128 Gitman/Zutter • Principles of Managerial Finance, Fourteenth Edition
Chapter 18
Mergers, LBOs, Divestitures,
and Business Failure
Instructor’s Resources
Overview
This chapter covers the fundamentals of mergers, leveraged buyouts (LBOs), and divestitures, as well as methods
for reorganizing or liquidating a firm in the event of a business failure. The motives for and types of mergers, as
well as procedures to analyze and negotiate mergers, are discussed. The techniques for estimating the value of a
target firm and analyzing cash or stock swap transactions are presented. The chapter next explains LBOs, another
technique to finance acquisitions, and international merger practices. Finally, the student is introduced to the types
of business failure and the private and legal means of resolution (reorganization and bankruptcy) for creditors and
stockholders. Chapter 18 describes the importance of strategic alliances and divestiture, and avoiding bankruptcy
along the way, in the student’s professional and personal life.
Suggested Answer to Opener-in-Review Question
Just before the public learned about the potential LBO of Dell, Inc., the company’s stock price was trading
for $10 per share. What is the size of the premium that Silver Lake and Michael Dell were offering public
shareholders? In July 2013, an independent firm that advises institutional investors on how they should cast
their votes at shareholders meetings issued a letter backing Michael Dell’s offer. They argued that in the
LBO transaction, shareholders would receive a premium “with certainty,” whereas with Carl Icahn’s offer,
it was uncertain whether the value of the company would ultimately be higher than the proposed LBO
price. How would that affect your vote if you were a Dell shareholder?
The price offered by Silver Lake was $13.65, which represents a 36.5% premium over the $10 market price that
prevailed prior to news of the LBO proposal becoming public. The answer to the second half of the question will
vary from student to student. Essentially, a shareholder has to decide whether the $13.65 offer, which is a sure
thing, is a fair price, or whether they believe that Dell’s stock price will be higher than that under Icahn’s
leadership.
Answers to Review Questions
1. a. A merger is the combination of two or more firms such that the resulting firm maintains the identity of one
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129 Gitman/Zutter • Principles of Managerial Finance, Fourteenth Edition
normally referred to as subsidiaries. The holding company arrangement differs from consolidation and
b. In a merger, the acquiring company attempts to acquire the target company.
c. A friendly merger is one where the target company’s management supports the acquiring company’s
d. Strategic mergers are undertaken to achieve economies of scale by combining operations of the merged
2. a. A company can use a merger to quickly grow in size or market share or to diversify its product offerings
b. Synergy refers to the economies of scale resulting from reduced overhead in the merged firms.
c. Mergers can improve a firm’s ability to raise funds because acquiring a cash-rich company increases
d. A firm may merge with another in order to acquire increased managerial skills or technology that will
e. Mergers can be undertaken to achieve tax savings; a profitable firm can merge with a firm with tax loss
f. Increased ownership liquidity can result when small firms merge to create a larger entity whose shares are
g. Mergers are also used as a defense against unfriendly takeovers; the target company finances an
3. a. A horizontal merger is the merger of two firms in the same line of business.
4. A leveraged buyout (LBO) is a form of financial merger using large amounts of debt (typically 90% or more)
5. A divestiture is the sale of some of a firm’s assets to achieve a more focused, streamlined operation and to
increase profitability. An operating unit is part of a business that contributes to the firm’s actual operations. It
6. Capital budgeting techniques are used to value target companies. If assets are being acquired, the acquisition
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Chapter 18 Mergers, LBOs, Divestitures, and Business Failure 130
7. The ratio of exchange is the amount paid per share of the target firm divided by the market price of the
8. The role of investment bankers is to find a suitable merger partner and assist in the negotiations between the
parties. Tender offers are made by a firm to its stockholders to buy a certain number of shares at a specified
9. a. In a white knight takeover defense, the target firm finds an acquirer, leading to competition between the
white knight and hostile acquirer for control of the target.
b. Poison pills are securities issued with special rights, such as voting rights or the right to purchase
10. The advantages of the holding company arrangement are the leverage effect resulting from being able to
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131 Gitman/Zutter • Principles of Managerial Finance, Fourteenth Edition
The disadvantages of the holding company arrangement are increased risk from the leverage obtained by a
holding company (losses as well as gains are magnified); double taxation, which results because a portion of
11. Differences exist in merger practices between U.S. companies and non-U.S. companies. In other countries,
12. The three types of business failure are (1) low or negative returns, (2) insolvency, and (3) bankruptcy.
Insolvency occurs when a firm cannot pay its liabilities as they come due, while bankruptcy is the situation in
13. In an extension, creditors receive payment in full but on an extended schedule. A composition is a pro rata
cash settlement of creditor claims. An extension and composition may be combined to produce a settlement
14. Chapter 11 of the Bankruptcy Reform Act of 1978 outlines the procedures for reorganization of a failed firm.
a. The filing firm is called the Debtor in Possession (DIP). Its first responsibility is the valuation of the
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Chapter 18 Mergers, LBOs, Divestitures, and Business Failure 132
15. Chapter 7 of the Bankruptcy Reform Act of 1978 specifies the manner and priority for the distribution of assets
16. Using the alphabetic characters to identify the items listed, the appropriate priority ordering of claims is (c),
Suggested Answer to Global Focus Box: International Mergers
If you had been a shareholder of Dow Jones, what tradeoffs would you have considered when deciding
whether to take the $60.00 per share or shares of Ruby Newco?
On the surface, this decision would seem to be relatively simple. A Dow Jones shareholder could multiply the price of
Suggested Answer to Focus on Ethics Box: Too Big to Fail?
Who benefits and who loses when a firm becomes too big to fail?
Firms and their management benefit. Too big to fail and the implicit government backstop allows a firm’s
Do financial managers have an incentive to make their firms too big (or too vital) to fail? What are some
actions they might take to increase their firm’s importance?
Yes, financial managers benefit when their firm is too big to fail because others (e.g., the government) assume some of
Answers to Warm-Up Exercises
E18-1. Tax loss carry forward
Answer:
After–Tax Earnings without a Merger
Year 1 Year 2 Year 3 Year 4 Year 5
EBIT $100,0
00
$100,00
0
$100,00
0
$100,000 $100,000
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133 Gitman/Zutter • Principles of Managerial Finance, Fourteenth Edition
Earnings with a Merger
Year 1 Year 2 Year 3 Year 4 Year 5
Earnings before losses $100,000 $100,000 $100,000 $100,000 $100,000
E18-2. Evaluation of a proposed merger
Answer: You may use a financial calculator to determine present values (PV):
E18-3. Stock swap
Answer: a. The ratio of exchange is $60 ÷ $45 1.333333
E18-4. Ratio of exchange in market price
Answer: Ratio of exchange $60 $55 1.091
E18-5. Percentage of the total assets controlled
Answer: a. Total assets controlled by All-Stores $130,000 $110,000 $240,000.
b. Percentage of the total assets controlled ($5,000 $240,000) 2.08%.
Solutions to Problems
P18-1. Tax effects of acquisition
LG 1, 3; Intermediate
a. Years Earnings Tax Liability After-Tax
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Chapter 18 Mergers, LBOs, Divestitures, and Business Failure 134
Earnings
Tax liability $112,000 15 $1,680,000
b. Years Earnings after Write-Off Tax Liability Tax Savings
1 $280,000 $280,000 0 $ 0 $112,000
Total $320,000
c. With respect to tax considerations only, the merger would not be recommended because the savings
($320,000) are less than the cost ($350,000). The merger must also be justified on the basis of future
operating benefits or on grounds consistent with the goal of maximizing shareholder wealth.
P18-2. Tax effects of acquisition
LG 1, 3; Intermediate
a.
Year
Net Profits before Taxes
(1)
Taxes
[0.40 (1)]
(2)
Net Income
[(1) (2)]
(3)
1 $150,000 $ 60,000 $ 90,000
b.
Year
Net Profits before Taxes
(1)
Taxes [0.40 (1)]
(2)
1 $150,000 $150 000 0 $ 0
c. Total benefits (ignoring time value): $880,000 $160,000 $720,000
d. Net benefit tax benefits (cost liquidation of assets)
P18-3. Tax benefits and price
LG 1, 3; Challenge
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135 Gitman/Zutter • Principles of Managerial Finance, Fourteenth Edition
a.
Reilly Investment Group
Year
Net Profit before Tax
(1)
Taxes [0.40 (1)]
(2)
Tax Advantage
(3)
1 $200,000 $200,000 $ 0 $ 80,000
b.
Webster Industries
Year
Net Profit before Tax
(1)
Taxes [0.40 (1)]
(2)
Tax Advantage
(3)
1 $ 80,000 $ 80,000 $ 0 $ 32,000
c. Reilly Investment Group PV of benefits:
Solve for PV $228,398.27
Webster Industries PV of benefits:
CF1 $32,000, CF2 $48,000, CF3 $80,000, CF4 $120,000, CF5 $40,000
d. Both firms receive $320,000 in tax shield benefits. However, Reilly can use these at an earlier time;
P18-4. Asset acquisition decision
LG 3; Challenge
a. Effective cost of press: $60,000 $90,000 $65,000 $85,000
b. Zarin should merge with Freiman because the NPV is greater than zero.
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Chapter 18 Mergers, LBOs, Divestitures, and Business Failure 136
c. CF0 $120,000, CF1 $26,000, F1 10
P18-5. Cash acquisition decision
LG 3; Challenge
a.
Year Calculator Inputs
Calculator
Solution
1–5 N 5, I 15%, PMT $25,000 $ 83,803.88
b. PV of equipment purchase (12%, 10yrs.):
c.
Year Calculator Inputs
Calculator
Solution
1–5 N 5, I 12%, PMT $25,000 $ 90,119.41
[or, CF0 $125,000, CF1 25,000,
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137 Gitman/Zutter • Principles of Managerial Finance, Fourteenth Edition
F1 5, C2 $50,000, F2 5; Set I 12%]
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