ACQUIRING A FIRM: TECHNICAL ASPECTS Chapter 16

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ACQUIRING A FIRM TECHNICAL ASPECTSChapter 16

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ACQUIRING A CLOSELY HELD FIRM

• VALUING A CLOSELY HELD FIRM
• Need to calculate two values
• The floor value
• The ceiling value

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ACQUIRING A CLOSELY HELD FIRM

• Establishing the FLOOR valuation.
• Book value - Does this say anything about the
  value of the firm?
• Market value of assets - Hard to ignore this.
• Replacement value -Talked about by sellers but of
  no practical importance.
• Liquidation Value - Can be highly important by
  itself this is the Real Bottom Price if seller
  knows it.
• Quick Sale - Items that should be written
  off
• Impending Judgments

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ACQUIRING A CLOSELY HELD FIRM

• For the FLOOR value consider ADJUSTED BOOK
  VALUE.
• Adjusted book value is where you take an
  individual look at each of the assets and
  liabilities and place realistic values on these
  items. For example,
• A/Rs- delete slow pays and other questionable
  items
• Inventory - delete obsolete or very slow turnover
  items
• Lower of cost or market
• Equipment- Give equipment liquidation value (or
  market value if you really feel good about the
  equipment and you really want to do the deal)

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ACQUIRING A CLOSELY HELD FIRM

• Adjusted Book Value - Continued
• Liabilities - Delete such items as Reserve for
  Deferred Federal Income Taxes may never have to
  be paid.
• Loan From Stockholder - Usually delete this as it
  represents de Facto equity of the stockholder.

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ACQUIRING A CLOSELY HELD FIRM

• THE CEILING FOR THE PRICE IS
• 1) Either the present value of Earnings (or,
  Cash Flow) or,
• 2) A multiple of ADJUSTED EBIT (or EBIT
  Depreciation), this multiple being somewhere
  between 2 and 9, with the range between 5 and 8
  being modal in todays market.
• For middle market firms, the most common way to
  value is the multiple of ADJUSTED EBIT.

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ACQUIRING A CLOSELY HELD FIRM

• The importance of ADJUSTING EBIT
• Closely held firms usually have a number of
  expenses that would be eliminated with the
  purchase of the company by an outsider. Examples
  might be relatives on the payroll, perquisites
  that are redundant ( airplanes, expensive cars,
  club memberships, etc..), inflated salaries and
  the like.
• No record, no addition!
• It behooves prospective new owners to identify
  these cost savings as they may contribute
  materially to the rate of return - and justify
  the price.

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ACQUIRING A CLOSELY HELD FIRM

• Once the FLOOR AND CEILING have been determined,
  you have to negotiate between these limits.

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FORMS OF TRANSACTION

• There are two (basic) forms of transaction for
  the acquisition of a firm.
• 1) Purchase/Sale of Assets
• 2) Purchase/Sale of Stock

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FORMS OF TRANSACTION Purchase of Assets

• Buyer can buy any or all of the assets and any
  or none of the liabilities.
• Preferred way for the buyer
• Not the preferred way for the seller
• assets sold are subject to depreciation
  recapture tax
• then it can declare a liquidating dividend
  which also gets taxed

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FORMS OF TRANSACTION Purchase of Assets

• Advantages to the buyer
• A major advantage to this form of acquisition is
  that the buyer escapes Contingent Liabilities.
• Taxes Write up assets to lower of cost or
  market and then depreciate.
• Inclusion of a Right of Offset clause
• Avoid Fraudulent Conveyance

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FORMS OF TRANSACTION Purchase of Assets

• CONTINGENT LIABILITY
• May come about from a number of sources, e.g., a
  worker with an old injury, a product liability
  claim, a civil lawsuit - maybe, patent
  infringement, but the one contingent liability
  that may be always present is TAX LIABILITY.
• The IRS has up to THREE years to audit companys
  books (if no fraud).

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FORMS OF TRANSACTION Purchase of Assets

• FRAUDULENT CONVEYANCE
• This is where a company borrows so much that
  bankruptcy results to the detriment of existing
  creditors.
• If firm goes bankrupt in first year after
  incurring a lot a debt, the new secured creditor
  may be thrown out as a secured creditor and
  placed behind the old creditors.
• This may come about through LBO where company
  takes on lots of debt.
• Purchase of Assets eliminates this problem.

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FORMS OF TRANSACTION Purchase of Assets

• Whats so bad about FRAUDULENT CONVEYANCE?
• Besides the obvious, lenders - especially FINANCE
  COMPANIES - wont lend on assets if there is
  chance of losing their secured position in
  bankruptcy.

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FORMS OF TRANSACTION Purchase of Stock

• Buyer buys the stock from a stockholder - the
  company is unaffected.
• Buyer therefore buys ALL ASSETS AND ALL
  LIABILITIES, INCLUDING ANY CONTINGENT
  LIABILITIES.
• Seller escapes all depreciation recapture taxes.
  Also, Seller may pay Capital Gains (lower) tax
  rate on the sales price over his/her basis

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FORMS OF TRANSACTION Purchase of Stock

• IF YOU CAN GET A LENDER TO LOAN ON THE ASSETS
  EVEN IF THERE IS A PURCHASE OF STOCK TYPE OF
  TRANSACTION, YOU MIGHT BE ABLE TO TURN THIS TO
  YOUR ADVANTAGE IN DOING A LBO.
• This is because of the BIG TAX BREAK you are
  giving the seller - a tax break that might be
  perceived to be bigger than it actually is!
• Taking advantage of the usual entrepreneur's
  hatred of TAXES.
• Maybe this advantage will induce seller to accept
  a subordinated note and it may be that without a
  subordinated note you can not do the deal. Do you
  know why?

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DEPRECIATION RECAPTURE TAX ILLUSTRATION

• On the sale of any asset - other than real
  estate- the difference between the sale price and
  the depreciated value is considered to be a
  taxable gain.
• If an asset that cost, say, 100,000 and is
  depreciated down to, say, 20,000 is sold for
  90,000, then 70,000 would be a taxable gain.
• Real Estate is subject to this recapture tax on
  only the amount of depreciation taken ABOVE
  straight line.

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IMPLICATION OF DIFFERING TAX POLICIES

• Under the present tax rules, the Capital Gains
  tax rate is a maximum of 20 vs. a maximum of
  about 39.7 for ordinary income.
• So sellers will be much more inclined to push for
  a SALE OF STOCK type of transaction.
• This could give LBO buyers additional problems
  but also additional leverage with the seller.

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IMPLICATION OF DIFFERING FORMS OF TRANSACTIONS

• Under a Purchase of Assets, the new buyer can
  write up the assets to the lower of cost or
  market and then gain the larger depreciation
  deduction
• thus reducing taxes.
• This is lost under a Purchase of Stock
  transaction.
• Again, this is something the buyer can remind the
  seller of and ask for a compensating concession.

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SOFT DOLLARS

• Term applied to various contracts that are given
  to the seller as part of the purchase price.
• Examples
• Consulting
• Non Compete agreement
• Rights to Patents
• Capital Gains to person receiving them (seller).
• Payments are expense items to the buyer.
• Payments are taxed to the seller as ordinary
  income (except for Patents, see above)

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APPENDIX TO ACQUIRING A FIRM

• Rappaports model, called ALCAR, is widely used
  for acquiring large publicly held firms.

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RAPPAPORTS STRATEGIC ANALYSIS FOR PROFITABLE
ACQUISITION

• Important to do a self evaluation first
• 1) How much is my company worth? And
• 2) How would its value be affected by several
  scenarios involving the acquisition of another
  company?
• To illustrate the acquisition process, Rappaport
  uses the ALCAR CASE. What follows are the steps
  needed for an acquisition using cash.

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RAPPAPORTS STRATEGIC ANALYSIS FOR PROFITABLE
ACQUISITION continued.

• Step 1) Project targets CASH FLOW-
• Cash flow is defined as
• CFt St-1 (1gt)(pt)(1-T) - (St - St-1)(ft
  wt) where CF
  Cash Flow
• S Sales
• g Annual growth rate in Sales
• p EBIT as a percentage of Sales
• f Capital investment reqd per of Sales
  inc..
• w Cash required for net working capital per .

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RAPPAPORTS STRATEGIC ANALYSIS FOR PROFITABLE
ACQUISITION Contd.

• Step 2) ESTIMATE MINIMUM ACCEPTABLE RATE OF
  RETURN BY USING WACC, where COST OF EQUITY is
  calculated using CAPM. Thus
• The Cost of Equity Capital Rf (Rm - Rf)

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RAPPAPORTS STRATEGIC ANALYSIS FOR PROFITABLE
ACQUISITION Contd.

• Step 3) COMPUTE MAXIMUM ACCEPTABLE CASH PRICE
  FOR SCENARIOS AND RANGE OF DISCOUNT RATES.

Cell values are total price (Mils) and price/sh
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RAPPAPORTS STRATEGIC ANALYSIS FOR PROFITABLE
ACQUISITION Contd.

• Step 4) COMPUTE RATES OF RETURN FOR VARIOUS
  OFFERING PRICES -

Cell values are Internal Rates of Return
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RAPPAPORTS STRATEGIC ANALYSIS FOR PROFITABLE
ACQUISITION Contd.

• Step 5) ANALYZE FEASIBILITY OF CASH PURCHASE -
• The maximum funds available for purchase equal
  the post merger debt capacity of combined company
  less the combined debt of the two companies plus
  combined pre-merger temporary investments of two
  companies. Net working capital not required for
  everyday operations are temporary investments.
• In short, do you have the cash and/or can you
  borrow the cash required.

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RAPPAPORTS STRATEGIC ANALYSIS FOR PROFITABLE
ACQUISITION Contd.

• Step 6) EVALUATE IMPACT OF ACQUISITION ON YOUR
  EPS AND D/E.
• Check to see if your EPS are diluted and if the
  capital structure after the merger is acceptable.
  
• ACQUISITION FOR STOCK -
• Estimate value of your shares.
• Compute maximum number of shares That you can
  exchange under the various scenarios and rate of
  return.
• Evaluate impact of acquisition on EPS and D/E.

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ACQUIRING A FIRM
END