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Corporate Finance

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Corporate Finance ­FIN 622
Lesson 36
This handout will take care of following topics:
Corporate Restructuring
Purpose of divestment
Types of buyouts
Financial distress ­ introduction
Corporate Restructuring
Corporate restructuring and improved corporate governance are essential parts of economic reform
programs under way in many countries. How can corporations be restructured to promote growth and
reduce excessive debt without placing undue burdens on taxpayers? What framework is needed to promote
better corporate governance?
CORPORATE Restructuring involves restructuring the assets and liabilities of corporations, including their
debt-to-equity structures, in line with their cash flow needs to promote efficiency, restore growth, and
minimize the cost to taxpayers. Corporate governance refers to the framework of rules and regulations that
enable the stakeholders to exercise appropriate oversight of a company to maximize its value and to obtain
a return on their holdings. Both corporate and financial sector restructuring are central to ongoing reform
programs in East Asia. This article focuses on reform efforts in Indonesia and Korea, as well as Malaysia
and Thailand.
Corporations, government, and banks have close relationships in many East Asian countries.
Conglomerates controlled by a small group, nontransparent accounting, interlocking ownership between the
corporate and financial sectors, and weak minority shareholder rights dominate many sectors of their
economies. It is estimated that the top 10 families in Indonesia in 1997 controlled corporations worth more
than half the country's market capitalization. Comparable figures are one-half in Thailand, one-fourth in
Korea and Malaysia, but only 2­3 percent in Japan. Fundamental cultural and institutional changes are
required if a new corporate governance structure is to be established with arm's-length, transparent relations
between corporations, government, and banks. Changing corporate governance, however, is a long-term
process. In East Asia, the immediate task is to deal with the present crisis by undertaking integrated
restructuring of the assets and liabilities of highly indebted firms, external debt restructuring, and financial
sector reform. Integrated restructuring of both corporate assets and liabilities is required if competitive
enterprise and financial sectors are to be developed, the risk of crises recurring is to be reduced, and the
cost to taxpayers of accomplishing these goals is to be minimized.
Build up of vulnerabilities in the corporate sector. Before the crisis hit, many East Asian corporations
expanded into sprawling conglomerates making extensive use of debt, because equity markets were
undeveloped and, in many cases, owners preferred to retain control of firms with concentrated holdings.
There were also structural weaknesses in these countries' banking supervision systems and internal bank
management. Much of the debt owed to banks and corporations was unheeded and short term, which led to
extreme over indebtedness following the devaluations and high interest rates of 1997 and 1998. Two factors
that make financial crises in East Asia difficult to manage are the large, short-term internal and external
debts and openness of many East Asian economies, both of which constrain their monetary and exchange
rate policies.
Need for a comprehensive approach. Resolving corporate sector, financial sector, and external debt
problems requires a comprehensive and integrated approach. Since good firms are necessary if an economy
is to have good banks, corporate restructuring must be linked to bank restructuring, which, in turn, must be
linked to the settlement of external debt problems. Perverse incentives and inequitable burden sharing can
result if obligations to short-term external creditors are met and losses are concentrated on the government,
labor, and, ultimately, the taxpayers. The costs to the government of bank recapitalization are high--we
estimate that they range between 15 and 35 percent of GDP for the four countries discussed in this article.
Financing these costs domestically is likely to increase government borrowing, thus increasing interest rates
and further slowing recovery of the corporate sector.
In the short term, there is an urgent need to restructure the corporate and financial sectors. It is important
to manage the crisis in such a way as to start the process of satisfying longer-term reform goals in each
country, including making the fundamental changes necessary to create arm's-length relations between the
Corporate Finance ­FIN 622
government, corporations, and banks. Necessary steps include broadening the ownership of corporations
by liberalizing foreign entry and expanding the role of capital markets. Protecting shareholder rights and
developing improved accounting standards and bank regulations are essential. Just as the Great Depression
led to legislation and reforms in the United States that diminished "relation-based" finance and laid the
foundation for a modern financial structure, so the crisis in East Asia offers a rare opportunity for countries
in that region to lay the foundation for a new, arm's-length system that is likely to be more efficient and
The challenge for policymakers is to undertake comprehensive reform that maintains pressure on all parties
in a way that promotes equitable burden sharing among borrowers, equity holders, the government, and
external creditors; restores credit to viable enterprises and confidence in the financial system; and leads to a
competitive corporate and financial system that minimizes the chances of recurrence of a crisis.
Sustainable reform and the resumption of growth require a fair sharing of the burdens of economic
restructuring among external participants (short-term creditors, equity holders, and bondholders) and
internal participants (shareholders, workers, and taxpayers). This burden sharing needs to be seen within the
context of creating a future structure in which arm's-length relations prevail between new private sector
owners, the government, sound financial institutions, and the broader capital market. The present
constraints of meeting external debt payments and tight capital- adequacy ratios effectively determine the
extent, pace, and costs (and, to a large extent, who bears these) of corporate and bank restructuring.
Framework for Corporate Restructuring
Corporate and financial restructuring takes time. In order to avoid an unnecessarily long period of
uncertainty and slow growth, however, a country's government needs to enhance efforts to resolve these
systemic problems. A comprehensive approach requires an active government that will eliminate obstacles
to restructuring; facilitate both formal and informal debt workouts; and establish an effective new legal,
regulatory, accounting, and institutional framework.
Obstacles to restructuring that need to be eliminated include tax policies that impede corporate
reorganizations, mergers, debt-for-equity swaps, or debt forgiveness; restrictions on foreigners' participation
as holders of domestic equity and investors in domestic banks; labor laws and other existing laws and
regulations that could hinder debt restructuring; and ineffective bankruptcy procedures.
Effective bankruptcy procedures, which can be legally enforced and serve as part of a country's debt-
restructuring process, are a very important means of ensuring that unviable firms do not continue to absorb
credit. An effective bankruptcy system also serves to maximize the value of the assets to be distributed to
creditors. Moreover, the presence of an effective bankruptcy system will create the appropriate incentives
for creditors and debtors to reach out-of-court settlements. Given the costs and risks associated with even
the most developed bankruptcy systems, a policy framework that facilitates out-of-court settlements that are
fast, fair, and acceptable is essential.
Experience in several countries demonstrates that the government can play a constructive, yet informal role
in facilitating an orderly workout of debts (sometimes referred to as the "London approach"). This
approach, used in the United Kingdom since 1989, has been designed to help bring together debtors and
creditors and facilitate negotiations. Many East Asian countries have adopted, or are adopting, a similar
framework to facilitate and encourage corporate restructuring that includes using new bankruptcy
provisions as an incentive for creditors and debtors to negotiate.
The government's policy framework should minimize costs to taxpayers. Because its primary focus is likely
to be on large and medium-sized corporations, neither direct nor should indirect subsidies be provided to
them. Small and medium-sized businesses require a different approach than large ones. Because many of the
former have only restricted access to banks and capital markets, it is important to have policies in place that
allow for rolling over their working capital and trade credit.
Policies are also needed to improve the competitiveness of the private sector. Competition policies that
reduce anticompetitive practices and stop large firms' abuses of market power need to be implemented in
parallel with corporate restructuring.
Approaches to Corporate Restructuring
Indonesia, Korea, Malaysia, and Thailand have all adopted an approach that facilitates and encourages
corporate restructuring and have moved to eliminate obstacles to restructuring. The extent of progress and
the degree of government involvement differ among countries, however, and are influenced by the share of
corporate debt held by domestic banks versus foreign banks, whether domestic banks are institutionally
strong enough to engage in active restructuring, and which sector the bad loans are concentrated in (real
Corporate Finance ­FIN 622
estate, commodity production, or manufacturing). In Indonesia, foreign private banks hold two-thirds, and
domestic private banks hold about one-third, of corporate debt. In Thailand, foreign private banks hold
about one-half the corporate debt. In Korea, most corporate debt is owed to domestic banks; similarly, in
Malaysia, domestic banks hold about 90 percent of corporate debt.
In Indonesia, most corporate debt is owed directly by the borrowing firms to foreign banks. The weak
domestic banks and their small share of total corporate debt imply that foreign banks will be an important
player in the process. The authorities have adopted a three-pronged restructuring approach that consists of
a framework to facilitate workouts on a voluntary basis, an improved bankruptcy system, and provision of
foreign exchange risk protection once a restructuring agreement is reached. To support this process, the
authorities are also eliminating regulatory obstacles to corporate restructuring.
In finance and economics, divestment or divestiture is the reduction of some kind of asset, for either
financial or social goals. A divestment is the opposite of an investment.
Divestment for Financial Goals
Often the term is used as a means to grow financially in which a company sells off a business unit in order
to focus their resources on a market it judges to be more profitable, or promising. Sometimes, such an
action can be a spin-off. A company can divest assets to wholly owned subsidiaries.
Either the prime objective for divestment may be the assets being sold does not conform to the overall
business strategy or they fail to meet the group hurdle rate. They are often a cheaper and cleaner alternative
than closure of the unit.
It is very important to calculate the financial effect of divestment before any final decision is made based on
the two aspects stated above. The evaluation will take the form of a comparison of the potential price
available for the relevant business unit and the financial effect on the remainder of the group, against the
financial return available from the business unit if it were retained. The divestment decision should only be
made if the returns of the business unit as retained as compared with the disinvestment opportunity cost.
For example, if a division of a group is earning 12% as compared to group return of 18%, then it should be
disposed off.
However, the cost of asset and price available for sale must be compared and evaluated before the decision
to sell.
For example, if an asset or group of assets costing Rs 100,000 is earning 12% or 12000 and could be sold
for 60,000/-. The group hurdle rate is 18%. Comparing 12,000 with 80,000, then ROCE is 15%
(12,000/80,000) and is under group hurdle rate of 18%, therefore, it can be disposed off.
However, if the offer price of asset in question is 50,000, the ROCE is 24%, which is well above the group's
rate of return of 18% and the asset in question should not be disposed off.
Divestment for Social Goals:
Although these types of divestments are for social purposes, yet they have financial repercussions. The term
also refers to the reduction of investment in firms, industries or countries for reasons of political or social
Examples of divestment for social reasons have included:
·  The withdrawal of firms from South Africa during the 1980s due to Apartheid
·  Discussion over whether it is ethical to invest in companies that sell tobacco
Definition of buyout
Buyout is defined as the purchase of a company or a controlling interest of a corporation's shares or
product line or some business. A leveraged buyout is accomplished with borrowed money or by issuing
more stock.
The purchase of a company or a controlling interest of a corporation's shares.
Management Buyouts
Management buyouts are similar in all major legal aspects to any other acquisition of a company. The
particular nature of the MBO lies in the position of the buyers as managers of the company and the
practical consequences that follow from that. In particular, the due diligence process is likely to be limited as
the buyers already have full knowledge of the company available to them. The seller is also unlikely to give
any but the most basic warranties to the management, on the basis that the management knows more about
Corporate Finance ­FIN 622
the company than the sellers do and therefore the sellers should not have to warrant the state of the
In many cases, the company will already be a private company, but if it is public then the management will
take it private.
Reasons for Buyouts:
The existing parent company of the victim firm may wish to dispose of it. The parent company may be
caught up in financial distress and is in acute need of cash and liquidity. The subsidiary on the other hand, is
not strategically fit with parent's overall business strategy.
In case of loss making, selling the unit to its management may be the better option than to dispose or
putting into liquidation, which has it own costs.
The purpose of such a buyout from the managers' point of view may be to save their jobs, either if the
business has been scheduled for closure or if an outside purchaser would bring in its own management
team. They may also want to maximize the financial benefits they receive from the success they bring to the
company by taking the profits for themselves.
Private Equity Financing
The management of a company will not usually have the money available to buy the company outright
themselves. While they could seek to borrow from a bank if the bank accepts the risk, they will commonly
look to private equity investors to back their buyout. They will invest money in return for a proportion of
the shares in the company, and sometimes also grant a loan to the management.
Private equity backers are likely to have somewhat different goals to the management. They generally aim to
maximize their return and make an exit after 3-5 years while minimizing risk to them, whereas the
management will be taking a long-term view. While certain aims do coincide - in particular the primary aim
of profitability - certain tensions can arise. The backers will invariably impose the same warranties on the
management in relation to the company that the sellers will have refused to give the management. This
"warranty gap" means that the management will bear all the risk of any defects in the company that affects
its value.
As a condition of their investment, the backers will also impose numerous terms on the management
concerning the way that the company is run. The purpose is to ensure that the management runs the
company in a way that will maximize the returns during the term of the backers' investment, whereas the
management might have hoped to build the company for long-term gains. Though the two aims are not
always incompatible, the management may feel restricted.
Leveraged Buyout ­ LBO
The acquisition of another company using a significant amount of borrowed money (bonds or loans) to
meet the cost of acquisition. Often, the assets of the company being acquired are used as collateral for the
loans in addition to the assets of the acquiring company. The purpose of leveraged buyouts is to allow
companies to make large acquisitions without having to commit a lot of capital.
In an LBO, there is usually a ratio of 90% debt to 10% equity. Because of this high debt/equity ratio, the
bonds usually are not investment grade and are referred to as junk bonds. Leveraged buyouts have had a
notorious history, especially in the 1980s when several prominent buyouts led to the eventual bankruptcy
of the acquired companies. This was mainly due to the fact that the leverage ratio was nearly 100% and the
interest payments were so large that the company's operating cash flows were unable to meet the obligation.
It can be considered ironic that a company's success (in the form of assets on the balance sheet) can be used
against it as collateral by a hostile company that acquires it. For this reason, some regard LBOs as an
especially ruthless, predatory tactic.
Employee Buyout ­ EBO
A restructuring strategy in which employees buy a majority stake in their own firms. This form of buyout is
often done by firms looking for an alternative to a leveraged buyout. Companies being sold can be either
healthy companies or ones that are in significant financial distress.
For small firms, an employee buyout will often focus on the sale of the company's entire assets, while for
larger firms; the buyout may be on a subsidiary or division of the company. The official way an employee
buyout occurs is through an employee stock ownership plan (ESOP). The buyout is complete when the
ESOP owns 51% or more of the company's common shares.
Management Buy In (MBI):
Management Buy in (MBI) occurs when a manager or a management team from outside the company
raises the necessary finance buys it and becomes the company's new management. A management buy-in
Corporate Finance ­FIN 622
team often competes with other purchasers in the search for a suitable business. Usually, a manager will lead
the team with significant experience at managing director level.
The difference to a management buy-out is in the position of the purchaser: in the case of a buy-out, they
are already working for the company. In the case of a buy-in, however, the manager or management team is
from another source.
Some of the private equity groups and executive search firms that focus on management buy-ins.
Spin out
To rotate out of control, as a skidding car leaving a roadway.
Factors to be considered in Management Buyout
A management buyout occurs when incumbent management takes ownership of a firm by purchasing a
sufficient amount of the firm's common stock. These transactions vary due to the conditions under which
the firm is offered for sale and the method of financing employed by the managers.
Consider the conditions that may encourage managers to purchase a controlling interest in the firm's stock.
The owners of a corporation are its stockholders. These stockholders are concerned with increasing the
value of their investment, not only in one specific firm, but for all investments. Therefore, if a majority of
the firm's stockholders perceive that the value of their investment will be enhanced by agreeing to be
acquired by another firm, they will elect to sell their stock to the acquiring firm at a price they consider fair.
Managers of a firm may consider this transfer of ownership a benign event. They may also, however, be
concerned that the new owners will not manage the firm most efficiently, that they will have less control
over the management of the firm, or that their jobs will be less secure. In this situation, the current
managers of the firm may consider purchasing the firm themselves.
Another situation that frequently leads to management buyouts is the case of financial distress. If the firm is
having serious difficulties meeting its financial obligations, it may choose to reorganize itself. This can be
done by closing failing operations to slow the drain on financial resources and by selling profitable
operations to an outside party for the cash needed to restore financial viability to remaining operations. It is
not uncommon for firms in this situation to give managers of the divisions being divested the opportunity
to buy the assets. This makes sense for two reasons. First, management probably has the greatest expertise
in managing the subset of assets offered for sale. Second, it saves the cost of searching for an external party
with an interest in the division, for sale.
Once incumbent management has decided it is interested in purchasing the firm or a particular portion of
the firm, they must raise the capital needed to buy it. Managers in many corporations are encouraged to
become stockholders in the firm by including stock and the option to buy more stock as part of their
compensation package. The non-management stockholders, however, will expect some compensation from
this sale and the value of manager-owned stock is not likely to be sufficient to finance the purchase of the
firm or one of its divisions. This means that managers must raise cash from other sources such as personal
wealth. If managers have sufficient capital in other investments, these can be sold and used to finance the
remainder of the purchase price.
While a management buyout is relatively straightforward when managers have sufficient personal capital to
meet the purchase price, the more common scenario requires managers to borrow significant amounts. It is
not un-common for managers to mortgage homes and other personal assets to raise needed funds, but in
many transactions, these amounts are still not sufficient. In these cases, managers will borrow larger
amounts using the assets of the firm they are acquiring as collateral. This type of transaction is called a
leveraged buyout, or LBO. The LBO is a common form of financing for large transactions. It provides
the management team with the financing needed to control the assets of the firm with only a small amount
of equity. Nevertheless, the new firm that emerges from this transaction has very high financial risk. The
large amounts of debt will require large periodic payments of interest. If the firm cannot meet this
obligation during any period, it can be forced into bankruptcy by the debt holders.
This description of a management buyout can be generalized to define an employee buyout. In some
situations, it is feasible that all employees, not just a small group of managers, can collectively purchase a
controlling interest in a firm's stock. This may be the long-term result of a carefully designed employee
stock ownership plan (ESOP), that management has instituted. It may also result from the pressures of
financial distress. In 1994, United Airlines was faced with declining profits and strained relations with labor.
Management and labor eventually agreed on a swap of wage concessions for a 55 percent equity stake in the
firm. In the five following years, the firm became more profitable, the stock price rose significantly, and
employees retained a controlling interest in Unity's common stock.
Corporate Finance ­FIN 622
It is important to note that managers (or employee owners) are no different than other investors. They will
assess the risk and rewards associated with a buyout, leveraged or otherwise, and will act in their own best
interests. As managers, they have specialized knowledge of the firm that may prove advantageous in
charting a future course of action for the acquired firm. By assuming ownership of the acquired firm, they
will also assume a riskier position personally. If the potential rewards associated with control are perceived
as adequate compensation for this risk, then the management buyout will be source of financial distress.
Sources of Financial Distress:
A situation in which available cash is insufficient to pay supplier, vendors, employees, banks and creditors is
known as financial distress. Signs of first-stage distress include negative net cash flow and earnings and a
falling market equity value. If this situation persists, then management must take actions to rectify it. The
second-stage signs of distress include managements' attempt to reduce costs, such as employee lay off and
plant closing.
If this situation goes on, the firm enters the third and final stage of distress marked by delayed and small
payments to creditors and vendors, employees and others. This may also include of sale of assets, issuing
loan stocks and rescheduling payment with creditors and banks. If these actions do not alleviate the
financial sufferings and the firm is likely to embrace the bankruptcy ­ the eventual result of financial
A firm incurs several costs when its financial position deteriorates, even if the firm does not declare
bankruptcy. These are called costs of financial distress. Bankruptcy involves additional fatal costs. As a
general definition, any loss of value that can be attributed to a firm's financial strength is a cost of financial
distress. These can be classified into three categories:
- In terms of favours to stakeholders to off set them for the risk of doing business with financially sick firm
- Loss of competitive edge in product market
- Loss of tax shield available
In the next hand out we shall cover the sources of financial distress in detail.
Table of Contents:
  4. Discounted Cash Flow, Effective Annual Interest Bond Valuation - introduction
  5. Features of Bond, Coupon Interest, Face value, Coupon rate, Duration or maturity date
  8. Capital Budgeting Definition and Process
  9. METHODS OF PROJECT EVALUATIONS, Net present value, Weighted Average Cost of Capital
  12. ADVANCE EVALUATION METHODS: Sensitivity analysis, Profitability analysis, Break even accounting, Break even - economic
  13. Economic Break Even, Operating Leverage, Capital Rationing, Hard & Soft Rationing, Single & Multi Period Rationing
  14. Single period, Multi-period capital rationing, Linear programming
  15. Risk and Uncertainty, Measuring risk, Variability of return–Historical Return, Variance of return, Standard Deviation
  16. Portfolio and Diversification, Portfolio and Variance, Risk–Systematic & Unsystematic, Beta – Measure of systematic risk, Aggressive & defensive stocks
  17. Security Market Line, Capital Asset Pricing Model – CAPM Calculating Over, Under valued stocks
  18. Cost of Capital & Capital Structure, Components of Capital, Cost of Equity, Estimating g or growth rate, Dividend growth model, Cost of Debt, Bonds, Cost of Preferred Stocks
  19. Venture Capital, Cost of Debt & Bond, Weighted average cost of debt, Tax and cost of debt, Cost of Loans & Leases, Overall cost of capital – WACC, WACC & Capital Budgeting
  20. When to use WACC, Pure Play, Capital Structure and Financial Leverage
  21. Home made leverage, Modigliani & Miller Model, How WACC remains constant, Business & Financial Risk, M & M model with taxes
  22. Problems associated with high gearing, Bankruptcy costs, Optimal capital structure, Dividend policy
  23. Dividend and value of firm, Dividend relevance, Residual dividend policy, Financial planning process and control
  24. Budgeting process, Purpose, functions of budgets, Cash budgets–Preparation & interpretation
  25. Cash flow statement Direct method Indirect method, Working capital management, Cash and operating cycle
  26. Working capital management, Risk, Profitability and Liquidity - Working capital policies, Conservative, Aggressive, Moderate
  27. Classification of working capital, Current Assets Financing – Hedging approach, Short term Vs long term financing
  28. Overtrading – Indications & remedies, Cash management, Motives for Cash holding, Cash flow problems and remedies, Investing surplus cash
  29. Miller-Orr Model of cash management, Inventory management, Inventory costs, Economic order quantity, Reorder level, Discounts and EOQ
  30. Inventory cost – Stock out cost, Economic Order Point, Just in time (JIT), Debtors Management, Credit Control Policy
  31. Cash discounts, Cost of discount, Shortening average collection period, Credit instrument, Analyzing credit policy, Revenue effect, Cost effect, Cost of debt o Probability of default
  32. Effects of discounts–Not effecting volume, Extension of credit, Factoring, Management of creditors, Mergers & Acquisitions
  33. Synergies, Types of mergers, Why mergers fail, Merger process, Acquisition consideration
  34. Acquisition Consideration, Valuation of shares
  35. Assets Based Share Valuations, Hybrid Valuation methods, Procedure for public, private takeover
  36. Corporate Restructuring, Divestment, Purpose of divestment, Buyouts, Types of buyouts, Financial distress
  37. Sources of financial distress, Effects of financial distress, Reorganization
  38. Currency Risks, Transaction exposure, Translation exposure, Economic exposure
  39. Future payment situation – hedging, Currency futures – features, CF – future payment in FCY
  40. CF–future receipt in FCY, Forward contract vs. currency futures, Interest rate risk, Hedging against interest rate, Forward rate agreements, Decision rule
  41. Interest rate future, Prices in futures, Hedging–short term interest rate (STIR), Scenario–Borrowing in ST and risk of rising interest, Scenario–deposit and risk of lowering interest rates on deposits, Options and Swaps, Features of opti
  43. Calculating financial benefit–Interest rate Option, Interest rate caps and floor, Swaps, Interest rate swaps, Currency swaps
  44. Exchange rate determination, Purchasing power parity theory, PPP model, International fisher effect, Exchange rate system, Fixed, Floating
  45. FOREIGN INVESTMENT: Motives, International operations, Export, Branch, Subsidiary, Joint venture, Licensing agreements, Political risk