FINANCIAL MANAGEMENT PART 17

1. Corporate Restructuring Chapter 17

10. Tax Losses Consider the following possible combination of Rich Inc. and Poor Inc. Operating independently Rich pays $700 in taxes while Poor pays nothing, for a combined total of $700. However, the merged companies pay a combined tax of only $350. Example $650 ($1,000) $1,400 EAT 350 -0- 700 Tax (35%) $1,000 ($1,000) $2,000 EBT Merged Poor Inc. Rich Inc.

22. The Price Premium—Example Q: The Aldebron Motor Company is considering acquiring Arcturus Gear Works, Inc. and has made a three-year projection of the firm's financial statements, including the following revenue and earnings estimate. Period 0 is the current year and not part of the forecast. Figures are in million of dollars. Example 130 117 106 95 EAT $2,000 $1,815 $1,650 $1,500 Revenue 3 2 1 0 Year

23. The Price Premium—Example Q: Aldebron expects that synergies will net $10 million after tax per year. It also expects that cash equal to depreciation will have to be reinvested to keep Arcturus's plant operating efficiently, and that 60% of the remaining cash generated by operations will need to be invested in growth opportunities. Otherwise the balance sheet will remain relatively unchanged. Results beyond three years become increasingly difficult to forecast in any detail, so Aldebron's plan simply assumes a 6% annual growth in all of the target's figures after the third year. Currently 90-day treasury bills are yielding 8% and the market returns 13% on an average stock. Arcturus's beta is 1.8 and the firm has 20 million shares of stock outstanding, which closed at $19 a share yesterday. How much should Aldebron be willing to pay for Arcturus's stock? Discuss the quality of the estimate. Example

24. The Price Premium—Example A: First we'll estimate the discount rate using the CAPM approach. k x = k RF + (k M – k RF )b x Then we'll estimate the cash flows for the next three years of operation for Arcturus Example $56 $51 $46 $42 Cash flow to Aldebron 84 76 70 63 Reinvested (60%) $140 $127 $116 $106 EAT/cash flow (merged)* 10 10 10 10 Synergies 130 117 106 95 EAT (unmerged) $2,000 $1,815 $1,650 $1,500 Revenue 3 2 1 0 Year

25. The Price Premium—Example A: Next we'll find the present value of the terminal value at year three Finally we'll find the present value of the three years of cash flows and the terminal value Example $372 $37 $39 Present Value $596 $51 $46 Total 540 Terminal Value $56 $51 $46 Operating cash flow 3 2 1 Year Notice how large the terminal value is compared to the operating cash flows Sum = $449

26. The Price Premium—Example A: Since Arcturus has 20 million outstanding shares, Aldebron should consider paying a maximum of about $22.45 per share for Arcturus. If the stock is currently selling for $19, this represents an 18.2% premium over its market price. NOTE: If the constant growth assumption were changed from 6% to 9%, the maximum acquisition price rises to $29.40. Example

45. Debt Restructuring—Example Q: The Adcock Company has 50,000 shares of common stock outstanding at a book value of $40, pays 10% interest on its debt, and is in the following financial situation Example ($300) Cash flows (100) Principal Repayment 200 Depreciation ($400) EAT --- Tax $8,000 Total capital ($400) EBT 2,000 Equity 600 Interest $6,000 Debt $200 EBIT Capital Income and Cash Flow Notice that although the company has positive EBIT, it doesn't earn enough to pay its interest let alone repay principal on schedule. Without help of some kind it will fail shortly. Devise a composition involving a debt for equity conversion that will keep the firm afloat.

46. Debt Restructuring—Example A: Suppose the creditors (perhaps a number of bondholders) are willing to convert $3 million in debt to equity at the $40 book value of the existing shares. This would require the firm to issue 75,000 new shares, resulting in the following financial situation. Example ($50) Cash flows (50) Principal Repayment 200 Depreciation ($100) EAT --- Tax $8,000 Total capital ($100) EBT 5,000 Equity 300 Interest $3,000 Debt $200 EBIT Capital Income and Cash Flow Notice that the company now has a slightly positive cash flow and can at least theoretically continue in business indefinitely. However, creditors now own a controlling interest in the firm.