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- - - - - - - - Chapter 13 - - - - - - - -. Financial Restructuring. Value of the Firm. Start with the value of an all equity firm Sources of potential increases or decreases in value PV of tax shields PV of other benefits or costs of leverage PV of benefits or costs of control changes

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Chapter 13 l.jpg

- - - - - - - - Chapter 13- - - - - - - -

Financial Restructuring

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 1


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Value of the Firm

  • Start with the value of an all equity firm

  • Sources of potential increases or decreases in value

    • PV of tax shields

    • PV of other benefits or costs of leverage

    • PV of benefits or costs of control changes

    • PV of benefits or costs from M&As

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 2


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  • PV of benefits or costs of changes in strategies, policies, operations, organization structure (restructuring)

  • PV of costs of financial distress

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 3


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Leverage and Leveraged Recapitalizations

  • Value enhancement of capital structure decisions

    • Acquisition of other firms

      • Debt as a source of funding for acquisition activity

      • Takeover of firm to capture unused tax benefits of debt

    • Defense against being acquired by others

      • Increase debt level to make firm less attractive

      • Use debt to reorganize management control of firm

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 4


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  • Effects of the use of leveraged recaps

    • Leveraged recap mechanism

      • Relatively large issue of debt

      • Payment of relatively large cash dividend to nonmanagement shareholders

      • Share repurchases

      • Increase in share ownership by management

      • Has been proposed as an alternative to merger when pooling is abolished, to avoid goodwill write-offs of purchase accounting

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 5


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  • Leverage recap characteristics

    • Book leverage measured by total debt to total capitalization increases from 20% to about 70%

    • Management ownership share increases from 9% to 24% on average

  • Market response to announcement of leveraged recap — defensive

    • Defensive leveraged recap — action taken in response to actual takeovers or indications of likely takeover bid

    • Both positive and negative returns

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 6


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  • Market response to announcement of leveraged recap — proactive

    • Cumulative positive abnormal return of about 30%

    • Return to bondholders of positive 5%

    • Action is a part of a longer-run program of improving the performance of the firm

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 7


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  • Subsequent performance

    • High rate of financial distress

    • Main factors influencing post-performance

      • Macroeconomic and industry conditions

      • Whether defensive or proactive

      • Whether operating improvements were achieved

    • Positive disciplinary role of debt

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 8


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  • Role of leveraged recaps

    • Leveraged recap more likely to succeed if

      • Part of a strategic plan to improve performance of firm in relation to changing environments

      • Success depends heavily on programs to improve performance

    • Takeover defense

      • Succeed by returning cash to shareholders

      • Shareowners continue to hold equity stubs

      • May discourage outside bidders — scorched-earth policy

      • High percentage of firms which adopt leveraged recaps are subsequently acquired

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 9


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Dual-Class Recapitalizations

  • Dual-class recapitalization (DCR) mechanism

    • Second class of common stock has limited voting rights and a preferential claim to cash flows

      • Class A shares — one vote per share but higher dividend rate than other class

      • Class B shares — cast multiple votes such as 3, 5, or 10 per share but dividend rate is lower than other class

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 10


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  • New class may be created by distributing limited voting shares pro rata to current shareholders

  • Some patterns

    • Officers and directors have 55-65% of common stock voting rights

    • Officers and directors have claim on about 25% of total cash flows

  • In substantial number of cases of DCR, controlled group represents founding families or their descendants

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 11


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  • Reasons for dual-class recapitalizations

    • Management can solidify control to carry out long-run programs

      • Avoid pressure for good short-term results

      • Operations are relatively complex and difficult to evaluate managerial performance

    • Managers are compensated when plans come to fruition

    • Negative — managers can entrench their position against takeover or being replaced

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 12


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  • Market response to dual-class recaps

    • Shareholder wealth not adversely affected by adoption of DCR

      • Positive abnormal returns of over 6% for 90-day period preceding announcement of DCR

      • Positive significant abnormal performance of 1% for event window of two or three days surrounding announcement

      • Negative but not significant cumulative stock price reaction over time period from announcement to approval at shareholder meeting

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 13


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  • Dual-class shares and takeover bids

    • When firm taken over, holder of superior voting right shares received differentially higher payment

    • Fewer firms with dual-class stock experienced takeover bids

    • Superior shares sell at a premium mainly because they receive more in takeover

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 14


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  • Paradox of the entrenchment - why DCRs are approved if their purpose is management entrenchment?

    • Ruback (1988)

      • Wealth of shareholders who retain superior-vote shares is transferred to shareholders who elect inferior-vote shares with higher dividends

      • All outside shareholders rationally choose shares with higher dividend

      • Shareholders face prisoners' dilemma — if collective action were possible, outside shareholders would collude to defeat exchange offer in order to avoid reduced probability of receiving takeover bid caused by recapitalization

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 15


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  • Lehn, Netter, and Poulsen (1990)

    • Comparison of dual-class recaps with leveraged buyouts

    • DCR experienced significantly higher growth rates in sales and number of employees than LBO firms — LBO firms mainly in mature industries with stable cash flows

    • Ratios of research and development expenditures to sales and advertising expenditures to sales were higher for DCR firms

    • DCR firm had lower pre-transaction tax liabilities

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 16


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  • Post-transaction performance

    • DCR uses higher percentage of cash flows for capital expenditures than LBO firms

    • Large proportion of DCR firms issue equity following recap

    • DCR achieves significantly higher industry-adjusted operating income to sales ratio

    • LBO firms outperform in terms of size of improvement and performance

    • Substantial increased management equity stake in LBOs; DCR firms' insiders already held 43.1% of common equity before transaction

    • DCR firms have relatively lower leverage policies and do not alter them as a consequence of the transaction

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 17


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  • LBOs often used as an antitakeover transaction

  • Takeover rumors or bids preceded DCRs in only 3 of 97 firms in sample

  • DCR firms' insider seeks to consolidate control to carry through growth plan, sacrificing current dividend income for possible larger long-term gain

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 18


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  • Moyer, Rao, and Sisneros (1992)

    • Examined whether DCRs are accompanied by ways to decrease managerial control such as increasing leverage, dividends, and monitoring by analysts and institutional investors

      • Mean proportion of outside directors on the board changed from 53.7 - 59.1% over two years preceding announcement

      • Significant change only in debt ratio and mean number of analysts covering firm

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 19


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  • Statistically insignificant changes in dividend payout and changes in number of institutions holding stock after recapitalization

  • For prior ownership levels of up to 7.5%, change in debt ratio is significantly greater in low prior ownership groups than in high prior ownership groups

  • Mean number of analysts following sample firms is 5.72 prior to announcement and 7.47 after announcement

  • Conclude that a moderate increase in external control took place

  • ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 20


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    Exchange Offers

    • Exchange offer mechanics

      • Provides one or more classes of securities, right or option to exchange part or all of holdings for different class of securities of firm

      • Terms of offer involve new securities of greater market value than pre-exchange offer announcement market value to induce security holders to accept offer

    ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 21


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    • Maximum number of securities that may be exchanged are usually specified

    • Many exchange offers contingent upon acceptance of minimum number of securities to be exchanged

    • Average life of offer is about seven weeks but frequently extended; initial announcement precedes beginning of exchange offer by nine months

    ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 22


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    • Tax aspects of exchange offers

      • When firm redeems debt at price below issue price, difference treated as ordinary corporate income

      • Debt redeemed at price above issue price, difference treated as ordinary loss

      • Stock tendered for debt, stockholders incur capital gain tax liability

      • Debt for common stock exchange likely to occur when stock selling at relatively low prices — shareholders incur little or no capital gain liability

    ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 23


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    • Empirical evidence

      • Positive abnormal returns

        • Main results

          • Debt for common stock +14.0%

          • Preferred for common stock +8.2%

          • Debt for preferred stock +2.2%

          • Income bonds for preferred stock +2.2%

        • Common characteristics

          • Leverage increasing

          • Imply increase in future cash flows

          • Imply undervaluation of common stock

          • Management share ownership increased

          • Control over management’s use of cash decreased

          • Positive signaling

    ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 24


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    • Negative abnormal returns

      • Main results

        • Common stock for debt -9.9%

        • Private swaps of common for debt -0.9%

        • Preferred stock for debt -7.7%

        • Common for preferred stock -2.6%

        • Calls forcing debt conversion -2.1%

      • Common characteristics

        • Leverage decreasing

        • Imply decrease in future cash flows

        • Imply overvaluation of common stock

        • Management share ownership decreased

        • Control over management's use of cash increased

        • Negative signaling

    ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 25


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    • q-ratio (Born and McWilliams, 1993)

      • 127 equity-for-debt exchange offers

      • Firms with q-ratios less than 1, significant negative abnormal returns on announcement

      • Firms with q-ratios greater than 1, no significant event response

      • Equity-for-debt exchanges with low q values may be used to rescue firm from pressures resulting from inability to service debt obligations

    ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 26


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    • Distressed exchanges

      • Used by firms that issued high-yield "junk" bonds

      • Exchange involved either

        • total exchange of preferred and/or common equity for old debt, or

        • combination of some equity and some new (but extended) debt for old debt

      • Firm attempts to restructure both its assets and liabilities after its operating and financial condition had deteriorated due to both chronic and cyclical problems

    ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 27


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    Reorganization Processes For Financially Distressed Firms

    • Distressed firm — when liquidation value of firm's assets is less than total face value of creditor claims

    • Out-of-court procedures

      • Exchange — residual or equity claim substituted for debt priority claim

      • Extension — maturity of debt can be postponed

      • Composition — obligations can be scaled down

    ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 28


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    • Merger into another firm — Clark and Ofek (1994)

      • Bidder CAR positively related to postmerger performance variables

      • Market's event returns forecast postmerger results

      • Bidders overpay for distressed targets

      • Much of postmerger performance results dominated by industry factors

    ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 29


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    • Financially distressed target firms are more likely to be successfully restructured than those with poor operating performance

    • Positive returns to bidder for distressed targets that are smaller relative to bidder

    • In majority of cases, takeovers do not successfully restructure distressed target — but may be the best alternative available at the time

    ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 30


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    • Formal legal proceeding

      • Firm allowed to continue — Chapter 11 reorganization where formal court procedures supervise composition or modification of claims

      • Firm ceases to exist

        • Statutory assignment — assignee liquidates assets under formal legal procedures

        • Liquidation under Chapter 7 — formal bankruptcy court supervised liquidation

    ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 31


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    • Provisions of 1978 Bankruptcy Code

      • Automatic stay

        • Permits firm to stop all principal and interest payments

        • Prevents secured creditors from taking possession of collateral

        • Makes it easier for firm to obtain additional financing

      • Debtor in possession — DIP financing

        • Possible to issue new debt claims

        • New debt with priority over existing debt

    ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 32


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    • Increased power of managers in restructuring process

      • Managers able to continue to make operating decisions

      • Managers have exclusive right to propose reorganization plan for 120 days after Chapter 11 filing; courts often grant extensions

      • Management has 180 days from filing date to obtain creditor and shareholder approval

      • If firm fails to propose plan or plan is rejected, creditors can propose their own plan

    ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 33


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    • New voting rules for creditors

      • Specify majority (in number) requirements for approval of plan

      • Provide that dissenters accept same terms as approved by majority

      • Each class of creditors behaves as one part in which minority creditors cannot hold out

      • Voting rules facilitate debt negotiation — potential for investment efficiency is improved by reducing bargaining costs

    ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 34


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    • Some flexibility in applying absolute priority rules on claims

      • Absolute priority means payments based on seniority of claims — in sequence to secured creditors, general creditors, preferred stock, common stock

      • Frequent, but small (2.3-7.6%) deviations from absolute priority occur

      • Possible explanations

        • Claimants may provide new or future financing

        • Estimated market values are used as basis for establishing priority positions

        • May facilitate approval of plan

    ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 35


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    Financial Engineering Strategies

    • Use of calls, puts, swaps, forward and future contracts to influence payoffs

    • Help limit financial exposure of business firms as well as of investors

    • Facilitate merger transactions — can share risk exposures

    ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 36


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    Liquidations and Takeover Bust-Ups

    • Involuntary

      • Creditors force firm to liquidate — “worth more dead than alive”

      • Often associated with involuntary bankruptcy proceedings

    ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 37


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    • Voluntary

      • Voluntary liquidations have more positive motivation

      • Liquidation may realize more for shareholders if firm can be sold in parts

      • Managers may decide to liquidate firm because of threat of "bust-up" takeover

    ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 38


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    • Tax effects of liquidation

      • Tax effects of liquidations compared with nontaxable mergers

        • Nontaxable merger

          • Had advantage of deferring recognition of gain to shareholders of selling firm until subsequent sales of securities involved

          • Unused tax credits and losses belonging to either of premerger firms are carried over

          • Step up tax basis cannot be done

        • Liquidation

          • Selling stockholders must recognize gain immediately

          • Unused tax credits and losses belonging to selling firm are lost

          • Permits acquiring firm to step up tax basis of assets acquired

    ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 39


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    • Tax Reform Act of 1986

      • Under General Utilities Doctrine — corporate capital gains to selling firm were not taxable if it adopted a plan of complete liquidation and all liquidating dividends were paid to shareholders within 12 months after plan adoption

      • Tax Reform Act of 1986 reduced tax advantage of liquidations as compared with nontaxable mergers

        • Repealed General Utilities Doctrine — eliminated tax incentive for firms to liquidate voluntary after partial sell-offs

        • Eliminated preferential personal capital gains tax rate — deferral of realization in nontaxable mergers more attractive

        • But preferential capital gains tax rates were reinstated by subsequent tax laws

    ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 40


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    • Empirical studies

      • Usually large positive returns to voluntary liquidations (+10 to +15%)

        • Can be structured to qualify for preferential tax treatment

        • Liquidations may have several purchasers

        • Selling firm can move its assets to purchasers from whom greatest values can be obtained

      • Returns to acquiring firm shareholders are small but not statistically significant

    ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 41


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    • Influence of executive ownership and executive compensation incentives on voluntary liquidations

      • Probability of liquidation increases as percent of ownership by top executives increases

      • Probability of liquidation increases as use of stock options and other executive compensation incentives increases

      • Executive compensation plans may motivate managers to shrink firm's assets, sometimes eliminating their own jobs

    ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 42


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