20

Mergers and
Acquisitions and
Financial Distress

Finance 3rd Edition

Cornett, Adair, and Nofsinger

Copyright 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education

Introduction
Mergers and acquisitions
Firms combine
Assets
Liabilities

Equity

20-2

Mergers & Acquisitions

Merger two firms combine to form one

larger firm
Acquisition one firm purchases another
Consolidation newly-created firm

absorbs bidder and target

20-3

Horizontal Mergers
A horizontal merger is the combination of

two firms in the same industry

Market extension merger (also horizontal)

combines two firms that sell the same

product in different markets

20-4

Vertical Merger
Combines a firm with a supplier or

distributor
Avoids fixed costs
Eliminates contracting, payment collection,

communication, advertising and coordination

costs
Improves inventory planning

20-5

Conglomerate Merger
Two companies merge that have no related

products or markets
Popular in 1960s and 1970s, but dismantled in

the 1980s and 1990s due to poor performance

20-6

Product Extension Merger

Firms merge that sell different, but

somewhat related products

A cross between horizontal and

conglomerate mergers

20-7

Revenue Enhancement
Acquisition of firm in growing area may

enhance revenues
The acquiring firms revenues may become
more stable
Acquisition of new markets

20-8

Cost Reduction
Economies of scale
Reduce or eliminate redundancies in firm
Cost of producing goods falls as size of firm

increases

20-9

Economies of Scale in Mergers

20-10

Long-Term Effect of Economies of Scale

20-11

Cost Reduction
Economies of Scope
Refers to merged firms abilities to generate

synergistic cost savings due to inter-relationship

among products and jointness in cost of
producing them

20-12

X-Efficiencies
Not directly due to economies of scope or

scale
Due to superior management as result of

replacing old, inefficient managers

20-13

Tax Considerations
Tax gains from an acquisition can result

from
Net operating losses
Unused debt capacity

Surplus funds

20-14

Lowering the Cost of Capital

A merger can lower a firms cost of capital
Cost of issuing securities declines
Diversification due to merger reduces debt risk

of merged firm, resulting in a lower interest rate

20-15

Managers Personal Incentives

Managers personal wishes may drive

merger rather than sound economic basis

Not favorable for the merged firm and can

cause stock price and shareholders wealth to

decline

20-16

Valuing a Merger
Net present value (NPV) or discounted

cash flow (DCF) method is most accurate

method for valuing a merger
Forecasted cash flows discounted to PV based

on merged firms weighted average cost of

capital (WACC)

20-17

Financial Distress
Economic Failure
Return on assets less than cost of capital

Business Failure
Most extreme type -- firm out of business

Technical Insolvency
Operating cash flows are not sufficient to pay

liabilities

20-18

Firm-Specific Causes of Financial Distress

Excess financial leverage
Highly volatile earnings stream
Poor management
Loss of key players on which production or

management depended

20-19

Market-Specific Causes of Financial Distress

Business cycle fluctuations

High interest rates

20-20

Informal Resolutions of Financial Distress

Debt agreement restructuring

Liquidation of firms assets

20-21

Restructuring a Firms Debt Agreements

Appropriate if financial distress is judged to

be temporary
Creditors and firm restructure debt

agreements in a workout

20-22

Informal Liquidation of a Firms Assets

Termination of the firm as a going concern

Assets sold; proceeds pay off the firms

creditors
Assignment passes liquidation of the firms

assets to third-party assignee or trustee

20-23

Federal Bankruptcy Laws

Creditors can force the firm into bankruptcy

if informal restructure agreement not

reached
Firm can voluntarily file for bankruptcy

20-24

Bankruptcy Reform Act of 1978

Chapter 11
Firm in temporary financial distress can

continue operating while creditors claims

settled

Chapter 7
Generally used if reorganization under Chapter

11 not feasible

20-25

Reorganization Procedures in Bankruptcy

Reorganization petition filed

Federal judge reviews petition

Firm submits reorganization plan within

120 days
Creditor committees appointed

20-26

Liquidation Procedures in Bankruptcy

Bankruptcy for firms too distressed to

reorganize via Chapter 7

Trustee protects the creditors interests
Priority of claims followed

20-27

Predicting Bankruptcy
Broad types of credit scoring models
Linear discriminant models
Linear probability models
Logit models

20-28