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.
Note to instructors: after the first print run of this edition, Congress passed the Tax Cuts and Jobs Act, which made
sweeping changes to the corporate tax code. Subsequent printings of this edition were revised to incorporate this
new material, so some students may have copies that reflect the new tax law while some students will have the
original material.
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
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 of the merged firms, while a consolidation is the combination of two or more firms to form a
completely new corporation. Consolidations are generally made between similarly sized firms; mergers
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
proposal, and the firms work together to negotiate the transaction. If the target company is not
d. Strategic mergers are undertaken to achieve economies of scale by combining operations of the merged
firms for greater productivity and profit. The goal of financial mergers is to restructure the acquired
2. a. A company can use a merger to quickly grow in size or market share or to diversify its product
offerings by acquiring a going concern that meets its objectives.
g. Mergers are also used as a defense against unfriendly takeovers; the target company finances an
acquisition by adding substantial debt, thereby making itself unattractive to its potential purchaser.
3. a. A horizontal merger is the merger of two firms in the same line of business.
b. A vertical merger involves the acquisition of a customer or supplier.
c. A congeneric merger is the acquisition of a firm in the same general industry but neither in the same
4. A leveraged buyout (LBO) is a form of financial merger using large amounts of debt (typically 90%
or more) to finance the acquisition. Three key attributes for an LBO acquisition candidate are (1) good
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 can be a plant, division, product line, or subsidiary. Four ways firms divest themselves of
6. Capital budgeting techniques are used to value target companies. If assets are being acquired, the
acquisition price, tax losses, and benefits from the asset purchase are analyzed. The resulting after-tax cash
flows are discounted at the cost of capital; if the net present value is greater than zero, the acquisition is
7. The ratio of exchange is the amount paid per share of the target firm divided by the market price of
the acquiring firm’s shares. The ratio of exchange is not based on the current price per share of the acquired
firm but on the negotiated price per share of the target firm and the market price per share of the acquiring
The initial impact of a stock swap acquisition may be a decrease in earnings per share (EPS) for the merged
company. However, the expected growth in earnings of the merged firm can have a significant impact on 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
without warning in order to catch management off guard.
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.
managerial control as a result of a merger.
10. The advantages of the holding company arrangement are the leverage effect resulting from being able to
control large amounts of assets with relatively small dollar investments, the risk protection resulting from the
diverse entities in a holding company.
Pyramiding of holding companies occurs when one holding company controls other holding companies.
This arrangement causes even greater magnification of earnings or losses.
11. Differences exist in merger practices between U.S. companies and non-U.S. companies. In other countries,
notably Japan, takeovers are less common. Hostile takeovers are more a U.S. phenomenon and typically are
However, in recent years there has been a shift toward the American model of corporate governance, due in
part to the increased competitiveness of the global marketplace. The move toward European economic
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 which a firm’s liabilities exceed the fair value of its assets. A bankrupt firm is therefore one having a
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
A voluntary settlement resulting in liquidation occurs when recommended by a creditor committee or if
creditors cannot agree upon a settlement to sustain the firm. The creditors must assign the power to
liquidate the firm to a committee or adjustment bureau. The assignee then liquidates the assets, obtaining
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
b. If reorganization is feasible, the DIP must draw up a plan for reorganization, which results in a new
capital structure and a scheme for exchanging securities in order to recapitalize the firm.
general, senior claims must be satisfied prior to junior claims.
15. Chapter 7 of the Bankruptcy Reform Act of 1978 specifies the manner and priority for the distribution of
assets in liquidation. The firm is liquidated when the court has determined that reorganization is not feasible.
16. Using the alphabetic characters to identify the items listed, the appropriate priority ordering of claims is (c),
(j), (h), (i), (k), (g), (f), (b), (e), (a), (d).
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 Ruby Newco Class B by 2.8681 and see if that was more or less than $60.00. If the value was less, the
shareholder would have taken the $60. However, the decision to take Ruby Newco shares had to be made prior to
Suggested Answer to Focus on Ethics Box: Is There Any Good in
Greed?
Technological change may raise average living standards over the long run, but in the short run, workers
in declining industries with firm-specific skills will lose jobs and income. How should a CEO view the
tradeoff between the shareholder and worker interests?
In a narrow sense, managers work for shareholders, so if it is in their interest to scale back operations in a
shrinking business segment, that’s what managers should do. However, in deciding whether to layoff workers or
find ways to redeploy them, managers should consider the long-run implications of either course of action. A
Answers to Warm-Up Exercises
E18-1. Note: The following answer corresponds to the question in the original press run of the book
that told students to assume a 34% tax rate. Newer versions apply a 21% tax rate, so the taxes in the
Likewise, the new tax law allows carryforwards only up to 80% of pretax earnings. In the second table
below, this means that the firm cannot take $100,000 of the tax loss in year 1 and year 2. Instead, the
An interesting discussion point is that a reduction in the tax rate, as well as the limitation on how much
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
Taxes 34,0
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):
Find the PV of cash outflows: $150,000
Based on net present value analysis, Cautionary Tales should not make the acquisition.
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
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
Earnings
1–15 $280,000 $112,000 $168,000
Note that in versions of the book that use a 21% tax rate the tax liability would be $58,800 per year
or $882,000 over 15 years.
b. Years Earnings after Write-Off Tax Liability Tax Savings
1$280,000 $280,000 0 $ 0 $112,000
Total $320,000
Again note that in versions of the book that use a 21% tax rate, the tax savings in years 1 and 2
c. With respect to tax considerations only, the merger would not be recommended because the savings
This conclusion holds (and in fact is evens stronger) if the tax rate is 21% rather than 40%.
P18-2. Note to instructors: The solution below reflects the situation prior to the passage of the Tax Cuts and
Jobs Act. Newer printings of the book modified the question to allow for a 21% tax rate rather than
differ slightly from what appears below.
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
2 400,000 160,000 240,000
Note that with a 21% tax rate, taxes in years 1–5 become $31,500, $84,000, $94,500, $126,000,
b.
Year Net Profits before Taxes
(1) Taxes [0.40 (1)]
(2)
1$150,000 $150 000 0 $ 0
2$400,000 $400,000 0 0
Under the new tax law, firms can deduct tax loss carryforwards only up to 80% of pretax earnings.
This means that Trapani cannot deduct as much from their taxes as is shown above. In fact, the tax
c. Total benefits (ignoring time value): $880,000 $160,000 $720,000
much smaller under the new law.
d. Net benefit tax benefits (cost liquidation of assets)
The proposed merger is recommended based on the positive net benefit of $220,000.
longer attractive.
P18-3. Tax benefits and price
LG 1, 3; Challenge
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
2$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
2$120,000 $120,000 0 48,000
c. Reilly Investment Group PV of benefits:
N 4, I 15%, PMT $80,000
Webster would pay no more than $205,220.
d. Both firms receive $320,000 in tax shield benefits. However, Reilly can use these at an earlier
time; therefore, the acquisition is worth more to this firm.