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Chapter 16: Alternative Exit and Restructuring Strategies
Divestitures, Spin-Offs, Carve-Outs, Split-Ups, and Split-Offs
Answers to End of Chapter Discussion Questions
16.1 What are the advantages and disadvantages of tracking or target stocks to investors and to the firm?
Answer: The purpose in creating tracking stock is to enable the financial markets to value the different operations
within a corporation based on their own performance. Tracking or targeted stocks provide the parent company with an
alternative means of raising capital for a specific operation by selling a portion of the stock to the public and an
16.2 How would you decide when to sell a business?
Answer: Many corporations review their business portfolio periodically to determine which operations continue to fit
their core strategies. Changes in the parent’s strategy or a desire to achieve a more focused business portfolio can
result in certain operations becoming strategically redundant. Such operations become prime candidates for
divestiture. Even if a business ‘‘fits’’ within the parent corporation’s current strategy, the business may not be earning
16.3 What factors influence a parent firm’s decision to undertake a spin-off rather than a divestiture or equity carve-out?
Answer: The decision as to which of these three strategies to use is often heavily influenced by the parent firm’s need
for cash, the degree of synergy between the business to be divested or spun-off and the parent’s other operating units,
16.4 How might the form of payment affect the abnormal return to sellers and buyers?
Answer: Abnormal returns to sellers are much smaller when the seller receives cash rather than buyer equity. Asset
16.5 How might spin-offs result in a wealth transfer from bondholders to shareholders?
Answer: There is evidence that spin-offs transfer wealth from bondholders to stockholders for several reasons. First,
16.6 Explain how executing successfully a large-scale divestiture can be highly complex. This is especially true when the
divested unit is integrated with the parent’s functional departments and with other units operated by the parent.
Consider the challenges of interdependencies, regulatory requirements, and customer and employee perceptions.
Answer: In many instances, units within larger organizations share resources such as human resources, accounting,
tax, public relations, data centers, and other functions which are often centralized at the parent level. An effort must be
made to reassign individuals from these functions to the unit to be divested. In other instances, the parent may
continue well beyond closing to provide services such as payroll processing and computer services to the divested unit
16.7 On April 25, 2001, in an effort to increase shareholder value, USX announced its intention to split U.S. Steel and
Marathon Oil into two separately traded companies. The breakup gives holders of Marathon Oil stock an opportunity
to participate in the ongoing consolidation within the global oil and gas industry. Holders of USX–U.S. Steel Group
common stock (target stock) would become holders of newly formed Pittsburgh-based United States Steel
Corporation. What other alternatives could USX have pursued to increase shareholder value? Why do you believe
they pursued the breakup strategy rather than some of the alternatives?
16.8 Hewlett Packard (HP) announced the spin-off of its Agilent Technologies unit to focus on its main business of
computers and printers. Hewlett Packard provided Agilent with $983 million in start-up funding. HP retained a
controlling interest until mid-2000, when it spun-off the rest of its shares in Agilent to HP shareholders as a tax-free
transaction. Discuss the reasons why HP may have chosen a staged transaction rather than an outright divestiture of
the business.
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16.9 After months of trying to sell its 81 percent stake in Blockbuster Inc., Viacom undertook a spin-off in mid 2004. Why
would Viacom choose to spin-off rather than divest its Blockbuster unit? Explain your answer.
16.10 Since 2001, GE, the world’s largest conglomerate, had been underperforming the S&P 500 stock index. In late 2008,
the firm announced that it was considering spinning off its consumer and industrial unit. What do you believe are
GE’s motives for their proposed restructuring? Why do you believe they chose a spin-off rather than an alternative
restructuring strategy?
Answer: GE’s long-term underperformance had disappointed stockholders for years. They were under pressure to
business.
Solutions to Chapter Case Questions
CBS Corporation and Entercom Merger in a Reverse Morris Trust Deal
Discussion Questions and Solutions:
1. The merger of CBS Radio and Entercom could have been achieved as a result of a CBS spin-off of CBS Radio. Explain the
details of how this might happen.
2. Speculate as to why CBS chose to split-off rather than spin-off CBS Radio as part its plan to merge CBS Radio with
Entercom. Be specific.
Answer: CBS chose a split-off rather than spin-off even though either would have resulted in a tax-free transaction for its
3. What are the Morris Trust tax regulations? How did they affect how this deal was structured? Why was the final ownership
distribution important?
Answer: The U.S. Tax Code restricts how certain types of corporate transactions can be structured to avoid taxes. Specifically,
split-offs or spin-offs implemented as part of a merger must be structured to satisfy Morris Trust tax code rules if the
transaction is to be deemed tax-free. The IRS’ concern is that a split-off or spin-off of a wholly-owned parent subsidiary is
undertaken with sole intent of evading taxes. The parent could have borrowed money and subsequently transferred the liability
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4. How is value created for the CBS and Entercom shareholders in this type of a transaction?
Answer: Ideally, the impact of taxes on investment decisions would be neutral, such that taxes would not impact how the free
market allocates capital. Resources would be transferred to those who can use them most efficiently, as they would be able to
offer the highest risk adjusted financial returns to attract investors.
CBS shareholders participating in the split-off would do so only if they believed the appreciation potential of the Entercom
shares received in exchange for the CBS Radio shares is greater than for CBS shares. No gain is realized until the Entercom
5. What are the advantages and disadvantages of a Reverse Morris Trust structure?
Answer: An advantage the Reverse Morris Trust is that it does not require approval by the parent shareholders for the spin-off
or merger. This is so because the spin-off firm is merging or combining with the merger partner and the parent approves this
Examination Questions and Answers
True/False Questions: Answer True or False to the following questions:
1. Divestitures, spin-offs, equity carve-outs, split-ups, and bust-ups are commonly used strategies to exit businesses.
True or False
2. Empirical studies show that the desire by parent firms to increase strategic focus is an important motive for exiting
businesses. True or False
3. Antitrust regulatory agencies may make their approval of a merger contingent on the willingness of the merger
partners to divest certain businesses. True or False
4. In deciding to sell a business, a parent firm should compare the business’ after-tax value in sale with its pre-tax value
to the parent as part of the parent.
True or False
5. The timing of a divestiture is important. If the business to be sold is highly cyclical, the sale should be timed to
coincide with the firm’s peak year earnings. True or False
6. A spin-off is a transaction involving a separate legal entity whose shares are sold to the parent firm’s shareholders.
True or False
7. A spin-off is a transaction in which a parent creates a new legal subsidiary and distributes shares it owns in the
subsidiary to its current shareholders as a stock dividend. True or False
8. In a spin-off, the proportional ownership of shares in the new legal subsidiary is the same as the stockholders’
proportional ownership of shares in the parent firm. True or False
9. In a spin-off, the board of directors is the same as the board of directors of the parent firm. True or False
10. A split-up involves the creation of a new class of stock for each of the parent’s operating subsidiaries, paying current
shareholders a dividend of each new class of stock, and then dissolving the remaining corporate shell. True or False
11. Spin-offs are generally immediately taxable to shareholders. True or False
12. Both a divestiture and a spin-off generally generate a cash infusion for the parent. True or False
13. Equity carve-outs have some of the characteristics of both divestitures and spin-offs. True or False
14. The parent firm generally retains control of the business involved in an equity carve-out. True or False
15. An equity carve-out is often a prelude to a complete divestiture of a business by the parent. True or False
16. Although the parent often retains control in an equity carve-out, the shareholder base of the subsidiary may be
different that that of the parent. True or False
17. In an equity carve-out, the cash raised by the subsidiary in this manner may be transferred to the parent as a dividend
or as an inter-company loan. True or False
18. When a parent creates a tracking stock for a subsidiary, it is giving up all control of that subsidiary. True or False
19. Tracking stocks are often created to give investors a pure play investment opportunity in one of the parent’s
subsidiaries. True or False
20. Tracking stocks may create internal operating conflicts among the parent’s business units in terms of how the
consolidated firm’s cash is allocated among its business units. True or False
21. Voluntary bust-ups or liquidations by the parent firm reflect management’s judgment that the sale of individual parts
of the firm could realize greater value than the value created by a continuation of the combined corporation. True or
False
22. In general, a voluntary bust-up or liquidation has the advantage over mergers of deferring the recognition of a gain by
the stockholders of the selling company until they eventually sell the stock. True or False
23. When a firm is unable to pay its liabilities as they come due, it is said to be in bankruptcy. True or False
24. Equity carve-outs are similar to divestitures and spin-offs in that they provide a cash infusion to the parent. True or
False
25. The divesting firm is required to recognize a gain or loss for financial reporting purposes equal to the difference
between the book value of the consideration received for the divested operation and its fair value. True or False
26. In a private solicitation, the parent firm may hire an investment banker or undertake on its own to identify potential
buyers to be contacted. True or False
27. A parent firm’s decision to sell or to retain a subsidiary is often made by comparing the after-tax equity value of the
subsidiary with the pre-tax and interest sale value of the business. True or False
28. A parent firm rarely chooses to divest an undervalued business and return the cash to shareholders either through a
liquidating dividend or share repurchase. True or False
29. The divestiture of a business always results in the parent receiving cash from the buyer? True or False
30. Management may sell assets to fund diversification opportunities? True or False
31. Many corporations, particularly large, highly diversified organizations, constantly are reviewing ways in which they
can enhance shareholder value by changing the composition of their assets, liabilities, equity, and operations. True or
False
32. Divestitures, spin-offs, equity carve-outs, split-ups, split-offs, and bust-ups are commonly used strategies to exit
businesses and to redeploy corporate assets by returning cash or noncash assets through a special dividend to
shareholders. True or False
33. Managing highly diverse and complex portfolios of businesses is both time consuming and distracting. This is
particularly true when the businesses are in largely related industries. True or False
34. A business that is rich in high-growth opportunities may be an excellent candidate for divestiture to a strategic buyer
with significant cash resources and limited growth opportunities. True or False
35. A substantial body of evidence indicates that increasing a firm’s degree of diversification can improve substantially
financial returns to shareholders. True or False
36. Empirical studies show that exit strategies, which return cash to shareholders, tend to have a highly unfavorable
impact on shareholder wealth creation. True or False
37. Acquiring companies often find themselves with certain assets and operations of the acquired company that do not fit
their primary strategy. Such assets may be divested to fund future investments. True of False
38. Divestitures always result in the parent receiving stock or debt from the buyer. True or False
39. The decision to sell or to retain the business depends on a comparison of the pre-tax value of the business to the parent
with the after-tax proceeds from the sale of the business. True or False
40. Although the sale value may exceed the equity value of the business, the parent may choose to retain the business for
strategic reasons. True or False
41. In a public solicitation, a firm can announce publicly that it is putting itself, a subsidiary, or a product line up for sale.
Either potential buyers contact the seller or the seller actively solicits bids from potential buyers or both. True or
False
42. In either a public or private solicitation, interested parties are asked to sign confidentiality agreements after they are
given access to proprietary information but before they are asked to make a bid. True or False
43. The divesting firm is required to recognize a gain or loss for financial reporting purposes equal to the difference
between the fair value of the consideration received for the divested operation and its market value. True or False
44. In a spin-off, some shareholders receive proportionately more shares than others. True or False
45. Like divestitures or equity carve-outs, the spin-off generally results in an infusion of cash to the parent company.
True or False
46. A split-up involves carving out a portion of the equity of each of the parent’s operating subsidiaries and selling the
shares to the public. True or False
47. Parent firms with a high tax basis in a business may choose to spin-off the unit as a tax-free distribution to
shareholders rather than sell the business and incur a substantial tax liability. True or False
48. Split-ups and spin-offs generally are taxable to shareholders. True or False
49. For financial reporting purposes, the parent firm should account for the spin-off of a subsidiary’s stock to its
shareholders at book value with no gain or loss recognized, other than any reduction in value due to impairment. True
or False
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50. In an equity carve-out, minority shareholders are eliminated. True or False
51. Although the parent retains control, the shareholder base of the subsidiary that has undergone an equity carve-out is
unlikely to be different than that of the parent as a result of the public sale of equity. True or False
52. In addition, stock-based incentive programs to attract and retain key managers can be implemented for each operation
with its own tracking stock. True or False
53. For financial reporting purposes, a distribution of tracking stock splits the parent firm’s equity structure into separate
classes of stock without a legal split-up of the firm. True or False
54. Unlike a spin-off or carve-out, the parent retains complete ownership of the business for which it has created a
tracking stock. True or False
55. A disadvantage of a split-off is that they tend to increase the pressure on the spun-off firm’s share price, because
shareholders who exchange their stock are more likely to sell the new stock. True or False
56. Equity ownership changes in spin-offs, but it does not change in split-ups. True or False
57. The reasons for selecting a divestiture, carve-out, or spin-off strategy are basically the same. True or False
58. A spin-off is tax free to the shareholders if it is properly structured. In contrast, the cash proceeds from an outright sale
may be taxable to the parent to the extent a gain is realized. True or False
59. Restructuring actions may provide tax benefits that cannot be realized without undertaking a restructuring of the
business. True or False
60. Parent firms often exit businesses that consistently fail to meet or exceed the parent’s hurdle rate requirements. True
or False
61. Divestitures are always taxable to the selling firm? True or False
1. Which of the following is generally considered a motive for exiting businesses?
a. Changing corporate strategy or focus
b. Underperforming businesses
c. Regulatory concerns
d. Lack of fit
e. All of the above
2. To decide if a business is worth more to the shareholder if sold, the parent firm generally considers all of the
following factors except for
a. The after-tax cash flows of the business to be sold
b. The after-tax sale value of the business to be sold
c. The parent’s cost of capital
d. A and B
e. A, B, and C
3. Which of the following is not a characteristic of a spin-off?
a. The parent creates a new legal subsidiary for the business to be spun-off
b. The shares of the new subsidiary are sold to the public
c. The ownership of shares in the new legal subsidiary is the same as the stockholders’ proportional ownership
of shares in the parent firm
d. The new business once spun-off has its own management and board
e. Spin-offs are generally not taxable to the parent’s shareholders if properly structured
4. A spin-off may create shareholder wealth for all of the following reasons except for
a. Spin-offs are generally not taxable if properly structured
b. The spin-off’s management and board is independent of the former parent
c. Investors will be better able to value the spin-off
d. The cost of capital of the spin-off is generally higher than when it was part of the parent
e. The spin-off may be subsequently acquired by another firm
5. An equity carve-out differs from a spin-off for all but which one of the following reasons?
a. Generates a cash infusion into the parent
b. Is undertaken when the unit has very little synergy with the parent
c. The proceeds often are taxable to the parent
d. Continues to be influenced by the parent’s management and board
e. The carve-out’s shareholders may differ from those of the parent’s shareholders
6. Which one of the following is generally not a reason for issuing tracking stocks?
a. To give investors a “pure play” in a specific business owned by the parent
b. To create a currency for the business to acquire other firms
c. To enhance the likelihood that the business will be acquired
d. To create an incentive for management receiving the stock
e. To raise capital for the parent or for the business for which the tracking stock is created
7. For a spin-off to be tax-free to the shareholder it must satisfy which of the following:
a. The parent firm must have a controlling interest in the subsidiary before it is spun off.
b. After the spin-off, both the parent and the subsidiary must remain in the same line of business in which each
was involved for at least 5 years before the spin-off.
c. The spin-off cannot have been used as a means of avoiding dividend taxation by converting ordinary income
into capital gains.
d. The parent’s shareholders must maintain significant ownership in both the parent and the subsidiary
following the transactions.
e. All of the above
8. Which of the following is not true of a divestiture?
a. May create cash infusion for the parent firm
b. Parent ceases to exist
c. Proceeds of sale taxable if returned to shareholders through a dividend or stock buyback
d. A new legal subsidiary may be created
e. B and C
9. Which of the following is not true of a spin-off?
a. Creates cash infusion for parent
b. Change in equity ownership of the spin-off
c. New legal entity created
d. New shares issued to the public
e. A, B, and D
10. Which of the following is not true of an equity carve-out?
a. Creates cash infusion for the parent
b. Change in equity ownership of the unit involved in the carve-out
c. New shares issued to the public
d. Taxable if proceeds returned to shareholders through a dividend or stock buyback
e. Parent ceases to exist
11. Which of the following is true about a voluntary bust-up?
a. Parent ceases to exist
b. Cash infusion to the parent
c. Parent stock is exchanged for subsidiary stock
d. New shares issued to the public
e. Parent remains in control
12. Which of the following is generally not considered a common motive for exiting businesses?
a. Changing strategy or focus
b. Desire to achieve economies of scale
c. Lack of fit with the parent’s other businesses
d. Discarding unwanted businesses from prior acquisitions
e. All of the above
13. An equity carve-out by a parent of one of its subsidiaries is often a precursor to a
a. Complete divestiture or spin-off of the subsidiary
b. An acquisition
c. A merger
d. Joint venture
e. The creation of a tracking stock
14. Which of the following is a common problem associated with tracking stocks?
a. Tracking stocks often de-motivate managers of the business for which the stock is created
b. Such stocks are too complicated for investors to understand
c. Tracking stocks may create internal operating conflicts among the parent’s business units
d. Such stocks often create huge tax liabilities for the parent
e. None of the above
15. Which of the following is not true of a split-off?
a. A split-off is a variation of a spin-off
b. Parent company shareholders receive shares in a subsidiary in return for surrendering their parent company
shares
c. Split-offs are best suited for disposing of a less than 100 percent investment stake in a subsidiary,
d. A split-off reduces the parent firm’s earnings per share.
e. The split-off reduces the pressure on the spun-off firm’s share price
11
16. A diversified automotive parts supplier has decided to sell its valve manufacturing business. This sale is referred to as
a
a. Merger
b. Divestiture
c. Spin-off
d. Equity carveout
e. Liquidation
17. As part of its restructuring plan, a holding company plans to undertake an IPO for 35 percent of the shares it owns in a
subsidiary. The sale of these shares would be called a
a. Divestiture
b. Split-off
c. Split-up
d. Equity carveout
e. Breakup
18. A firm decides to distribute all of the shares it holds in a subsidiary to its shareholders. The distribution would be
called a
a. Divestiture
b. Split-up
c. Spin-off
d. Split-up
e. Equity carveout
19. The board of directors of a large conglomerate has decided that the investment opportunities for the firm are limited
and that greater value could be created for the shareholders if the firm were divided into four independent businesses.
Following approval by shareholders, the firm executed this strategy which is best described as a
a. Split-up
b. Split-off
c. Spin-off
d. Equity carveout
e. Reverse merger
20. The board of directors of a firm approves an exchange offer in which their shareholders are offered stock in one of the
firm’s subsidiaries in exchange for their holdings of parent company stock. This offer is best described as a
a. Split-up
b. Split-off
c. Equity carve-out
d. Spin-off
e. Tender offer
Case Study Short Essay Examination Questions
RETURNS TO ITS INDUSTRIAL ROOTS
_____________________________________________________________________________________
Key Points
• Firms often restructure to realign their business focus
• Restructuring strategies can range from divestitures to spin-offs to split-offs of unwanted businesses
• Companies interested in divesting specific operating units often undertake “controlled auctions” to minimize
disruption to the business
______________________________________________________________________________
As part of GE’s strategy to focus the conglomerate on its industrial businesses, the firm announced in late 2015 that it had sold
the bulk of its private equity lending business to the Canada Pension Plan Investment Board (CPPIB) for $12 billion. Known
within GE as the Financial Sponsor Group (FSG), FSG finances leveraged buyouts. FSG consists of Antares Capital (a private
equity lender) and a $3 billion bank loan portfolio. The unit for years had been considered a “crown jewel” within GE’s
financial services business. Under the terms of the deal, Antares Capital will retain its name and operate as a standalone
"simpler, more valuable company" focused on its less opaque industrial operations. GE expects to retain only financial services
businesses that are closely related to its core industrial businesses such as equipment leasing or financing, which often helps in
selling large pieces of industrial equipment. Investors welcomed the move by bidding up its shares.
GE had a number of bidders in its “controlled auction” for FSG in which it approached potential buyers to determine if they
were interested in participating in the bidding process. GE utilized this method in order to include only firms likely to realize
significant step in exiting much of its financial services group. For CPPIB, the acquisition enabled it to become a major lender
to buyout firms that are investing in midsize U.S. businesses. The pension fund has been increasingly active in private-equity
investing and ranks as one of the most aggressive private equity lenders today. As a pension fund, CPPIB is focused on
investments that generate steady returns over the long term to help fund its future pension obligations. The GE loan portfolio
aligns with that goal by providing it with a bigger source of recurring interest rate income from the outstanding loans, and
CFPPIB’s strategy involves more direct investing rather than hiring private equity funds to invest on their behalf. In doing so,
CFPPIB will save millions of dollars in fees paid to third party private equity funds.
The Anatomy of a Reverse Morris Trust Transaction--
The Coty Cosmetics Saga
______________________________________________________________________________
Key Points:
• Greater shareholder value may be created by exiting rather than operating a business.
• How? By increasing the focus of the parent firm exiting the business.
• How the deal is structured also can create shareholder value.
_____________________________________________________________________________
Consumer product giant Proctor & Gamble (P&G) agreed to sell its portfolio of 43 beauty brands to beauty products maker
Coty Inc. (Coty) for $12.5 billion on July 8, 2015. Included in the deal are professional salon and retail hair products like
Nice & Easy and VS Salonist, as well as cosmetics and fine fragrances from Gucci and Dolce & Gabbana. The deal is part of
P&G’s strategy to shed more than 100 brands and focus on 10 core product lines, like Tide, that tend to grow faster than the
beauty brands.
hopes its global marketing and distribution network and widely recognized brand will reinvigorate growth for many of the
beauty products acquired from P&G.
The deal was structured as a reverse Morris Trust in which P&G created a separate subsidiary spun off to its shareholders
through a split-off to become a public company and subsequently merged with Coty Cosmetics. P&G shareholders post deal
will own 52% of the combined company with Coty’s current shareholders owning the remainder. The new firm will have $10
would be deferred until shareholders sold their shares in the newly created subsidiary. The new entity created by the split off
is immediately merged with a new wholly-owned merger subsidiary created by Coty. The Reverse Morris Trust acquisition
combines a divisive reorganization (e.g., a spin-off or split-off) with an acquisitive reorganization (e.g., a statutory merger) to
allow a tax-free transfer of a subsidiary under U.S. law. The use of a divisive reorganization results in the creation of a public
company which is subsequently merged into a shell subsidiary of another firm, with the shell surviving.
billion ($12.5 - $1.9) equity portion of the purchase price negotiated for the 43 P&G beauty brands reflected the present value
of projected net cash flows of the brands plus an appropriate premium to justify the transfer of ownership to Coty. Based on
Coty's common stock price at the time of the announcement, Coty would have to issue 411 million new shares valued at
$25.79 per share (i.e., $10.6 billion/ Coty’s then share price = 411 million shares). The Coty share price was allowed to
fluctuate within a $22.06 and $27.06 collar based on the trading price of Coty’s stock prior to the close of the transaction.
Figure 16.3 illustrates the three stages of the deal: (1) the creation of the wholly owned subsidiary of P&G called RMT
Brands into which the assets and liabilities associated with the 43 brands are transferred in exchange for the common stock of
the subsidiary, (2) the exchange offer to P&G shareholders allowing them to exchange P&G shares for RMT Brands common
shares (split-off), and (3) the reverse merger of RMT Brands into Coty’s Merger Sub with Merger Sub surviving the deal.
Note the numbers in parentheses in Figure 16.3 refer to each stage of the transaction. To implement the reverse merger, the
RMT Brands common shares distributed in connection with the split-off exchange offer automatically convert into the right
to receive common shares of Coty Cosmetics on a one for one basis. After the reverse merger, Coty Cosmetics owned RMT
Brands through its Merger Sub. P&G shareholders not exchanging their RMT Brand shares for Coty shares could be
“squeezed out” by Coty through a backend merger at a later date.
Discussion Questions:
1. The merger of Coty and the P&G subsidiary RMT Brands could have been achieved as a result of a P&G spin-
off of RMT Brands. Explain the details of how this might have happened.
Answer: By creating a wholly-owned shell subsidiary, P&G could have distributed the shares to its
2. Speculate as to why P&G chose to split-off rather than spin-off RMT Brands as part its plan to merge RMT
Brands with Coty. Be specific.
Answer: P&G chose a split-off rather than spin-off even though either would have resulted in a tax-free
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3. What are the Morris Trust tax regulations? How did they affect how this deal was structured?
Answer: The U.S. Tax Code restricts how certain types of corporate transactions can be structured to avoid
taxes. Specifically, split-offs or spin-offs implemented as part of a merger must be structured to satisfy
Morris Trust tax code rules if the transaction is to be deemed tax free. The IRS’ concern is that a split-off or
spin-off of a wholly-owned parent subsidiary could be undertaken in which the transaction would be tax free
4. How is value created for the P&G and Coty shareholders in this type of transaction?
Answer: Ideally, the impact of taxes on investment decisions would be neutral, such that taxes would not
impact how the free market allocates capital. Resources would be transferred to those who can use them most
efficiently, as they would be able to offer the highest risk adjusted financial returns to attract investors.
P&G shareholders participating in the split-off would do so only if they believed the appreciation potential of
5. Why is the percentage distribution of ownership in the newly created firm following closing important in a
Reverse Morris Trust transaction?
6. What was the purpose of the collar arrangement used in this deal? How could it protect both P&G and Coty
shareholders?
15
Answer: Reverse Morris Trust split-off mergers are very complicated, often taking up to a year between
P&G Shareholders
Coty Shareholders
Proctor & Gamble
Coty Cosmetics
Pre-Merger and Pre-Split-Off Structure
16
The Anatomy of a Spin-Off—Northrop Grumman Exits
the Shipbuilding Business
Reverse Morris Trust Split-Off Structure
Post-Merger Structure
P&G Shareholders
Merger Sub
(RMT Brands)
RMT Brands
P&G Shareholders
46 Beauty
Brands (1)
RMT Common
Equity (1)
Coty Shareholders
Coty Merger Sub
P&G Assets &
Liabilities
brands)
Coty Shareholders
RMT Common
Equity (3)
RMT Brands Merges
into Merger Sub
Figure 16.3 Reverse Morris Trust Split-Off Transaction
In an effort to focus on more attractive growth markets, Northrop Grumman Corporation (NGC), a global leader in aerospace,
communications, defense, and security systems, announced that it would exit its mature shipbuilding business on October 15,
2010. Huntington Ingalls Industries (HII), the largest military U.S. shipbuilder and a wholly owned subsidiary of NGC, had
been under pressure to cut costs amidst increased competition from competitors such as General Dynamics and a slowdown in
orders from the U.S. Navy. Nor did the outlook for the shipbuilding industry look like it would improve any time soon.
Given the limited synergy between shipbuilding and NGC’s other businesses, HII’s operations were largely independent of
30, 2011. Each NGC shareholder received one HII common share for every six shares of NGC common stock held.1
The spin-off process involved an internal reorganization of NGC businesses, a Separation and Distribution Agreement, and
finally the actual distribution of HII shares to NGC shareholders. The internal reorganization and subsequent spin-off is
illustrated in Figure 16.3. NGC (referred to as Current Northrop Grumman Corporation) first reorganized its businesses such
that the firm would become a holding company whose primary investments would include Huntington Ingalls Industries (HII)
HII stock to NGC’s common shareholders.
Following the spin-off, HII became a separate company from NGC, with NGC having no ownership interest in HII.
Renamed Titan II, Current NGC became a direct, wholly owned subsidiary of HII and held no material assets or liabilities
other than Current NGC’s guarantees of HII performance under certain HII shipbuilding contracts (under way prior to the spin-
off and guaranteed by NGC) and HII’s obligations to repay intercompany loans owed to NGC. New NGC changed its name to
flows.
Before the spin-off, HII entered into a Separation and Distribution Agreement with NGC. The Agreement governed the
relationship between HII and NGC after completion of the spin-off. It also provided for the allocation between the two firms of
assets, liabilities, and obligations (e.g., employee benefits, intellectual property, information technology, insurance, and tax-
related assets and liabilities). The Agreement also provided that NGC and HII each would indemnify (compensate) the other
1 The share-exchange ratio of one share of HII common for each six shares of NGC common was calculated by dividing HII’s
48.8 million common shares (having a par value of $.01) by the 298 million NGC shares outstanding. Since fractional shares
were created, shareholders owning 100 shares would be entitled to 16.6667 shares—100/6. In this instance, the shareholder
18
Figure 16.3 Spin-Off Illustration
Discussion Questions
1. Speculate as to why Northrop Grumman used a spin-off rather than a divestiture, split-off or split up to separate
Huntington Ingalls from the rest of its operations? What were the advantages of the spin-off over the other
restructuring strategies.
Current Northrop
Grumman Corp
New Northrop
Public
Shareholders
Public
Shareholders
Northrop Grumman
Systems Corp.
(NGSC)
Titan II, Inc.
(Formerly Current
NGC)
NGC Pre-Internal Reorganization NGC Post-Internal Reorganization
Northrop Grumman
Shipbuilding Inc
(NGSB)
19
Answer: Spin-offs may involve businesses which are first transferred to a newly formed wholly-owned subsidiary
corporation, with the stock of that corporation then distributed to the shareholders of the parent firm. Other times, the
stock of a pre-existing subsidiary is distributed. Section 355 of the U.S. Tax Code permits the division of a
corporation tax-free, including a spin-off, split-off, and split-up. A spin-off involves a pro rata distribution of a
2. What is the likely impact of the spin-off on Northrop Grumman’s share price immediately following the spin-off of
Huntington Ingalls assuming no other factors offset it?
3. Why do businesses that have been spun off from their parent often immediately put antitakeover defenses in place?
Answer: Antitakeover defenses are put in place to reduce the likelihood that a change in control can take place as a
4. Why would the U.S. Internal Revenue Service be concerned about a change of control of the spun-off business such
that it might revoke its ruling that the spin-off satisfied the requirements to be tax-free?
Answer: The IRS is concerned that a spin-off may be used for tax avoidance rather than for a sound business purpose.
.
5. Describe how you as an analyst would estimate the potential impact of the Huntington Ingalls Industries spin-off on
the long-term value of Northrop Grumman’s share price?
Answer: An important stated motivation for the spin-off by Northrop Grumman’s management is to simplify the
corporation, enable management to focus on those businesses it better understands, concentrate limited investment
The Anatomy of a Reverse Morris Trust Transaction:
The Pringles Potato Chip Saga2
Key Points
Greater shareholder value may be created by exiting rather than operating a business.
Deal structures can impose significant limitations on a firm’s future strategies and tactics.
_____________________________________________________________________________________________
Following a rigorous portfolio review and an informal expression of interest in the Pringles brand by Diamond Foods
(Diamond) in late 2009, Proctor & Gamble (P&G), the world’s leading manufacturer of household products, believed that
Pringles could be worth more to its shareholders if divested than if retained. Pringles is the iconic potato chip brand, with sales
in 140 countries and operations in the United States, Europe, and Asia.
Diamond’s executive management had long viewed the Pringles’ brand as an attractive fit for their strategy of building,
acquiring, and energizing brands. The acquisition of Pringles would triple the size of the firm’s snack business and provide
greater merchandising influence in the way in which its products are distributed. The merger would also give Diamond a
substantial presence in Asia, Latin America, and Central Europe. The increased geographic diversity means the firm would
a one-time after-tax earnings increase for P&G of $1.5 billion due to the firm’s low tax basis in Pringles.
The offer to exchange Pringle shares for P&G shares reduced the number of outstanding P&G common shares, partially
offsetting the impact on P&G’s earnings per share of the loss of Pringles earnings. Diamond agreed to issue one share of its
common stock for each Pringles common share. The 29.1 million common shares issued by Diamond resulted in P&G
shareholders’ participating in the exchange offer, owning a 57% stake in the combined firms, with Diamond’s shareholders
The structure of the deal involved four discrete steps, outlined in separation and transaction agreements signed by P&G and
Diamond. These steps included the following: (1) the creation by P&G of a wholly owned subsidiary containing Pringles’
assets and liabilities; (2) the recapitalization of the wholly owned Pringles subsidiary; (3) the separation of the wholly owned
subsidiary through a split-off exchange offer; and (4) a merger with a wholly owned subsidiary of Diamond Foods. The
separation agreement covered the first three steps, with the final step detailed in the transaction agreement.
their P&G shares for Pringles shares.
In addition, the Pringles Company borrowed $850 million and used the proceeds to pay P&G a cash dividend and to acquire
certain Pringles business assets held by P&G affiliates. Since P&G is the sole owner of the Pringles Company, the dividend is
2 The deal discussed in this case is for illustration only. Following the disclosure that Diamond Food’s reported earnings were
