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Finance 3rd Edition

Cornett, Adair, and Nofsinger

20

Copyright 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Mergers and

Acquisitions and

Financial Distress

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Introduction

Mergers and acquisitions Firms combine

Assets

Liabilities

Equity

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Mergers & Acquisitions

Merger two firms combine to form onelarger firm

Acquisition one firm purchases another

Consolidation newly-created firm

absorbs bidder and target

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Horizontal Mergers

A horizontal merger is the combination oftwo firms in the same industry

Market extension merger (also horizontal)

combines two firms that sell the sameproduct in different markets

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Vertical Merger

Combines a firm with a supplier ordistributor

Avoids fixed costs

Eliminates contracting, payment collection,communication, advertising and coordination

costs

Improves inventory planning

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Conglomerate Merger

Two companies merge that have no relatedproducts or markets

Popular in 1960s and 1970s, but dismantled in

the 1980s and 1990s due to poor performance

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Product Extension Merger

Firms merge that sell different, butsomewhat related products

A cross between horizontal and

conglomerate mergers

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Revenue Enhancement

Acquisition of firm in growing area mayenhance revenues

The acquiring firms revenues may become

more stableAcquisition of new markets

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Cost Reduction

Economies of scale Reduce or eliminate redundancies in firm

Cost of producing goods falls as size of firm

increases

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Economies of Scale in Mergers

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Long-Term Effect of Economies of Scale

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Cost Reduction

Economies of Scope Refers to merged firms abilities to generate

synergistic cost savings due to inter-relationship

among products and jointness in cost ofproducing them

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X-Efficiencies

Not directly due to economies of scope orscale

Due to superior management as result of

replacing old, inefficient managers

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Tax Considerations

Tax gains from an acquisition can resultfrom

Net operating losses

Unused debt capacity Surplus funds

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Lowering the Cost of Capital

A merger can lower a firms cost of capital Cost of issuing securities declines

Diversification due to merger reduces debt risk

of merged firm, resulting in a lower interest rate

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Managers Personal Incentives

Managers personal wishes may drivemerger rather than sound economic basis

Not favorable for the merged firm and can

cause stock price and shareholders wealth todecline

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Valuing a Merger

Net present value (NPV) or discountedcash flow (DCF) method is most accurate

method for valuing a merger

Forecasted cash flows discounted to PV basedon merged firms weighted average cost of

capital (WACC)

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Financial Distress

Economic Failure Return on assets less than cost of capital

Business Failure

Most extreme type -- firm out of business

Technical Insolvency

Operating cash flows are not sufficient to pay

liabilities

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Firm-Specific Causes of Financial Distress

Excess financial leverage Highly volatile earnings stream

Poor management

Loss of key players on which production ormanagement depended

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Market-Specific Causes of Financial Distress

Business cycle fluctuations High interest rates

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Informal Resolutions of Financial Distress

Debt agreement restructuring Liquidation of firms assets

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Restructuring a Firms Debt Agreements

Appropriate if financial distress is judged tobe temporary

Creditors and firm restructure debt

agreements in a workout

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Informal Liquidation of a Firms Assets

Termination of the firm as a going concernAssets sold; proceeds pay off the firms

creditors

Assignment passes liquidation of the firmsassets to third-party assignee or trustee

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Federal Bankruptcy Laws

Creditors can force the firm into bankruptcyif informal restructure agreement not

reached

Firm can voluntarily file for bankruptcy

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Bankruptcy Reform Act of 1978

Chapter 11 Firm in temporary financial distress cancontinue operating while creditors claimssettled

Chapter 7

Generally used if reorganization under Chapter11 not feasible

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Reorganization Procedures in Bankruptcy

Reorganization petition filedFederal judge reviews petition

Firm submits reorganization plan within

120 days

Creditor committees appointed

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Liquidation Procedures in Bankruptcy

Bankruptcy for firms too distressed toreorganize via Chapter 7

Trustee protects the creditors interests

Priority of claims followed

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Predicting Bankruptcy

Broad types of credit scoring models Linear discriminant models

Linear probability models

Logit models