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. 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. 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.
II. 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.

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 C. 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.
III. 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.

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 E. Unused debt potential: Assuming the 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.
IV. 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 acquiring 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) market price of a firm's common stock,
(4) chop-shop value, and (5) 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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 3. If a stock is listed on a major securities exchange, such as the New
York Exchange, and widely traded, an approximate value can be
established on the basis of the market value. The justification is based
on the fact that the market quotations indicate the investors’ different
opinions on a firm's earnings potential and the corresponding risk.
The market value approach is the one most frequently used in valuing
large corporations. However, this value can change abruptly.
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.
5. 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.
V. 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.

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 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.

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 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
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. 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 the going-concern
concept 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.

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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 PROBLEMS
Solutions to Problem Set A
23-1A. Aramus, Inc. - Chop shop valuation

Business Capital-to- Segment Theoretical

Segment Sales Sales Values

Sunglasses distribution 1.0 3,500 $3,500

Reading glasses distribution 0.9 2,000 1,800
Technical products 1.2 6,500 7,800
Total Value $13,100

Business Capital-to- Segment Theoretical

Segment Assets Sales Values

Sunglasses distribution 0.8 1,000 $ 800

Reading glasses distribution 0.8 1,500 1,200
Technical products 1.0 8,500 8,500
Total Value $10,500

Business Capital-to- Segment Theoretical

Segment Operating Income Sales Values

Sunglasses distribution 8.0 350 $2,800

Reading glasses distribution 10.0 250 2,500
Technical products 7.0 1,200 8,400
Total Value $13,700

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Average Theoretical Value $12,433

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23-2A. Argo Corporation (numbers expressed in millions)

Beyond
Year 2001 2002 2003 2004 2004
Sales $200.00 $225.00 $240.00 $250.00 $275.00
Cost of goods sold 120.00 135.00 144.00 150.00 165.00
Admin. & selling costs 15.00 20.00 27.00 28.00 30.00
Depreciation 10.00 15.00 17.00 20.00 24.00
Earnings before taxes $55.00 $55.00 $52.00 $52.00 $56.00
Taxes (34%) 18.70 18.70 17.68 17.68 19.04
Earnings after taxes $36.30 $36.30 $34.32 $34.32 $36.96
Depreciation 10.00 15.00 17.00 20.00 24.00
Capital expenditures 12.00 13.00 15.00 17.00 20.00
Free cash flows $34.30 $38.30 $36.32 $37.32 $40.96

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

$29.83 $28.96 $23.88 $21.34 $156.13

Total present value $260.14

Cost of acquisition 290.00
($250 paid + $40 debt assumed)
Net present value -$29.86

 $40.96 
* =  /(1+.15)4 = $156.13
 .15 

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23-3A. Prime Corporation - Free cash flow valuation

Year 2001 2002 2003 2004 Beyond '04

Sales $300.00 $330.00 $375.00 $400.00 $425.00
Cost of Goods 180.00 198.00 225.00 240.00 255.00
Sold
Admin.& selling 40.00 50.00 58.00 62.00 65.00
Depreciation 25.00 30.00 35.00 38.00 40.00
Earnings before tax $55.00 $52.00 $57.00 $60.00 $65.00
Taxes (34%) 18.70 17.68 19.38 20.40 22.10
Earnings after tax. $36.30 34.32 $37.62 $39.60 $42.90
Depreciation 25.00 30.00 35.00 38.00 40.00
Capital expenditures 30.00 37.00 45.00 48.00 50.00
Free Cash Flows $31.30 $27.32 $27.62 $29.60 $32.90

Weighted Cost of Capital . 4(10%) + .6(20%) = 16%

$26.98 $20.30 $17.69 $16.35 $113.56

Total Present Value $194.88
Cost of Acquisition 180.00
($150 paid + $30 debt assumed)
Net Present Value $14.88

 $32.90 
* =  /(1+.16)4 = $113.56
 .16 

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Solutions to Problem Set B

23-1B. Cornutt, Inc. - Chop-shop valuation

Business Capital-to- Segment Theoretical
Segment Sales Sales Values
Consumer wholesale 0.75 $1,500 $1,125
Specialty services 1.10 800 880
Retirement centers 1.00 2,000 2,000
Total value $4,005
Business Capital-to- Segment Theoretical
Segment Assets Assets Values
Consumer wholesale 0.60 $750 $450
Specialty services 0.90 700 630
Retirement centers 0.60 3,000 1,800
Total value $2,880
Business Capital-to- Segment Theoretical
Segment Income Income Values
Consumer wholesale 10.00 $100 $1,000
Specialty services 7.00 150 1,050
Retirement centers 6.00 600 3,600
Total value $5,650
Average theoretical value $4,178

23-2B Wrongway, Inc. - Chop-shop valuation

Business Capital-to- Segment Theoretical
Segment Sales Sales Values
Sunglasses distribution 0.8 2,200 1,760
Reading glasses distribution 1.2 1,000 1,200
Technical products 1.2 3,500 4,200
Total value $7,160
Business Capital-to- Segment Theoretical
Segment Assets Assets Values

Sunglasses distribution 1.0 600 600

Reading glasses distribution 0.9 700 630
Technical products 1.1 5,000 5,500
Total value $6,730
Business Capital-to- Segment Theoretical
Segment Income Income Values

Sunglasses distribution 8.0 200 1,600

Reading glasses distribution 10.0 150 1,500
Technical products 12.0 500 6,000
Total Value $9,100
Average Theoretical Value $7,663

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23-3B. Brown Corporation. - Free cash flow valuation

Beyond
Year 2001 2002 2003 2004 2004
Sales $260.00 $265.00 $280.00 $290.00 $300.00
Cost of goods sold (50%) 130.00 132.50 140.00 145.00 150.00
Admin. & selling costs 25.00 25.00 25.00 30.00 30.00
Depreciation 15.00 17.00 18.00 23.00 30.00
Earnings before taxes $90.00 $90.50 $97.00 $92.00 $90.00
Taxes (34%) 30.60 30.77 32.98 31.28 30.60
Earnings after taxes $59.40 $59.73 $64.02 $60.72 $59.40
Depreciation 15.00 17.00 18.00 23.00 30.00
Capital expenditures 22.00 18.00 18.00 20.00 22.00
Free cash flows $52.40 $58.73 $64.02 $63.72 $67.40

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

$44.22 $41.82 $38.47 $32.32 $184.76

Total present value $341.59
Cost of acquisition ($225 paid plus $75 debt assumed) 300.00
Net present value $41.59

 $67.40 
* =  /(1+.185)4 = $184.76
 .185 

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23-4B. Little Corporation - Free cash flow valuation

Year2001 2002 2003 2004 Beyond 2004

Sales $200.00 $220.00 $245.00 $275.00 $300..00
Cost of goods sold 140.00 154.00 171.50 192.50 210.00
Admin. & selling 30.00 35.00 38.00 40.00 45.00
Depreciation 18.00 20.00 22.00 25.00 30.00
Earnings before tax $12.00 $11.00 $13.50 $17.50 $15.00
Taxes (34%) 4.08 3.74 4.59 5.95 5.10
Earnings after tax $7.92 $7.26 $8.91 $11.55 $9.90
Depreciation 18.00 20.00 22.00 25.00 30.00
Capital expend. 20.00 22.00 25.00 28.00 30.00
Free Cash Flows $5.92 $5.26 $5.91 $8.55 $9.90

Weighted Cost of Capital:

.5 (15%) + .5 (25%) = 20%

$4.93 $3.65 $3.42 $4.12 $23.87

Total Present Value $39.99
Cost of Acquisition 37.00
($25 paid + $12 debt assumed)
Net Present Value $2.99

 $9.90 
** =  /(1+.20)4 = $23.87
 .20 

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