Chapter 2
Special Topics in Mergers and Acquisitions
SUMMARY OF ASSIGNMENT MATERIAL
Item / Topics Covered / Level / TimeQ2.1 / Definition of takeover. / Low / 5-10
Q2.2 / Discuss how junk bonds facilitate takeovers. / Low / 5-10
Q2.3 / Explain why it is difficult to determine the present value of a junk bond. / Low / 5-10
Q2.4 / Discuss the features which differentiate a leveraged buyout from a conventional merger. / Low / 5-10
Q2.5 / Differentiate among the three entities -- Target Company, Buyout Company, and New Company. / Low / 5-10
Q2.6 / Discuss why in an LBO stockholder=s equity which was positive before acquisition could become negative. / Mod / 10-15
Q2.7 / Discuss the reasons why the issue of change in control is important in accounting for a leveraged buyout. / Mod / 10-15
Q2.8 / Identify what circumstances should exist for shareholders who hold a smaller interest in New Company than they held in Target Company to be considered part of the new control group. / Mod / 10-15
Q2.9 / Discuss when the predecessor basis is used in valuing assets acquired in an LBO. / Mod / 10-15
Q2.10 / Discuss the reasons for a spinoff of a business unit. / Mod / 10-15
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SUMMARY OF ASSIGNMENT MATERIAL (cont=d.)
Item / Topics Covered / Level / TimeQ2.11 / Discuss the reasons why companies reduce their scope of operations (refocus). / Mod / 10-15
Q2.12 / Discuss why companies employ takeover defenses. / Mod / 15-20
E2.1 / Compute the valuation of a company's stock when the discount rate to be used to find the present value of the debt involved is varied. / Low / 15-20
E2.2 / Determine whether a change of control occurs in four independent cases. / Mod / 20-25
E2.3 / Determine for five separate cases whether the party involved would be considered part of a new control group. / Mod / 20-25
E2.4 / Determine the residual interest of an individual in New Company and whether the individual would be considered a member of the new control group if he held an 18% residual interest. / Mod / 20-25
E2.5 / Determine whether the shareholders of Target Company will be considered members of the new control group. / Mod / 15-20
E2.6 / Given the facts in E2.5, determine whether a change in control has occurred. / Mod / 10-15
E2.7 / Assuming that a change in control did not occur, prepare the balance sheet following a merger of Buyout and Target. / Mod / 15-20
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SUMMARY OF ASSIGNMENT MATERIAL (cont=d.)
Item / Topics Covered / Level / TimeE2.8 / Using the same facts as E2.7, but assuming a change in control did take place and no shareholders of Target are involved in any way in Buyout, prepare a balance sheet following the merger. / Mod / 15-20
E2.9 / Record entry for spinoff of a business. / Low / 10-15
E2.10 / Analyze, from the stockholder perspective,the effects of a spinoff compared to a sale and cash distribution. / High / 20-25
E2.11 / Prepare the entry to record the purchase of a raider's stock at a price in excess of market price. / Mod / 10-15
E2.12 / Describe the role of poison pills as a takeover defense and how the poison pill might be designed. / Mod / 10-15
P2.1 / Prepare a post-merger balance sheet for a debt-financed acquisition assuming that the bonds are discounted at 20 percent, and assuming that an appropriate discount rate cannot be determined but that an all-cash offer exists. / Mod / 30-40
P2.2 / Prepare the acquirer's journal entry to record the acquisition of 90 percent of the stock of the acquired company in a debt-financed acquisition. / Mod / 20-30
P2.3 / Prepare the balance sheet of the buyout company before and after the stock purchase and prepare a balance sheet after the acquirer is merged with the acquired company to form New Company. / Mod / 30-40
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SUMMARY OF ASSIGNMENT MATERIAL (cont=d.)
Item / Topics Covered / Level / TimeP2.4 / Assume the same facts as P2.3, and complete the same requirements except that management does not participate in the buyout. / Mod / 30-40
P2.5 / Prepare the balance sheet of the acquiring company before and after the stock purchase. Prepare the balance sheet of the new company following the merger. / Mod / 35-45
P2.6 / Assume the same facts as in P2.5,except that the assets received by the seller are different. Prepare the balance sheet of the acquirer before and after stock purchase and prepare the balance sheet of the new firm. / Mod / 35-45
P2.7 / Prepare two years= journal entries for a spinoff. / High / 30-35
P2.8 / Prepare journal entries to reflect the adoption of various takeover defenses. / Mod / 35-45
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CARRYBACK TABLE
The carryback table identifies the assignment items which are new in this edition and those which are carried over from the seventh edition. For the latter, the problem number in the seventh edition is shown.
New Problem Number / Source / New Problem Number / Source / New Problem Number / SourceQ2.1 / new / E2.1 / E2.1 / P2.1 / P2.1
Q2.2 / Q2.2 / E2.2 / E2.2 / P2.2 / P2.2
Q2.3 / Q2.3 / E2.3 / E2.3 / P2.3 / P2.3
Q2.4 / Q2.4 / E2.4 / E2.4 / P2.4 / P2.4
Q2.5 / Q2.5 / E2.5 / E2.5 / P2.5 / P2.5
Q2.6 / Q2.6 / E2.6 / E2.6 / P2.6 / P2.6
Q2.7 / Q2.7 / E2.7 / E2.7 / P2.7 / P2.7
Q2.8 / Q2.8 / E2.8 / E2.8 / P2.8 / P2.8
Q2.9 / Q2.9 / E2.9 / E2.9
Q2.10 / Q2.10 / E2.10 / E2.10
Q2.11 / Q2.11 / E2.11 / E2.11
Q1.12 / Q1.12 / E1.12 / E1.12
Carryforward tables for all chapters, identifying the disposition of seventh edition assignment items, appear at the beginning of the solutions manual.
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ANSWERS TO QUESTIONS
Q2.1
A takeover is an acquisition of one public company by another. The
would-be acquirer makes a fixed-price offer, known as a tender offer, to buy some or all the shares of the target company. Debt financing is usually employed.
Q2.2
Junk bonds facilitate takeovers by providing a source of large amounts of capital, with little direct risk to the acquirer. An extensive market for these high-risk, high-yield debt securities has enabled acquirers to combine large amounts of borrowed money with their own (often limited) capital to finance large-scale takeovers.
Q2.3
It is difficult to determine the present value of a junk bond because the risk characteristics are hard to estimate, and hence selection of an appropriate discount rate cannot be done with confidence.
Q2.4
A leveraged buyout (LBO) is differentiated from a conventional merger by the following features: (1) an LBO is usually heavily financed by debt, whereas a conventional merger usually involves large amounts of cash and equity; (2) the presence of substantial debt means that much of the purchase price in an LBO will come from cash generated by the acquired company, either through its operations or the sale of its assets, while most of the purchase price in a conventional merger comes from the resources or equity of the acquirer; and (3) the acquirers in an LBO are often investment firms and management groups, while the acquirers in a conventional merger are usually other business firms.
Q2.5
Target Company is the company to be acquired. Buyout Company is a company created to purchase Target Company. New Company results from the post-acquisition merger of Buyout Company and Target Company.
Q2.6
Following the acquisition of a company with positive stockholders' equity in a leveraged buyout, stockholders' equity of the new company may be negative because the heavy debt of the buyout company may exceed the net assets of the target company.
Q2.7
A change of control (that is, a change of controlling ownership) is deemed necessary to justify the establishment of a new basis of accountability. If there is no change of control--that is, the existing ownership interests are simply restructured in some way--then existing accounting values are continued. If a change of control occurs--that is, existing ownership interests are replaced by new interests--then a transaction has occurred which justifies a new basis of accounting based on the transaction price. This is essentially the same as the logic of the pooling of interests method of accounting versus the purchase method of accounting.
Q2.8
Stockholders who hold a smaller interest in New Company than they held in Target Company are considered part of the new control group if they retain a significant voting interest (as measured by the 20 percent voting-interest test) or if they retain a significant economic interest (as measured by the 20-percent capital-at-risk test).
Q2.9
Predecessor basis is used in valuing all assets acquired in a leveraged buyout when there is no change of control. Predecessor basis is also used, to a limited extent, when there is a change of control (1) to the extent of the new control group's residual interest in Target or in Buyout, whichever is less, and (2) for continuing stockholders who are not members of the new control group, to the extent of their residual interest in Buyout. The residual interest of these shareholders in Buyout must be at least five percent individually and 20 percent in the aggregate.
Q2.10
While the company receives nothing in exchange in the case of a spinoff, the company's stockholders may receive significant value. The combined value of the shares of the original company and the spinoff company may be expected to exceed the pre-spinoff value of the original company shares. The first obligation of the Board of Directors, which makes decisions on matters such as spinoffs, is to the stockholders of the company, not to the company itself or its management. Thus, a spinoff may be chosen as a way of maximizing shareholder value.
Q2.11
Among the reasons why companies reduce the size and scope of their operations, by restructuring or refocusing, are:
!To focus on core businesses. Companies may decide to dispose of noncore businesses for operating, managerial, marketing, or risk reasons, and to focus its activities in the areas of its primary (core) competencies.
!To enhance shareholder value. Companies may decide that the value of the business is higher if structured as several separate companies than as one big company. The separated entities may be sold to others, or spun off to shareholders.
!To meet cash needs. Especially after a debt-financed acquisition, a company may dispose of segments of the business to raise cash for debt service. For this purpose, the restructuring would result in sales rather than spinoffs.
!To meet legal or regulatory requirements. Dispositions may be required to meet antitrust requirements, or to separate regulated from unregulated businesses.
Q2.12
Companies enter into takeover defenses to attempt to prevent an undesirable takeover, especially a hostile takeover. Motivation for takeover defenses may include management's desire to protect its own position, and a board of directors' attempt to extract the highest possible price from an acquirer, for the benefit of stockholders.
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SOLUTIONS TO EXERCISES
E2.1VALUATION OF BONDS IN ACQUISITION
Using a discount rate of 10 percent, the valuation of Dallas Industries' stock is:
Cash price / $ 1,000,000Present value of bonds:
Principal $10,000,000 x.3855 / 3,855,000
Interest $1,700,000 x 6.1446 / 10,445,820
$15,300,820
Using a discount rate of 20 percent, the valuation of Dallas Industries' stock is:
Cash price / $ 1,000,000Present value of bonds:
Principal $10,000,000 x .1615 / 1,615,000
Interest $1,700,000 x 4.1925 / 7,127,250
$ 9,742,250
E2.2LEVERAGED BUYOUT: CHANGE OF CONTROL
Requirement 1:
Yes, a change of control occurs because a single shareholder, D, who did not control Keys Corp., has control after the buyout.
Requirement 2:
No, a change of control does not occur, because the now sole-shareholder C previously held a 70 percent interest.
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E2.2 (cont=d.)
Requirement 3:
Yes, a change of control occurs. While the new control group consists of A and B who were prior shareholders, none of these, either individually or in combination, controlled Keys Company before the buyout.
Requirement 4:
Yes, a change of control occurs, because the new control group consists entirely of new stockholders.
E2.3LEVERAGED BUYOUT: NEW CONTROL GROUP
(1)Because the management group is actively promoting the LBO, it is considered part of the new control group.
(2)This stockholder would not be considered part of the new control group, because the stockholder's residual interest in New Company is less than five percent.
(3)This stockholder's residual interest increases and will equal or exceed five percent, qualifying the stockholder as a member of the new control group.
(4)This stockholder would not be considered a member of the new control group. Residual interest will decrease, and neither the 20-percent voting-interest test nor the 20-percent capital-at-risk test will be met.
(5)This stockholder qualifies as a member of the new control group. Residual interest will decrease, but at least one of the two tests (20-percent voting interest or 20-percent capital at risk) will be met.
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E2.4LEVERAGED BUYOUT: RESIDUAL INTEREST
Requirement 1:
Total / HarmonPreferred stock A / 10,000 / --
Preferred stock B / -- / --
Voting common stock / 10,000 / 1,000
Nonvoting common stock / 50,000 / 15,000
70,000 / 16,000
Harmon's residual interest is 22.9% (= 16,000/70,000).
Requirement 2:
Yes, Harmon would be a member of the new control group because his residual interest has increased, and it exceeds five percent.
E2.5LEVERAGED BUYOUT: NEW CONTROL GROUP
Harris and Hill each have a lesser residual interest. They qualify as members of the new control group only if they pass either the 20-percent voting-interest test (which they obviously do not, as each holds only one percent of the voting common stock) or the 20-percent capital-at-risk test.
Calculation of Harris' capital at risk:
Security / Percentage / Cumulative PercentageVoting common stock / 1.0%($1,000/$100,000) / 1.0%($1,000/$100,000)
Preferred stock / 30.0%($45,000/$150,000) / 18.4%($46,000/$250,000)
Debt / 20.0%($400,000/$2,000,000) / 19.8%($446,000/$2,250,000
Harris' cumulative percentage does not reach 20 percent at any stage of the test, so Harris is not a member of the new control group.
E2.5 (cont=d.)
Calculation of Hill's capital at risk:
Security / Percentage / Cumulative PercentageVoting common stock / 1%($1,000/$100,000) / 1%($1,000/$100,000)
Preferred stock / 30%($45,000/$150,000) / 18.4%($46,000/$250,000)
Debt (including guarantee of $500,000) / 45%($900,000/$2,000,000) / 42%($946,000/$2,250,000)
Hill's cumulative percentage does reach the 20 percent level, so Hill is a member of the new control group.
E2.6LEVERAGED BUYOUT: CHANGE OF CONTROL
A change in control occurs when either (1) the new control group consists entirely of new shareholders or (2) the new control group includes prior shareholders but none of these, individually or in combination, controlled the target company before the buyout.
From E2.5, Hill qualifies as a member of the new control group but Harris does not. Hill owned 50 percent of HH Industries, which is not a controlling interest. Thus test (2) above is met, and there has been a change in control.
If, however, it could be shown that Hill had the ability to implement major operating and financial policies (e.g., Harris was a "silent partner" and Hill managed the firm), then we would conclude that Hill had control prior to the LBO. In this case, since Hill is a member of the new control group, there would be no change in control.
E2.7LEVERAGED BUYOUT: POST-ACQUISITION BALANCE SHEET
New Company
Balance Sheet
After Merger
Assets / $700,000 / Liabilities / $900,000Stockholders' Equity / (200,000)
$700,000
Because there was no change in control, there is no change in the valuation of Target Company's assets in recording the merger.
E2.8LEVERAGED BUYOUT: POST-ACQUISITION BALANCE SHEET
New Company
Balance Sheet
After Merger
Assets / $875,000 / Liabilities / $900,000Goodwill / 75,000 / Stockholders' Equity / 50,000
$950,000 / $950,000
Target's net assets are valued at fair value ($750,000) in the merger. Because no stockholder of Target was involved in any way with Buyout, no use of predecessor basis is required. The acquisition was for cash, and therefore the monetary test is met.
E2.9RECORDING A SPINOFF
A spinoff is recorded at book value. Thus stockholders' equity will be reduced by the book value of net assets of the entity spun off to the stockholders. The entry is:
Liabilities / 850,000Additional Paid-in Capital / 550,000
Assets / 1,400,000
E2.10 SALE vs SPINOFF
The sale and distribution of after-tax proceeds to the stockholders would net them $5,330,000 after taxes, as follows:
Jack's proceeds from sale of Jill / $10,000,000Less: tax on gain (= .3 x ($10,000,000-$4,000,000)) / 1,800,000
Cash available for distribution to stockholders / $ 8,200,000
Less: tax paid by stockholders on dividends(= .35 x $8,200,000) / 2,870,000
After-tax benefit to stockholders / $ 5,330,000
The spinoff would provide the stockholders with 1,000,000 shares of Jill Company stock, having an aggregate market value of $7,500,000. No tax would be payable at the time of the stock distribution. The spinoff would provide greater immediate wealth to the stockholders (stock worth $7,500,000 versus cash of $5,330,000).
Taxes would be due if and when the stockholders sell the Jill stock. While income tax laws would provide that some of the basis of their Jack stock be allocated to the Jill stock, no increase in total basis would occur. Thus we may view the entire $7,500,000 as being subject to tax, part of it when Jill shares are sold and the remainder when Jack shares are sold. If the same 35 percent rate applies to the gains from the sale of stock, the income tax would eventually be $2,625,000, for an ultimate net cash benefit of $4,875,000.
E2.10 (cont=d.)
While this amount is lower than the immediate cash benefit, several factors would need to be considered in deciding which is preferable. These factors include:
1.The time value of money, as the tax would not be incurred until shares are sold, which may be many years in the future.
2.The possibility that no income tax will be due at all, because the stockholder holds the stock until death, when it passes at fair value to heirs, avoiding any income tax on appreciation.
E2.11 RECORDING A TAKEOVER DEFENSE
Treasury Stock / 5,600,000Expense of Takeover Defense / 4,000,000
Cash / 9,600,000
To record repurchase of 8,000,000 shares at $12,
a price in excess of the current market value of $7.
E2.12 TAKEOVER DEFENSES
Poison pills are devices which become operable when a hostile takeover is imminent. The purpose is to prevent the takeover by increasing its cost, or if the takeover does occur, to increase the payoff to existing stockholders.
A poison pill might be designed as a stock rights plan, whereby existing stockholders could buy additional shares at a very favorable price upon occurrence of the triggering event. Another possible design would be preferred stock that is redeemable for cash in the event of a takeover.
SOLUTIONS TO PROBLEMS
P2.1DEBT-FINANCED ACQUISITION
Requirement 1:
Present value of bonds, using 20 percent discount rate:Principal $8,000,000 x .1615 / $1,292,000
Interest $1,200,000 x 4.1925 / 5,031,000
Present value of bonds / $6,323,000
Cash / 1,000,000
Common stock 10,000 shares x $50 / 500,000
Total purchase price / $7,823,000
Stockholders' equity acquired / (3,000,000)
Purchase premium / $4,823,000
Attributed to:
Current assets ($2,000,000 - $1,500,000) / ( 500,000)
Plant and equipment ($5,000,000 - $3,000,000) / (2,000,000)
Goodwill / $2,323,000
Kelly, Inc.
Balance Sheet
January 2, 20X0
Current Assets / $ 4,000,000Plant and Equipment, Net / 14,000,000
Goodwill / 2,323,000
$20,323,000
Current Liabilities / $ 1,500,000
Long-Term Liabilities / 4,000,000
Bonds Payable / $8,000,000
Less: Discount / ( 1,677,000) / 6,323,000
Common Stock, $10 Par / 1,100,000
Additional Paid-In Capital / 2,900,000
Retained Earnings / 4,500,000
$20,323,000
P2.1 (cont=d.)