CHAPTER 23

Corporate Restructuring:
Combinations and Divestitures
CHAPTER ORIENTATION
Corporate restructuring comes through combining assets (mergers and acquisitions) and
uncombining assets (divestitures). This chapter examines how mergers and acquisitions can
create shareholder wealth and the methods used to value a potential merger candidate. Firms
may also increase shareholder wealth by divesting themselves of some portion of its current
operations. This chapter discusses the different divestiture options available to a firm.

CHAPTER OUTLINE
I.

II.

There are two principal ways by which a firm may grow:

A.

Internally, through the acquisition of specific assets which are financed by the
retention of earnings and/or external financing, or

B.

Externally, through the combination with another company. We turn now to a

discussion of external growth through mergers with, and acquisition of, other
firms.

There have been five identifiable time periods where the number and amount of
mergers and acquisitions were particularly accentuated.
A.

End of the 19th century and beginning of the 20th century. During this time,
many industries were merged. The resulting firms had enormous economic
power. Example firms include U.S. Steel, American Tobacco, and Standard
Oil.

B.

The decade of the 1920s. This merger wave was closely related to the
creation of oligopolies (industries dominated by a few firms), such as IBM,
General Foods, and Allied Chemical. During this time, the developments in
transportation, communications, and merchandising fostered the growth.

53

C.

III.

Between the 1950s and the 1970s. No longer permitted by the Federal Trade
Commission to acquire firms in their own industry, companies actively began
acquiring companies outside their own industries. The bringing together of
these dissimilar firms into one corporate entity came to be known as the
conglomerate.
1.

The creation of a conglomerate was thought to be an efficient way of

monitoring individual businesses by subjecting them to regular
quantitative evaluations by the central office.

2.

With hindsight we now see that conglomerate acquisitions have, for

the most part, proven unsuccessful.

D.

The 1980s. In this period, the pattern became that of acquiring a

conglomerate, breaking it up into its individual business units, and selling off
the segments to large corporations in the same businesses. The 1980s merger
activity came to an end, however, largely because the huge amounts of debt
financing used to fund many of the acquisitions dried up.

E.

The 1990s. During the 90s the financial services and telecommunication
industries went through a period of consolidation resulting in some of the
largest mergers ever recorded.

Why mergers create value. For a merger to create wealth it has to provide
shareholders with something they get for free by merely holding the individual shares
of the two firms. Such benefits might include:
A.

Tax benefits: If a merger were to result in a reduction of taxes that is not

otherwise possible, then wealth is created by the merger. This can be the case
with a firm that has lost money and thus generated tax credits, but does not
currently have a level of earnings sufficient to utilize those tax credits.

B.

Reduction of agency costs: An agency problem is a result of the separation of

management and the ownership in the firm. A merger, particularly when it
results in a holding company or conglomerate organizational form may reduce
the significance of this problem, because top management is created to
monitor the management of the individual companies making up the
conglomerate. Alternatively, it can be argued that the creation of a
conglomerate might result in increased agency costs. This might occur as
shareholders in conglomerates feel they have less control over the firm's
mangers, as a result of the additional layers of management between them and
the decision makers.

C.

The release of free cash flows to the owners: A merger can create wealth by
allowing the new management to distribute the free cash flow out to the
shareholders, thus allowing them to earn a higher return on these cash flows
than would have been earned by the firm.

D.

Economies of scale: Wealth can be created in a merger through economies of

scale. Redundant functions of the combined firms, such as accounting,
computer operations, and management, provide opportunities to reduce
staffing and its associated costs or to increase productivity.

54

IV.

E.

Unused debt potential: Assuming the acquired firm has unused debt capacity,
a new management can increase debt financing, and reap the tax benefits
associated with the increased debt.

F.

Complementary financial slack: It may be possible to create wealth by

combining cash-rich bidders and cash-poor targets, with wealth being created
as a result of the positive NPV projects taken by the merged firm that the
cash-poor firm would have passed up.

G.

Removal of ineffective management: If a firm with ineffective management

can be acquired, it may be possible to replace the current management with a
more efficient management team, and thereby create wealth.

H.

Increased market power: The merger of two firms can result in an increase in
the market or monopoly power of the two firms. While this can result in
increased wealth, it may also be illegal.

I.

Reduction in bankruptcy costs: Presuming that bankruptcy costs exist, a

merger that reduces the possibility of bankruptcy creates wealth.

J.

The creation of "chop shop" value: It may be less expensive to purchase

assets through an acquisition than it is to obtain those assets in any other way.

Determining a firm's value

A.

The value of a firm depends not only on its earnings capabilities but also on
the operating and financial characteristics of the acquired firm. To determine
an acceptable price of a corporation, a number of factors must be carefully
evaluated. The final objective of this valuation process is to maximize the
stockholders' wealth (stock price) of both firms.

B.

The value of a firm may be represented in a number of ways including (l)

book value, (2) appraisal value, (3) chop-shop value, and (4) the free cash
flow value.
1.

The book value of a firm's net worth is the depreciated value of the
company's assets less its outstanding liabilities. Book value alone is not
a significant measure of the worth of a company but should be used as
a starting point to be compared with other analyses.

2.

Appraisal value, acquired from an independent appraisal firm, may be

useful in conjunction with other methods. Advantages include
a.

The reduction of accounting goodwill by increasing the

recognized worth of specific assets.

b.

A test of the reasonableness of results obtained through other

evaluation methods.

c.

The discovery of strengths and weaknesses that otherwise

might not be recognized.

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V.

3.

The "chop shop" approach to valuation attempts to identify multiindustry companies that are undervalued and would be worth more if
separated into their parts. As such, this approach encompasses the
idea of attempting to buy assets below their replacement cost.

4.

The free cash-flow approach to merger valuation requires that we

estimate the incremental net cash flows available to the bidding firm as
a result of the merger or acquisition. The present value of these cash
flows will then be determined, and this will be the maximum amount
that should be paid for the target firm. The initial outlay can then be
subtracted out to calculate the net present value from the merger.

Divestitures
A.

Divestitures, or "reverse mergers," have become an important factor in

restructuring corporations.

B.

A successful divestiture allows the firm's assets to be used more efficiently, and
therefore, be assigned a higher value by the market forces.

C.

The different types of divestitures may be summarized as follows:

1.

Selloff. A selloff is the sale of a subsidiary, division, or product line by

one company to another.

2.

Spinoff. A spinoff involves the separation of a subsidiary from its

parent, with no change in the equity ownership.

3.

Liquidation. A liquidation in this context is not a decision to shut down

or abandon an asset. Rather, the assets are sold to another company
and the proceeds are distributed to the stockholders.

4.

Going private. Going private results when a company, whose stock is

traded publicly, is purchased by a small group of investors and the
stock is no longer bought and sold on a public exchange.

5.

Leveraged buyout. The leveraged buyout is a special case of going

private. The existing shareholders sell their shares to a small group of
investors. The purchasers of the stock use the firm's unused debt
capacity to borrow the funds to pay for the stock.

56

ANSWERS TO
END-OF-CHAPTER QUESTIONS
23-1.

Clearly, for a merger to create wealth it would have to provide shareholders with
something they could not get for free by merely holding the individual shares of the
two firms. Restating the question: What benefits are there to shareholders from
mergers and acquisitions? Potential benefits would include the following:
a.

If a merger were to result in a reduction of taxes that is not otherwise

possible, then wealth is created by the merger.

b.

As a result of agency problems, stockholders and bondholders impose a

premium on funds supplied to the firm to compensate them for this
inefficiency in management. A merger, particularly when it results in a
holding company or conglomerate organizational form, may reduce the
significance of this problem, because top management is created to monitor
the management of the individual companies making up the conglomerate.
As a result, management of the individual companies can be effectively
monitored without any forced public announcement of proprietary
information, such as new product information that might aid competitors. If
investors recognize this reduction in the agency problem as being material in
scope, they may provide funds to the firm at a reduced cost, no longer
charging as large of an "agency problem premium."
Alternatively, it can be argued that the creation of a conglomerate might
result in increased agency costs. This might occur as shareholders in
conglomerates feel they have less control over the firm's mangers, as a result
of the additional layers of management between them and the decision
makers.

c.

Free cash flow should be paid out to shareholders; otherwise it would be

invested in projects returning less than the required rate of return.
Unfortunately, managers may not wish to pass these funds to the
shareholders, because they may feel that their power would be reduced.
Moreover, if they return these surplus funds they may, at a later date, be
forced to go outside for financing if more profitable investment
opportunities are identified. This situation is a form of the agency problem,
but these actions may be more a result of the corporate management culture
than of any attempt by the managers to maintain their own position as
opposed to maximizing shareholder wealth. A merger can create wealth by
allowing the new management to pay this free cash flow out to the
shareholders, thus allowing them to earn a higher return on this excess than
would have been earned by the firm.

d.

Wealth can be created in a merger through economies of scale. For

example, administrative expenses including accounting, computing, or
simply top-management costs, may fall as a percent of total sales as a result
of sharing these resources.

57

e.

Some firms simply do not exhaust their debt capacity. If a firm with unused
debt potential is acquired, the new management can then increase debt
financing, and reap the tax benefits associated with the increased debt.

f.

It may be possible to create wealth by combining cash-rich bidders and cashpoor targets, with wealth being created as a result of the positive NPV
projects taken by the merged firm that the cash-poor firm would have passed
up.

g.

If a firm with ineffective management can be acquired, it may be possible to

replace the current management with a more efficient management team,
and thereby create wealth.

h.

The merger of two firms can result in an increase in the market or monopoly
power of the two firms. While this can result in increased wealth, it may
also be illegal.

i.

Firm diversification, when the earnings from the two firms are less than
perfectly positively correlated, can reduce the chance of bankruptcy. Since
costs are associated with bankruptcy, reduction of the chance of bankruptcy
has a very real value to it.

23-2.

The basic function of book value is to establish the costs as set forth by accounting
principles, not to determine value. These costs may bear little relationship to the
value of the organization or to its ability to produce earnings.

23-3.

The advantages of an independent appraisal include:

(1)

Accounting goodwill may be reduced by increasing the recognized worth of

specific assets.

(2)

The reasonableness of the results obtained through other valuation methods

are tested.

(3)

Strengths and weaknesses may be uncovered that otherwise might not be

recognized.

23-4.

The "chop-shop" approach to valuation attempts to identify multi-industry

companies that are undervalued and would be worth more if separated into their
parts. As such, this approach encompasses the idea of attempting to buy assets
below their replacement cost.

23-5.

The NPV, or free cash flow valuation model, is familiar to us, since it merely
involves finding the present value of cash flows, as we did in our studies in capital
budgeting. Using the cash-flow approach to merger valuation requires that we
estimate the incremental net cash flows available to the bidding firm as a result of
the merger or acquisition. The present value of these cash flows will then be
determined, and this will be the maximum amount that should be paid for the target
firm. The initial outlay can then be subtracted out to calculate the net present value
from the merger. While this is very similar to what was proposed when we
examined the capital budgeting problem, there are differences, particularly when
estimating the initial outlay.

58

23-6.

Types of divestitures include:

(1)

Selloff. A selloff is the sale of a subsidiary, division, or product line by one

company to another.

(2)

Spinoff. A spinoff involves the separation of a subsidiary from its parent

with no change in the equity ownership.

(3)

Liquidation. A liquidation in this context is not a decision to shut down or

abandon an asset. Rather, the assets are sold to another company, and the
proceeds are distributed to the stockholders.

(4)

Going private. Going private results when a company whose stock is traded
publicly is purchased by a small group of investors, and the stock is no
longer bought and sold on a public exchange.

(5)

Leveraged buyout. The leveraged buyout is a special case of going private.

The existing shareholders sell their shares to a small group of investors. The
purchasers of the stock use the firm's unused debt capacity to borrow the
funds to pay for the stock.

SOLUTIONS TO
END-OF-CHAPTER PROBLEMS
Solutions to Problem Set A
23-1A.

Aramus, Inc. - Chop shop valuation (In Thousands)

Business
Segment
Sunglasses distribution
Reading glasses distribution
Technical products
Total Value
Business
Segment
Sunglasses distribution
Reading glasses distribution
Technical products
Total Value

Capital-toSales
1.0
0.9
1.2
Capital-toAssets
0.8
0.8
1.0

59

Segment
Sales
3,500
2,000
6,500
Segment
Sales
1,000
1,500
8,500

Theoretical
Values
$3,500
1,800
7,800
$13,100
Theoretical
Values
$ 800
1,200
8,500
$10,500

Business
Segment

Capital-toOperating Income

Sunglasses distribution
Reading glasses distribution
Technical products
Total Value

Segment
Sales

8.0
10.0
7.0

Theoretical
Values

350
250
1,200

$2,800
2,500
8,400
$13,700

Average Theoretical Value

23-2A.

$12,433

Argo Corporation (numbers expressed in millions)

Year
Sales
Cost of goods sold
Admin. & selling costs
Depreciation
Earnings before taxes
Taxes (34%)
Earnings after taxes
Depreciation
Capital expenditures
Free cash flows

2004
$200.00
120.00
15.00
10.00
$55.00
18.70
$36.30
10.00
12.00
$34.30

2005
$225.00
135.00
20.00
15.00
$55.00
18.70
$36.30
15.00
13.00
$38.30

2006
$240.00
144.00
27.00
17.00
$52.00
17.68
$34.32
17.00
15.00
$36.32

2007
$250.00
150.00
28.00
20.00
$52.00
17.68
$34.32
20.00
17.00
$37.32

Beyond
2007
$275.00
165.00
30.00
24.00
$56.00
19.04
$36.96
24.00
20.00
$40.96

Weighted cost of capital: (.30) x 8% + (.70) x 18% = 15%

$29.83

$28.96

Total present value

Cost of acquisition
($250 paid + $40 debt assumed)
Net present value

$23.88

$21.34

$156.13*
$260.14
290.00
-$29.86

*=

$40.96
/(1+.15)4=$156.13
.
15

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23-3A.

Prime Corporation - Free cash flow valuation (In Millions)

Year
Sales
Cost of Goods
Sold
Admin.& selling
Depreciation
Earnings before tax
Taxes (34%)
Earnings after tax.
Depreciation
Capital expenditures
Free Cash Flows

2004
$300.00
180.00

2005
$335.00
201.00

2006
$370.00
222.00

2007
$400.00
240.00

Beyond
2007
$425.00
255.00

40.00
25.00
$55.00
18.70
$36.30
25.00
30.00
$31.30

50.00
30.00
$54.00
18.36
35.64
30.00
37.00
$28.64

58.00
35.00
$55.00
18.70
$36.30
35.00
45.00
$26.30

62.00
38.00
$60.00
20.40
$39.60
38.00
48.00
$29.60

65.00
40.00
$65.00
22.10
$42.90
40.00
50.00
$32.90

$16.35

$113.56*
$195.02
180.00

Weighted Cost of Capital

. 4(10%) + .6(20%) = 16%

$26.98

$21.28

Total Present Value

Cost of Acquisition
($150 paid + $30 debt assumed)
Net Present Value

$16.85

$15.02

*=

$32.90
/(1+.16)4=$113.56
.16

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Solutions to Problem Set B

23-1B.

Cornutt, Inc. - Chop-shop valuation (In Thousands)

Business
Segment
Consumer wholesale
Specialty services
Retirement centers
Total value

Capital-toSales
0.75
1.10
1.00

Segment
Sales
$1,500
800
2,000

Theoretical
Values
$1,125
880
2,000
$4,005

Business
Segment
Consumer wholesale
Specialty services
Retirement centers
Total value

Capital-toAssets
0.60
0.90
0.60

Segment
Assets
$750
700
3,000

Theoretical
Values
$450
630
1,800
$2,880

Segment
Income
$100
150
600

Theoretical
Values
$1,000
1,050
3,600
$5,650
$4,178

Business
Capital-toSegment
Operating Income
Consumer wholesale
10.00
Specialty services
7.00
Retirement centers
6.00
Total value
Average theoretical value
23-2B

Wrongway, Inc. - Chop-shop valuation (In Thousands)

Business
Segment
Sunglasses distribution
Reading glasses distribution
Technical products
Total value
Business
Segment
Sunglasses distribution
Reading glasses distribution
Technical products
Total value
Business
Segment

Capital-toSales
0.8
1.2
1.2

Segment
Sales
2,200
1,000
3,500

Theoretical
Values
1,760
1,200
4,200
$7,160

Capital-toAssets

Segment
Assets

Theoretical
Values

1.0
0.9
1.1
Capital-toOperating Income

Sunglasses distribution
Reading glasses distribution
Technical products
Total Value
Average Theoretical Value

8.0
10.0
12.0

62

600
700
5,000
Segment
Income
200
150
500

600
630
5,500
$6,730
Theoretical
Values
1,600
1,500
6,000
$9,100
$7,663

23-3B.

Brown Corporation. - Free cash flow valuation (In Millions)

Beyond
Year
Sales
Cost of goods sold (50%)
Admin. & selling costs
Depreciation
Earnings before taxes
Taxes (34%)
Earnings after taxes
Depreciation
Capital expenditures
Free cash flows

2004
$260.00
130.00
25.00
15.00
$90.00
30.60
$59.40
15.00
22.00
$52.40

2005
$265.00
132.50
25.00
17.00
$90.50
30.77
$59.73
17.00
18.00
$58.73

2006
$280.00
140.00
25.00
18.00
$97.00
32.98
$64.02
18.00
18.00
$64.02

2007
$290.00
145.00
30.00
23.00
$92.00
31.28
$60.72
23.00
20.00
$63.72

$300.00
150.00
30.00
30.00
$90.00
30.60
$59.40
30.00
22.00
$67.40

Weighted average cost of capital = .25 x 8% + .75 x 22% = 18.50%

$44.22

$41.82

Total present value

Cost of acquisition ($225 paid plus $75 debt assumed)
Net present value

*=

$67.40
/(1+.185)4=$184.76
.
185

63

$38.47

$32.32 $184.76*
$341.59
300.00
$41.59

23-4B. Little Corporation - Free cash flow valuation (In Millions)

Year
Sales
Cost of goods sold
Admin. & selling
Depreciation
Earnings before tax
Taxes (34%)
Earnings after tax
Depreciation
Capital expend.
Free Cash Flows

2004
$200.00
140.00
30.00
18.00
$12.00
4.08
$7.92
18.00
20.00
$5.92

2005
$220.00
154.00
35.00
20.00
$11.00
3.74
$7.26
20.00
22.00
$5.26

2006
$245.00
171.50
38.00
22.00
$13.50
4.59
$8.91
22.00
25.00
$5.91

$3.65

$3.42

Beyond
2007
2007
$275.00 $300..00
192.50
210.00
40.00
45.00
25.00
30.00
$17.50
$15.00
5.95
5.10
$11.55
$9.90
25.00
30.00
28.00
30.00
$8.55
$9.90

Weighted Cost of Capital:

.5 (15%) + .5 (25%) = 20%
$4.93
Total Present Value
Cost of Acquisition
($25 paid + $12 debt assumed)
Net Present Value

$4.12 $23.87**
$39.99
37.00
$2.99

**=

$9.90
/(1+.20)4=$23.87
.
20

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