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Chapter 26 - Mergers and Acquisitions
CHAPTER 26
MERGERS AND ACQUISITIONS
CHAPTER WEB SITES
Section Web Address
26.1 www.marketwatch.com
www.firstlist.com
www.mergernetwork.com
26.4 www.thedeal.com
CHAPTER ORGANIZATION
26.1 The Legal Forms of Acquisitions
Merger or Consolidation
Acquisition of Stock
Acquisition of Assets
Acquisition Classifications
A Note about Takeovers
Alternatives to Merger
26.2 Taxes and Acquisitions
Determinants of Tax Status
Taxable versus Tax-Free Acquisitions
26.3 Accounting for Acquisitions
The Purchase Method
More about Goodwill
26.4 Gains from Acquisition
Synergy
Revenue Enhancement
Cost Reductions
Lower Taxes
Reductions in Capital Needs
Avoiding Mistakes
A Note about Inefficient Management
26.5 Some Financial Side Effects of Acquisitions
EPS Growth
Diversification
26.6 The Cost of an Acquisition
Case I: Cash Acquisition
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Chapter 26 - Mergers and Acquisitions
Case II: Stock Acquisition
Cash versus Common Stock
26.7 Defensive Tactics
The Corporate Charter
Repurchase and Standstill Agreements
Poison Pills and Share Rights Plans
Going Private and Leveraged Buyouts
Other Devices and Jargon of Corporate Takeovers
26.8 Some Evidence on Acquisitions: Do M&A Pay?
26.9 Divestitures and Restructurings
26.10 Summary and Conclusions
ANNOTATED CHAPTER OUTLINE
Video Note: See “Mergers and Acquisition”
26.1 The Legal Forms of Acquisitions
Bidder firm – the company making an offer to buy the stock or assets of another
firm
Target firm – the firm that is being sought
Consideration – cash or securities offered in an acquisition or merger
Lecture Tip: Overall, the massive wave of mergers and restructurings of the
1980s resulted in increased competitiveness, lower costs, and greater efficiency. A
not-uncommon downside to the picture, however, is the job loss and dislocation
associated with the redeployment of corporate assets. Unfortunately, popular
press writers rarely grasp the true causes of such events. One person who does is
Peter Lynch, the successful former manager of the Fidelity Magellan fund.
Consider some of his statements.
“It’s amazing that the basic cause of downsizing is so rarely
acknowledged: these companies have more workers than they
really need – or can afford to pay.
CEOs aren’t callous Scrooges shouting ‘Bah, humbug!’ as they
shove people out the door; they are responding to a competitive
situation that demands that they become more productive.
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If we must blame somebody for the layoffs, it ought to be you and
me. All of us are looking for the best deals in clothing, computers
and telephone service – and rewarding the high-quality, low-cost
providers with our business. I haven’t met one person who would
agree to pay AT&T twice the going rate for phone service if AT&T
would promise to stop laying people off. These companies are
responding to the constant pressure from consumers and
shareholders.”
A. Merger or Consolidation
Merger – the complete absorption of one company by another
(assets and liabilities). The bidder remains and the target ceases to
exist.
Advantage - legally simple and relatively cheap
Disadvantage - must be approved by a majority vote of the
shareholders of both firms, usually requiring the cooperation of
both managements
Consolidation – a new firm is created. Joined firms cease their
previous existence.
Lecture Tip: Appearing relatively infrequently in previous
decades, the use of the hostile takeover bid to acquire control of a
target firm exploded in the 1980s. The term “corporate raider”
(used previously to describe someone who attempted to acquire
board seats via a proxy contest) entered the mainstream and the
stereotypical raider was cemented in the public consciousness in
the guise of the Gordon Gekko character from the movie “Wall
Street.”
Hostile takeover bids are often made via tender offer to current
shareholders, which obviates the need to obtain approval from the
target firm board. The rapid growth of hostile takeovers resulted in
the creation of an array of defensive mechanisms with which to
fight them off.
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Often, but not always, hostile bids are launched against firms that
have been performing poorly; the combination of a depressed
share price and dissatisfaction with management increases the
bidder’s chance of success. Of course, bids occur for other
reasons; the series of attempts by Kirk Kerkorian against Chrysler
came following tremendous firm growth. Kerkorian, however,
wanted management to release some of the $7 billion in cash
reserves the firm had built up.
B. Acquisition of Stock
Taking control by buying the voting stock of another firm with
cash, securities, or both.
Tender offer – offer by one firm or individual to buy shares in
another firm from any shareholder. Such deals are often contingent
on the bidder obtaining a minimum percentage of the shares;
otherwise no go.
Some factors involved in choosing between a tender offer and a
merger:
1. No shareholder vote is required for a tender offer. Shareholders
choose to sell or not.
2. The tender offer bypasses the board and management of the
target firm.
3. In unfriendly bids, a tender offer may be a way around unwilling
managers.
4. In a tender offer, if the bidder ends up with less than 80% of the
target firm’s stock, it must pay taxes on any dividends paid by the
target.
5. Complete absorption requires a merger. A tender offer is often
the first step toward a formal merger.
C. Acquisition of Assets
In an acquisition of assets, one firm buys most or all of another’s
assets, but liabilities are not involved as with a merger.
Transferring titles can make the process costly. The selling firm
may remain in business.
D. Acquisition Classifications
1. Horizontal acquisition – firms in the same industry
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2. Vertical acquisition – firms at different steps of in the production
process
3. Conglomerate acquisition – firms in unrelated industries
Real-World Tip: It is useful to give names to the various types of
mergers. For example, McDonnell-Douglas/Boeing,
Conoco/Phillips, and SBC/AT&T are all examples of horizontal
mergers. An example of a vertical merger would be Texaco (excess
refining capacity) and Getty Oil (significant oil reserves). U.S.
Steel’s acquisition of Marathon Oil would be a conglomerate
acquisition.
E. A Note about Takeovers
Lecture Tip: The popularity of proxy contests as a means of
gaining control has waxed and waned over the last several
decades. In the 1950s, this approach was a relatively popular
means of removing target firm management; as noted previously,
those who initiated proxy contests were even referred to in the
popular press as “corporate raiders!” Empirical evidence
suggests, however, that proxy contests are time-consuming,
expensive for the dissident shareholder, and unlikely to result in
complete victory.
Tender offers came to the fore in the 1960s and 1970s. Some
believe that the use of the proxy battle waned because of its
relatively high cost and low probability of success. However, the
ubiquity of takeover defenses and regulatory constraints has
contributed to the return of the importance of the proxy battle as a
means of gaining control.
Real-World Tip: An interesting example of a long, drawn-out
proxy battle appeared in The Wall Street Journal on October 8,
1996. Physician Steven Scott founded Coastal Physicians Group,
Inc., but was subsequently ousted by its board of directors. Dr.
Scott then filed suit and launched a proxy fight. In return, the
firm’s management counter-sued and blamed him for the firm’s
poor performance. Following several months of wrangling, two
candidates backed by Dr. Scott won board seats. The struggle for
control of Coastal is not unlike many proxy fights, in that they are
often associated with claims and counter-claims, lawsuits, and a
great deal of acrimony and expense.
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Four means to gain control of a firm:
1. Acquisitions – merger or consolidation, tender offer, acquisition
of assets
2. Proxy contests – gain control by electing directors using proxies
3. Going private – all shares bought by a small group of investors
4. Leveraged buyouts (LBOs) – going private with borrowed
money
F. Alternatives to Merger
Firms could simply agree to work together via a joint venture or
strategic alliance.
26.2 Taxes and Acquisitions
A. Determinants of Tax Status
Tax-free – acquisitions must be for a business purpose, and there
must be a continuity of equity interest
Taxable – if cash or a security other than stock is used, the
acquisition is taxable
B. Taxable versus Tax-Free Acquisition
Capital gains effect – if taxable, the target’s shareholders may end
up paying capital gains taxes, driving up the cost of the acquisition
Write-up effect – if taxable, the target’s assets may be revalued,
i.e., written up and depreciation increased. However, the Tax
Reform Act of 1986 made the write up a taxable gain, making the
process less attractive.
26.3 Accounting for Acquisitions
In 2001, FASB eliminated the pooling of interest option.
There are no cash flow consequences stemming from the
accounting method used.
A. The Purchase Method
The target firm’s assets are reported at fair market value on the
bidder’s books. The difference between the assets’ market value
and the acquisition price is goodwill.
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Below is an additional example depicting the balance sheet effects
of the purchase method.
Example: Firm X borrows $10 million to acquire Firm Y, creating
Firm XY.
Balance Sheets (in millions) prior to the acquisition:
Firm X Firm Y
Working Capital $ 2 Debt $ 0 Working Capital $
1
Debt $ 0
Fixed Assets 18 Equity 20 Fixed Assets 5 Equity 6
Total Assets $20 Total L&E $20 Total Assets $6 Total L&E $6
Firm Y’s fixed assets have a market value of $8 million, making
total assets worth $9 million.
Balance Sheet after the acquisition
Firm XY
Working Capital $ 3 Debt $10
Fixed Assets 26 Equity 20
Goodwill 1
Total Assets $30 Total L & E $30
B. More about Goodwill
Because of the requirement that all mergers be accounted for using
the purchase method, the FASB changed the rules on Goodwill.
Companies are no longer required to amortize goodwill. However,
it must be reduced in the case where the value has decreased.
26.4 Gains from Acquisition
A. Synergy
The difference between the value of the combined firms and the
sum of the individual firms is the incremental gain, V = VAB –
(VA + VB).
Synergy – the value of the whole exceeds the sum of the parts (V
> 0)
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The value of Firm B to Firm A = VB* = V + VB. VB* will be
greater than VB if the acquisition produces positive incremental
cash flows, CF.
CF = EBIT + Depreciation - Taxes - Capital Requirements
CF = Revenue - Costs - Taxes - Capital Requirements
B. Revenue Enhancement
1. Marketing gains – changes in advertising efforts, changes in the
distribution network, changes in the product mix
2. Strategic benefits (beachheads) – acquisitions that allow a firm
to enter a new industry that may become a platform for further
expansion
3. Market power – reduction in competition or increase in market
share
Lecture Tip: The text notes several reasons for M&A activity. The
following was sent via email to members of a mergers and
acquisitions listserv.
“Do you know a business experiencing a decline in
sales, loss of direction, no longer competitive,
ineffective management, … Or a business that’s being
neglected by its corporate parent … Or a [sic] owner
looking to retire that built a once successful business
now needing reinventing … or a company that needs
strong marketing, finance, and manufacturing
disciplines … If you know such a business … it will be
worth your while to reply.”
C. Cost Reductions
1. Economies of scale – per unit costs decline with increasing
output
2. Economies of vertical integration – coordinating closely related
activities or technology transfers
3. Complementary resources (economies of scope) – example:
banks that allow insurance or stock brokerage services to be sold
on premises
D. Lower Taxes
1. Net operating losses (NOL) – a firm with losses and not paying
taxes may be attractive to a firm with significant tax liabilities
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Chapter 26 - Mergers and Acquisitions
-Carry-back and carry-forward provisions reduce incentive to
merge
-IRS may disallow or restrict the use of NOL
2. Unused debt capacity – adding debt can provide important tax
savings
3. Surplus funds – firms with significant free cash flow can:
-Pay dividends
-Repurchase shares
-Acquire shares or assets of another firm
Lecture Tip: The IRS requires that the merger must have
justifiable business purposes for the NOL carry-over to be
allowed. And, if the acquisition involves a cash payment to the
target firm’s shareholders, the acquisition is considered a taxable
reorganization that results in a loss of NOLs. NOL carry-overs are
allowed in a tax-free reorganization that involves an exchange of
the acquiring firm’s common stock for the acquired firm’s common
stock. Additionally, if the target firm operates as a separate
subsidiary within the acquiring firm’s organization, the IRS will
allow the carry-over to shelter the subsidiary’s future earnings, but
not the acquiring firm’s future earnings.
E. Reductions in Capital Needs
1. A firm needing capacity acquires a firm with excess capacity
rather than building new facilities
2. Possible advantages to raising capital given economies of scale
in issuing securities
3. May reduce the investment in working capital
F. Avoiding Mistakes
1. Do not ignore market values. Use the current market value as a
starting point and ask “What will change if the merger or
acquisition takes place?”
2. Estimate only incremental cash flows. These are the basis of
synergy
3. Use the correct discount rate. Make sure to use a rate appropriate
to the risk of the cash flows
4. Be aware of transaction costs. These can be substantial and
should include fees paid to investment bankers and lawyers, as
well as disclosure costs
G. A Note about Inefficient Management
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Chapter 26 - Mergers and Acquisitions
If management isn’t doing its job well, or others may be able to do
the job better, acquisitions are one way to replace management.
The threat of takeover may be enough to make managers act in the
best interest of shareholders.
Lecture Tip: One of the fathers of modern takeover theory is
Henry Manne, who published “Mergers and the Market for
Corporate Control” in 1965. In this seminal work, Manne
proposes the (now commonly accepted) notion that poorly run
firms are natural takeover targets because their market values will
be depressed, permitting acquirers to earn larger returns by
running the firms successfully. This proposition has been verified
empirically in dozens of academic studies over the last four
decades.
26.5 Some Financial Side Effects of Acquisitions
A. EPS Growth
An acquisition may give the appearance of growth in EPS without
actually changing cash flows. This happens when the bidder’s
stock price is higher than the target’s, so that fewer shares are
outstanding after the acquisition than before.
Example: Pizza Shack wants to merge with Checkers Pizza. The
merger won’t create any additional value, so, assuming the market
isn’t fooled, the new firm, Stop ‘n Go Pizza, will be valued at the
sum of the separate market values of the firms.
Stop ‘n Go is valued at $1,875,000 and has 125,000 shares
outstanding with a price of $15 per share. Pizza Shack
stockholders receive 100,000 shares, and Checkers Pizza
stockholders receive 25,000 shares.
Before and after merger financial positions
Pizza
Shack
Checkers
Pizza
Stop ‘n Go
Pizza
Total Earnings $150,000 $75,000 $225,000
Number of Shares 100,000 50,000 125,000
Earnings per Share $1.50 $1.50 $1.80
Price per Share $15.00 $7.50 $15.00
Price-to-Earnings
Ratio
10 5 8.33
Total Value $1,500,00
0
$375,00
0
$1,875,00
0
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Chapter 26 - Mergers and Acquisitions
Lecture Tip: Who have been some of the top dealmakers? The
February 2007 edition of Mergers and Acquisitions Journal
indicates that six firms advised in 200 or more transactions during
2006. The number of deals and the dollar volume involved was as
follows:
2006
Leaders
(200+
Deals)
Company No. of M&A
Deals
$ Volume of M&A
Deals (millions)
1 Goldman Sachs 269 $735.4
2 JP Morgan 252 $554.5
3 Morgan Stanley 230 $616.4
4 Credit Suisse 226 $435.3
5 UBS 221 $375.6
6 Citigroup 217 $568.4
B. Diversification
A firm’s attempt at diversification does not create value because
stockholders could buy the stock of both firms, probably more
cheaply. Firms cannot reduce their systematic risk by merging.
Lecture Tip: In earlier chapters, we pointed out that conflicts of
interest may exist between stockholders and managers in publicly
traded firms. As noted above, diversification-based mergers don’t
create value for shareholders (this was illustrated using option
pricing theory in an earlier chapter); however, these mergers may
increase sales and reduce the total variability of firm cash flows. If
managerial compensation and/or prestige is related to firm size, or
if less variable cash flows reduce the likelihood of managerial
replacement, then some mergers may be initiated for the wrong
reasons – they may be in the best interest of managers but not
stockholders.
26.6 The Cost of an Acquisition
The NPV of a merger = VB* - Cost to Firm A of the acquisition
Merger premium – amount paid above the stand-alone value
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Chapter 26 - Mergers and Acquisitions
Reconsider Pizza Shack’s merger with Checkers Pizza. Suppose
Pizza Shack acquires Checkers in a buyout. Pizza Shack has
estimated the incremental value of the acquisition, V, to be
$75,000. The value of Checkers to Pizza Shack is VC* = V + VC =
$75,000 + $375,000 = $450,000. Checkers shareholders are willing
to sell for $400,000. Thus, the merger premium is $25,000.
A. Case I: Cash Acquisition
Suppose Pizza Shack pays Checkers’ stockholders $400,000 in
cash. Then, NPV = $450,000 – $400,000 = $50,000.
The value of the combined firm = $1,500,000 + $50,000 =
$1,550,000
With 100,000 shares outstanding, the price per share becomes
$15.50
B. Case II: Stock Acquisition
Suppose, instead of cash, Pizza Shack gives Checkers stockholders
Pizza Shack stock valued at $15 per share. Checkers stockholders
will get 400,000 / 15 = 26,667 shares (rounded). The new firm will
have 126,667 shares outstanding and a value of $1,500,000 +
$375,000 + $75,000 = $1,950,000 for a per share price of $15.39.
The total consideration is 26,667(15.39) = $410,405.13. The extra
$10,405.13 comes from allowing Checkers stockholders
proportional participation in the $50,000 NPV.
C. Cash versus Common Stock
1. Sharing gains – When cash is used, the target’s stockholders
can’t gain beyond the purchase price. Of course, they can’t fall
below either.
2. Taxes – Cash transactions are generally taxable; exchanging
stock is generally tax-free.
3. Control – Using stock may have implications for control of the
merged firm.
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Chapter 26 - Mergers and Acquisitions
Lecture Tip: Emphasize that the logic used in determining the
NPV of an acquisition is the same as that used to find the NPV of
any other project. The acquisition is desirable if the present value
of the incremental cash flows exceeds the cost of acquiring them.
However, some financial theorists argue that many acquisitions
contain a “winner’s curse.” The argument is that the winner of an
acquisition contest is the firm that most overestimates the true
value of the target. As such, this bid is most likely to be excessive.
For a more detailed discussion of the “winner’s curse,” see Nik
Varaiya and Kenneth Ferris, “Overpaying in Corporate
Takeovers: The Winner’s Curse,” Financial Analysts Journal,
1987, vol. 43. no. 3. Richard Roll, in “The Hubris Hypothesis of
Corporate Takeovers,” Journal of Business, 1986, vol. 59, no. 2,
attributed the rationale for this behavior to hubris, i.e., the
excessive arrogance or greed of management.
26.7 Defensive Tactics
A. The Corporate Charter
-Usually, 67% of stockholders must approve a merger. A
supermajority amendment requires 80% or more to approve a
merger.
-Staggered terms for board members
B. Repurchase and Standstill Agreements
A standstill agreement involves getting the bidder to agree to back
off, usually by buying the bidder’s stock back at a substantial
premium (targeted repurchase); also called greenmail.
Example: Ashland Oil bought off the Belzbergs of Canada in a
targeted repurchase. Ashland also had an established employee
stock ownership with 27% of outstanding shares owned by
employees and had earlier adopted a supermajority provision.
C. Poison Pills and Share Rights Plans
In a share rights plan, the firm distributes rights to purchase stock
at a fixed price to existing shareholders. These can’t be detached or
exercised until “triggered,” but they can be bought back by the
firm. They are usually triggered when a tender offer is made.
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Flip-over provision – the “poison” in the pill. Effectively, the target
firm’s shareholders get to buy stock in the target firm at half price.
D. Going Private and Leveraged Buyouts
Can prevent takeovers from management’s point of view.
E. Other Devices and Jargon of Corporate Takeovers
1. Golden parachutes – compensation to top management in the
event of a takeover
2. Poison puts – forces the firm to buy stock back at a set price
3. Crown jewels – a “scorched earth” strategy of threatening to sell
major assets
4. White knights – target of hostile bid hopes to find a friendly firm
(white knight) to buy a large block of stock (often on favorable
terms) to halt takeover
5. Lockups – option granted to friendly firm giving it the right to
buy stock or major assets at a fixed price in the event of a hostile
takeover
6. Shark repellent – any tactic designed to discourage unwanted
takeovers
7. Bear hug – “an offer you can’t refuse”
8. Fair price provision – all selling shareholders must receive the
same price from the bidder – eliminates the ability to make a two-
tier offer to encourage shareholders to tender early
9. Dual class capitalization – more than one class of common stock
with most of the voting power privately held
10. Countertender offer – “Pac-man” defense - target offers to buy
the bidder
Ethics Note, page 834: In The Law and Finance of Corporate
Insider Trading: Theory and Evidence (Kluwer Publishing, 1993)
Arshadi and Eyssell argue that an active market for corporate
control will be characterized by increases in the nature and
complexity of defensive tactics and by an increasing volume of pre-
announcement insider trading. In the case of the former, managers
facing an environment that is (from their perspective) increasingly
hostile and will seek to defend themselves and their positions.
Defensive tactics will be implemented, tested by takeover bids and
in the courts, and modified.
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Trading on nonpublic information has been shown in numerous
academic studies to be extremely profitable (albeit illegal); thus
the conclusion that financial markets are not strong-form efficient.
In the case of takeover bids, insider trading is argued to be
particularly endemic because of the large potential profits
involved and because of the relatively large number of people “in
on the secret.” Managers, employees, investment bankers,
attorneys, and financial printers have all been accused in various
takeover-related insider trading cases.
Lecture Tip: Less common, but not rare, are “reverse mergers,” in
which a firm goes public by merging with a public (often shell)
company. Ted Turner gained control of Rice Broadcasting (WJRJ-
TV) in 1970 by doing a reverse merger. Rice Broadcasting was
“virtually insolvent,” but by merging into a public company,
Turner was obtaining financing for subsequent growth.
26.8 Some Evidence on Acquisitions: Do M&A Pay?
Available evidence suggests that target stockholders make
significant gains – more in tender offers than in mergers. On the
other hand, bidder stockholders earn comparatively little, breaking
even on mergers and making a few percent on tender offers.
Lecture Tip: It is probably not overstating the matter to say that
the accepted wisdom in modern finance is that, in the aggregate,
more merger and acquisition activity is preferred to less. Dozens of
event studies report that, on average, the wealth of target firm
stockholders is greatly enhanced, while the wealth of acquiring
firm stockholders is unaffected, or at worst, slightly diminished.
For many, the notion that an active market for corporate control is
a good thing has become so ingrained that we are somewhat
surprised when others don’t view things the same way. However, in
an interesting essay in the August 1998 issue of Harpers magazine,
Lewis H. Lapham likens the sequential announcements of
seemingly ever-larger corporate combinations to the elephant act
at the circus:
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“The corporate ringmasters left out the part with the
trapeze artists and the clowns. Instead of a band they
brought accountants, introducing Jumbo or Babar to
the cameras in the hotel ballroom with a blare of press
releases – how much cash for what class of stock, the
sum of the combined assets and the disposition of the
principal executives, the fate of 12,000 superfluous
workers, the newly merged colossus proclaimed the
wonder of the age. The attending media never failed to
greet the number with a roar of superlatives (the
biggest this, the richest that), and over a period of eight
weeks so many elephants plodded in and out of the
headlines that I began to wonder how the company
mahouts would manage to fit them all under the same
tent or onto the same golf course. I didn’t take a
complete set of notes, but even a brief list of some of
the more memorable exits and entrances attests to the
great and golden truth that size matters, that big is
beautiful and biggest best of all.”
In at least one sense, Lapham is correct. The 1998 merger pace
was torrid. In the first five months of the year, $630 billion worth
of mergers and acquisitions were announced. Compare that to
1996, a record year for M&A during which activity totaled $658.8
billion for the entire year. Then, take a look at 2000 when volume
was 1.78 trillion, with annual volume exceeding $1trillion in 1998-
2001, and during 2006. When you discuss mergers and the market
for corporate control in your Corporate Finance courses, you may
wish to hunt up Mr. Lapham’s essay to use as a starting point for
class discussion. While you may not agree with the points he
makes, it is extremely well-written and makes a compelling case
for what business strategists have advocated for many years –
getting back to the firm’s “core business” and doing it well.
26.9 Divestitures and Restructurings
Divestiture – a firm sells assets, operations, divisions, or segments
Reasons for a divestiture
1. Requirement after an acquisition for antitrust purposes
2. Unit may be unprofitable
3. Company may need the cash
4. Company may want to focus on core competency
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Equity carve-out – parent company creates a separate company of
the division in question and then arranges an IPO where a small
fraction of the company is sold to the public. The parent company
retains enough shares to maintain control.
Spin-off – parent company distributes shares of the subsidiary to
existing stockholders in the same proportion as their ownership in
the parent company.
Split-up – company breaks into two or more companies, and
shareholders receive shares in all of the new companies.
26.10 Summary and Conclusions
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