Transcript Chapter 26 - Leasing
Chapter 26 - Leasing
• What is a Lease?
• Why Lease?
• Operating versus Financial Leases • Valuing Leases • When Do Leases Pay?
1
The Basics
– A lease is a contractual agreement between a lessee and lessor. – The agreement establishes that the lessee has the right to use an asset and in return must make periodic payments to the lessor.
– The lessor is either the asset’s manufacturer or an independent leasing company.
2
Buying versus Leasing
Firm
U
Buy buys asset and uses asset; financed by debt and equity.
Manufacturer of asset Lease Lessor buys asset, Firm
U
leases it.
Manufacturer of asset 1.
Firm
U
Uses asset 2.
Owns asset 1.
Lessor Owns asset 2. Does not use asset 1.
Lessee (Firm
U
) Uses asset 2. Does not own asset Equity shareholders Creditors Equity shareholders Creditors 3
Reasons for Leasing
• Good Reasons – Taxes may be reduced by leasing.
– The lease contract may reduce certain types of uncertainty.
– Transactions costs can be higher for buying an asset and financing it with debt or equity than for leasing the asset.
• Bad Reasons – Leasing and accounting income – 100% financing 4
Operating Leases
• Usually not fully amortized. This means that the payments required under the terms of the lease are not enough to recover the full cost of the asset for the lessor.
• Usually require the lessor to maintain and insure the asset.
• Lessee enjoys a cancellation option. This option gives the lessee the right to cancel the lease contract before the expiration date.
5
Financial (Capital) Leases
The exact opposite of an operating lease.
1. Do not provide for maintenance or service by the lessor.
2. Financial leases are fully amortized.
3. The lessee usually has a right to renew the lease at expiry.
4. Generally, financial leases cannot be cancelled, i.e., the lessee must make all payments or face the risk of bankruptcy.
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Sale and Lease-Back
• A particular type of financial lease.
• Occurs when a company sells an asset it already owns to another firm and immediately leases it from them.
• Two sets of cash flows occur: – The lessee receives cash today from the sale.
– The lessee agrees to make periodic lease payments, thereby retaining the use of the asset.
7
Leveraged Leases
• A leveraged lease is another type of financial lease.
• A three-sided arrangement between the lessee, the lessor, and lenders.
– The lessor owns the asset and for a fee allows the lessee to use the asset.
– The lessor borrows to partially finance the asset.
– The lenders typically use a nonrecourse loan. This means that the lessor is not obligated to the lender in case of a default by the lessee.
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Leveraged Leases
Lessor buys asset, Firm
U
leases it. Manufacturer of asset Lessor borrows from lender to partially finance purchase 1.
Lessor Owns asset 2. Does not use asset Equity shareholders 1.
Lessee (Firm
U
) Uses asset 2. Does not own asset Creditors The lenders typically use a nonrecourse loan. This means that the lessor is not obligated to the lender in case of a default by the lessee In the event of a default by the lessor, the lender has a first lien on the asset. Also the lease payments are made directly to the lender after a default.
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Accounting and Leasing
• In the old days, leases led to off-balance-sheet financing.
• In 1979, the Canadian Institute of Chartered Accountants implemented new rules for lease accounting according to which financial leases must be “capitalized.” • Capital leases appear on the balance sheet— the present value of the lease payments appears on both sides.
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Accounting and Leasing
Truck is purchased with debt
Truck $100,000 Land $100,000 Total Assets $200,000
Operating Lease
Truck Land Total Assets
Capital Lease
Assets leased Land Total Assets $100,000 $100,000 $100,000 $100,000 $200,000 Balance Sheet Debt Equity Total Debt & Equity $100,000 $100,000 $200,000 Debt Equity Total Debt & Equity $100,000 $100,000 Obligations under capital lease Equity Total Debt & Equity $100,000 $100,000 $200,000 11
Financial (Capital) Lease
A lease must be capitalized if any one of the following is met: – The present value of the lease payments is at least 90-percent of the fair market value of the asset at the start of the lease.
– The lease transfers ownership of the property to the lessee by the end of the term of the lease.
– The lease term is 75-percent or more of the estimated economic life of the asset.
– The lessee can buy the asset at a bargain price at expiry.
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• • •
Taxes and Leases
The principal benefit of long-term leasing is tax reduction.
Leasing allows the transfer of tax benefits from those who need equipment but cannot take full advantage of the tax benefits of ownership to a party who can.
If the CRA (Canada Revenue Agency) detects one or more of the following, the lease will be disallowed.
1. The lessee automatically acquires title to the property after payment of a specified amount in the form of rentals.
2. The lessee is required to buy the property from the lessor.
3. The lessee has the right during the lease to acquire the property at a price less than fair market 13 value.
Operating Lease
Example :
Acme Limo has a client who will sign a lease for 7 years, with lease payments due at the start of each year. The following table shows the NPV of the limo if Acme purchases the new limo for $75,000 and leases it for 7 years. Initial cost Maintenance, insurance, selling, and administrative costs Tax shield on costs Depreciation tax shield Total
NPV @ 7% = - $98.15
0 -75 -12 4.2
0 -82.8
1 -12 4.2
5.25
-2.55
2 -12 4.2
8.4
0.6
Year 3 -12 4.2
5.04
-2.76
4 -12 4.2
3.02
-4.78
5 -12 4.2
3.02
-4.78
6 -12 4.2
1.51
-6.29
Break even rent(level) Tax Break even rent after-tax
NPV @ 7% = - $98.15
26.18
-9.16
17.02
26.18
-9.16
17.02
26.18
-9.16
17.02
26.18
-9.16
17.02
26.18
-9.16
17.02
26.18
-9.16
17.02
26.18
-9.16
17.02
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Financial Leases
Example :
Greymare Bus Lines is considering a lease. Your operating manager wants to buy a new bus for $100,000. The bus has an 8 year life. The Bus Saleswoman says she will lease Greymare the bus for 8 years at $16,900 per year, but Greymare assumes all operating and maintenance costs. Should Greymare Buy or Lease the bus?
Cash flow consequences of the lease contract to Greymare 0 1 2 Year 3 4 5 6 7 Cost of new bus Lost Depr tax shield Lease payment Tax shield of lease Cash flow of lease 100.00
(16.90) 5.92
89.02
(7.00) (16.90) 5.92
(17.98) (11.20) (16.90) 5.92
(22.18) (6.72) (16.90) 5.92
(17.70) (4.03) (16.90) 5.92
(15.01) (4.03) (16.90) 5.92
(15.01) (2.02) (16.90) 5.92
(13.00) (16.90) 5.92
(10.98) 15
Financial Leases
Example - cont
Greymare Bus Lines can borrow at 10%, thus the value of the lease should be discounted at 6.5% or .10 x (1-.35). The result will tell us if Greymare should lease or buy the bus. 0 1 2 Year 3 4 5 6 7 Cost of new bus Lost Depr tax shield Lease payment Tax shield of lease Cash flow of lease 100.00
(16.90) 5.92
89.02
(7.00) (16.90) 5.92
(17.98) (11.20) (16.90) 5.92
(22.18) (6.72) (16.90) 5.92
(17.70) (4.03) (16.90) 5.92
(15.01) (4.03) (16.90) 5.92
(15.01) (2.02) (16.90) 5.92
(13.00) (16.90) 5.92
(10.98) 16
Financial Leases
Example – A loan with same cash flows as lease
Amount borrowed at year end Interest paid @ 10% Tax shield @ 35% Interest paid after tax Principal repaid Net cash flow of equivalent loan 0 1 2 Year 3 4 5 6 7 89.72
77.56
-8.97
3.14
-5.83
-12.15
60.42
-7.76
2.71
-5.04
-17.14
46.64
-6.04
2.11
-3.93
-13.78
34.66
-4.66
1.63
-3.03
-11.99
21.89
-3.47
1.21
-2.25
-12.76
10.31
-2.19
0.77
-1.42
-11.58
0.00
-1.03
0.36
-0.67
-10.31
89.72
-17.99
-22.19
-17.71
-15.02
-15.02
-13.00
-10.98
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Financial Leases
Example - cont
The Greymare Bus Lines lease cash flows can also be treated as a favorable financing alternative and valued using APV.
APV APV
NPV of project
NPV of lease
3,000
7
00
$3,700
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Financial Lease Benefits
Value of lease to lessor = -89.02
17.99
1.065
.
70 or $ 700 22 .
19 1.065
17 .
71 1.065
15 .
02 1.065
4 13 1.065
10 .
98 1.065
6 Value of lease = 100
t
7 0 16 .
9 ( 1 .
10 )
t
100 99 .
18 .
82 or $ 820 19
Example
• Consider a firm, ClumZee Movers, that wishes to acquire a delivery truck.
• The truck is expected to reduce costs by $4,500 per year.
• The truck costs $25,000 and has a useful life of five years.
• If the firm buys the truck, they will depreciate it straight line to zero. • They can lease it for five years from Tiger Leasing with an annual lease payment of $6,250 paid at the
end of the year
.
• The firm’s borrowing rate is 7.70% and its marginal tax rate is 34%.
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Example Q1: continue
Suppose ClumZee movers is actually in the 25% tax bracket and Tiger Leasing is in the 35% tax bracket and a before tax borrowing rate of 7%. If Tiger reduces the lease payment to $6,200, can both firms have a positive NPV?
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Summary
• • There are three ways to value a lease.
1. Use the real-world convention of discounting the incremental after tax cash flows at the lessor’s after tax rate on secured debt.
2. Calculate the increase in debt capacity by discounting the difference between the cash flows of the purchase and the cash flows of the lease by the after-tax interest rate. The increase in debt capacity from a purchase is compared to the extra outflow at year 0 from a purchase.
3. Use APV (APV = All-Equity Value + Financing NPV) They all yield the same answer.
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Practice Question 1
• • • • • • • • Calculate NPV for lessee and lessor Cost of machine = $85,000 CCA rate = 30% Operating costs = $ 10,000 per year maintenance expense Lease payments = $53,600 per year Lessor provides maintenance as a part of the lease contract.
Cost of debt (r D ) = 15% After-tax cost of debt, r D (1 -T C ) = 9% TC = 40% (for both the lessee and the lessor) 23
Practice Question 2
• A noncancellable lease contract lasts for 4 years with payments of $37,000 at the end of each year. The lessee pays maintenance expense under either the lease or buy alternatives. If purchased, the $100,000 asset has a CCA rate of 30%. The before-tax cost of debt is 10% and the corporate tax rate is 40%. What is the value of the lease to the lessee?
• If the lease in problem were cancelable, how much must the cancellation option be worth to make the lease alternative better than the purchase alternative?
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Chapter 26 - Hedging
• Why Manage Risk?
• Insurance • Forward and Futures Contracts • SWAPS • How to Set Up A Hedge 25
Risk Reduction
Why risk reduction does not add value 1. Hedging is a zero sum game 2.
Investors’ do-it-yourself alternative 26
Risk Reduction
Risks to a business 1. Cash shortfalls 2. Financial distress 3. Agency costs 27
Insurance
• Most businesses face the possibility of a hazard that can bankrupt the company in an instant.
• Insurance companies have some advantages in bearing risk.
• The cost and risk of a loss due to a hazard, however, can be shared by others who share the same risk. 28
Insurance
Example
An offshore oil platform is valued at $1 billion. Expert meteorologist reports indicate that a 1 in 10,000 chance exists that the platform may be destroyed by a storm over the course of the next year. How can the cost of this hazard be shared?
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Insurance
What do you expect the premium of an insurance contract on this oil platform to be? Think of the following: – Administrative costs – Adverse selection – Moral hazard 30
Insurance – Catastrophe Risk
• The loss of an oil platform by a storm may be 1 in 10,000. The risk, however, is larger for an insurance company since all the platforms in the same area may be insured, thus if a storm damages one it may damage all in the same area. The result is a much larger risk to the insurer • Catastrophe Bonds - (CAT Bonds) Allow insurers to transfer their risk to bond holders by selling bonds whose cash flow payments depend on the level of insurable losses NOT 31 occurring.
Insurance – What to Insure
Two Possibilities: • Most Common - buy insurance only for large potential losses. • BP case – buy insurance for small risks only. 32
Hedging with Forwards and Futures
Business has risk
Business Risk - variable costs Financial Risk - Interest rate changes Goal - Eliminate risk HOW?
Hedging & Forward Contracts 33
Hedging with Forwards and Futures
Ex - Kellogg produces cereal. A major component and cost factor is sugar. • Forecasted income & sales volume is set by using a fixed selling price.
• Changes in cost can impact these forecasts.
• To fix your sugar costs, you would ideally like to purchase all your sugar today, since you like today’s price, and made your forecasts based on it. But, you can not. • You can, however, sign a contract to purchase sugar at various points in the future for a price negotiated today.
• This contract is called a “Futures Contract.” • This technique of managing your sugar costs is called “Hedging.” 34
Hedging with Forwards and Futures
1- Spot Contract - A contract for immediate sale & delivery of an asset. 2- Forward Contract - A contract between two people for the delivery of an asset at a negotiated price on a set date in the future. 3- Futures Contract - A contract similar to a forward contract, except there is an intermediary that creates a standardized contract. Thus, the two parties do not have to negotiate the terms of the contract.
The intermediary is the Commodity Clearing Corp (CCC). The CCC guarantees all trades & “provides” a secondary market for the speculation of Futures. 35
Types of Futures
Commodity Futures -Sugar -Wheat -Corn -Soy beans -OJ -Pork bellies Financial Futures -Tbills -Yen -Stocks -Eurodollars -GNMA Index Futures -S&P 500 -Value Line Index -Vanguard Index 36
Futures Contract Concepts
• Not an actual sale • Always a winner & a loser (unlike stocks) • “Settled” every day. (Marked to Market) • Hedge - used to eliminate risk by locking in prices • Speculation - used to gamble • Margin - not a sale - post partial amount
Futures and Spot Contracts
The basic relationship between futures prices and spot prices for equity securities.
F F S
0
r f t t
S
0 ( 1
r f
futures
y
price )
t
on contract of t length Today' s spot price Risk free rate
y
Dividend yield 38
Futures and Spot Contracts
Example
The DAX spot price is 3,970.22. The interest rate is 3.5% and the dividend yield on the DAX index is 2.0%. What is the expected price of the 6 month DAX futures contract? 39
Futures and Spot Contracts
The basic relationship between futures prices and spot prices for commodities.
F F t t
S
0 ( 1
r f
futures
sc
cy
)
t price on contract of S
0
Today' s spot price r f
Risk free rate cy
Convenienc e yield t length sc
ncy
Experss storage cost cy
sc
Net Convenienc e yield
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Futures and Spot Contracts
Example
In July the spot price for coffee was $.7310 per pound. The interest rate was 1.5% per (1.3% per 10 months). The 10 month futures price was $0.8285? What is the net convenience yield? 41
Homemade Forward Rate Contracts
Suppose you know that you will receive $100m in one year. You are worried that interest rates might go down? You can enter a FRA (forward rate agreement) with a bank.
Borrow for 1 year at 10% Lend for 2 years at 12% Net cash flow Year 0 +90.91
-90.91
0 Year 1 -100 -100 Year 2 114.04
114.04
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Swaps
Friendly Bancorp invested $50 M in debt carrying 8% fixed interest rate and maturing in 5 years. Annual payments are $4m. However, friendly Bancorp is predicting increases in interest rates, so it wants a floating rate. Here is what it can do.
Year 0 1 2 3 4 5
1. Borrow $66.67 at 6% fixed rate 2. Lend $66.67 at LIBOR floating rate 66.67
-66.67
-4 .05x66.67
-4 -4 -4 -70.67
LIBOR1 x66.67 LIBOR2x66.67 LIBOR3x66.67
LIBOR4x66.67
+66.67
Net cash flow 0 Standard fixed-to floating swap 0 -4 -4 -4 -4 -4 .05x66.67
LIBOR1x66.67 LIBOR2x66.67 LIBOR3x66.67 LIBOR4x66.67
-4 -4 -4 -4 -4 .05x66.67
LIBOR1x66.67 LIBOR2x66.67 LIBOR3x66.67 LIBOR4x66.67
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SWAPS
Birth 1981 Definition - An agreement between two firms, in which each firm agrees to exchange the “interest rate characteristics” of two different financial instruments of identical principal
How to Set a Hedge?
• In practice, the commodity that a firm sells is likely not identical to the one traded on the exchange.
• Delta measures the sensitivity of A to changes in the value of B.
• Duration is also used in setting hedge. (if two assets have the exact duration, they will be equally affected by change in interest rates).
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Ex - Settlement & Speculate
Example -
You are speculating in Hog Futures. You think that the Spot Price of hogs will rise in the future. Thus, you go Long on 10 Hog Futures (1K is of $30,000 pound). If the price drops .17 cents per pound ($.0017) what is total change in your position?
Commodity Hedge
In June, farmer John Smith expects to harvest 10,000 bushels of corn during the month of August. In June, the September corn futures are selling for $2.94 per bushel (1K = 5,000 bushels). Farmer Smith wishes to lock in this price (hedge).
Show the transactions if the Sept spot price drops to $2.80. Show the transactions if the Sept spot price rises to $3.05.
Commodity Speculation
You have lived in independently wealthy.
NYC your whole life and are You think you know everything there is to know about pork bellies (uncured bacon) because your butler fixes it for you every morning.
Because you have decided to go on a diet, you think the price will drop over the next few months. On the CME, each PB K is 38,000 lbs. Today, you decide to short three May Ks @ 44.00 cents per lbs. In Feb, the price rises to 48.5 cents and you decide to close your position. What is your gain/loss?
If In Feb the price drops to 40.0 cents, what is your gain/loss?
Margin
• The amount (percentage) of a Futures Contract Value that must be on deposit with a broker.
• Since a Futures Contract is not an actual sale, you need only pay a fraction of the asset value to open a position = margin.
• CME margin requirements are 15% • Thus, you can control $100,000 of assets with only $15,000.
Chapter 32 - Mergers
• Sensible Motives for Mergers • Some Dubious Reasons for Mergers • Estimating Merger Gains and Costs • The Mechanics of a Merger • Takeover Battles and Tactics • Mergers and the Economy 50
The Basic Forms of Acquisitions
• There are three basic legal procedures that one firm can use to acquire another firm: – Merger (or consolidation) – Acquisition of Stock – Acquisition of Assets • Although these forms are different from a legal standpoint, the financial press frequently does not distinguish among them.
• In our discussions, we use the term merger regardless of the actual form of the acquisition.
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Merger or Consolidation
• A merger refers to the absorption of one firm by another. The acquiring firm retains its name and identity, and acquires all the assets and liabilities of the acquired firm. After the merger, the acquired firm ceases to exist as a separate entity.
• A consolidation is the same as a merger except that an entirely new firm is created. In a consolidation, both the acquiring firm and the acquired firm terminate their previous legal existence.
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Acquisition of Stock
• A firm can acquire another firm by purchasing target firm’s voting stock in exchange for cash, shares of stock, or other securities.
• A tender offer is a public offer to buy shares made by one firm directly to the shareholders of another firm.
– If the shareholders choose to accept the offer, they tender their shares by exchanging them for cash or securities.
– A tender offer is frequently contingent on the bidder’s obtaining some percentage of the total voting shares.
– If not enough shares are tendered, then the offer might be withdrawn or reformulated.
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Acquisition of Assets
• One firm can acquire another by buying all of its assets.
• A formal vote of the shareholders of the selling firm is required.
• Advantage of this approach: it avoids the potential problem of having minority shareholders that may occur in an acquisition of stock.
• Disadvantage of this approach: it involves a costly legal process of transferring title.
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A Classification Scheme
Financial analysts typically classify acquisitions into three types: – Horizontal acquisition: when the acquirer and the target are in the same industry.
– Vertical acquisition: when the acquirer and the target are at different stages of the production process; example: an airline company acquiring a travel agency.
– Conglomerate acquisition: the acquirer and the target are not related to each other.
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Date June 2002 Jan 2002 Jan 2002
Recent Mergers in Canada
Amount ($M) Target 6,320 8,000 9,203 Bell Canada Canada Trust PanCanadian Energy Acquiring BCE Inc.
TD Bank Alberta Energy 56
Sensible Reasons for Mergers
Economies of Scale
A larger firm may be able to reduce its per unit cost by using excess capacity or spreading fixed costs across more units.
Reduces costs
$ $ $ 57
Sensible Reasons for Mergers
Combining Complementary Resources
Merging may results in each firm filling in the “missing pieces” of their firm with pieces from the other firm.
Firm A Firm B 58
Sensible Reasons for Mergers
Mergers as a Use for Surplus Funds
If your firm is in a mature industry with few, if any, positive NPV projects available, acquisition may be the best use of your funds.
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Source of Synergy from Acquisitions
• Revenue Enhancement • Cost Reduction – Including replacement of ineffective managers.
• Tax Gains – Net Operating Losses – Unused Debt Capacity • Incremental new investment required in working capital and fixed assets 60
Dubious Reasons for Mergers
• Diversification – Investors should not pay a premium for diversification since they can do it themselves.
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Dubious Reasons for Mergers
The Bootstrap Game Acquiring Firm has high P/E ratio Selling firm has low P/E ratio (due to low number of shares) After merger, acquiring firm has short term EPS rise Long term, acquirer will have slower than normal EPS growth due to share dilution.
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Dubious Reasons for Mergers
The Bootstrap Game EPS Price per share P/E Ratio Number of shares Total earnings Total market value Current earnings per dollar invested in stock World Enterprises (before merger) Muck and Slurry $ 2.00
$ 40.00
20 100,000 $ 200,000 $ 4,000,000 $ $ $ $ 2.00
20.00
10 100,000 200,000 2,000,000 World Enterprises (after buying Muck and Slurry) $ $ $ $ 2.67
40.00
15 150,000 400,000 6,000,000 $ 0.05
$ 0.10
$ 0.067
63
Dubious Reasons for Mergers
Earnings per dollar invested (log scale) World Enterprises (after merger) World Enterprises (before merger) Muck & Slurry .10
.067
.05
Now Time 64
Lower Financing Costs
The combined company can borrow at lower interest rates than either firm could separately.
That is what we would expect in well functioning markets, but it does not increase value for shareholders 65
Estimating Merger Gains
• Questions – Is there an overall economic gain to the merger?
– Do the terms of the merger make the company and its shareholders better off?
PV(AB) > PV(A) + PV(B)
66
Estimating Merger Gains
Gain
PV AB
(
PV A
PV B
)
PV AB Cost
Cash paid
PV B NPV
(
A
)
gain
cos
t
PV AB
(
cash
PV B
) 67
Estimating Merger Gains
Example – Two firms merge creating $25 million in synergies. A pays B a sum of $65 million.
PV A
$ 200
PV B
Gain
$ 50
PV AB
$ 25 68
Estimating Merger Gains
Look at Incremental Economic Gain Economic Gain = PV(increased earnings) = New cash flows from synergies discount rate 69
Cash versus Common Stock Acquistion
• Estimating Cost with Stock • Taxes – Cash acquisitions usually trigger taxes.
– Stock acquisitions are usually tax-free.
• Sharing Gains from the Merger – With a cash transaction, the target firm shareholders are not entitled to any downstream synergies.
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The Tax Forms of Acquisitions
• In a taxable acquisition (cash offer), the shareholders of the target firm are considered to have sold their shares, and they will have capital gain/losses that will be taxed.
• In a tax-free acquisition, since the acquisition is considered an exchange instead of a sale, no capital gain or loss occurs.
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Tax Consequences of a Merger
In 1995 Seacorp (fully owned by Captain B) purchases a boat for $300,000. In 2005, the boat’s book value is $150,000, but its market value is $280,000. In 2005 Seacorp also holds $50,000 of marketable securities so its market value is $330,000.
Suppose Baycorp acquires Seacorp for $330,000.
Taxable Merger Tax-free Merger
Impact on Captain B Captain B must recognize a Capital gain can be deferred $30000 capital gain and recapture until Captain B sells the Baycorp depreciation $130,000.
shares.
Impact on baycorp Boat is revalued at $280000. Tax depreciation increases to $280000/10=$28000 per year (assuming 10 years of remaining life) Boat's value remains at $150000, and tax depreciation continues at $15000 per year.
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Defensive Tactics
• Target-firm managers frequently resist takeover attempts.
• It can start with press releases and mailings to shareholders that present management’s viewpoint and escalate to legal action.
• Management resistance may represent the pursuit of self interest at the expense of shareholders.
• Resistance may benefit shareholders in the end if it results in a higher offer premium from the bidding firm or another bidder.
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Takeover Defenses Terminology
White Knight
- Friendly potential acquirer sought by the target company’s management. The white knight promises to maintain the jobs of existing management and helps to threaten an unwelcome suitor.
Shark Repellent
- Amendments to a company charter made to forestall takeover attempts.
Poison Pill
- Measure taken by a target firm to avoid acquisition; for example, the right for existing shareholders to buy additional shares at an attractive price if a bidder acquires a large holding.
Golden parachutes
firm management.
- are compensation to outgoing target
Crown jewels
- are the major assets of the target. If the target firm management is desperate enough, they will sell off the crown jewels.
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The Control Block and Anti-Takeover Legislation
• If one individual or group owns 51-percent of a company’s stock, this control block makes a hostile takeover virtually impossible.
• Control blocks are typical in Canada, although they are the exception in the United States.
• In the US, however, anti-takeover legislation has received wide attention.
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Exclusionary Offers and Nonvoting Stock
The target firm makes a tender offer for its own stock while excluding targeted shareholders.
An example: – In 1986, the Canadian Tire Dealers Association offered to buy 49% of the company’s voting shares from the founding Billes family.
– The offer was voided by the OSC, since it was viewed as an illegal form of discrimination against one group of shareholders.
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Going Private and LBOs
• If the existing management buys the firm from the shareholders and takes it private.
• If it is financed with a lot of debt, it is a
leveraged buyout
(LBO).
• The extra debt provides a tax deduction for the new owners, while at the same time turning the previous managers into owners. • This reduces the agency costs of equity as 77 managers are now also owners.
Abnormal Returns in Successful Canadian Mergers
Mergers 1964--83 Going private Transactions 1977--89 - Minority buyouts - Non-controlling bidder Target 9% 25% 27% 24% Bidder 3% NA NA NA 78
Comparison of U.S. vs. Canadian Mergers
• The evidence both in U.S. and Canada strongly suggests that shareholders of successful target firms achieve substantial gains from takeovers.
• Shareholders of bidding firms earn significantly less from takeovers. The balance is more even for Canadian mergers than for U.S. ones.
One possible reason: – There is less competition among bidders in Canada.
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Divestitures
• The basic idea is to increase corporate focus.
• Divestiture can take three forms: – Sale of assets: usually for cash – Spinoff: parent company distributes shares of a subsidiary to shareholders. Shareholders wind up owning shares in two firms. Sometimes this is done with a public IPO.
– Issuance if tracking stock: a class of common stock whose value is connected to the performance of a particular segment of the parent company.
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Summary and Conclusions
• The three legal forms of acquisition are 1. Merger and consolidation 2. Acquisition of stock 3. Acquisition of assets • M&A requires an understanding of complicated tax and accounting rules.
• The synergy from a merger is the value of the combined firm less the value of the two firms as separate entities. 81
Summary and Conclusions
• The possible synergies of an acquisition come from the following: – Revenue enhancement – Cost reduction – Lower taxes – Lower cost of capital • The reduction in risk may actually help existing bondholders at the expense of shareholders. 82
Practice Q1
Suppose Todd Trucking Company's stock is trading for $50 a share while Hamilton Company's stock goes for $25 a share. The EPS of Todd is $1 while the EPS of Hamilton is $2.50. Neither company has debt in its current capital structure. Both companies have one million shares of stock outstanding.
a. If Todd can acquire Hamilton for stock in an exchange based on market value, what should be the post-merger EPS?
b. Suppose Todd pays a premium of 20% in excess of Hamilton's current market value. How many shares of Todd must be given to Hamilton's shareholders for each of their shares?
c. Based on your results in b, what will Todd's EPS be after it acquires Hamilton?
d. If Hamilton were to acquire Todd by offering a 20% premium in excess of Todd's current market price, how many shares of stock would Hamilton have to offer, and what would be the effect on Hamilton's EPS?
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Practice Q2
Susie's Pizza is analyzing the possible acquisition of Janet's Electric. The projected cash flows to debt and equity expected from the merger are as follows: Year(s) CF 1 2 150,000 170,000 3 4 200,000 200,000 5 on 6% growth per year The current market price of Janet's debt is $800,000, the risk-free rate is 8%, the required return on the market is 12%, and the beta of the firm being acquired is 1.5.
a. Determine the maximum price (NPV) Susie can afford to pay.
b. If Janet's current equity value is $1,100,000 and she demands a 30% premium, will the merger take place?
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