Category Finance

Sources of financing

Firmsconsulting Leave a comment

When it comes to sources of financing, firms at any stage of the company’s life cycle have three options from which to choose:

  1. Internal financing – using retained profits.
  2. External financing – using funds invested by outside investors and lenders. Investors include the common stockholders, venture capitalists and entrepreneurs.
  3. Spontaneous financing – such as accounts payable, which increase automatically with increases in sales. Accounts payable, which is also called trade credit, are funds payable to suppliers.

Further, an entrepreneur needs to take into account certain variables when making a decision on optimal sources of financing. Particularly, entrepreneurs need to decide if they are willing to give up part of the voting control which will be inevitable if equity financing is chosen. Entrepreneurs also need to decide if they are willing to take on bigger financial risk which is inevitable when debt financing is selected.

Debt financing increases financial risk because debt must be repaid regardless of whether or not the firm makes a profit. If debt is not repaid according to an agreed upon schedule, creditors may even force the enterprise into bankruptcy. Alternatively, an equity investor is not entitled to more than what is earned by the enterprise.

Personal Sources of Financing

It is most likely that entrepreneurs will have to invest some of his or her “personal” money or money from “personal” sources to ensure that others will even consider investing in the enterprise. The “personal” sources of financing could be personal savings, credit cards, borrowing from friends and relatives or any other way of obtaining money such as selling an asset, such as a car or a summer house, to free up funds for investment in the enterprise.

Personal savings are usually the leading source of “personal” funds. Credit cards are often used but needed to be used with extreme caution as interest rates on outstanding amounts can be incredibly high.

Borrowing from friends and family is also very tricky and should be done with extreme care. If the business fails or does not perform as expected and money is not repaid when agreed than it can destroy or severely damage important relationships. When borrowing from friends and family, it is a good guideline to ensure that it is seen as an investment rather than a gift by the lending side of the transaction. Agreed upon deals should be put in writing since memories are not always reliable. Moreover, the amount borrowed should be repaid as soon as possible.

Bootstrapping

Bootstrapping is usually a strategy that entrepreneurs follow to survive at the beginning stages of business establishment and growth.A bootstrapping or bootstrap financing refers to a situation when entrepreneur uses his or her initiative to find capital or use capital more efficiently to survive.

It includes minimization of the company’s investments and refers to such situations as leasing instead of buying, adapting just-in-time inventory system, operating business from home, obtaining free publicity instead of paying for advertising and using other people’s resources as much as possible, while paying as little as possible.

Other examples of bootstrap financing include factoring and trade credit. Factoring refers to the situation when the business sells its accounts receivable to a financial institution at a discount rate. Factor refers to the financial institution which business is to purchase accounts receivable from other companies. Trade credit refers to situations when suppliers provide their products and services on credit. Suppliers usually extend interest free credit for 30 days or less commonly for 60 or 90 days interest free credit.

Borrowing from the Bank

When borrowing from the bank, an entrepreneur has a number of options. The following types of loans are generally available:

Lines of credit – this is when the bank agrees to make money available to the business. Agreement is made for up to a certain amount and is not guaranteed but only in place if the bank has sufficient funds available. Such agreement is generally made for a period of 1 year.

Revolving credit agreement – this is similar to the lines of credit but the amount is guaranteed by the bank. A commitment fee of less than 1% of the unused balance is generally charged. Therefore, such an arrangement is generally more expensive for the borrower.

Term loans – such loans are generally used for financing of equipment. The loan generally corresponds to the useful life of the equipment.

Mortgages – such loans are long-term loans and are available for purchase of the property which is used as collateral for the loan.

When banks consider loaning money, they generally will have to consider certain requirements before they will even consider loaning the funds. Such requirements include the request of a business plan to learn whether or not the entrepreneur have their “own skin in the game”.

Other considerations include the entrepreneur’s own net worth which refers to personal assets less personal liabilities. The projected annual income of the entrepreneur is also considered.

If the company is not a start up, the historical financial statements may be requested. Further, pro forma financial statements may be requested which include pro forma income statements, balance sheets and cash flow statements.

It is advisable for the entrepreneur to cultivate a good relationship with the banker since intuitive judgments also play a role when bankers decide whether or not they should lend money to the particular borrower. However, this is only valuable if all other considerations discussed above are attended to.

Banks use different methods to evaluate the appropriateness of the potential borrower. One of such methods, the five C’s method, is discussed below.

Five Cs of credit:

  1. Capital – businesses position with regards to debt versus equity
  2. Collateral – whether or not the entrepreneur has assets that can be sold to cover debt
  3. Character – borrower’s history of meeting obligations
  4. Capacity – ability to repay the loan. This is judged by such indicators as projected cash flows
  5. Conditions – conditions surrounding this particular lending opportunity such as market conditions and transaction conditions

Venture Capital

In exchange for investment, venture capitalists obtain partial ownership of the business. Convertible preferred stock or convertible debt is usually preferred. This is because venture capital firm would like to have the senior claim on assets in case of liquidation but still have an option to convert it to common stock if the business becomes successful.

Angel Investors

Angel Investors, which are also referred to as informal venture capital, are wealthy private individuals who invest in the firms in their individual capacity. Very small percentage of start ups manage to get such funding. Therefore, entrepreneur should have other options available as well.

Government Programs

There are also government supported financing options available which are specific to an entrepreneur’s location.

Other

Other less feasible options exist. One example is to obtain funding from large corporation which is willing to invest in the enterprise.

 

Holding companies

Firmsconsulting Leave a comment

A holding company is a company that owns a big large percentage of common stock shares of a company or group of companies to exercise voting control over such business or businesses. Such voting control includes control over operations, management and boards of directors. Holding companies originated in 1889 in New Jersey, USA. New Jersey was the first state that made it legal to form a company with the single purpose of owning stocks in other companies.

The companies controlled by a holding company are called subsidiaries and holding company itself is called a parent company of such subsidiaries. If a holding company owns all the shares of the subsidiary than such subsidiary is called a wholly owned subsidiary.

The purpose of a holding company is usually only to own shares in other companies. However, if a holding company also runs the business operations then it is called a holding-operating company.

Liability of the holding company is limited to the value of the stock it has in particular companies. Acquiring control over the business via a holding company is much easier than to do so via leveraged buyouts or mergers.

Advantages of holding companies

One of the advantages of holding company includes isolation of risks.This occurs because each organization the holding company controls operates independently. If one of the organizations fails or becomes involved in a lawsuit then other organizations are not affected. This also allows the holding company to take on bigger risks at individual subsidiaries.

There are some exceptions to this. In certain circumstances the parent company may feel responsible for rectifying the problems in particular subsidiaries to maintain its reputation. Lenders may also require guarantee from the holding company when lending to subsidiaries. Therefore, this advantage is not always relevant for holding companies.

Holding companies are also able to control many assets with fractional ownership. Holding companies control a large amount of assets with a relatively small percentage of ownership and therefore relatively small investment. The percentage of shares required to obtain voting control differs from situation to situation. In smaller organizations it may be around 30%. However, if the holding company wants to obtain the voting control of a large company with widely distributed shares, than even 10-20% of the outstanding stock may be enough to have such control.

Disadvantages of holding companies

One of the disadvantages of holding company is double taxation. In the United States, if the holding company wants to obtains tax consolidation benefits such as tax free dividends than it needs to own at least 80% of the subsidiaries to do so. If it owns from 20% to 80% than it needs to pay taxes on 20% of the dividends received from the subsidiaries. If it owns below 20% than it needs to pay taxes on 30% of dividends received from subsidiaries. Such disadvantage is not relevant to mergers as no double taxation occurs in mergers.

Another disadvantage of holding companies is costly administration. This occurs because each subsidiary is maintained as a separate entity and therefore no economies of scale are possible as in the case of a merger.

A further disadvantage of holding companies is increased risk. If a holding company finances investments through debt than it needs to service the debt. If one or more of subsidiaries are not able to distribute dividends due to economic downturn or any other reasons then the holding company may not be in a position to be able to service debt and may be forced into bankruptcy.

It is also easier to request dissolution of the holding company if it is found guilty in breaking antitrust laws.

Another disadvantage is that due to the availability of voting control, the holding company may ignore interests of the minority shareholders.

 

Hostile Takeover (Hostile Merger) Defence Strategies

Firmsconsulting 2 Comments

A target company has various options on how to fight a hostile takeover, which is also called a hostile merger. The target company generally obtains assistance of an investment banker and lawyer to ensure that fighting the hostile takeover will be successful. Below are the nine common hostile takeover defence strategies used by target companies.

Target companies may inform shareholders why the merger will be disadvantageous for the company.

Repurchase of stock is sometimes undertaken by companies to decrease the attractiveness of the target company for hostile takeover. Mergers can be attractive due to a company’s liquidity position. If the company has a lot of cash, it can be used to cover all or part of the debt undertaken to finance the acquisition. By using available cash to repurchase stock, the firm decreases its attractiveness as a takeover target. Moreover, repurchase of shares increases the price per share which makes hostile takeover more expensive.

Greenmail is another defensive strategy against hostile takeover. It leads to the target company buying a large bulk of shares from one or more shareholders which attempted a hostile takeover.

Another strategy to protect itself against hostile takeover is defensive acquisition. The purpose of such action is for the target company to make itself less attractive to the acquiring company. In such situations, the target company will acquire another company as a defensive acquisition and finance such acquisition with debt. Due to increased debt of the target company, the acquiring company, which previously planned hostile takeover, will likely lose interest in acquiring now highly leveraged target company. Before a defensive acquisition is undertaken, it is important to make sure that such action is better for shareholders’ wealth than the merger with the acquiring company which pursues a hostile takeover.

Finding a white knight is another hostile takeover defence strategy. It involves finding a more appropriate acquiring company that will take over the target company on more favourable terms and at a better price than the original bidder. White knights are seen as a protector of the target company against the black knight which is the acquiring company which attempted a hostile takeover.

Golden parachutes is another way to discourage hostile takeover. This strategy means including provisions in the employment contracts of top executives which will require a large payments to key executives if the organization is taken over. Nevertheless, the amounts to be paid are small relative to the size of the transaction. Therefore, this strategy may not be sufficiently effective on its own but will make the acquisition target less attractive.

Leveraged recapitalization is yet another way to deter hostile takeover. It refers to the distribution of a sizable dividend financed by debt. This increases the financial leverage of the target company and decreases its attractiveness.

The term poison pill was created by mergers and acquisitions lawyer Martin Lipton in the 1980’s and refers to a further hostile takeover defence strategy. It involves an arrangement that will make the target company’s stock unattractive for the acquiring company.

The poison pill strategy includes two main variations. Such variations are flip-in and flip-over. Flip-in tactic occurs when management offers to buy shares at a discount to all investors except for the acquiring company. Such an option is exercised when the acquiring company purchases a certain amount of the shares of the target company. Flip-over occurs where the Target Company will be able to purchase shares of the acquiring company at a discount after the merger is completed. This will decrease the value of the acquiring company’s shares and dilute the company’s control.

The poison pill can be effective in discouraging a hostile takeover and allows the target company more time to find a white knight. Yahoo is a famous example of a company that uses poison pill as a defence strategy. It will be exercised if any company or investor buys more than 15% of its shares without the approval of the board of directors.

The target company may also use the crown jewel defence strategy. Crown jewels refer to the most valuable assets and parts of the company. According to this strategy, the target company has the right to sell its best and most profitable assets and valuable parts of the business to another party if a hostile takeover occurs. This discourages hostile takeover as it makes the target company less attractive.

Pac-Man defence is a hostile defence strategy named after the popular arcade video game of the 1980’s. According to this strategy, the target company “turns the tables” and attempts to acquire an acquiring company which attempted a hostile takeover.

Although these hostile takeover defence strategies may be successful, there are costs such as transaction costs which are involved in undertaking them. Transaction costs may include hiring of investment bankers and lawyers. In making decisions whether or not to undertake any defence actions against hostile takeover, management needs to continue to act in the best interests of shareholders by keeping the maximization of the shareholders’ wealth as the main objective.

Blogbschool.com is powered by www.firmsconsulting.com. Firmsconsulting is a training company that finds and nurtures tomorrow’s leaders in business, government and academia via bespoke online training to develop one’s executive presence, critical thinking abilities, high performance skill-set, and strategy, operations and implementation capabilities. Learn more at www.firmsconsulting.com.

Sign up to receive a 3-part FREE strategy video training series here.

Merger Negotiations

Firmsconsulting Leave a comment

Merger negotiations and mergers, similar to marriages, often fail. Therefore, it is very important to plan and execute merger negotiations properly to improve a merger’s chances for success.

Acquiring firms need to understand the deal very well before approaching the target company. Space for bargaining should be considered. For example, acquiring firm could initially offer somewhere between 75-90% of what it believes the target company is worth. However, it is also important to be reasonable when the initial offer is made. If the price will be too low then the relationship between parties may be severely damaged.

Good atmosphere and a respectful and positive tone of negotiations should be created. A Win-win mindset in negotiation should be maintained, not a win-lose mindset.

It is also important for the acquiring firm not to show its eagerness as this will decrease its bargaining power. Another essential point is the vital importance of being completely ethical and honest in conducting negotiations. Conflicts of interest also should be carefully avoided.

Negotiations should also be seen as an extension of the due diligence. It should be used to find explanations to unclear issues. It is important to remain sceptical and to check the information provided by the other party.

It is also recommended to engage competent advisors to attend to various important areas associated with merger negotiations. Such areas include, but are not limited to, due-diligence, tax, legal, regulatory matters and the valuation of the company.

Investment bankers are often hired to manage merger negotiations. Investment bankers may be hired by the acquiring company and/or target company and assists either party from the very beginning of the process by finding a target or a buyer all the way throughout assisting in merger negotiations, use of tender offers and in the execution of hostile merger defence strategies. The compensation of investment bankers may be commission-based, fixed fee or a combination of both.

In terms of personnel issues, it is imperative to be aware of the sensitivity with which employees of the target company are likely to approach possible relocation, changes in management, changes in the way operations are conducted and titles.

A good way for the target company to secure a good price is to follow a closed auction strategy. According to a closed auction strategy, the target company invites all interested parties to submit their sealed bids before the deadline. This is in comparison to open auction where all parties are aware of the previous bids submitted by other interested parties.

Prior to the submission of bids, all interested parties should receive a memorandum and an ability to undertake a limited due diligence. A closed auction strategy usually involves few rounds and concurrent negotiations with various interested parties.

The target company may even follow this strategy if there is only one company interested in the acquisition. This is possible because interested parties have no access to information regarding how many organizations are involved in a closed auction.

If a friendly takeover is not welcomed by the target company, the acquiring company may undertake a hostile takeover (hostile merger). The acquiring company will do so by using a tender offer. Tender offers refer to a formal offer made to the shareholders in the market place to obtain certain amount of shares at a given price which is above the current market price.

 

Finding the Market Price Ratio of Exchange

Firmsconsulting Leave a comment

When the acquiring company knows the ratio of exchange, it can be used to find the market price ratio of exchange. The market price rate of exchange is found as follows:

(MP of acquiring company * ratio of exchange)/ MP of the target company

Where: MP refers to the market price per share.

The market price ratio of exchange indicates how much of market price per share of the acquiring firm is exchanged for every $1.00 of the market price per share of the target company.

It is normal for the market price ratio of exchange to be above 1. This is an indication that the acquiring company pays a premium above the market price to acquire a target company.

Test yourself:

ABC (acquiring company) is acquiring BCD (target company) with the use of a stock swap transaction. ABC’s market price is $60 and BCD’s market price is $55. However, during merger negotiations, ABC agreed to a 1.5 ratio of exchange where it valued BCD’s shares at $90.

Find the market price per share in the ABC/BCD merger.

Solution:

(60*1.5)/55=1.6

This means that ABC gives $1.6 of its market price in exchange for every dollar of the BCD’s market price.

Blogbschool.com is powered by www.firmsconsulting.com. Firmsconsulting is a training company that finds and nurtures tomorrow’s leaders in business, government and academia via bespoke online training to develop one’s executive presence, critical thinking abilities, high performance skill-set, and strategy, operations and implementation capabilities. Learn more at www.firmsconsulting.com.

Sign up to receive a 3-part FREE strategy video training series here.

Stock Swap

Firmsconsulting Leave a comment

Stock swap transactions are one of the popular ways in which mergers can be financed. Stock swap refers to the situation when an acquiring company exchanges its common stock shares for common stock shares of the target company at the agreed upon ratio.

The ratio, which is called ratio of exchange, is determined during merger negotiations. The acquiring company often needs to repurchase shares in the market place to obtain an adequate amount of shares to be able to complete the stock swap transaction.

To find the ratio of exchange, the dollar amount required to be paid per share of the target company must be divided by the market value of the shares of the acquiring company.

Ratio of exchange = amount required to be paid per share of the target company/market value of the shares of the acquiring company

Test yourself:

ABC Company would like to acquire company BCD by using a stock swap transaction to finance the merger. ABC’s shares currently trade for $60 per share. BCD’s shares are traded for $55. However, in merger negotiations, it was agreed that BCD’s shares should be valued at $90 per share. What is the ratio of exchange in this merger stock swap transaction?

Solution:

The ratio of exchange is 1.5 (90/60). ABC will need to exchange 1.5 shares of common stock to obtain 1 common stock share of BCD.

Test yourself:

ABC (acquiring company) is acquiring BCD (target company) with the use of a stock swap transaction where it will exchange 1.5 shares of common stock for each common stock share of BCD. ABC’s shares trade at $60 per share. It was agreed during merger negotiations that BCD’s shares will be valued at $90 each. The real market price of BCD’s shares is $55 per share. Find out how many shares does ABC need to exchange in the stock swap transaction if BCD needs to obtain 15,000 shares?

Solution:

ABC needs 22,500 (15,000*1.5) to complete stock swap transaction with BCD at a ratio of exchange of 1.5:1.

Test yourself:

ABC (acquiring company) is acquiring BCD (target company) with the use of a stock swap transaction. ABC’s earnings before the merger were $400,000 per year and it has 110,000 of shares of common stock outstanding. ABC will have to issue 22,500 shares of additional common stock to complete the stock swap transaction with BCD. BCD’s earnings before the merger are $65,000 and it has 15,000 shares of common stock outstanding. The ratio of exchange is 1.5 of ABC’s shares for 1 share of BCD.

What are current earnings per share (EPS) of ABC and BCD and what will be the initial earnings per share of ABC after the merger, if earnings are assumed to stay unchanged?

Solution:

Current (before the merger) earnings per share (EPS) of ABC is $3.6 (400,000/110,000).

Current (before the merger) earnings per share (EPS) of BCD is $4.3 (65,000/15,000).

Initial earnings per share of ABC after the merger is:

= ((400,000+65,000)/(110,000+22,500))

=485,000/132,500

= $3.5

It is common for earnings per share of acquiring company to initially decrease. This happens because acquiring company pays a large premium above the target company’s market price. In the long run, however, earning per share will likely be higher than it would be without the merger.

If the price/earnings ratio (P/E ratio) paid for the target firm by the acquiring firm is greater than the P/E of acquiring firm then, the EPS of the acquiring firm will initially decrease and vice versa. However, in the long term, the EPS of acquiring firm should increase. The P/E Ratio is found by dividing the market price per share by earnings per share (EPS).

Test yourself:

ABC (acquiring company) is acquiring BCD (Target Company) with the use of a stock swap transaction. ABC’s market price is $60 and its earnings per share are $3.6. BCD’s market price is $55 and its earnings per share are $4.3. However, during merger negotiations ABC agreed to a 1.5 ratio of exchange where it value BCD’s shares at $90.

A. Explain how ratio of exchange was determined.

B. Calculate the P/E ratio for ABC and BCD before the merger at market prices per share.

C. Calculate the P/E ratio of BCD at the agreed upon price per share for the merger.

Solution:

A.

The ratio of exchange of 1.5 is calculated by dividing $90 (the agreed upon price of BCD’s share) by $60 (the market price of ABC’s share). ABC will need to exchange 1.5 shares of common stock to obtain 1 common stock share of BCD.

B.

P/E ratio of ABC before the merger is $60/$3.6=16.6

P/E ratio of BCD before the merger is $55/$4.3=12.7

C.

The P/E ratio of BCD at the agreed upon price per share for the merger is:

$90/$4.3=20.9

The P/E ratio paid by ABC for target company (BCD) was larger than the P/E ratio of ABC. This was due to an agreed upon price for BCD common stock shares which was $35 ($90-55) or 63.6% (35/(55/100)) above the  target company’s market price. It is common for an acquiring firm to pay approximately 50% above the target company’s market price. Consequently, in such situations the P/E ratio paid is often higher than the acquirers P/E ratio. This results in the initial earnings per share to be lower after the merger.

Blogbschool.com is powered by www.firmsconsulting.com. Firmsconsulting is a training company that finds and nurtures tomorrow’s leaders in business, government and academia via bespoke online training to develop one’s executive presence, critical thinking abilities, high performance skill-set, and strategy, operations and implementation capabilities. Learn more at www.firmsconsulting.com.

Sign up to receive a 3-part FREE strategy video training series here.

Establishing a Value for the Target Company

Firmsconsulting Leave a comment

An acquiring company may be interested in acquiring entire business or just acquiring individual assets and selling off the rest of the assets. When considering a merger, companies can use capital budgeting techniques to find the value of the company. If the net present value of the relevant cash flows is positive then a merger is considered acceptable.

If the acquiring company is interested in the whole business rather than in just few assets of the target company then post-merger pro forma statements for the target company should be prepared and the cost of capital of the acquiring company must be adjusted to reflect the cost of capital of the target company.

Test yourself:

ABC Company would like to obtain assets of BCD Company. BCD Company is a loss maker, it made losses over the last 4 years. However, it has three assets which ABC needs for its operations which are assets a, b and c. BCD is not willing to sell the assets separately but willing to sell the entire company for $95,000. According to the balance sheet of BCD:

  • asset a is worth $25,000
  • asset b is worth $20,000
  • asset c is worth $50,000
  • BCD also has $5,000 in cash, $12,000 in accounts receivable, and $5,000 in relatively obsolete inventory
  • ABC found out that they can sell accounts receivable and inventory of BCD for $10,000
  • BCD’s liabilities account for $70,000
  • After the merger, three assets of BCD will generate $15,000 in cash inflows over the next 10 years
  • ABC’s cost of capital is 12%

How should ABC establish if it should undertake this investment?

Solution:

BCD requires $95,000. Out of this money, $70,000 will be used to cover liabilities and $25,000 will be going to the owners of the target company. ABC will be able to recover $10,000 from selling accounts receivable and inventory and it will also obtain $5,000 in cash. Therefore, its actual investment is $80,000 ($95,000-10,000-5,000).

Next we need to determine the net present value of the relevant cash flows. Since it is an annuity, we can calculate it very simply. We will use a financial calculator. The calculation is as follows:

PMT: 15,000

N: 10

I: 12

PV: calculate = 84,753

Since investment required is $80,000, we can find the NPV as follows:

84,753 – 80,000 = 4,753

There is another way to calculate NPV using a financial calculator. It is advisable to try them both to make sure that the answer you obtain is correct. The second way is as follows:

CF0: -80,000

CF1: 15,000

Second function Nj: 10

I: 10

Second function NPV: calculate = $4,753

Since both calculations gave us the same answer, we can be confident that the answer is correct.

Since NPV is $4,753 which is higher than zero, a merger with BCD is acceptable.

 

Divestiture (Divestment)

Firmsconsulting 1 Comment

Divestiture, which is also called divestment, refers to a company selling (divesting) parts of its business or specific assets because it believes that by following such an action the value of the business will be improved. As an example, a company may sell part of its operations which is not a core business so that it can focus its full attention on the core business and invest money obtained from the sale on expansion of the core business.

Sometimes selected operating units or departments are sold to its current management. Such transactions are usually financed via leveraged buyouts (LBOs).

Spin-off is another way to undertake divestment. This occurs when a certain operating unit becomes an independent business.

If a buyer cannot be found for part of the business or specific assets the business no longer would like to keep, then liquidation of the  business or assets is another option in which divestiture can be accomplished. Liquidation is, for obvious reasons, the least attractive option to accomplish divestiture.

It is often the case that an organization’s breakup value is greater than its current value. Breakup value, which is also called private market value (PMV), refers to the sum of values of each part of the business that could have been sold independently. A company with a high breakup value is more attractive acquisition target for acquiring company. This is because the acquirer can keep the valuable parts and sell the parts it does not need at a high price and use the money to pay down the price of the original acquisition.

 

Leveraged Buyouts (LBOs)

Firmsconsulting 1 Comment

Leveraged buyouts (LBOs) are also called “bootstrap” transactions or highly-leveraged transactions (HLT). It occurs when a lot of debt, which is also referred to as leverage or borrowing, is used to acquire an organization or controlling percentage of shares of the organisation. As much as 90% or more of debt is used to finance a leveraged buyout.

The assets of the target company are typically used as collateral to finance the merger. Leveraged buyouts often involve situations when a public company is taken private. LBOs are examples of financial mergers.

Due to the nature of the acquisition, certain organizations are especially attractive candidates for leveraged buyouts. Such characteristics include under priced stock, healthy liquidity position, low debt level, inefficient current management of the organization which can be rectified by the new owners, consistent stable earnings of the target company, strong cash flow or the possibility of stronger cash-flows and a good position within the industry and availability of assets to account for sufficient collateral.

Repurchase of stock is sometimes undertaken by companies to decrease attractiveness of the company as a leveraged buyout target. Takeovers can be attractive due to a company’s liquidity position. If a company has a lot of cash, it can be used to cover all or part of the debt undertaken to finance the acquisition. By using available cash to repurchase stock, a firm decreases its attractiveness as a takeover target. Moreover, repurchase of shares increases the price per share which makes takeover more expensive.

Another strategy that management of the target company may use to protect itself against hostile takeover via leveraged buyout is defensive acquisition. The purpose of such an action is for the target company to make itself less attractive to the acquiring company. In such situations, the target company will acquire another company as a defensive acquisition and finance such an acquisition through debt. Due to increased debt of the target company, the acquiring company, which previously planned the hostile takeover, may lose interest in acquiring a highly leveraged target company. Before a defensive acquisition is undertaken, it is important to make sure that such action is better for shareholders’ wealth than a merger with acquiring company which pursues hostile takeover.

The nature of leveraged buyouts changed over the last 30 years. Whereas before, LBOs were mostly used to finance hostile takeovers, currently leveraged buyouts are predominantly used to finance management buyouts.

 

Types of mergers

Firmsconsulting Leave a comment

There are four types of mergers, which are presented below:

Conglomerate merger – acquisition of businesses in different lines of business to diversify risk.

Congeneric merger – acquisition of company in the same general industry to cross-sell products and services. It can be further subdivided into:

a. Market-extension merger – which refers to acquisition of company which operates in different market.

b. Product-extension merger – which involves acquisition of company that operate within same market but which product and service mix is different but related to that of the acquiring company.

Horizontal merger – acquisition of company in the same line of business which operates in the same market. This refers to acquisition of the direct competitor.

Vertical merger – acquisition of a supplier or customer.