Merger Fundamentals

Firms sometimes use mergers to expand externally by acquiring control of another firm. The objective for a merger should be to improve the firm’s share value, a number of more immediate motivations such as diversification, tax considerations, and increasing owner liquidity frequently exist. Sometimes mergers are pursued to acquire specific assets owned by the target rather than by a desire to run the target as a going concern.

Mergers, Consolidations, and Holding Companies

• A merger occurs when two or more firms are combined and the resulting firm maintains the identity of one of the firms. Usually, the assets and liabilities of the smaller firm are merged into those of the larger firm.

• Consolidation involves the combination of two or more firms to form a completely new corporation. The new corporation normally absorbs the assets and liabilities of the companies from which it is formed.

• A holding company is a corporation that has voting control of one or more other corporations. Having control in large, widely held companies generally requires ownership of between 10% and 20% of the outstanding stock.

• Subsidiaries are the companies controlled by a holding company. Control of a subsidiary is typically obtained by purchasing a sufficient number of shares of its stock.

Acquiring versus Target Companies

• Acquiring company is the firm in a merger transaction that attempts to acquire another firm.

• Target Company is the firm that the acquiring company is pursuing.

Generally, the acquiring company identifies, evaluates, and negotiates with the management and/or shareholders of the target company. Occasionally, the management of a target company initiates its acquisition by seeking out potential acquirers.

Friendly versus Hostile Takeovers

Mergers can occur on either a friendly or a hostile basis. Typically, after identifying the target company, the acquirer initiates discussions. If the target management is receptive to the acquirer’s proposal, it may endorse the merger and recommend shareholder approval.

• Friendly merger – If the stockholders approve the merger, the transaction is typically consummated either through a cash purchase of shares by the acquirer or through an exchange of the acquirer’s stock, or some combination of stock and cash for the target firm’s shares.

• Hostile merger – If the takeover target’s management does not support the proposed takeover, it can fight the acquirer’s actions. In this case, the acquirer can attempt to gain control of the firm by buying sufficient shares of the target firm in the marketplace. This is typically accomplished by using a tender offer, which is a formal offer to purchase a given number of shares at a specified price.

Hostile mergers are more difficult to consummate because the target firm’s management acts to deter rather than facilitate the acquisition. Regardless, hostile takeovers are sometimes successful.

Strategic versus Financial Mergers

• Strategic mergers seek to achieve various economies of scale by eliminating redundant functions, increasing market share, improving raw material sourcing and finished product distribution, and so on. In these mergers, the operations of the acquiring and target firms are combined to achieve synergies, thereby causing the performance of the merged firm to exceed that of the pre-merged firms. An interesting variation of the strategic merger involves the purchase of specific product lines (rather than the whole company) for strategic reasons.

• Financial mergers are based on the acquisition of companies that can be restructured to improve their cash flow. These mergers involve the acquisition of the target firm by an acquirer, which may be another company or a group of investors that may even include the target firm’s existing management. The objective of the acquirer is to cut costs drastically and sell off certain unproductive or non-compatible assets in an effort to increase the target firm’s cash flow. The increased cash flow is used to service the sizable debt that is typically incurred to finance these transactions. Financial mergers are based not on the firm’s ability to achieve economies of scale but rather on the acquirer’s belief that through restructuring, the firm’s unrealized value can be unlocked.

MOTIVES FOR MERGING

Firms merge to fulfill certain objectives. The overriding goal for merging is maximization of the owners’ wealth as reflected in the acquirer’s share price. More specific motives include growth or diversification, synergy, fund raising, increased managerial skill or technology, tax considerations, increased ownership liquidity, and defense against takeover. These motives should be pursued when they lead to owner wealth maximization.

Growth or Diversification

Companies that desire rapid growth in size or market share or diversification in the range of their products may find that a merger can fulfill this objective. Instead of relying entirely on internal or “organic” growth, the firm may achieve its growth or diversification objectives much faster by merging with an existing firm. Such strategy is often less costly than the alternative of developing the necessary production capacity. If a firm that wants to expand operations can find a suitable going concern, it may avoid many of the risks associated with the design, manufacture, and sale of additional or new products. Moreover, when a firm expands or extends its product line by acquiring another firm, it may remove a potential competitor.

Synergy

The synergy of mergers is the economies of scale resulting from the merged firms’ lower overhead. These economies of scale from lowering the combined overhead increase earnings to a level greater than the sum of the earnings of each of the independent firms. Synergy is most obvious when firms merge with other firms in the same line of business because many redundant functions and employees can be eliminated. Staff functions, such as purchasing and sales, are probably most greatly affected by this type of combination.

Fund Raising

Firms combine to enhance their fund-raising ability. A firm may be unable to obtain funds for its own internal expansion but able to obtain funds for external business combinations. Quite often, one firm may combine with another that has high liquid assets and low levels of liabilities. The acquisition of this type of “cashrich” company immediately increases the firm’s borrowing power by decreasing its financial leverage. This should allow funds to be raised externally at lower cost.

Increased Managerial Skill or Technology

Occasionally, a firm will have good potential that it finds itself unable to develop fully because of deficiencies in certain areas of management or an absence of needed product or production technology. If the firm cannot hire the management or develop the technology it needs, it might combine with a compatible firm that has the needed managerial personnel or technical expertise. Of course, any merger should contribute to maximizing the owners’ wealth.

Tax Considerations

Quite often, tax considerations are a key motive for merging. In such a case, the tax benefit generally stems from the fact that one of the firms has a tax loss carry forward. This means that the company’s tax loss can be applied against a limited amount of future income of the merged firm over 20 years or until the total tax loss has been fully recovered, whichever comes first.

Two situations could actually exist.

1. A company with a tax loss could acquire a profitable company to use the tax loss. In this case, the acquiring firm would boost the combinations after tax earnings by reducing the taxable income of the acquired firm. 2. A tax loss may also be useful when a profitable firm acquires a firm that has such a loss.

In either situation, the merger must be justified not only on the basis of the tax benefits but also on grounds consistent with the goal of owner wealth maximization. The tax benefits described can be used only in mergers—not in the formation of holding companies—because only in the case of mergers are operating results reported on a consolidated basis.

Increased Ownership Liquidity

The merger of two small firms or of a small and a larger firm may provide the owners of the small firm(s) with greater liquidity. This is due to the higher marketability associated with the shares of larger firms. Instead of holding shares in a small firm that has a very “thin” market, the owners will receive shares that are traded in a broader market and can thus be liquidated more readily. Also, owning shares for which market price quotations are readily available provides owners with a better sense of the value of their holdings. Especially in the case of small, closely held firms, the improved liquidity of ownership obtainable through merger with an acceptable firm may have considerable appeal.

Defense against Takeover

When a firm becomes the target of an unfriendly takeover, it will acquire another company as a defensive tactic. Such a strategy typically works like this: The original target firm takes on additional debt to finance its defensive acquisition; because of the debt load, the target firm becomes too highly leveraged financially to be of any further interest to its suitor. To be effective, a defensive takeover must create greater value for shareholders than they would have realized had the firm been merged with its suitor.

TYPES OF MERGERS

1. A horizontal merger results when two firms in the same line of business are merged.

2. A vertical merger occurs when a firm acquires a supplier or a customer. The economic benefit of a vertical merger stems from the firm’s increased control over the acquisition of raw materials or the distribution of finished goods.

3. A congeneric merger is achieved by acquiring a firm that is in the same general industry but is neither in the same line of business nor a supplier or customer. The benefit of a congeneric merger is the resulting ability to use the same sales and distribution channels to reach customers of both businesses.

4. A conglomerate merger involves the combination of firms in unrelated businesses. The key benefit of the conglomerate merger is its ability to reduce risk by merging firms that have different seasonal or cyclic patterns of sales and earnings.

LEVERAGED BUYOUTS (LBOS)

• Leveraged buyout (LBO) is a popular technique that was widely used during the 1980s to make acquisitions. It involves the use of a large amount of debt to purchase a firm. LBOs are a clear-cut example of a financial merger undertaken to create a high-debt private corporation with improved cash flow and value.

Typically, in an LBO, 90% or more of the purchase price is financed with debt. A large part of the borrowing is secured by the acquired firm’s assets, and the lenders, because of the high risk, take a portion of the firm’s equity. Junk bonds have been routinely used to raise the large amounts of debt needed to finance LBO transactions. The purchasers in an LBO expect to use the improved cash flow to service the large amount of junk bond and other debt incurred in the buyout.

An attractive candidate for acquisition via a leveraged buyout should possess three key attributes:

1. It must have a good position in its industry, with a solid profit history and reasonable expectations of growth.

2. The firm should have a relatively low level of debt and a high level of “bankable” assets that can be used as loan collateral.

3. It must have stable and predictable cash flows that are adequate to meet interest and principal payments on the debt and provide adequate working capital.

DIVESTITURES

• Divestiture is the selling of some of a firm’s assets. Companies often achieve external expansion by acquiring an operating unit— plant, division, product line, subsidiary, and so on—of another company. In such a case, the seller generally believes that the value of the firm will be enhanced by converting the unit into cash or some other more productive asset.

Unlike business failure, divestiture is often undertaken for positive motives: to generate cash for expansion of other product lines, to get rid of a poorly performing operation, to streamline the corporation, or to restructure the corporation’s business in a manner consistent with its strategic goals.

Firms divest themselves of operating units by a variety of methods.

1. Sale of a product line to another firm. Outright sales of operating units can be accomplished on a cash or stock swap basis.

2. Sale of the unit to existing management. This sale is often achieved through the use of a leveraged buyout (LBO).

3. Spin-off. Results in an operating unit becoming an independent company. A spin-off is accomplished by issuing shares in the divested operating unit on a pro rata basis to the parent company’s shareholders. Such an action allows the unit to be separated from the corporation and to trade as a separate entity. This approach achieves the divestiture objective, although it does not bring additional cash or stock to the parent company.

4. Liquidation of the operating unit’s individual assets.

Regardless of the method used to divest a firm of an unwanted operating unit, the goal typically is to create a more lean and focused operation that will enhance the efficiency as well as the profitability of the enterprise and create maximum value for shareholders. Recent divestitures seem to suggest that many operating units are worth much more to others than to the firm itself.

Comparisons of post divestiture and pre-divestiture market values have shown that the breakup value—the sum of the values of a firm’s operating units if each were sold separately—of many firms is significantly greater than their combined value. As a result of market valuations, divestiture often creates value in excess of the cash or stock received in the transaction. Although these outcomes frequently occur, financial theory has been unable to explain them fully and satisfactorily.

Analyzing and Negotiating Mergers

We now turn to the procedures that are used to analyze and negotiate mergers. Initially, we will consider how to value the target company and how to use stock swap transactions to acquire companies. Next, we will look at the merger negotiation process. We will then review the major advantages and disadvantages of holding companies. Finally, we will discuss international mergers.

VALUING THE TARGET COMPANY

Once the acquiring company isolates a target company that it wishes to acquire, it must estimate the target’s value. The value is then used, along with a proposed financing scheme, to negotiate the transaction—on a friendly or hostile basis.

Acquisitions of Assets

A firm is acquired not for its income-earning potential but as a collection of assets (generally fixed assets) that the acquiring company needs. The price paid for this type of acquisition depends largely on which assets are being acquired; consideration must also be given to the value of any tax losses. To determine whether the purchase of assets is financially justified, the acquirer must estimate both the costs and the benefits of the target assets. This is a capital budgeting problem because an initial cash outlay is made to acquire assets, and as a result, future cash inflows are expected.

Acquisitions of Going Concerns

Acquisitions of target companies that are going concerns are best analyzed by using capital budgeting techniques similar to those described
for asset acquisitions. The methods of estimating expected cash flows from an acquisition are similar to those used in estimating capital budgeting cash flows. Pro forma income statements reflecting the post-merger revenues and costs attributable to the target company are prepared. They are then adjusted to reflect the expected cash flows over the relevant time period. Whenever a firm considers acquiring a target company that has different risk behaviors, it should risk-adjust the cost of capital before applying the appropriate capital budgeting techniques.

STOCK SWAP TRANSACTIONS

Once the value of the target company is determined, the acquirer must develop a proposed financing package. The simplest (but probably the least common) case is a pure cash purchase. Beyond this extreme case, there are virtually an infinite number of financing packages that use various combinations of cash, debt, preferred stock, and common stock.

Here we look at the other extreme—stock swap transactions, in which the acquisition is paid for using an exchange of common stock. The acquiring firm exchanges its shares for shares of the target company according to a predetermined ratio. The use of stock swaps to finance mergers is a popular approach.

Ratio of Exchange

The ratio of exchange of shares is determined in the merger negotiations. This ratio affects the various financial yardsticks that are used by existing and prospective shareholders to value the merged firm’s shares. When one firm swaps its stock for the shares of another firm, the firms must determine the number of shares of the acquiring firm to be exchanged for each share of the target firm.

The first requirement is that the acquiring company has sufficient shares available to complete the transaction. A firm’s repurchase of shares is necessary to obtain sufficient shares for such a transaction. The acquiring firm generally offers enough of its own shares that the value of the shares given up exceeds the value of one target share.

The actual ratio of exchange is merely the ratio of the amount paid per share of the target company to the market price per share of the acquiring firm. It is calculated in this manner because the acquiring firm pays the target firm in stock, which has a value equal to its market price.

Effect on Earnings per Share

Although cash flows and value are the primary focus of merger analysis, it is useful to consider the effects of a proposed merger on earnings per share—the accounting returns that are related to cash flows and value. The resulting earnings per share differ from the premerger earnings per share for both the acquiring firm and the target firm. They depend largely on the ratio of exchange and the premerger earnings per share of each firm. It is best to view the initial and long-run effects of the ratio of exchange on earnings per share separately.

• Initial Effect When the ratio of exchange is equal to 1 and both the acquiring firm and the target firms have the same premerger earnings per share, the merged firm’s earnings per share will initially remain constant.

• Long-Run Effect The long-run effect of a merger on the earnings per share of the merged company depends largely on whether the earnings of the merged firm grow.

An initial decrease in the per-share earnings of the stock held by the original owners of the acquiring firm is expected, the long-run effects of the merger on earnings per share are quite favorable. Because firms generally expect growth in earnings, the key factor enabling the acquiring company to experience higher future EPS than it would have without the merger is that the earnings attributable to the target company’s assets grow more rapidly than those resulting from the acquiring company’s premerger assets.

Effect on Market Price per Share

The market price per share does not necessarily remain constant after the acquisition of one firm by another. Adjustments occur in the marketplace in response to changes in expected earnings, the dilution of ownership, changes in risk, and certain other operating and financial changes. By using the ratio of exchange, we can calculate a ratio of exchange in market price. It indicates the market price per share of the acquiring firm paid for each dollar of market price per share of the target firm. This ratio, the MPR, is defined by Equation:

MPR = MPacquiring x RE
MPtarget

Where:
MPtarget = market price per share of the target firm MPacquiring = market price per share of the acquiring firm MPR = market price ratio of exchange
RE = ratio of exchange

Although the behavior exhibited in the preceding example is not unusual, the financial manager must recognize that only with proper management of the merged enterprise can its market value be improved. If the merged firm cannot achieve sufficiently high earnings in view of its risk, there is no guarantee that its market price will reach the forecast value. A policy of acquiring firms with low P/Es can produce favorable results for the owners of the acquiring firm. Acquisitions are especially attractive when the acquiring firm’s stock price is high, because fewer shares must be exchanged to acquire a given firm.

MERGER NEGOTIATION PROCESS

Mergers are often handled by investment bankers—financial intermediaries who, in addition to their role in selling new security issues, can be hired by acquirers to find suitable target companies and assist in negotiations. Once a target company is selected, the investment banker negotiates with its management or investment banker. When management wishes to sell the firm or an operating unit of the firm, it will hire an investment banker to seek out potential buyers.

If attempts to negotiate with the management of the target company break down, the acquiring firm, often with the aid of its investment banker, can make a direct appeal to shareholders by using tender offers. The investment banker is typically compensated with a fixed fee, a commission tied to the transaction price, or a combination of fees and commissions.

Management Negotiations

To initiate negotiations, the acquiring firm must make an offer either in cash or based on a stock swap with a specified ratio of exchange. The target company then reviews the offer and, in light of alternative offers, accepts or rejects the terms presented. A desirable merger candidate may receive more than a single offer. Normally, it is necessary to resolve certain nonfinancial issues related to the existing management, product line policies, financing policies, and the independence of the target firm. The key factor, of course, is the per-share price offered in cash or reflected in the ratio of exchange. Sometimes negotiations break down.

Tender Offers

When negotiations for an acquisition fail, tender offers may be used to negotiate a “hostile merger” directly with the firm’s stockholders.

• A tender offer is a formal offer to purchase a given number of shares of a firm’s stock at a specified price.

The offer is made to all the stockholders at a premium above the market price. Occasionally, the acquirer will make a two-tier offer, in which the terms offered are more attractive to those who tender shares early. The stockholders are advised of a tender offer through announcements in financial newspapers or through direct communications from the offering firm. Sometimes a tender offer is made to add pressure to existing merger negotiations. In other cases, the tender offer may be made without warning as an attempt at an abrupt corporate takeover.

Fighting Hostile Takeovers

If the management of a target firm does not favor a merger or considers the price offered in a proposed merger too low, it is likely to take defensive actions to ward off the hostile takeover. Such actions are generally taken with the assistance of investment bankers and lawyers who help the firm develop and employ effective takeover defenses.

• The white knight strategy involves the target firm finding a more suitable acquirer and prompting it to compete with the initial hostile acquirer to take over the firm.

• Poison pills typically involve the creation of securities that give their holders certain rights that become effective when a takeover is attempted. The “pill” allow the shareholders to receive special voting rights or securities that make the firm less desirable to the hostile acquirer.

• Greenmail is a strategy by which the firm repurchases, through private negotiation, a large block of stock at a premium from one or more shareholders to end a hostile takeover attempt by those shareholders. Clearly, greenmail is a form of corporate blackmail by the holders of a large block of shares.

• Leveraged recapitalization which is a strategy involving the payment of a large debt financed cash dividend. This strategy significantly increases the firm’s financial leverage, thereby deterring the takeover attempt. In addition, as a further deterrent, the recapitalization is often structured to increase the equity and control of the existing management.

• Golden parachutes are provisions in the employment contracts of key executives that provide them with sizable compensation if the firm is taken over. Golden parachutes deter hostile takeovers to the extent that the cash outflows required by these contracts are large enough to make the takeover unattractive to the acquirer. S • Shark repellents which are antitakeover amendments to the corporate charter that constrain the firm’s ability to transfer managerial control of the firm as a result of a merger. Although this defense could entrench existing management, many firms have had these amendments ratified by shareholders.

Because takeover defenses tend to insulate management from shareholders, the potential for litigation is great when these strategies are employed. Lawsuits are sometimes filed against management by dissident shareholders. In addition, federal and state governments frequently intervene when a proposed takeover is deemed to be in violation of federal or state law. A number of states have legislation on their books limiting or restricting hostile takeovers of companies domiciled within their boundaries.

HOLDING COMPANIES

A holding company is a corporation that has voting control of one or more other corporations. The holding company may need to own only a small percentage of the outstanding shares to have this voting control. In the case of companies with a relatively small number of shareholders, as much as 30% to 40% of the stock may be required. In the case of firms with a widely dispersed ownership, 10% to 20% of the shares may be sufficient to gain voting control. A holding company that wants to obtain voting control of a firm may use direct market purchases or tender offers to acquire needed shares. Although there are relatively few holding companies and they are far less important than mergers, it is helpful to understand their key advantages and disadvantages.

Advantages of Holding Companies

1. Leverage effect that permits the firm to control a large amount of assets with a relatively small dollar investment. The owners of a holding company can control significantly larger amounts of assets than they could acquire through mergers. The high leverage obtained through a holding company arrangement greatly magnifies earnings and losses for the holding company.

2. Pyramiding of holding companies occurs when one holding company controls other holding companies, thereby causing an even greater magnification of earnings and losses. The greater the leverage, the greater the risk involved. The risk–return trade-off is a key consideration in the holding company decision.

3. Risk protection resulting from the fact that the failure of one of the companies does not result in the failure of the entire holding company.

4. Tax benefits may be realized by each subsidiary in its state of incorporation.

5. Lawsuits or legal actions against a subsidiary do not threaten the remaining companies.

6. Generally easy to gain control of a firm, because stockholder or management approval is not generally necessary.

Disadvantages of Holding Companies

1. Increased risk resulting from the leverage effect. When general economic conditions are unfavorable, a loss by one subsidiary may be magnified.

2. Double taxation. Before paying dividends, a subsidiary must pay federal and state taxes on its earnings. Although 70% tax exclusion is allowed on dividends received by one corporation from another, the remaining 30% received is taxable. (In the event that the holding company owns between 20% and 80% of the stock in a subsidiary, the exclusion is 80%; if it owns more than 80% of the stock in the subsidiary, 100% of the dividends are excluded.) If a subsidiary were part of a merged company, double taxation
would not exist.

3. Difficult to analyze is another disadvantage. Security analysts and investors typically have difficulty understanding holding companies because of their complexity. As a result, these firms tend to sell at low multiples of earnings (P/Es), and the shareholder value of holding companies may suffer.

4. High cost of administration that result from maintaining each subsidiary company as a separate entity.

INTERNATIONAL MERGERS

Perhaps in no other area does U.S. financial practice differ more fundamentally from practices in other countries than in the field of mergers. Outside of the United States (and, to a lesser degree, Great Britain), hostile takeovers are virtually nonexistent, and in some countries (such as Japan), takeovers of any kind are uncommon. The emphasis in the United States and Great Britain on shareholder value and reliance on public capital markets for financing is generally not shared by companies in continental Europe. This is because companies there are generally smaller and because other stakeholders, such as employees, bankers, and governments, are accorded greater consideration. The U.S. approach is also not the norm in Japan and other Asian nations.

Changes in Western Europe

Today, there are signs that Western Europe is moving toward a U.S.-style approach to shareholder value and public capital market financing. Since the European Union’s (EU’s) economic and monetary union (EMU) integration involving the introduction of a single European currency, the euro, on January 1, 2002, the number, size, and importance of cross-border European mergers has continued to grow rapidly. Nationally focused companies want to achieve economies of scale in manufacturing, encourage international product development strategies, and develop distribution networks across the continent. They are also driven by the need to compete with U.S. companies, which have been operating on a continent-wide basis in Europe for decades.

These larger Europe-based companies are expected to become even more formidable competitors as more national barriers are removed. Although the vast majority of these cross-border mergers are friendly in nature, a few have been actively resisted by target firm managements. It seems clear that as European companies come to rely more on public capital markets for financing, and as the market for common stock becomes more truly European in character, rather than French or British or German, active markets for European corporate equity will continue to evolve.

Foreign Takeovers of U.S. Companies

Both European and Japanese companies have been active as acquirers of U.S. companies in recent years. Foreign companies purchased U.S. firms for two major reasons: to gain access to the world’s single largest, richest, and least regulated market and to acquire world-class technology. British companies have been historically the most active acquirers of U.S. firms. In the late 1980s, Japanese corporations surged to prominence with a series of very large acquisitions, including two in the entertainment industry: Sony’s purchase of Columbia Pictures and Matsushita’s acquisition of MCA. More recently, German firms have become especially active acquirers of U.S. companies as producing export goods in Germany has become prohibitively expensive. (German workers have some of the world’s highest wages and one of the shortest workweeks.) The Global Focus box describes recent mergers by Australian media giant News Corp. It seems inevitable that, in the years ahead, foreign companies will continue to acquire U.S. firms even as U.S. companies continue to seek attractive acquisitions abroad.

Business Failure Fundamentals

A business failure is an unfortunate circumstance. Although the majority of firms that fail do so within the first year or two of life,
other firms grow, mature, and fail much later. The failure of a business can be viewed in a number of ways and can result from one or more causes.

TYPES OF BUSINESS FAILURE

1. Returns are negative or low. A firm that consistently reports operating losses will probably experience a decline in market value. If the firm fails to earn a return that is greater than its cost of capital, it can be viewed as having failed. Negative or low returns, unless remedied, are likely to result eventually in one of the following more serious types of failure.

2. Insolvency occurs when a firm is unable to pay its liabilities as they come due. When a firm is insolvent, its assets are still greater than its liabilities, but it is confronted with a liquidity crisis. If some of its assets can be converted into cash within a reasonable period, the company may be able to escape complete failure.

3. Bankruptcy occurs when the stated value of a firm’s liabilities exceeds the fair market value of its assets. A bankrupt firm has a negative stockholders’ equity. This means that the claims of creditors cannot be satisfied unless the firm’s assets can be liquidated for more than their book value. Although bankruptcy is an obvious form of failure, the courts treat insolvency and bankruptcy in the same way. They are both considered to indicate the financial failure of the firm.

MAJOR CAUSES OF BUSINESS FAILURE

1. Mismanagement which accounts for more than 50% of all cases. Numerous specific managerial faults can cause the firm to fail.

2. Overexpansion

3. Poor financial actions include bad capital budgeting decisions (based on unrealistic sales and cost forecasts, failure to identify all relevant cash flows, or failure to assess risk properly), poor financial evaluation of the firm’s strategic plans prior to making financial commitments, inadequate or nonexistent cash flow planning, and failure to control receivables and inventories.

4. Ineffective sales force

5. High production costs

6. Economic activity. If the economy goes into a recession, sales may decrease abruptly, leaving the firm with high fixed costs and insufficient revenues to cover them. Rapid rises in interest rates just prior to a recession can further contribute to cash flow problems and make it more difficult for the firm to obtain and maintain needed financing.

7. Corporate maturity. Firms, like individuals, do not have infinite lives. Like a product, a firm goes through the stages of birth, growth, maturity, and eventual decline. The firm’s management should attempt to prolong the growth stage through research, new products, and mergers. Once the firm has matured and has begun to decline, it should seek to be acquired by another firm or liquidate before it fails. Effective management planning should help the firm to postpone decline and ultimate failure.

VOLUNTARY SETTLEMENTS

When a firm becomes insolvent or bankrupt, it may arrange with its creditors a voluntary settlement, which enables it to bypass many of the costs involved in legal bankruptcy proceedings. The settlement is normally initiated by the debtor firm, because such an arrangement may enable it to continue to exist or to be liquidated in a manner that gives the owners the greatest chance of recovering part of their investment. The debtor arranges a meeting between itself and all its creditors. At the meeting, a committee of creditors is selected to analyze the debtor’s situation and recommend a plan of action. The recommendations of the committee are discussed with both the debtor and the creditors, and a plan for sustaining or liquidating the firm is drawn up.

Voluntary Settlement to Sustain the Firm

The rationale for sustaining a firm depends on whether the firm’s recovery is feasible. By sustaining the firm, the creditor can continue to receive business from it. A number of strategies are commonly used.

1. Extension is an arrangement whereby the firm’s creditors receive payment in full, although not immediately. Normally, when creditors grant an extension, they require the firm to make cash payments for purchases until all past debts have been paid.

2. Composition is a pro rata cash settlement of creditor claims. Instead of receiving full payment of their claims, creditors receive only a partial payment.

3. Creditor control. In this case, the creditor committee may decide that maintaining the firm is feasible only if the operating management is replaced. The committee may then take control of the firm and operate it until all claims have been settled.

Voluntary Settlement Resulting in Liquidation

After the situation of the firm has been investigated by the creditor committee, the only acceptable course of action may be liquidation of the firm. Liquidation can be carried out in two ways:

1. Privately

2. Legal procedures

If the debtor firm is willing to accept liquidation, legal procedures may not be required. Generally, the avoidance of litigation enables the creditors to obtain quicker and higher settlements. However, all the creditors must agree to a private liquidation for it to be feasible.

The objective of the voluntary liquidation process is to recover as much per dollar owed as possible. Under voluntary liquidation, common stockholders (the firm’s true owners) cannot receive any funds until the claims of all other parties have been satisfied. A common procedure is to have a meeting of the creditors at which they make an assignment by passing the power to liquidate the firm’s assets to an adjustment bureau, a trade association, or a third party, which is designated the assignee. The assignee’s job is to liquidate the assets, obtaining the best price possible. The assignee is sometimes referred to as the trustee because it is entrusted with the title to the company’s assets and the responsibility to liquidate them efficiently. Once the trustee has liquidated the assets, it distributes the recovered funds to the creditors and owners (if any funds remain for the owners). The final action in a private liquidation is for the creditors to sign a release attesting to the satisfactory settlement of their claims.

Reorganization and Liquidation in Bankruptcy

If a voluntary settlement for a failed firm cannot be agreed on, the firm can be forced into bankruptcy by its creditors. As a result of bankruptcy proceedings, the firm may be either reorganized or liquidated. Although firms of all sizes go bankrupt, it is usually the larger firms that are most recognizable. The following Matter of Fact box lists ten of the largest U.S. bankruptcies.

Ten Largest U.S. Bankruptcies

Company Bankruptcy date Total assets pre-bankruptcy
($ billions) Lehman Brothers Holdings, Inc. Sept. 15, 2008 $691.0
Washington Mutual Sept. 26, 2008 327.9
Worldcom, Inc. July 21, 2002 103.9
General Motors June 1, 2009 91.0
CIT Group Nov. 1, 2009 71.0
Enron Corp. Dec. 2, 2001 65.5
Conseco, Inc. Dec. 17, 2002 61.0
Chrysler April 30, 2009 39.0
Thornburg Mortgage May 1, 2009 36.5
Pacific Gas and Electric Co. April 6, 2001 36.0

BANKRUPTCY LEGISLATION

• Bankruptcy in the legal sense occurs when the firm cannot pay its bills or when its liabilities exceed the fair market value of its assets. In either case, a firm may be declared legally bankrupt. However, creditors generally attempt to avoid forcing a firm into bankruptcy if it appears to have opportunities for future success.

The governing bankruptcy legislation in the United States today is the Bankruptcy Reform Act of 1978, which significantly modified earlier bankruptcy legislation. Chapter 7 of the Bankruptcy Reform Act of 1978 details the procedures to be followed when liquidating a failed firm. Chapter 7 typically comes into play once it has been determined that a fair, equitable, and feasible basis for the reorganization of a failed firm does not exist (although a firm may of its own accord choose not to reorganize and may instead go directly into liquidation). Chapter 11 outlines the procedures for reorganizing a failed (or failing) firm, whether its petition is filed voluntarily or involuntarily. If a workable plan for reorganization cannot be developed, the firm will be liquidated under Chapter 7.

REORGANIZATION IN BANKRUPTCY (CHAPTER 11)

There are two basic types of reorganization petitions:

1. Voluntary reorganization and involuntary. Any firm that is not a municipal or financial institution can file a petition for voluntary reorganization on its own behalf.

2. Involuntary reorganization is initiated by an outside party, usually a creditor. An involuntary petition against a firm can be filed if one of three conditions is met:

1. The firm has past-due debts of $5,000 or more.

2. Three or more creditors can prove that they have aggregate unpaid claims of $5,000 against the firm. If the firm has fewer than 12 creditors, any creditor that is owed more than $5,000 can file the petition.

3. The firm is insolvent, which means that (a) it is not paying its debts as they come due, (b) within the preceding 120 days a custodian (a third party) was appointed or took possession of the debtor’s property, or (c) the fair market value of the firm’s assets is less than the stated value of its liabilities.

Procedures

A reorganization petition under Chapter 11 must be filed in a federal bankruptcy court. On the filing of this petition, the filing firm becomes the debtor in possession (DIP) of the assets. If creditors object to the filing firm being the debtor in possession, they can ask the judge to appoint a trustee. After reviewing the firm’s situation, the debtor in possession submits a plan of reorganization and a disclosure statement summarizing the plan to the court. A hearing is held to determine whether the plan is fair, equitable, and feasible and whether the disclosure statement contains adequate information. The court’s approval or disapproval is based on its evaluation of the plan in light of these standards. A plan is considered fair and equitable if it maintains the priorities of the contractual claims of the creditors, preferred stockholders, and common stockholders. The court must also find the reorganization plan feasible, which means that it must be workable. The reorganized corporation must have sufficient working capital, enough funds to cover fixed charges, adequate credit prospects, and the ability to retire or refund debts as proposed by the plan.

Once approved, the plan and the disclosure statement are given to the firm’s creditors and shareholders for their acceptance. Under the Bankruptcy Reform Act, creditors and owners are separated into groups with similar types of claims. In the case of creditor groups, approval of the plan is required by holders of at least two-thirds of the dollar amount of claims, as well as by a numerical majority of creditors. In the case of ownership groups (preferred and common stockholders), two-thirds of the shares in each group must approve the reorganization plan for it to be accepted. Once accepted and confirmed by the court, the plan is put into effect as soon as possible.

Role of the Debtor in Possession (DIP)

Because reorganization activities are largely in the hands of the debtor in possession (DIP), it is useful to understand the DIP’s responsibilities. The DIP’s first responsibility is the valuation of the firm to determine whether reorganization is appropriate. To do this, the DIP must estimate both the liquidation value of the business and its value as a going concern. If the firm’s value as a going concern is less than its liquidation value, the DIP will recommend liquidation. If the opposite is found to be true, the DIP will recommend reorganization, and a plan of reorganization must be drawn up.

The key portion of the reorganization plan generally concerns the firm’s capital structure. Because most firms’ financial difficulties result from high fixed charges, the company’s capital structure is generally recapitalized to reduce these charges. Under recapitalization, debts are generally exchanged for equity or the maturities of existing debts are extended. When recapitalizing the firm, the DIP seeks to build a mix of debt and equity that will allow the firm to meet its debts and provide a reasonable level of earnings for its owners.

Once the revised capital structure has been determined, the DIP must establish a plan for exchanging outstanding obligations for new securities. The guiding principle is to observe priorities. Senior claims (those with higher legal priority) must be satisfied before junior claims (those with lower legal priority). To comply with this principle, senior suppliers of capital must receive a claim on new capital equal to their previous claim. The common stockholders are the last to receive any new securities. (It is not unusual for them to receive nothing.) Security holders do not necessarily have to receive the same type of security they held before; often they receive a combination of securities. Once the debtor in possession has determined the new capital structure and distribution of capital, it will submit the reorganization plan and disclosure statement to the court as described.

LIQUIDATION IN BANKRUPTCY (CHAPTER 7)

The liquidation of a bankrupt firm usually occurs once the bankruptcy court has determined that reorganization is not feasible. A petition for reorganization must normally be filed by the managers or creditors of the bankrupt firm. If no petition is filed, if a petition is filed and denied, or if the reorganization plan is denied, the firm must be liquidated.

Procedures

When a firm is adjudged bankrupt, the judge may appoint a trustee to perform the many routine duties required in administering the bankruptcy. The trustee takes charge of the property of the bankrupt firm and protects the interest of its creditors. A meeting of creditors must be held between 20 and 40 days after the bankruptcy judgment. At this meeting, the creditors are made aware of the prospects for the liquidation. The trustee is given the responsibility to liquidate the firm, keep records, examine creditors’ claims, disburse money, furnish information as required, and make final reports on the liquidation. In essence, the trustee is responsible for the liquidation of the firm. Occasionally, the court will call subsequent creditor meetings, but only a final meeting for closing the bankruptcy is required.

Priority of Claims

It is the trustee’s responsibility to liquidate all the firm’s assets and to distribute the proceeds to the holders of provable claims. The courts have established certain procedures for determining the provability of claims. The priority of claims, which is specified in Chapter 7 of the Bankruptcy Reform Act, must be maintained by the trustee when distributing the funds from liquidation. Any secured creditors have specific assets pledged as collateral and, in liquidation, receive proceeds from the sale of those assets. If these proceeds are inadequate to fully satisfy their claims, the secured creditors become unsecured, or general, creditors for the unrecovered amount, because specific collateral no longer exists. These and all other unsecured creditors will divide up, on a pro rata basis, any funds remaining after all prior claims have been satisfied. If the proceeds from the sale of secured assets are in excess of the claims against them, the excess funds become available to meet claims of unsecured creditors.

In spite of the priorities listed in items 1 through 7, secured creditors have first claim on proceeds from the sale of their collateral. The claims of unsecured creditors, including the unpaid claims of secured creditors, are satisfied next, and then, finally, the claims of preferred and common stockholders.

Final Accounting

After the trustee has liquidated all the bankrupt firm’s assets and distributed the proceeds to satisfy all provable claims in the appropriate order of priority, he or she makes a final accounting to the bankruptcy court and creditors. Once the court approves the final accounting, the liquidation is complete.