash; Wire transfers (minimize float), zero balance and

remote disbursement accounts, cash pooling. Optimize Cash Conversion Cycle (Inventory

management, Receivable management, Trade Credit)