Category MBA

Corporate Restructuring

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Corporate restructuring is the process of reorganizing the ownership, legal, operating or any other structures of the company. It may involve expansion or contraction of the operations of the business.

There are various types of corporate restructuring such as mergers, consolidations and leveraged buyouts (LBOs). Successfully restructured organization should result in an increase of the owners’ wealth and more effective operations.

Restructuring can be necessary in various situations. Some of the reasons are as follows.

  • If company was the target of a leveraged buyout than it is likely to be restructured by the new owner and sold for a profit after the restructuring is successfully completed.
  • Restructuring can also be necessary in situations when the organization became too large, to the point that the structure established for the organization earlier can no longer support the operations of the organization.
  • If an organization grows to be too large for its current structure, restructuring may allow the organization to make its operations more efficient. For example, some parts of the organization can be converted into subsidiaries to obtain tax advantages and to ensure more effective management of the operations.
  • Another situation which may require restructuring is an organization struggling to survive. Such a situation can occur for various reasons such as the downturn in the economy, market entry of an unexpectedly strong competitor or revolutionary changes in technology which make some of the business’s product offerings obsolete. Contraction of the operations of such an organization may be necessary to ensure that the business can continue its existence and start rebuilding itself from the size it can currently sustain.

There are of course many more reasons why an organisation can be restructured. In general, restructuring implies the organization will continue its operations in one way or another.

 

 

Purchase versus Lease Decision

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When deciding on whether to purchase or lease an asset, a firm should compare after-tax cash outflows associated with each option. The option with the lowest present value of after-tax cash outflows should be selected.

To make a decision between purchase and lease alternatives, we need to do the following:

  • Determine after-tax cash outflows for lease alternatives.
  • Determine after-tax cash outflows for purchase alternatives.
  • When completing steps 1 and 2,  the purchase option at the end of the lease should be incorporated into analysis in step 1 and sale of purchased asset at the end of the term (equivalent to the lease term) should be incorporated in analysis in step 2. This will ensure that we compare assets of equal lives.
  • Find the present value of the cash outflows under lease and purchase. The after-tax cost of debt should be used as a discount rate. One can use a financial calculator to find present value of the mixed stream of outflows or find the present value of the annuity.
  • Select an option with the lowest present value.

It is also important to remember that financial manager must always attempt to find options with the lowest cost of capital to ensure maximization of the owners’ wealth.

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Financial Lease (Capital Lease)

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Finance lease (also called financial lease or capital lease) refers to the lease of the asset where the useful life is closely aligned to the term of the lease. The lease term is longer than operating lease. Finance leases are usually leases for an asset which does not become technologically obsolete. Under a capital lease, the lessee is usually responsible for all maintenance and other costs. Comparatively, under an operational lease, lessor is usually responsible for such costs.

A lessor purchases an asset selected by the lessee. The lessee will be able to use the asset during the duration of the lease agreement as long as contractual, periodic and timely payments are made by lessee to the lessor.

At the end of the term, the lessee may have a purchase option which allows the lessee to acquire an ownership of the asset. The lessee is not allowed to cancel the lease which makes a financial lease similar to long-term debt. If a lessee misses contractual or periodic payments, the lessee may be forced into bankruptcy.

Because under a finance lease, the lessee may have some ownership of the asset with some risks and benefits that comes with ownership, a finance lease must be recorded as a capitalized lease. This refers to recording the present value of all contractual payments and assets and corresponding liabilities on the balance sheet.

Under a finance lease, the firm benefits from the tax-deductibility of the interest paid on the leased asset as well as from depreciation of the leased asset which is recorded as an expense on the firm’s income statement.

This leads to increases in the debt/equity ratio and therefore an increase in financial leverage compared to an operational lease. It also leads to a decrease in working capital due to an increase in current liabilities.

Moreover, part of the payments due to a financial lease are recorded as a reduction in lease liability under operating cash flows and part is recorded as lease interest payments under financing cash flows. This leads to an increase in operating cash flow compared to records under operating lease where only operating cash flow is affected.

Because firms have an incentive to report leases as operational leases, certain regulatory rules were established by Financial Accounting Standards Board (FASB) which specify which assets can qualify for operational leases. The following is a list of characteristics of financial leases. If even one of such characteristic is met than an asset should be recorded as financial lease.

  • A lease term is 75% or more of the useable life of the asset.
  • At the commencement of the lease agreement, the present value of the lease payments is equal to 90% or more of the fair market value of the leased asset.
  • Ownership of the asset is transferred to the lessee at the maturity of the lease agreement.
  • A lease agreement contains an option to purchase the asset at the “bargain price” which must be the fair market value.

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Operating and Financial Leases (Capital Leases)

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Within an accounting context, a lease can be classified as an operating lease or a financial lease.

Operating lease (service lease) refers to a short-term lease of an asset with a useful life longer than the term of the lease. For example, this applies when fixed assets with a useful life of 15 years are leased for 3 years. This type of lease is common for fixed assets with a longer useful life but which become less efficient and even technologically obsolete relatively fast, such as computer systems and office equipment.

Operating leases usually can be cancelled but generally a cancellation penalty will apply. They also usually include maintenance clauses which require the lessor to conduct maintenance of the asset as well as tax and insurance payments.

Operational leases usually include a renewal option since the economic life of the asset is generally relatively longer than the lease term. This allows the lessee to renew the lease of the asset at the end of the term of the lease. A purchase option may be included at the end of the lease which will allow the lessee to acquire the asset.

Under an operating lease, a lessor transfers to lessee only the right to use the asset. The lessee does not have any level of ownership over the asset. Under an operating lease, periodic payments, as per the lease agreement, are recorded as expenses in the income statement. Operating lease expense is not recorded in the balance sheet.

Consequently, under an operating lease (compared to capital lease), financial ratios present misleading results. For example, leverage ratios are understated because no liability is recorded associated with the lease. For example, the debt-equity ratio is lower and so is the debt ratio. The times interest earned ratio is higher because under an operating lease, depreciation is not recorded.

Liquidity ratios are also affected. Both, the current ratio and quick (Acid-Test) ratio are overstated because the lease is not reflected in current liabilities. Moreover, the ROA profitability ratio is overstated because total assets are not affected under an operating lease.

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Advantages & Disadvantages of Leasing

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Advantages of Leasing

  • Businesses avoid large capital outlays when acquiring the use of an asset, thereby freeing up cash for more productive uses.
  • In the case of the start ups, leasing also helps to ascertain a business’s asset requirements before purchase of assets is made. As an example, a business can rent a building space for a year to obtain a better understanding of the business’s building requirements before committing to purchasing a space.
  • Leasing offers flexibility, especially with assets which tend to become obsolete very fast.
  • Leasing does not result in restrictions on company’s financial operations due to loan covenants.
  • If firm experiences liquidity problem, it can lease back an asset to the lessor that the firm already owns. Sale-leaseback arrangements consist of selling an asset to the lessor and leasing it back. Such action can the improve liquidity of the firm.
  • If the firm will go bankrupt or if it is undertaking reorganization, the firm is better off if assets are leased because the lessor can claim a maximum of 3 years worth of lease payments. Lenders, on the other hand, can claim the entire outstanding debt.
  • Leases usually do not require down payment. Therefore, lease provides 100% financing. In comparison, when an asset is purchased, lenders often usually require down payment of 10% or at least 5% of the asset.
  • Under operational lease some financial ratios look better because the asset is not capitalized, which refers to asset not being recorded in the balance sheet as an asset and corresponding liability.
  • Lease can be undertaken as a hedge against rapid obsolescence of equipment.
  • Leasing allows the revenue generated by the asset to provide funds for the payment for the asset. This benefit is especially relevant for start ups which usually have very limited resources.
  • Organizations can adjust the term of the lease for the duration of time when the leased asset is planned to be used and then update the asset when required.
  • Leasing provides organizations with options. Under a lease agreement the organization may have options of returning the asset, renewing the lease or purchasing the asset.
  • It is usually easier to obtain a lease that to obtain a loan to purchase the asset.
  • Leases may offer tax advantages which depend on how the lease is structured.

Disadvantages of leasing

  • Purchase is likely to be preferred to lease if the asset is planned to be used for a long duration of time without renewal of asset.
  • If the business no longer requires an asset or if the asset becomes obsolete before the end of the lease term, it may be expensive and very difficult to terminate the lease before the end of the contract. If asset is owned, it may be easier to make appropriate arrangements to sell or rent out the unnecessary or obsolete asset.
  • Although the initial large cash outlay is avoided, over the long-term the lease may account for a larger capital outlay than if firm purchased an asset instead.

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Leasing

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A lease is a contract between tenant (a lessee) and owner (a lessor) of the asset which allows the tenant to use owner’s property over specified period of time in exchange for periodic payments which the lessee makes to lessor. The contract must be signed by both lessee and lessor and is usually called a lease agreement.

Leases can be arranged for both tangible and intangible assets. Lease of tangible assets is lease of assets that one can see and touch and includes assets such as automobiles, buildings and equipment. Lease of intangible assets is a lease of assets that one cannot see and touch. An example will be a lease of use of a radio frequency.

Leasing is a substitute for purchase of a fixed asset. It is one of the ways in which an organization can finance its assets. It allows the firm to make use of an asset in exchange for contractual periodic payments which are tax deductible.

 

Agency problem and agency costs

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Agency costs refer to costs which arise due to an agency problem. Agency problem, which is also called principal–agent problem or agency dilemma, occurs when an agent acts on behalf of the principal. The problem arises because agents’ interests and priorities may be different from that of the principal.

Agency costs are costs that a principal incurs to decrease or eliminate the agency problem by providing agent with incentive to act in the best interests of the principal as well as by monitoring the agent’s actions to ensure the agent is acting honestly and in the best interests of the principal.

In the context of an organization

In the context of an organization, agency costs refer to the costs of eliminating or decreasing the agency problem which arises due to management (agent) acting on behalf of shareholders (principal).

Agency problem, in the context of an organization, refers to the tendency of management to pursue its own needs as a first priority, which may be at the expense of the needs of the shareholders.

Agency costs include costs which arise due to maintenance of corporate governance structure of the organization. The goal is to give the management incentive to treat the needs of shareholders as a priority as well as ensuring honest dealings of management and monitoring management’s performance.

A typical example of agency costs occurs when rewards of management are tied to shareholders’ wealth maximization or performance of the company.

As an example, to tie rewards of management to the shareholders’ wealth maximization management may be given portion of shares of the company. Therefore, management becomes shareholders as well and their needs and interests become more aligned with other shareholders.

Alternatively, management is given stock options which will allow purchasing stock at the market price set at the time when stock options are granted at some point in the future. This gives management an incentive to be interested in shareholders’ wealth maximization since management will be able to benefit from it personally by buying appreciated shares at some point in the future at the price set at the time stock options were granted (at the lower price).

To tie rewards of management to the performance of the company, management may be evaluated based on their ability to achieve certain measures such as EPS. Performance shares or cash bonus may be given to reward management for meeting specific performance measures.

The other ways which help to decrease the agency problem in organisations is the pressure that shareholders place on the management and negative implications which will materialize if management cannot meet shareholders’ expectations.

Another factor that helps to decrease the agency problem in organisations is the threat of takeover by an individual, group or company which believes that company could be managed better. It serves as impetus for management to work harder in meeting shareholders’ needs.

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Stock repurchases (share buyback)

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Stock repurchases is a form of dividends. If stock repurchases are made instead of cash payment, it increases the earnings per share of current shareholders and it increases the market price per share.

Market price per share increases because earnings available for distribution to shareholders are now divided among fewer shareholders. Share price also increases because when a firm is buying back its shares it sends a positive signal to the market that management considers shares undervalued. Of course, repurchasing stock is especially beneficial for firm to undertake if the share price is really perceived by management to be undervalued.

Repurchase of stock also discourages unfriendly takeovers. This happens firstly because takeover can be attractive due to a company’s liquidity position. If a company has a lot of cash, it can be used to cover 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 benefit of repurchase of stock is that it delays the tax liability of the shareholders. If cash dividends are paid out to the shareholders, then shareholders will have to pay part of it to the government as taxes. Repurchase of stock delays taxes that shareholders will be liable for until capital gain is realized, which occurs when shareholder sells stock.

Agency problem also have something to do with managements’ incentive to repurchase stock. Executive’s rewards are often tied to performance measures such as earnings per share. If firms have fewer shares outstanding and earnings stay the same than its earnings per share will inevitably increase.

Therefore, a part of the agency cost that firm has to incur is due to a necessity to monitor management actions to ensure that stock is not repurchased because an executive’s compensation is tied to EPS measure.

Repurchase of stock also allows a firm to have shares available for employee stock option plans. Buying back shares also temporarily provides a higher floor for the stock price.

Shares repurchase methods

The most common share repurchase method is purchasing shares on the open market. A second option is to negotiate with major stockholders to purchase a large bulk of shares. Another option is a formal fixed price tender offer that can be made to purchase shares at above market price.

Dutch auction tender offer, which originated in 1981, is another option to repurchase stock. This option entails invitation to shareholders to tender their shares at prices within  ranges established by the firm. The firm will try to purchase shares at the lowest possible prices. Thus, if more than enough shares are tendered then shares will be purchased up to a certain price at which an adequate amount of shares will be available. If not enough of shares are tendered then firm can either cancel the offer or buy back all the shares tendered.

Under every method of shares repurchase the reasons behind repurchase of shares must be clearly stated to the shareholders. The intention as to how repurchased shares are intended to be used should also be communicated. For example, it can be used for executive compensation or for trading it in exchange for shares of another firm.

In conclusion, companies need to maintain a target payout ratio which is suitable for the company’s needs. Organizations must also try not to neglect acceptable projects (with NPV higher than zero and IRR greater than weighted marginal cost of capital) to pay out large dividends. The main objective, as always, should be owner’s wealth maximization.

Also it is important to remember that whereas it is important to try not to decrease dividends to ensure that no negative signals are sent to the market, it is also important to maintain a healthy liquidity position. Organizations certainly should not borrow to be able to pay out large dividends.

 

Stock splits and reverse stock splits

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Organizations undertake stock splits when it is perceived within the firm that shares of the company are traded at a too high price and this may slow down trading activity. If a stock split is undertaken, the market value of shares can slightly increase. Such increase tends to be maintained as long as dividends after the split also increase.

If a firm undertakes a 2 for 1 split than 2 new shares will be given in exchange for every 1 old share. The stock split does not affect the organizational capital structure.

Organizations can also do reverse stock splits when firm wants to increase the share price. Increase in share price may help to enhance trading of a shares activity. This occurs because unsophisticated investors tend to equate low priced stocks to low quality investments.

If firm undertakes a 1 for 2 split, one new share will be exchanged for 2 old shares.

Dividend policies and dividend payout ratio

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An important concept to know when it comes to the distribution of dividends is the dividend payout ratio. The dividend payout ratio indicates which percentage of each dollar earned is distributed in cash to the shareholders. It is calculated as follows:

Dividend payout ratio = cash dividend per share/earnings per share

Generally the higher the dividend payout ratios the more attractively are shares of the firm seen by investors. Dividend payout ratios vary significantly between industries and organizations. The liquidity position of the company is one of the factors that affect the dividend payout ratio the company selects.

Test yourself:

ABC Company issued cash dividends of $3 per share. ABC’s earnings per share are $8. What is the dividend payout ratio?

Solution:

Dividend payout ratio of ABC = 3/8= 37.5%

This indicates that out of each dollar of earnings, 37.5% is distributed to shareholders as cash dividends.

Constant payout ratio dividend policy – according to this dividend policy, stockholders receive dividends at a fixed percentage rate from earnings every financial period that resulted in a profit. In financial periods when loss is incurred, no dividends are distributed. Dividends increase or decrease based on the amount of profit the firm made during a particular year. This type of dividend policy is not recommended because fluctuations in the dividends from one period to another may adversely affect the share price.

Constant dollar (stable) dividend policy – according to this dividend policy, a fixed amount of dollars per share are paid each period which resulted in a profit. The amount of fixed dollar dividend only increases after an increase in earnings proves to be stable.

Regular with extras dividend policy – according to this dividend policy, fixed amount of dollars per share is paid every period. On years when the profit exceeds normal, extra dividend is paid.

Residual dividend policy – This dividend policy is aligned with the residual theory of dividends. The residual from retained earnings is paid after all acceptable investments were undertaken.

Target dividend payout ratio

It is advisable for firms to establish target dividend payout ratio and then use it for guidance in determining dividend levels. Target dividend payout ratio refers to a specific percentage of earnings that firms would like to pay in dividends.

For example, if the target dividend payout ratio is 40% then the firm intends to try to keep its dividends around 40% of its earnings. The target dividend payout ratio is very useful in cases of constant dollar dividend policy and regular with extras dividend policy. Under these policies a regular dividend is paid each period. However, organizations can use the target dividend payout ratio as a guide to decide when dividends can be adjusted to reflect a stable new level of earnings.

Shareholders usually prefer regular and regular with extras dividend policies because it involves a smaller degree of uncertainty regarding the dividends to be received in each period.

Cash dividends and stock dividends

Cash dividends are dividends which are paid out in cash to the shareholders via cheque or electronic transfer. When cash dividends are distributed to shareholders, the share price tends to drop by an amount similar to the cash dividend. This occurs because the economic value was distributed from the firm to shareholders. Shareholders have to pay tax on cash dividends. Therefore, the amount that they receive decreases in value.

Stock dividends are dividends paid out in additional stock. There is no cash outflow. The funds are just shifted between accounts (from retained earnings to common stock and paid-in capital in excess of par).

If a company issues a 3% stock dividend this means that if one owns 100 shares of this company than 3 additional shares will be received. Overall, stock dividends do not bring any value to the shareholder. Stock dividends decrease the share price.

To determine by how much share price will decrease, let’s look at an example. Assume that shares of ABC sold for $17 each. ABC decided to distribute a 10% stock dividend. The share price will decrease as follows: $17 * (1/1.1)=$15.45.

If individual Y owned 1,000 shares before the stock distribution, after stock distribution individual Y will own 1,100 shares. The market value of shares of individual Y remains unchanged as shown below:

1,000 * $17     = $17,000

1,100 * $15.45 = $16,995

Therefore, as can be seen from the above, the shareholders’ market value of shares remains unchanged.

If the most recent earnings of ABC were $350,000 and individual Y owned 1% of the firm’s shares than earnings per share before stock dividends were $3.5 ($350,000/$100,000). If earnings are expected to stay the same than after the stock dividends, then earnings per share would decrease to $3.18 ($350,000/$110,000). Individual Y’s share in earnings stays the same. It was $3,500 (3.5*1000) and now it is $3498 (3.18*1,100).

Shareholders do not really obtain real value due to such stock dividends. It is more a perceived value of obtaining more stock. Consequently, shareholders generally do not have to pay tax on stock dividends unless the cash dividend option is present. For organizations, stock dividends are more costly but can be appropriate if the organization needs cash to finance a rapid growth.

Test yourself:

ABC shares are currently sold for $20 each. ABC decided to distribute 5% stock dividend. By how much the share price will decrease?

Solution:

The share price will decrease as follows: $20 * (1/1.05)=$19.05.

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