Special Topics
Question 1
Change in corporate control refers to transfer of the decision making authority of a company from one group of persons to another group. This power entitles individuals to make decisions concerning operations and strategic planning of the company, allocation of capital, acquisitions, marketing decisions and production decisions. Publicly traded companies are prone to corporate control changes when large investors, especially institutional investors and other companies, strive to seize control from existing shareholders and managers. Change of corporate control can be effected through; tender offers, negotiated offers and proxy fights .
Negotiated offers are the process by which outsiders negotiate with a company’s management about taking over control of the company. Negotiated offers can only be successful if the target company is willing to cede control. Proxy fight is the process by which outsiders attempt to convince existing shareholders to use their voting powers to instate new management that will be open to a takeover bid. Outsiders can then easily take over the target company if the proxy fight is successful. It is a strategy that normally accompanies a hostile takeover.
Tender offers is different from negotiated mergers and proxy fights in the sense that instead of outside investors discussing the merger with managers, they negotiate directly with shareholders by passing management and the board of directors of the firm. It is the most effective means of taking control of a company. Normally, the outsiders offer existing shareholders above the prevailing market price of their shares in a bid to purchase ownership position that is enough to exercise control.
Question 2
Signaling theory of mergers states that the mode of payment an acquiring firm offers to the target company signals inside information about the firm to the financial markets resulting in price corrections. Signaling theory of mergers works in inefficient markets where information asymmetry between managers and investors exists. Managers have all the information about the firm which is not available to investors and the public. Investors therefore analyze the actions of managers to understand the message they are conveying. In efficient markets, investors have both inside and any other information available to the public and the price of securities already reflects all the information. Therefore, action of management will not affect share prices in any way in an efficient market .
Managers have various sources of finance for acquisition such as issuing new shares, using retained earnings and using debt. Normally, managers will finance acquisition transactions with the cheapest financing source available to the company. Financing an acquisition transaction with equity signals to the capital market that equity is a relatively cheaper source of capital compared to other sources of finance. This will be interpreted to mean that the acquirer’s common shares are overvalued. This will reduce demand of the acquirer’s shares at the prevailing prices causing a downward movement of the share price. This is because investors will only be willing to buy the acquirer’s shares at a lower price forcing buyers to accept the price or to continue holding onto them. Therefore, acquirer’s common stock’s price is likely to reduce when a managers of an acquirer’s firm uses equity to finance an acquisition transaction .
Question 3
Financial rehabilitation is an out-of court process of debt restructuring to enable an insolvent company to restore or improve its liquidity position. Financial rehabilitation is an alternative to liquidation which involves selling all assets of a company to pay off creditors. Creditors normally prefer financial rehabilitation plans over liquidation for various reasons. These reasons include; to avoid lengthy legal procedures, guarantee of payment, to maintain their income, opportunity to acquire equity and ownership rights .
Liquidation proceeding are governed by the bankruptcy laws which are lengthy and tedious. Liquidation can only be effected by a court order. Liquidation involves appointing an official receiver, separate meetings of contributories and creditors and appointment of a committee of inspection. The official receiver then complies and presents a report to court which then makes a dissolution order. This process is time wasting. Financial rehabilitation is an out-of court arrangement therefore it is the company and the creditors who set their own terms .
Creditors are not guaranteed of their investment during the liquidation process since the company’s assets may be less than the existing liabilities. However, with a financial rehabilitation there is a possibility that the company will turn around and improve its financial position assuring creditors of their full investment. When a company is liquidated, debt holders and creditors are paid and they will lose any interest income they were to receive. However, with a financial rehabilitation plan they will receive interest until the contractual period ends. Lastly, when financial rehabilitation involves capital restructuring and creditors may be offered common stock to offset amounts owed to them. This gives them a chance to acquire ownership stake in the company .
Question 4
Altman’s z-score is a formula that is used to predict the likelihood of a firm going bankrupt within the next two years. The z-score looks at the earnings before interest and tax to total assets ratio, net sales to total assets ratio, equity market value to total liabilities ratio, working capital to total assets ratio and the retained earnings to total assets ratio. Employees of a firm will want to know the Altman’s score of the firm to know the stability of the firm. This will enable them to know their job stability and determine whether to keep their current jobs or to start searching for employment in other firms. The Altman’s z-score will be useful to current and potential investors, lenders, customers, employees and management .
Current and potential investors will need the Altman’s z-score information in order to assess the risk inherent in their investment. This information will enable them decide whether to maintain, decrease, increase or dispose their entire shareholding in a firm. Management will use the Altman’s z-score information for decision making and planning. It will also help them in evaluating the consequences of past decisions. Customers will be interested in the Altman’s score of a firm to determine whether there is need to source for new suppliers to avoid any inconveniences due to lack of supplies. Lenders will be interested in the Altman’s z-score to know whether the firm is still a going concern in the foreseeable future. This is important to them because it will determine whether they will receive their principal and interest as and when it falls due .
Exercise
Question 1
Conglomerate mergers are mergers between two or more firms that that are engaged in different businesses. Conglomerate mergers can be classified into two; pure and mixed. A pure conglomerate merger involves two companies that have nothing in common whereas a mixed conglomerate involves companies that are seeking for product or market extensions. Portfolio theory is an investment approach that attempts to minimize risk while maximizing returns by cautiously selecting proportions of various assets. Conglomerate mergers and portfolio theory are similar in the sense that they both involve diversification of investments to minimize risk while maximizing returns .
There are many reasons why unrelated businesses may seek to merge. One of the reasons is increasing their collective market share. Another reason is cross selling which is the practice of selling goods or services between or among established clients. Another reason why unrelated businesses merge is to reduce exposure to systemic risk by diversification. A firm may also be seeking improvement in its overall synergy and increased productivity by maximizing use of its capacity .
Empirical evidence has shown that corporate diversification through conglomerate mergers has been largely successful. Case studies have shown that corporate diversification reduces a firm’s exposure to systemic risk. However, conglomerate mergers can be unsuccessful if it is not undertaken cautiously since the two firms have different structures and practices. This was evident in the United States in the 1960s when conglomerate mergers among US firms were the general trend. Many of the firms that merged were unsuccessful since the mergers were hurriedly done .
Question 2
Voluntary work out to resolve financial distress is done out of courts unlike bankruptcy proceedings. Bankruptcy proceeding are governed by the bankruptcy laws which are lengthy and tedious. Bankruptcy involves appointing an official receiver, separate meetings of contributories and creditors and appointment of a committee of inspection. The official receiver then complies and presents a report to court which then makes a dissolution order. This process is time wasting compared to voluntary workout to resolve financial distress. Another advantage of voluntary work out is that the firm can continue with its ordinary business. Voluntary work of financial distress is also cheaper because the firm does not need to engage the services of an advocate. The only disadvantage of voluntary work out is that there is likelihood that the firm will be more distressed hence creditors will receive less compensation to settle their claims. .
Declaring bankruptcy has several advantages .When a firm is declared bankrupt some debts such as civil judgment, past due accounts and foreclosures are discharged hence reducing liabilities of the firm. Some debts are partially discharged in consideration with the company’s financial position. Secondly, when a firm is declared bankrupt, its assets are protected and creditors cannot enforce their security by selling the firm’s assets. There is however a limit on the assets that can be protected. Lastly, it gives a firm time to resolve its financial difficulties away from creditors. The primary disadvantage of declaring bankruptcy is that it dents a company’s image and negatively affects its credit rating .
Question 3
Corporate managers are in charge of day to day operations of a firm unlike other stakeholders. Therefore, they are the first to know when a company is undergoing financial distress and when declaring bankruptcy is necessary. Managers tend to delay bankruptcy for various reasons. Managers will allow a company’s financial condition to deteriorate and still hold on even when bankruptcy seems inevitable because they are expecting that the firm will turn around back to liquidity. Corporate managers delay bankruptcy in a bid to protect their jobs. Under the bankruptcy laws, when bankruptcy proceedings begin, all employees of a firm seize to be employees. Their salaries and other related benefits of employment are stopped. Managers therefore fear losing their jobs and searching for new ones.
A manager of a firm that has been declared bankrupt knows that their worth professionally in the job market will sharply decline. They will therefore be reluctant to accept financial difficulties until they have unsuccessfully tried out all alternatives. Lastly, managers fear that legal proceeding may be instituted against them. Under the bankruptcy laws, if a liquidator or the courts during liquidation finds out that the company’s business was conducted in a manner likely to suggest intention to defraud creditors or with any other fraudulent reasons it may hold persons who were party to it individually and severally liable. They may also be held criminally liable. Managers therefore fear that their past misdeeds may be uncovered during bankruptcy since liquidators are normally keen on searching for corporate mistakes .
Question 4
An acquirer firm may pay shareholders of a target company by cash or by issuing them shares of the acquirer firm in exchange of their ownership stake in the target company. When the acquirer firm pays shareholders of the target company cash, they seize being members and the target company comes under the control of the acquirer shareholders. When payment is in form of the acquirer’s stock, shareholders of the target company are retained in the surviving company .
Firms consider several factors when selecting a mode of payment during acquisition. The acquirer firm may opt to pay cash to avoid sending the wrong signal to the capital markets. Financing an acquisition transaction with equity signals to the capital market that equity is a relatively cheaper source of capital compared to other sources of finance. This will be interpreted to mean that the acquirer’s common shares are overvalued. This will result in reduction in the acquirer’s firm share prices. Taxes are another consideration. Financing an acquisition transaction with cash is taxable whereas the transaction will not be taxed if it is financed by equity. The acquirer will consider the resultant impact on its capital structure. The firm will choose a mode of payment that retains its desired capital structure. Lastly the acquirer firm will consider its liquidity position. A firm can only pay shareholders of the target company cash if it is liquid enough to finance the transaction without affecting its ability to meet short term obligations as and when they fall due .
References
Ehrhardt, M. C., & Brigham, E. F. (2008). Corporate Finance: A Focused Approach (3, illustrated ed.). New York: Cengage learning.
Graham, J., Smart, S. B., & Megginson, W. L. (2007). Corporate Finance (2,illustrated ed.). Thompson South-Western: Cengage Learning.
Vernimmen, P., & Quiry, P. (2009). Corporate Finance: Theory and Practice (2, illustrated ed.). Chicago: John Wiley and Sons.
Vishwanath, S. R. (2009). Corporate Finance: Theory and Practice (2, illustrated ed.). Chicago: SAGE.
