Special topics
Question 1
Would it ever be in the selling shareholders' best interest to structure a taxable acquisition? Explain.
A taxable acquisition is not in the best interest of the selling shareholders. Acquisition refers to the corporate strategy where a corporation buys all or a major ownership stake in the target company in order to control it. Acquisitions are mostly paid in the acquiring company shares, cash or both. Selling shareholders are shareholders of the target company who are bought off. A taxable acquisition is one which the shareholders of the target company are considered to have sold their shares, and therefore the capital gains are subject to capital gain tax.
A taxable accusation is not in the best interest of the selling shareholders because the value of assets the selling shareholder receives at the conclusion of the transaction is substantially lower than the assets value before the transaction. In taxable acquisitions, all assets of the target firm are revalued forcing shareholders of the target firm to pay taxes capital gains. Selling shareholders will therefore receive less for their shares at the end of the transaction for a taxable acquisition than they would have received for a tax free acquisition. However in jurisdiction that capital gains are not subjected to tax all acquisition transaction tend to be tax neutral and therefore do not affect what the selling shareholders receive for their assets.
The capital taxes paid are minimized by capital gains effect. This is because since the target firm shareholders expects to pay capital gains, whey will want a higher payout for their shares as a compensation for the capital taxes they will pay. This is what is referred to as capital gains effect by financial theorists. Buying shareholders will therefore be forced to pay more for a taxable acquisition than they would have paid for a tax free acquisition.
Question 2
Carbondale Scientific was worth $40 per share. What is the merger premium offered in the following case: Edwardsville Bio technics offers $55 cash per share?
Merger price = Cash per share – Share price
= 55-40 = $15
Question 3
Under what circumstances will reorganization be preferred over liquidation?
Reorganization is an out-of court method of debt restructuring to enable an insolvent corporation to return to liquidity or improve the firm’s liquidity position. Liquidation on the hand refers to selling off a company’s assets to pay creditors. Under certain circumstances, rehabilitation is a better alternative to liquidation. These circumstances include; when liquidation procedures are lengthy, when creditors are not guaranteed payment, when creditors want to maintain their income and lastly when creditors have been offered ownership and equity rights
Liquidation proceeding are directed by bankruptcy laws. In some jurisdiction these proceedings are lengthy and hence tedious. For example under US laws liquidation must be sanctioned by a court order, separate meetings of creditors and contributories must be held, an official receiver must be appointed and a committee of inspection must be appointed. Reorganization is an out-of –court arrangement and is therefore not governed by any rules. In jurisdictions with lengthy liquidation proceedings, creditors may prefer a reorganization arrangement to liquidation.
Secondly in circumstances where creditors are in doubt whether the company’s assets exceed its total liabilities, they may prefer a reorganization arrangement. This is because liquidation does guarantee extinguishment of creditors debts. It only extinguishes creditor’s debts to the extent of the receipts for company’s assets sold. However, under reorganization there is a possibility of the firm returning to liquidity, assuring creditors of their full debt. In some instances, creditors may wish to maintain their interest income hence opting for reorganization. Liquidation ends the legal life of a company which relieves it of all contractual obligations. Under reorganization, debt holders will continue receiving interest on their principal hence maintaining their income streams. Lastly, creditors may prefer reorganization in circumstances where creditors have been offered equity shares for their debt. This is because is because they stand to make capital gains if the company restores its liquidity position.
Question 4
A firm's liquidation value is $80 million. Under reorganization, its annual after-tax operating cash flows will be $10 million indefinitely. If the appropriate discount rate is 10%, should the firm liquidate or reorganize?
Value of the firm under reorganization = Annual after tax operating cash flows to infinity/Discount rate
= $10m/0.1 = $ 100m
The firm should reorganize since it value will be higher than its liquidation value by $20m
References
Ehrhardt, M. C., & Brigham, E. F. (2008). Corporate Finance: A Focused Approach (3, illustrated ed.). London: Cengage Learning.
Emery, D. R., Finnerty, J. D., & Stowe, J. D. (2007). Corporate financial management (3, revised ed.). New Jersey: Prentice Hall.
Vishwanath, S. R. (2007). Corporate Finance: Theory and Practice (2, illustrated ed.). New York: SAGE.
