CH-20-23 Short-Term Financial Planning – Fundamentals of Corporate Finance : Chapter Notes

This Document Contains Chapters 20 to 23 CHAPTER 20 SHORT-TERM FINANCIAL PLANNING CHAPTER IN PERSPECTIVE The early part of the text is focused on the value creating aspects of business; capital budgeting (investment), long-term financing decisions such as debt policy, and dividend policy. While long-term value building is not generally associated with the details of working capital management or short-term financial planning, poor short-term decisions may negatively impact firm value. Working capital inefficiencies, lack of liquidity, and policies adversely affecting customer relationships can have severe impact on firm value. This chapter opens with showing the connections between short-term and long-term financing. Presented with a seasonal variation in asset needs or a long-term trend, how should working capital (current assets) be financed? Short-term financing rates average well below long-term, but must be rolled over frequently if one is financing permanent working capital needs. Long-term financing costs more but fewer trips to the market are necessary. Three alternative financing strategies are discussed. The second section presents a general discussion of working capital, the net working capital concept, followed by the flow concept of the working capital, operating cycle and cash conversion cycle. The time line is used to discuss these concepts. (See General Teaching Note at the end of this file) The third section of the chapter is directed toward short-term planning using the sources and uses of cash and cash budget formats. Note the assumption of proportional cash flows/day in the cash budget. A shorter time period, such as weekly or daily, may be necessary for greater precision. The fourth section explores the working capital financing alternatives available. Bank and finance company negotiated loans and direct financial market financing via commercial paper are the alternatives discussed. Finally, interest computational formats are discussed. Distinguish between simple interest paid each period and compound interest costs incurred if interest is not paid each period (usually monthly). The effective rate is the same as the simple interest rate for interest paid each period. The effective rate increases with the length of interest payment deferral, is higher for discounted loans, and compensating balance requirements that increase the amount of deposit balances. 20-1 This Document Contains Chapters 20 to 23 CHAPTER OUTLINE 20.1 LINKS BETWEEN LONG-TERM AND SHORT-TERM FINANCING 20.2 WORKING CAPITAL The Components of Working Capital Net Working Capital, Operating Cycle and the Cash Conversion Cycle The Working Capital Trade-Off 20.3 TRACING CHANGES IN CASH AND WORKING CAPITAL 20.4 CASH BUDGETING Forecast Sources of Cash Forecast Uses of Cash The Cash Balance 20.5 A SHORT-TERM FINANCING PLAN Dynamic Mattress’s Financing Plan Evaluating the Plan 20.6 SOURCES OF SHORT-TERM FINANCING Bank Loans Secured Loans Commercial Paper Banker’s Acceptance 20.7 THE COST OF BANK LOANS Simple Interest 20-2 Discount Interest Interest with Compensating Balances 20.8 SUMMARY TOPIC OUTLINE, KEY LECTURE CONCEPTS, AND TERMS 20.1 LINKS BETWEEN LONG-TERM AND SHORT-TERM FINANCING A. The cost of total assets in the firm is called the total capital requirement. The total capital requirements change over time, increasingly steadily in a growing company, varying seasonally as in lawn and garden stores, and decreasing as a firm is slowly liquidated. See Figure 20.1. B. The financial manager has a choice of financing the total capital requirement with debt or equity (discussed earlier) or short-term or long-term financing. Three variations of short-term/long-term financing are studied here. There is a risk/return tradeoff between the extremes. See Figure 20.2a, 20.2b and 20.2c. C. The “relaxed strategy” is a conservative, mostly long-term financing with few payoff requirements in the short run. This strategy has considerable cash assets at times and emphasizes liquidity. The current ratio and level of net working capital would be very high, but the return on assets will likely be lower, because this strategy favours liquidity over profitability. 20-3 D. The “middle-of-the-road” policy recognizes that a certain minimum level of current asset investment is always present or is permanent. Using the matching policy, the firm would finance the permanent portion of current asset investment with long-term financing and the short-term current asset needs with short-term financing. There are times in the seasonal cycle when the firm will borrow short- term, and there are times when idle funds will be invested in marketable securities waiting for the next seasonal cycle. In this case the firm will use the liquidity from both marketable securities and short-term financing. E. The “restrictive strategy” uses the matched maturity approach and finances long- term assets with long-term financing and short-term assets with short-term financing. At times there will be a high level of short-term financing providing funds for a seasonal increase in inventory and accounts receivable. The current ratio will fluctuate considerably with the seasonal fluctuation in current assets and current liabilities, as will profitability as interest financing rates move up and down. This strategy is more profitability focused, but also more risky. Short-term financing may not always be affordable or available. 20-4 20.2 WORKING CAPITAL The Components of Working Capital A. Short-term circulating current assets, invested to support long-term fixed assets, and current liabilities are called working capital. B. Current assets, composed of cash accounts, marketable securities, accounts receivable, and inventories represent an important level of asset investment for business that must be financed. See Table 20.1. C. There are advantages of having plenty of current assets, such as having plenty of ready cash, promoting sales with generous credit terms (accounts receivable), and large amounts of inventories. D. There are disadvantages of having too much invested in working capital. The profitability of assets is lowered if too much cash assets are idle, too generous credit terms may bring losses, and inventory investments are unable to earn their opportunity rates of return. 20-5 E. Current liabilities are short-term obligations to pay suppliers (accounts payable), employees and borrowed funds (accrued expenses), and short-term lenders such as commercial banks. Net Working Capital, Operating Cycle, and the Cash Conversion Cycle A. The difference between current assets and current liabilities is called net working capital (NWC). The term NWC is often used interchangeably with working capital discussed above. NWC is the extent that the circulating current asset pool exceeds the current liabilities and is often thought of as the net liquidity of the business. See Figure 20.3. 20-6 Figure 20.3 B. NWC is also the extent to which current assets are financed by long-term, non- current liabilities, sources of financing. C. Working capital needs fluctuate with changes in sales, changes in credit policies, changes in production techniques, types of products produced, desired finished goods stocks, the credit terms of suppliers, the pay periods of employees, and many other variables which are related to business policies, the type of the business, and the external operating environment. D. Four key dates in the production cycle affect the level of investment in working capital. The longer the periods, the larger the investment. See Figure 20.4. 20-7 E. The first time period is the accounts payable period, the length of time the firm has between purchasing materials and the payment date for the materials. The longer the period, the larger the accounts payable balance and the shorter the cash conversion cycle. F. The second key period is the inventory period, the time between the purchase of raw materials and the sale of the finished goods. The longer the time period, the greater the investment in inventory. G. The third key period is the accounts receivable period, the time period from the sale of the goods (on credit) to when cash is collected from the customer. Again, the longer the period, the larger the investment is in accounts receivable. The sum of the inventory period and the accounts receivable period is the operating cycle, the period of time between the purchase of raw materials and the collection of cash from the sale of finished goods. Operating cycle = inventory period + receivables period H. The fourth key period is the cash conversion cycle or the time between the payment for raw materials and the collection of cash from the customer. Note that the accounts payable period, or the credit offered by suppliers, provides some financing for the working capital cycle, but the longer the cash conversion cycle, the larger the investment in working capital. Cash conversion cycle = (inventory period + receivables period - accounts payable period) I. The length of the inventory period is the average inventory divided by the daily cost of sales (COGS/365). The accounts receivable period is the average accounts receivable divided by average daily sales (sales/365). The accounts payable period is the average accounts payable divided by the daily cost of goods sold or purchases (COGS/365). The Working Capital Trade-Off A. The cash conversion cycle is influenced by management policies, such as credit policy, levels of inventory, and credit policies of suppliers. B. The higher the level of working capital, the greater the carrying costs or the costs of maintaining current assets, including the opportunity cost of capital to finance the current assets. C. The lower the level of working capital, the greater the shortage costs or the costs incurred from shortages in current assets, such as inventory stock outs and lost sales from a restrictive credit policy. 20-8 D. The financial manager must attempt to minimize the total opposing carrying and shortage costs. 20.3 TRACING CHANGES IN CASH AND WORKING CAPITAL A. Comparing two balance sheets (points in time) enables the financial manager to see the changes or flows that occurred in the period between the two balance sheets. B. The sources and uses of cash statement (Table 20.5) are constructed by first noting the change in each of the balance sheet accounts (Table 20.3) and several items from the income statement (Table 20.2). C. Sources of funds are indicated by the cash flows from operations, decreases in assets, and increases in liability and equity accounts. D. Uses of funds are indicated by the increases in assets and decreases in liabilities and equity, including dividends paid. 20.4 CASH BUDGETING A. The cash budget estimates sources and uses of funds in future periods and provides information related to future cash needs and a plan for future cash flows. Forecast Sources of Cash A. A sales forecast is the primary independent variable behind a cash budget. B. Cash inflows are derived primarily from the collections of accounts receivable which are related to the credit terms, the payment practices of customers, the collection efforts of the firms, and the level of credit sales. An estimate of the collections and the extent to which these lag behind sales is an important estimate. See Table 20.6, Panel A. C. Other cash inflows are added to each period considered which could be weekly, monthly, or here, quarterly. 20-9 Quarter First Second Third Fourth 1. Receivables at start of period $30 $32.5 $30.7 $38.2 2. Sales 87.5 78.5 116.0 131.0 3. Collections Sales in current period (80%) 70.0 62.8 92.8 104.8 Sales in last period (20%) 15.0a 17.5 15.7 23.2 Total Collections $85.0 $80.3 $108.5 $128.0 4. Receivables at end of period (Row 4 = Rows 1+ 2 - 3) $32.5 $30.7 $38.2 $41.2 a Sales in the fourth quarter of the previous year were $75 million. Forecast Uses of Cash A. Cash outflow estimates in the coming periods include payments of accounts payable, labour and administrative costs and other expenses, capital expenditures, taxes, interest, principal payments on loans, and dividends. See Table 20.6, Panel B. B. Delaying payment or stretching payable offers the benefit of saving cash but the cost of discounts missed and possible termination of the supplier relationship. The Cash Balance A. The cash budget is usually comprised of a starting cash position in each period, followed by the net cash flow in the period giving the cash at the end of the period. B. A minimum cash balance is assumed and a cumulative cash surplus or shortage (borrowing needed) balance is estimated. The changes in the cumulative account are caused by the net cash flow in each period adjusted for borrowing and lending. See Table 20.6, Panel C. Cash at start of period $5 -$40 -$55 -$29 Net cash inflow (from Row 24) -45 -15 +26 +35 Cash at end of periodb -40 -55 -29 +6 Minimum operating cash balance 5 5 5 5 Cumulative short-term financing required(minimum cash balance minus cash at the end of the peroid)c $45 $60 $34 -$1 b Of course firms cannot literally hold a negative amount of cash. This line shows the amount of cash the firm will have to raise to pay its bills. c A negative sign indicates that no short-term financing is required. Instead the firm has a cash surplus. 20-10 20.5 A SHORT-TERM FINANCING PLAN Dynamic Mattress’s Financing Plan A. The options for short-term financing include trade credit (trade payables), accruals (delay in the receipt of services such as labour before payment), and negotiated, short-term borrowing. B. Stretching payables is costly if discounts are missed, but must be compared with taking the discounts and financing the early payments at the bank. Evaluating the Plan A. Short-term financing plans must be developed by trial and error. A financial manager must lay out one plan, think about it, then try again with different assumptions on financing and investment alternatives until no further improvements are possible. 20.6 SOURCES OF SHORT-TERM FINANCING Bank Loans A. A business interested in bank financing should establish a line of credit with the bank, an agreement by a bank that a company may borrow at any time up to an established limit. B. A revolving credit arrangement is a line of credit that establishes, for a fee to the bank, a level of credit that the business may borrow at any time during the period. The fee that is paid for ensuring the availability of the revolving line of credit is called a commitment fee. Secured Loans A. Current assets such as inventory and accounts receivable are often used as security for business loans. B. Accounts receivable may be pledged or assigned as security for a loan or sold or factored to shorten the cash conversion cycle. C. Standardized, identifiable inventory, such as autos, make excellent collateral for loans, whereas perishable low value items are less likely to serve as security for a loan. 20-11 D. A lender must establish some control over inventory pledged for a loan. The lender may have a general lien on inventory, hold title as with autos, store in a warehouse away from the business, or set certain inventory items aside in a field warehouse to limit access by the borrower. Commercial Paper A. A larger business with a high quality credit rating may issue short-term, unsecured notes, called commercial paper, in financial markets. B. The credit quality of commercial paper is enhanced by backup lines of credit from commercial banks, which would provide loans to the borrowing business to pay- off the commercial paper if credit problems arose and new commercial paper could not be sold to the market. C. In Canada, commercial paper can sometimes have a maturity of a year, although corporations mostly issue these instruments for periods of 1, 2 or 3 months. Banker’s Acceptance A. This instrument is created when a time draft (which is much like a post-dated cheque) is submitted by a firm to the bank for acceptance. When the bank stamps “accepted” on the draft it becomes a banker’s acceptance and represents an unconditional promise of the bank to pay the amount stated on the draft when it matures. B. As such, a banker’s acceptance becomes the bank’s IOU and can be sold to portfolio investors, such as money market funds, pension funds and banks, in the acceptance market. We shall revisit this topic in Chapter 22. 20.7 THE COST OF BANK LOANS Simple Interest A. Simple interest (interest paid each period) loans are calculated as principal times periodic rate (annual rate/# of rate periods per year) times time (length of time in interest period). B. Deferring monthly interest payments owed compounds the cost and increases the effective cost of financing. Discount Interest A. Discounting interest (deducting interest when the loan is made) increases the effective cost of financing. 20-12 B. Discounting reduces the amount of available funds. Interest with Compensating Balances A. Compensating balance requirements, to the extent that they require more deposit balances, increases the effective cost of funds. In Canada, banks cannot demand customers to maintain compensating balances. However, a Canadian company with an account at a US bank, physically located in the US, may be required to maintain a compensating balance. B. For a given amount of borrowing, compensating balances reduce the amount of available funds. C. Compensating balances, because they force the business to borrow more or use less of the loan, may increase the effective cost of the loan. D. The effective cost of a loan is the total charges paid annualized, divided by the amount of borrowed funds available to the business. In general terms, this is: Effective interest rate = actual interest paid on compensating balance borrowed funds available The formula for the effective annual rate on a loan with compensating balances is provided in page 662 of the book. 20.8 SUMMARY PEDAGOGICAL IDEAS General Teaching Note—As noted earlier, students come to this course with an accounting perspective of a business as a balance sheet. While the balance sheet is a reasonable perspective at a point in time, the business manager manages the “flow,” investing, borrowing, paying bills, making working capital policy decisions affecting the working capital and cash conversion cycle—flow cycles. These time line perspectives help students conceptualize the “flow” aspect of business, but we should frequently refer to one of their strong perspectives, the balance sheet. Walk through the working capital or cash conversion cycle, noting the impact on balance sheet accounts. The balance sheet is a vertical plane through the time line at any time. Later, when the cash budget is formulated, note the changes/levels on the balance sheet, the students’ conceptual reference point. Student Career Planning—It is interviewing time on campus. Students get cleaned up, a hair cut, and “the” suit shows up in class, usually with wet armpits. Why all the anxiety? 20-13 And think of all that energy waiting for the interview! Suggest to students that they turn that energy into an interview plan. An interview is dialogue. Students should plan their interview by thinking of, and discussing with a few peers, a variety of future dialogues or topics. Thinking through the topics, and better, talking through the topics alone in the car or shower, lets the student know “what they are all about.” Below is a list of common questions asked in interviews. Make them a copy and be the “professor of the day.” They will likely ask you for the answers, but they have the answers. Next time someone is “sweating” an interview, hand them these questions and tell them to work off their nervous energy. Questions Frequently Asked during Employment Interviews 1. What are your future career plans? 2. In what college activities have you participated? Why? Which did you enjoy the most? Why? 3. How do you spend your spare time? What are your hobbies? 4. Describe your ideal job with us in one year. 5. Why do you think you might like to work for our company? 6. What jobs have you held? How were they obtained and why did you leave? 7. What college courses did you like the best? Least? Why? 8. Why did you choose your major and this career area? 9. What do you know about our company? 10. What qualifications do you have that make you feel that you will be successful in your field? 11. If you were starting college all over again, what courses would you take? 12. Do you prefer any specific geographic location? Why? 13. How much money do you hope to earn at age thirty? Forty? 14. How did you rank in your high school graduating class? Estimate of your rank in your college class? 15. What do you think determines a person’s progress in a good company? 20-14 16. What personal characteristics are necessary for success in your chosen field? 17. Why do you think you would like this particular type of job? 18. What have you learned from some of the jobs you have held? 19. Can you get recommendations from previous employers? 20. What interests you about our product or service? 21. How did you happen to go to college? 22. What do you know about opportunities in the field in which you are trained? 23. What size city do you prefer? 24. Define cooperation? 25. Are you willing to go where the company sends you? 26. What job in our company would you choose if you were entirely free to do so? 27. Have you plans for graduate school? 28. What jobs have you enjoyed the most? Least? Why? 29. What are your own special abilities? 30. What job in our company do you want to work for? 31. What about overtime work? 32. Do you think that grades should be considered by employers? Why or why not? 33. Are you interested in research? 34. What salary level is right for you? Internet Exercises - There are several comprehensive sites, and a business student could 20-15 spend weeks linking and researching various topics. Three favorites are the Financial Post’s databases, CEO Express and Investmove.com. We described the Financial Post database in Chapter 1. The second is a “portal” for the businessperson/student, linking to almost every dimension of business. The third, Investmove.com, is best known for its “lists” of top-ten investment-related sites. Yahoo Finance is another that we recommend to students as a starter site when they are faced with a research question. The comprehensive nature of these sites will impress your students and provide them with a valuable bookmark for future projects. http://www.fpinfomart.ca/ The Financial Post database is also an excellent source of researching Canadian companies. Universities often have access to the database through licensing arrangements. Without the licensing many of the databases are not accessible. The database includes separate reference sources, such as Company Snapshots, Dividends, Investor Reports, and Corporate Analyzer. The Dividends databases offer detailed financial information on a large number of publicly traded Canadian companies; the Investor Reports database provides access to historical, investor and industry reports of leading Canadian companies; while the Analyzer database allows the user to retrieve and analyze data. http://www.ceoexpress.com The CEO Express is a comprehensive site for the business executive and for those aspiring to be businesspersons, our students. One is challenged to find a website with as many links to various sources of information. The themes on the this site include “Daily News & Info”, “Business Research”, “Office Tools & Travel” and “Breaktime”. From the major daily newspapers around the world, business and breaking news, business and other magazines, search engines, financial markets, SEC, government agencies, business and economic statistics, investor services, company research, legislative process, law, and more students can learn what is going on the in world. Using the “Office Tools & Travel” and “Breaktime” sites they can find out some the issues that CEOs deal with. This site is also a place to start for any business student who is building a home page or a bookmark file. 20-16 CHAPTER 21 CASH AND INVENTORY MANAGEMENT CHAPTER IN PERSPECTIVE This is the first chapter of a two-part section entitled “Short-Term Financial Decisions.” Cash and inventory investment considerations are discussed here; accounts receivables are covered in the next chapter. The level of cash and inventories are investment decisions that are approached in similar ways. Financial managers are seeking returns on added investment that exceed the opportunity cost of capital. There could be myriad reasons for firms wanting to hold cash balances, but we can categorize the main ones as follows: A. Meet Transactions Needs B. Hedge against uncertain future C. Speculative reason D. Compensating balance requirement. The optimal cash level provides liquidity and operational support. Too little cash and securities selling or borrowing costs are incurred. Too much cash in the bank or in the mail and profitability ratios (ROA) are adversely affected. Inventory levels, whether related to raw material, work in progress, or finished goods are approached in the same way. Too little and stock outs (opportunity cost of lost margins) and production down- time increases. Too much and efficiency is hindered. The opposing cost decision models discussed here are similar for cash and inventory. The optimal point is that level that minimizes the sum of the two opposing costs. Working capital balances have a tendency to increase quickly to control limits. Sales managers want ready inventory and generous credit, production managers want to avoid down-time. As the cash cycle time increases, so does the level of investment and the eventual conflict between the financial/credit manager and production and sales. The “flow” concepts developed in the last chapter related to working capital management are extended here. The business is a constant flow of values and managers must work to shorten and reduce the time line (reduce the level) needed to serve the capital assets. 21-1 CHAPTER OUTLINE 21.1 CASH COLLECTION, DISBURSEMENT, AND FLOAT Float Valuing Float 21.2 THE PAYMENT SYSTEM AND THE FLOAT 21.3 MANAGING FLOAT Speeding Up Collections Controlling Disbursements Electronic Funds Transfer 21.4 MANAGING INVENTORIES AND CASH BALANCES Inventory Management Models Just-in-Time Inventory Management Managing Inventories of Cash Uncertain Cash Flows Cash Management in Large and International Corporations 21.5 INVESTING IDLE CASH: THE MONEY MARKET 21.6 SUMMARY CHAPTER OUTLINE, KEY LECTURE CONCEPTS, AND TERMS 21.1 CASH COLLECTION, DISBURSEMENT, AND FLOAT A. Businesses keep their cash in the form of bank deposits and pay and receive funds via cheques and other forms of value transfer. B. Because cheques must be physically presented to the bank for payment, there are 21-2 lags or delays in the movement of cheques through a business, through the mail, and through the bank clearing system. Float A. The lag or delay in the cheque delivery and clearing system is called float. B. When a company has written a cheque on its bank account and mailed the payment, it deducts the balance from its chequing ledger. Payment float is the time lag between the time the cheque was sent to when it is presented against (debited) the chequing account. The bank account balance (recorded by the bank) is the sum of the business’ ledger balance plus the float, or the float is the difference between the bank’s balance and the cheque book’s balance. C. When cheques are deposited, the funds are often not immediately available. This lag or time delay is called availability float. The bank delays the availability because its funds availability is delayed when it sends the cheque to the Bank of Canada or the Canadian Payments Association’s member financial institutions for clearing. The company’s bank balance is the sum of what is available plus what is deferred for a time (availability float). See the figure below: D. The net float for a business is the payment float less the availability float or the funds the firm has paid but has not cleared less the funds due the business but is deferred by the bank. Valuing Float A. Float has a value because of the opportunity cost of funds. Money due the firm cannot be invested until “available,” and cheques sent to suppliers but still “floating” may be used or invested until the cheque is presented at the bank. B. Payment float results from the delay between writing a cheque and the reduction in the chequing account. The level of payment float is related to the size of the average cheque and the length (days) of the float. The payment float is the product of the average daily cheques written times the number of days float. The benefit of the payment float to the business is the total float times the opportunity rate of return for the period. The availability float is a cost to the receiving firm and the cost is the total float (average deposits delayed times the number of days delayed) times the opportunity rate of return. A business may have a net payment or net availability float. C. Reducing the float provides (availability float) or reduces (payment float) the net float saving (costing) the business a one time amount of funds available or lost for investment. The present value of a permanent reduction in net availability float is the amount by which the float is reduced. 21-3 21.2 PAYMENT SYSTEM AND THE FLOAT A. Canada’s payments system includes the set of rules and procedures which guide the clearing, exchange and mechanism for settling different types of payments. The system is run by the Canadian Payments Association, a non-profit organization which was created by an Act of Parliament in 1980. Its members are deposit-taking institutions which offer chequing privileges such as banks, trust companies, credit unions, and caisses populaires. B. The Bank of Canada and the Canadian Payments Association (CPA) are responsible for clearing cheques and other types of payment. The CPA owns and operates two major payment systems in Canada, the Automated Clearing Settlement System (ACSS) and the Large Value Transfer System (LVTS). The ACSS is the system by which cheques and certain types of automated payments (such as direct deposits) are cleared and settled. LVTS is an electronic wire transfer system which can be used by Canadian companies for their domestic and international payments. C. There are essentially three steps in the process of clearing and settlement of payments. Step 1: PAYMENT by cheque, debit card, direct deposit or other means. Step 2: CLEARING, or the daily process by which CPA members exchange deposited payment items, and then determine the net amounts owed to each other. Step 3: SETTLEMENT, or the procedure by which CPA members use funds on deposit at the Bank of Canada to meet their net payment obligations to other member institutions. D. Canadians usually receive immediate credit for the cheques they deposit, even if they do so at another branch of their financial institution or on the other side of the country. The same-day settlement on cheques keeps transit float to a minimum. In contrast, in the United States a cheque may be placed on hold until it has been verified that the person who wrote it has the funds in their account. In the United Kingdom, it could take an average of 4 days for a cheque to clear. 21.3 MANAGING FLOAT A. Several kinds of delays or float can occur in the cheque payment system: mail, processing, and clearing. B. The sum of the three floats above is associated with receiving a payment: the mailing time, the company processing time to get the cheque to the bank and the clearing (availability) delays of the banking system. We saw earlier while discussing Canada’s Payments System, that Canadians often receive immediate credit for the cheques they deposit and so this type of float is not significant here. However, this may be important if 21-4 you are doing business in other countries such as the United States or the United Kingdom where the delay could be longer. C. Efforts to speed up collections are usually countered by efforts by payers to delay disbursements. Speeding Up Collections A. A lock-box system directs the customer to make payments to a post office box, the bank picks up the mail, quickly processes the cheque into the clearing system, and the customer posting is finished last. B. A lock box-system reduces float, increases funds available for investment which may now earn a rate of return, but is profitable only if the annual added rate of return exceeds the annual cost of the lock-box. Controlling Disbursements A. Controlling disbursements is a process for lengthening the payment float or time it takes a mailed cheque to a supplier to reach the payer’s bank. B. Remote disbursement, or mailing cheques from a location distant from the supplier lengthens the mail float portion of the payment float. In the United States, the clearing float may be lengthened by writing cheques on banks in remote geographic areas far away from Federal Reserve Banks or larger clearing banks. C. A zero-balance account, or account in which a paying business keeps only the daily amount of cheques presented, may be a part of the remote disbursement system. Electronic Funds Transfer A. Technologies help to speed up money transfer too. Electronic funds transfer (EFT) systems now exceed amounts paid by paper cheques. Combined with Electronic Data Interchange (EDI), a system allowing companies to exchange financial information such as purchase orders, shipping notices and invoices, the process of billing and collecting payments has been substantially shortened, reducing the need for float. B. Advantages of electronic funds transfer to business include the ability to outsource many record keeping functions at a low per transaction cost and significant reductions in float. 21-5 21.4 MANAGING INVENTORIES AND CASH BALANCES A. Cash and inventory are similar in that to have them costs money and to not have enough also costs money. Excess working capital reduces the return on assets; too little working capital loses sales, slows production, and could result in lack of liquidity. The same analytical techniques used to assess the “right” balance that minimizes the total cost may be used with both inventory and cash management. B. Cash management is a trade-off of having too little cash and possibly incurring cost of selling interest-bearing securities, paying commissions, and taking losses, to having too much cash in an idle, non-earning or low earning account. C. Inventory management has similar tradeoffs. Too little inventory minimizes carrying costs but customer service and missed sales hurt the business. Too much investment in inventory maximizes sales, but requires added capital and incurs carrying costs. Inventory Management Models A. Carrying costs increase as inventory investment increases; ordering costs decrease as fewer orders are made during a period of time. B. The economic order quantity is a cost minimization model which computes the EOQ which minimizes total inventory costs, the sum of carrying and ordering costs. The EOQ is the square root of the product of two times the total inventory used in a period (sales) times the cost per order divided by the carrying cost. Just-in-Time Inventory Management A. The concept of just-in-time approach is that finished goods should be produced just in time for delivery, and raw materials should be delivered just in time for production. When this occurs, inventories are reduced to the minimum level. Managing Inventories of Cash A. The Baumol model applies the EOQ model to cash management and determines the amount of securities to be sold at one time to replenish cash accounts. The business is assumed to have its cash resources in either non-earning cash (chequing account) or short-term securities. At an assumed rate of cash usage, an assumed interest rate on the securities, and a cost of selling the securities (note opposing costs of earning and selling), there is a level of securities one must sell each time to minimize the total costs of cash versus securities. B. The Baumol model calculates the optimum amount of securities to be sold as the square root of two times the annual cash disbursements times the cost per sale of securities divided by the earning interest rate on securities. The total costs of trading 21-6 securities versus the opportunity costs of having cash and not securities are minimized at the Q*. Uncertain Cash Flows A. The Baumol model assumes a certain, steady cash outflow without any random variations. The Miller-Orr model considers cash inflows and outflows with random, unpredictable changes. B. The Miller-Orr model establishes a permissible range of cash balances and actions (sell/buy securities) that only occur if an upper/lower balance is reached. The range between the upper and lower limits is established by three factors: daily variance of cash flows, cost of buying or selling securities, and the rate of interest on the securities. C. When the daily variation in cash flow is small, the cost of buying/selling low, or the interest rate high, the upper/lower limits should be narrow. With the variation low, it will seldom hit the limits. With the trading cost low, it will not cost much to buy (upper limit) or sell (lower limit). Finally, with interest rates high the cost of high cash balances encourages a narrow range. D. The return point (replenished cash level) in the Miller-Orr model is one-third of the range up from the lower limit (point where one would sell securities), making it more likely to hit the lower limit. E. The Miller-Orr model return point minimizes the sum of transaction costs and opportunity interest costs (money not made by being in cash). Cash Management in Large Domestic and International Corporations A. For large balances normally associated with large businesses, the cost of selling securities to replenish cash is a very low proportional cost, so the average cash balance should normally be quite low. B. Large firms do hold cash balances as compensating balances for banking services and, with many decentralized plants and divisions operating around the country, each with a bank account, the balances sum to a rather large amount. C. Efficient cash management implies that centralization of balances for efficient investment or allocation is necessary. D. For multinational corporations a centralized cash management system is not necessarily possible. A multinational corporation may have to establish a local concentration account with a bank in each country. E. To centralize the system, multinational corporations favour banks that have branches around the world. The development of global internet-based banking services 21-7 provided by banks is helping multinational corporations manage their cash. Using these services the corporation can easily do cash transfers between its various bank accounts around the world. 21.5 Investing Idle Cash: The Money Market A. When excess cash is present, securities are purchased. When funds are needed, securities are sold. The securities normally used for temporary investments are usually purchased in the money market where short-term, high quality, marketable securities are traded. B. When cash needs are known, securities of specific short-term maturity may be selected. If cash is needed, money market securities may be sold quickly, and because there is little price variability if market interest rates change, the cost of selling the securities is kept at a minimum. C. One choice of short-term, high quality investment is treasury bills. These are the most liquid of assets and are traded actively over-the-counter by banks and security dealers. Treasury bills are issued by the Canadian government with original maturities ranging from 1 month to a year. These securities are sold at weekly auctions. D. Another high quality investment choice is commercial paper, the short-term notes (maturities usually up to 365 days) issued by industrial and financial corporations. E. Asset-backed commercial paper (ABCP) is another type of commercial paper. ABCP is a short-term security issued by a finance company or a special limited purpose trust, where the cash flow for paying interest comes from pools of underlying assets such as mortgages and credit card receivables. E. Guaranteed Investment Certificates (GIC) are term deposits at Canadian banks. GICs is provides rates of return over fixed periods, between 6 months and a year. Most have fixed interest rates but some have variable interest rates. Unlike a demand deposits (chequing accounts) not all GICs can be withdrawn before the maturity date. If withdrawal is allowed a penalty is charged. In the US the equivalent of the GIC are certificates of deposits (CDs), short-term notes issued by commercial banks. F. Repurchase agreements (repos or buybacks), the purchase of securities under agreement to resell (at a higher price) are issued by banks when the chequing account of the business is higher than desired. The money stays in the bank and the business has a temporary earning investment. 21-8 21.5 SUMMARY PEDAGOGICAL IDEAS General Teaching Note - The cash cycle time line developed in the last chapter is easily extended to this chapter. The time line is extended to include the time a cheque is mailed for payment of goods to the time received, processed, deposited, and cleared extends the cash cycle. Money received now can be defined as usable balances in the bank. Just as in the last chapter, reducing mail, processing, and clearing float is a one-time added amount of funds investable at some rate of return or applied to debt outstanding. The decision focus is the incremental gain (return on investment) versus the incremental cost of reducing the float. Student Career Planning- Many of your students will soon be interviewing for that first entry-level job. While they will be asked many questions and should be prepared for such, they are often asked to ask questions in order to see the extent they have thought about this first job. Here is a list of ten good questions to ask the interviewer. The answers should provide information as to how challenging the job will be and how the student will develop over the first two to three years. Interviewee Questions 1. What are the goals and strategic plan of the business? 2. Who (background, etc.) are the people with whom I will be working? May I interview them? 3. When and why do you have to fill this position? Where is the person who last had the job? 4. Why are you not promoting internally? Or are there internal candidates for this job? 5. May I have a copy of the job description? What may be one of my first assignments? 6. Why do you think this job might be the right spot for me? 7. Do you have a performance appraisal system? How is it structured? How often will I be evaluated? 8. What is the potential for promotion? Where are other people (jobs, duties) who have worked in this position? 9. What type of training will I receive? Do you encourage continued formal education such as an MBA or other professional training? 21-9 10. What is the estimated value of the fringe benefit program? May I have a copy of the fringe benefit program manual to review? Internet Exercises - As this chapter covers cash management and investment in marketable securities, it is an opportune time to mention the vast Internet sources of information for business students from Scotiabank, the Bank of Canada and the Department of Finance, Government of Canada. In the United States, the site of the Federal Reserve Board is also worth a visit. http://www.scotiabank.com/ca/en/0,,1205,00.html This is the website of ScotiaGlobal Electronic Banking. ScotiaGlobal electronic banking is an internet-based banking platform providing a single point of access to Scotiabank accounts in Canada, the U.S.A. and Mexico. With ScotiaGlobal, you can monitor and control your cash position and manage your cross-border operations with convenience from one centralized location. You can have students explore the wide variety of services provided by ScotiaBank. http://www.bankofcanada.ca/ The Bank of Canada website is truly informative. In addition to regular updates on key market indicators, monetary variables, exchange rates, etc, the site provides detailed information on the central bank’s activities. You can also access information on bonds and other securities, currency, financial markets, monetary policy, payments systems, in addition to a useful database of research and publications. The section on rates and statistics is also very useful. http://www.federalreserve.gov/ The Board of Governors of the Federal Reserve System, based in Washington, D.C., has an excellent Internet site, providing students with information about the processes of monetary policy, banking and financial research reports for individual research, consumer information related to leasing and consumer credit, a number of very informative publications available online, and the recent press releases related to the chairman, currently Ben S. Bernanke. Under the Monetary policy page and click on “Reports” students can access the current economic conditions of the twelve districts from the Beige Book. Also review the latest available minutes of the Federal Open Market Committee (FOMC) meetings (the primary monetary policy determining body), and review the calendar of future FOMC meetings. Under the Economic Research and Data link, students can find the current and past interest rate levels of the money market securities studied in the chapter. The H.15 (weekly) and G.13 (monthly) Selected Interest Rates tables list the weekly rates for all the money market securities and U.S. Treasury bill, notes, and bond rates. The Consumer Information section provides guidance for becoming a more “proactive” consumer in relations with banks and credit-granting 21-10 financial institutions, in selecting credit cards, and in leasing autos. 21-11 CHAPTER 22 CREDIT MANAGEMENT AND COLLECTION CHAPTER IN PERSPECTIVE In this second chapter two-part section entitled “Short-Term Financial Decisions.” In this chapter credit management is the focal point. Trade receivables represent a significant investment for business. Why give credit? Credit is a competitive necessity, and combined with the product or service, is a major factor influencing sales. Like investment in capital assets, working capital investments should, at the margin, provide returns in excess of the firm’s minimum required rate of return. This investment level is affected by who receives credit, the level of sales, the terms of sales, and the paying practices and/or collection efforts of the firm. This chapter provides most nonfinance students with their first and only look at credit management concepts. While most students will not work in the specific area of credit management, almost all involved at some point in their careers in businesses with credit operations. While working capital does not seem to have the “value impact” of other aspects of financial management, a significant aspect of this chapter is the credit management concepts orientation for future business people. CHAPTER OUTLINE 22.1 TERMS OF SALE 22.2 CREDIT AGREEMENTS 22.3 CREDIT ANALYSIS Financial Ratio Analysis Numerical Credit Scoring When to Stop Looking for Clues 22.4 THE CREDIT DECISION Credit Decisions with Repeat Orders 22-1 Evaluating a Credit Policy Switch Some General Principles 22.5 COLLECTION POLICY 22.6 SUMMARY TOPIC OUTLINE, KEY LECTURE CONCEPTS, AND TERMS 22.1 TERMS OF SALE A. Credit terms of sale vary between industries and are directly related to the credit rating of the customer, the size of the account, the durability of the product and the length of time it takes the customer to sell the product. B. Credit terms range from cash before delivery (CBD), cash on delivery (COD), as well as net terms without trade discounts and with trade discounts for early, or timely, payments. End of the month (EOM) billing and terms is common with continuous purchase/shipment activity. C. Trade credit terms of 2/10, net 30 allow a 2 percent discount if paid within ten days of the invoice, with the net due in thirty days. D. The effective annual cost of passing the discount on the tenth day and paying twenty days later (30 days after the purchase): 1 discounted price Effective annual rate 1 discount extra days credit 365  −      = + In the above example, if the discount is passed on the tenth for the added twenty days, the effective rate is: = [1 + .02/(1 - .02)] 365/20 -1 = .446, 44.6% E. The cost of discounts missed is usually much higher than commercial bank lending rates. Business should, if needed, borrow on the tenth, pay the discount, and lower their costs of discounts missed. F. High effective rates for discounts missed penalize firms that stretch their accounts payable. 22-2 22.2 CREDIT AGREEMENTS A. Credit agreements between supplier and customer vary from very informal to formal IOU’s. B. An open account is a trade credit agreement without any formal debt contract. A promissory note formalizes the obligation, as does an accepted commercial draft called a trade acceptance, which is an acknowledgment of payments due on receipt of goods (sight draft) or later (time draft). If the customer’s bank accepts the customer’s obligation as their own, the trade acceptance becomes a banker’s acceptance. C. A conditional sales agreement maintains title to goods until payment is made. 22.3 CREDIT ANALYSIS A. The procedure to determine if the customer is likely to pay for goods shipped or services rendered is called credit analysis. B. Prior payment practices, high ratings from credit analysis firms such as Dun & Bradstreet, rating agencies such as Moody’s, and credit bureaus help discriminate payers from nonpayers. Financial Ratio Analysis A. A supplier providing trade credit may assess the ability and willingness to pay by performing their own financial analyses with their customers’ financial data. B. With reference to Chapter 4, the liquidity, debt capacity and long-term profitability of a customer is assessed. Numerical Credit Scoring A. The scope of a financial analysis includes an assessment of the customer with regard to the “five Cs of credit”: character, capacity to pay, capital, collateral, and conditions. B. Numerical credit scoring models are developed and used to discriminate between characteristics of those who pay as agreed and those customers who do not. C. The credit scoring model is an effective screening device for low-risk and high- risk customers, with the latter undergoing substantial credit analysis. 22-3 D. Considerable research effort, including classic research by E. I. Altman and the Z score has been devoted to this area. When to Stop Looking for Clues A. Credit analysis costs money and there are two general rules as to when to stop. B. The two rules are (1) do not undertake a full credit analysis unless the order is large enough to justify it, and (2) undertake a full credit analysis for the doubtful or higher risk customers only. 22.4 THE CREDIT DECISION A. Credit policy establishes standards determining the amount and type of credit terms to extend to customers. B. Credit should be extended if the expected profit from the credit sale is greater than the expected profit from refusing credit. If paid as agreed, the profit margin will be realized on the sale; if payment is not received, the firm loses the cost of sales. Refusing credit makes no profit. See Figure 22.1. Figure 22.1 Credit Decisions with Repeat Orders A. The chances of repeat orders and future profits from a credit customer increase the expected value of granting credit and encourage credit extension. Some General Principles A. The job of the credit manager is to maximize profits, not minimize losses. Tight Refuse credit Offer credit Payoff = Rev - Cost Payoff = - Cost Payoff = Rev - Cost Payoff = - Cost Customer pays = p Customer defaults = 1-p Payoff = 0 Customer pays = p Customer defaults = 1-p Payoff = 0 22-4 credit terms turn away good repeat customers, so some losses are expected. B. Concentrate efforts on large order, high-risk accounts. C. Consider a new account as a possible long-term customer. Offer small amounts of credit to high-risk customers until a good payment record is established. 22.5 COLLECTION POLICY A. Slow payers impose two costs on a business: collection expenses and a greater investment in working capital, specifically accounts receivable. B. The investment in accounts receivable is the product of the average daily sales times the average collection period. As the collection period is extended by slow payers or no payers, the investment increases and required opportunity cost of capital is incurred. C. Collections policy includes the procedures to collect and monitor receivable. D. An aging schedule classifies accounts receivable by the length of time they are outstanding. See Table 22.1. E. Collections efforts range from friendly reminders to collection agency and court actions. F. There is always a conflict of interest between the sales department, which desires generous credit terms, and the collections department which “reminds” good customer and deadbeats of their payment practices or the financial manager who must control the level of accounts receivable investment in order to maximize value. 22.6 SUMMARY 22-5 PEDAGOGICAL IDEAS General Teaching Note - The concept related to the cost of discounts missed was covered in your students’ accounting courses when they accounted for an expense called purchased discounts missed. This usually high effective rate is often difficult for students to grasp, but a numerical example may help. For an invoice of $100,000 with terms of 3/10, net 30 (like the text example), if the discount is not taken on the 10th day, $3000 is given up to finance $97,000 for 20 days. The effective rate of interest of 74.3% is calculated as $3000 for $97,000 raised to the 365/20 power or [1 + 3000/97,000] 365/20 - 1. Borrowing $97,000 for 20 days at 10% would cost $531.50 compared to $3000. Student Career Planning - All of us including our students are aware of the importance of nurturing a child through the first five years of life. Our students did not have any control over their first five years of life, but they, and no one else, are in charge and are responsible for the next important five-year block that follows college. Their college years were well structured and most were well prepared for college. While their college years tuned their work ethic, habits, sociability, and maybe maturity, most colleges do very little for the next big step—the search, evaluation, and selection of the first meaningful job. The experiences, training, and personal associations in the second most important five-years of life will significantly affect their lifestyle, earnings, and the successfulness of their career. In five years they will not be known as a graduate of your university or college. They will be known by what they did in those five years. Remind them that planning and actively working on that five years is something they should be doing every day. Become a nuisance in your class. Remind them of their career planning responsibility until they tell you to quit. You, besides their drinking buddy, are the most influential person in your students’ lives today. Internet Exercises - What are the issues currently facing financial executives? If you or your students have need for a current issue topic, CFOnet and the Financial Executives Institute have excellent Internet sites. They are designed to serve practicing financial executives and provide both academics and students with the current “financial manager” issues. Both sites support their excellent professional publications, CFO and Financial Executive, probably found in your library. Each site provides highlights of their current and past publications issues plus many current articles and links thought to be helpful to financial managers. http://cfonet.com The CFOnet site, supported by CFO Publishing Corporations, publishers of CFO and the new e-CFO, provides current issues and articles of interest to financial managers, summaries of current and past issues of CFO, and a Research Center focusing on topics such as Banking & Finance, Careers & Compensation, Insurance & Risk Management, and Performance Measures. A look at the site map reveals many links to SEC data, new filings, upcoming conferences (students are often amazed at the continuing education activities of senior managers), surveys, and so on. This is an excellent site for academics 22-6 who would like to keep up with the practice of financial management and provide a balance of finance theory and practice for their students. http://www.financialexecutives.org and http://www.feicanada.org/ The Financial Executives Institute (FEI), an organization of financial professionals, has an excellent Internet site for its members. It can also serve as a resource for students looking for current issue topics for reports and for academics interested in keeping pace with the “practice” of financial management and current issues. The FEI has local chapters in urban centers throughout the country, which welcome academics into their membership. The local chapters provide area colleges and universities with the opportunity to name an outstanding student for the Financial Executives Institute Award. The award includes a subscription to the Financial Executive and recognition at a local dinner meeting. The local FEI chapter may also provide “mentoring” opportunities for your better students. The FEI site provides a large number of current events articles related to accounting issues, technology, tax issues, cash management, and more. On the Canadian FEI site click the “About FEI Canada” link and learn about the FEI organization and activities. Want to find the closest local chapter? Click the Chapters link. In the FEI Canada News and Media Centre are a variety of publications. They include e-Newsletter and publications of Canadian Financial Executives Research Foundation (CFERF). Every professional area has educational and professional organizations that students (future managers) can join. A course in Finance ought to introduce the professional organizations and publications of Finance. An assignment or “show and tell” review of this site provides excellent coverage and an example of the services of professional organizations for our future managers. Further, the focus on continued education provides a message to our students that they are just at the beginning of their learning and that continued and more intensive learning awaits them after graduation. 22-7 CHAPTER 23 MERGERS, ACQUISITIONS, AND CORPORATE CONTROL CHAPTER IN PERSPECTIVE When one company buys another, it is making an investment, and the basic principles of capital investment decision apply. The investments are often motivated by possible gains in efficiency from combining operations - synergies. When one company buys another, the ownership of the target company changes. Just as there are markets for securities and commodities, so is there a market for corporate control, the buying and selling of controlling influence over business. The transactions are mergers, acquisitions, leverage buy-outs, and other similar terms. The deals are carried out in corporate head offices, special shareholder meetings, in the mail for proxies, and in large expensive ads in The Globe and Mail and The National Post. This chapter provides the terminology and concepts related to the market for corporate control. It is an extensive, intuitive chapter centering on one of the two exciting activities of financial management. The other is going public, covered in an earlier chapter. There is always an interesting takeover occurring during each semester to provide a good current event discussion and assignment. CHAPTER OUTLINE 23.1 SENSIBLE MOTIVES FOR MERGERS Increased Revenues Economies of Scale Economies of Vertical Integration Combining Complementary Resources Merging to Reduce Taxes Mergers as a Use for Surplus Funds 23-1 23.2 DUBIOUS REASONS FOR MERGERS Diversification The Bootstrap Game 23.3 THE MECHANICS OF A MERGER The Form of the Acquisition Mergers, Antitrust Law, and Popular Opposition 23.4 EVALUATING MERGERS Mergers Financed by Cash Mergers Financed by Stock A Warning Another Warning 23.5 THE MARKET FOR CORPORATE CONTROL Ownership Structure and the Effectiveness of the Market for Corporate Control 23.6 METHOD 1: PROXY CONTESTS 23.7 METHOD 2: TAKEOVER BIDS Takeover Bid Tactics 23.8 METHOD 3: LEVERAGED BUYOUTS Barbarians at the Gate? Recent LBO Activities 23.9 METHOD 4: DIVESTITURES, SPIN-OFFS AND EQUITY CARVE- OUTS 23-2 23.10 THE BENEFITS AND COSTS OF MERGERS 23.11 SUMMARY TOPIC OUTLINE, KEY LECTURE CONCEPTS, AND TERMS 23.1 SENSIBLE MOTIVES FOR MERGERS A. Mergers are categorized as horizontal, vertical, or conglomerate, depending upon the nature of the business acquired. B. If a firm in a similar line of business is acquired, the merger is called a horizontal merger. If a supplier or a customer is acquired (vertical in the supply chain), it is a vertical merger. A conglomerate merger is the acquisition of an unrelated line of business. C. The motives for acquiring another business or its assets include the desire to replace existing management, and to improve efficiency or to produce synergies. The synergies, or the value added by combining businesses, may be explained by the following factors. Increased Revenues A. To create value through revenue enhancement, the sum of the revenues of the companies in a merger must be greater than their revenues if separate. This implies customers either buy more or pay a higher price than before the merger. B. Horizontal mergers are most likely to create the opportunity for increased revenues by increasing the market power of the companies, giving them opportunity to raise prices. Regulators do not like mergers that lessen competition and thus an attempt to increase market power may result in the merger being disallowed, or more commonly, the companies required to sell-off sufficient chunks of the businesses to permit new competition. Economies of Scale A. The ability to derive reduced cost efficiencies through larger operations is an often-quoted benefit of mergers. B. Horizontal mergers, in the same line of business, and from centralizing such functions as finance and accounting are likely to produce economies of scale. 23-3 Economies of Vertical Integration A. Efficiencies related to controlling raw material supplies and final customer contact may benefit some industries. B. Benefits in this area are often questionable. Combining Complementary Resources A. Some mergers involve firms where each has valuable assets which complement the other so the total becomes more efficient or better serves the customer. Merging to Reduce Taxes A. By merging it may be possible for one company to use the tax losses that the other company has. However, rules limiting this motive for merging make it an uncommon reason for merging. B. Unused interest tax shield, due to using less debt than optimal, can create a tax- benefit from merging. Mergers as a Use for Surplus Funds A. The presence of free cash flow in a mature firm often motivates managers to purchase other firms. B. Unless the merger contributes positive NPVs, increasing dividends or stock repurchase via downsizing is the better option for shareholders. 23.2 DUBIOUS REASONS FOR MERGERS Diversification A. It is easier for shareholders to diversify than businesses via asset investment. B. Diversification by itself is a poor reason for mergers, unless the merger is likely to produce value added (positive NPVs). The Bootstrap Game A. The bootstrap effect is the arithmetical result of a higher post merger earnings per share created when the acquiring firm has a higher price/earnings ratio. See Figure 23.2 23-4 B. Bootstrapping merger-oriented firms are able to produce high earnings growth rates, attract added demand for shares and increased stock prices, and higher P/Es which continues until the market assesses the actual added value of the mergers. The market usually is able to see through the “smoke and mirrors.” 23.3 THE MECHANICS OF A MERGER The Form of the Acquisition A. There are three ways for one firm to acquire another: (1) amalgamate, (2) purchase a majority of its shares, or (3) purchase its assets. Something is purchased and something is given in consideration. A. In Canada the combination of the assets and liabilities of two companies is an amalgamation. In the U.S. the legal term for this is merger, the combination of two firms into one. In some amalgamations the acquired firm ceases to exist and the former shareholders are given cash or securities, perhaps in the acquiring firm. Sometimes a new firm is created by combining the two firms involved in the amalgamation. C. Another means by which a firm is acquired is by the purchase of the target company’s stock. Cash or securities are paid, stockholders change places, and change is affected via board and management changes. When an acquirer invites shareholders to offer or tender their shares at a specified price to the acquirer this is called a takeover bid in Canada and a tender offer in the U.S. D. The third way to buy the target company’s assets. The ownership of the assets is transferred and payment is made to the selling firm. Again cash and/or securities are the likely consideration. Mergers, Antitrust Law, and Popular Opposition A. The federal government or foreign governments may block mergers if they deem 23-5 the mergers to be anti-competitive or to create too much market power. B. Popular resentment may also hinder mergers. Political pressures generated by popular resentment may cause the politicians and government to intervene. 23.4 EVALUATING MERGERS Mergers Financed by Cash A. Economic gain from merger occurs only if the two firms are worth more together than apart. Estimating and evaluating the economic gain is the central focus of merger analysis. B. The economic gain is shared between the selling shareholders and the purchasing shareholders with the fraction to each determined by the price paid or negotiated. C. The focus of a merger evaluation is the estimated amount of economic gain produced by the merger and the splitting of the gain between seller and buyer. D. The cost of a merger is the share of economic gain given to the selling shareholders. The sellers’ gain is the buyers’ cost. Mergers Financed by Stock A. The key to successful mergers is the estimation of the gain and the negotiation of the allocation of the gain between the shareholders of the companies. B. When evaluating the economic gain, instead of estimating the target firm’s future cash flows, the analyst should estimate the current value of the target firm and adjust this value by the estimated changes in future cash flows after the merger. C. Economic gain from the merger will be derived from the value added (positive NPVs from added cash flows) produced after the merger. D. The market evaluates all mergers, the estimated gain and the sharing of the gain. E. The merger should be undertaken by the acquirer if the economic gain (the added value of the combination) exceeds the cost (the share of the gain given to the selling shareholders). The cost of the merger is often difficult to assess. F. When the compensation for selling shareholders is cash, the distribution of the gain is thought to be easily determined versus the difficult problem of assessing the value of securities used as payment. 23-6 A Warning A. The cost (gain given up by the buyer) is difficult to determine because the price of the selling stock may include some of the estimated premium (cost) paid by the buyer. B. When cash is used as compensation to the selling shareholders, the cost is not affected by the actual economic gain from the merger. It is fixed, for the good or bad of it. Another Warning A. When securities are used as compensation to the selling shareholders, the value of securities given is related to the economic gain to be derived. Thus, the cost is related to the future economic gain derived, because the economic gains that occur will be included in the share prices. B. Evaluate the changes in cash flow from the merger. 23.5 THE MARKET FOR CORPORATE CONTROL A. In a small corporation the shareholders, directors, and managers are likely to be the same people, unlike the major corporations that dominate business. B. Shareholders elect the board of directors who in turn appoint management. Control of the business is vested in management, with the board left to an oversight role. C. When managers or directors take actions adverse to shareholders’ interests, agency costs occurs. D. Ownership and control of businesses change. The market place where this exchange takes place is called the market for corporate control. E. As shown in the following chart, there are four ways that the management of a corporation can change: a proxy contest, merger, leveraged buyout, and divestiture. Tools Used To Acquire Companies Proxy Contest Proxy Contest Merger and Acquisitions Merger and Acquisitions Leveraged Buy-Out Leveraged Buy-Out Divestiture Divestiture 23-7 F. In any business transaction, including mergers, one must distinguish between what is purchased, what is used for payment and how much is paid for it, and how and who will manage the assets/business in the future. Ownership Structure and the Effectiveness of the Market for Corporate Control A. How well the market for corporate control operates is a function of the ownership structure of the company. B. Some companies are private, where the shares are not publicly traded. Proxy contests and tender offers never occur. On the other hand, often shareholders are also the managers, reducing the potential for conflict of interest. C. Some companies are publicly traded but have a large, possibly majority, shareholder. With a large shareholder, it is difficult for an outsider to change management through a proxy fight or an acquisition without first getting the approval of the large shareholder. In Canada, it is not uncommon for companies to use two classes of equity, one with more votes per share than the other, to permit the large shareholder to retain voting power while still accessing public equity markets. Whether such structures are good for noncontrolling shareholders’ wealth is a debatable point. D. To reduce the potential for conflict of interest between controlling shareholders and noncontrolling shareholders, special rules have been established by Canadian securities commissions to govern non-arm’s length transactions. E. In Canada it is relatively rare for companies to be widely-held, with shares spread over many investors and no one shareholder holding a significant block. However, it is the widely-owned firm that is most likely to be acquired in a tender offer. 23.6 METHOD 1: PROXY CONTESTS A. Existing management may be changed or replaced by the board of directors, or failing that, by changing the board of directors who are elected by the shareholders. B. A proxy contest is an attempt to replace the board, and later management, by an outsider group or owners or other interested parties. Shareholders may delegate or “proxy” their vote on issues to others. A group may wage a proxy fight to elect directors. Control is decided by shareholders by how they vote or to whom they proxy their vote. C. Most proxy fights by outsiders fail for existing managers have the advantages of 23-8 company funding and inertia. 23.7 METHOD 2: TAKEOVER BIDS A. Mergers may be negotiated between managers or between managers and the acquiring firm’s shareholders in a takeover bid. With a takeover bid the company attempting the acquisition does not have to get the approval of the management of the target company. Takeover Bid Tactics A. Takeover defenses are commonly approved by shareholders or legislated by states to “protect” their businesses (managers) from unwanted takeovers. B. One takeover defense is commonly called poison pill contingency plans to distribute large numbers of common stock to friendly shareholders if an unwanted takeover offer occurs. C. Another takeover defense commonly used are generically named shark repellent where shareholders approve amendments to the charter and bylaws that require a large majority of shareholders to approve a merger, or make changes in the number of directors number and/or how directors are elected. 23.8 METHOD 3: LEVERAGED BUYOUTS A. When a firm’s assets or stocks are purchased by private group using borrowed funds, the change in corporate control is called a leveraged buyout (LBO). B. Publicly owned (large number of shareholders) corporations are taken “private” when managers (management buyout or MBO) borrow and buy the outstanding shares of the company. They become owner/managers with large obligations over their heads. They work harder, cut costs, and compete more effectively. C. Example 23.8 examines the RJR Nabisco LBO by KKR. In this hotly contested LBO, entrenched management was outbid in their LBO attempt by an outside investor group. D. KKR expected to repay the enormous debt incurred to buy the RJR Nabisco stock and realize economic gains with the expected interest tax shields, favourable financing rates, and availability in the junk bond market, reduced capital expenditure (free cash flow theory) and operating expenses, and the sale of some parts of RJR Nabisco. E. The decline in the available high-risk bond market and in the increased cost of borrowing at the time forced KKR to add equity to the deal. 23-9 Barbarians at the Gate? A. The LBO activity of the late 1980s had considerable negative press but has some redeeming features. B. Sellers seem to have received most of the economic gain, not the buyers or raiders. C. LBO activities were driven by the relatively cheap and available junk bond markets. D. While an LBO generates more borrowing or debt, the benefits of LBOs seem to come from benefits other than tax benefits and leverage benefits. E. Bondholders seem to lose at the expense of selling stockholders in the LBO period. High rated bonds became junk as massive debt levels were added to finance the repurchase of stock. F. LBOs provide considerable incentives to the owner/manager to improve economic efficiency. G. The presence of free cash flows in mature industries was a major, but not the only incentive for LBO activity. Recent LBO Activity A. LBOs had a comeback in the late 1990s and early 2000s, coincident with a substantial increase in private equity funds and low interest rates. Now, 2011, LBOs are occurring more frequently than the past few years. 23.9 METHOD 4: DIVESTITURES, SPIN-OFFS AND EQUITY CARVE-OUTS A. Divisions, subsidiary corporations and assets may be sold to other businesses (divestiture) or sold or spun-off to the general public or new owner group. B. Divisions, subsidiary corporations and assets may be sold to other businesses (divestiture) or sold or spun-off to the general public or new owner group. C. Companies sometimes spin off a business by separating it from the parent firm and distributing to their shareholders the stock in the newly independent company. D. Companies sometimes sell a business to new stockholders in a public offering. The divestitures in this way are carve-outs. 23-10 . 23.10 THE BENEFITS AND COSTS OF MERGERS A. Merger activity has occurred in cycles in this century, coinciding with periods of increased stock prices. B. Who benefits from mergers or who receives the economic gain, if any, from a merger? C. Research indicates that target or selling shareholders have taken the larger share of the “gain.” D. Acquiring shareholders have received the smaller share of the gains or seem to break-even. E. Sellers receive the larger share because of competitor bidding. A firm receiving an unwanted takeover bid often offers other firms to bid, or use legal and other defenses to force the bid higher. “Professionals,” such as accountants, lawyers, etc., seem to get their share of the gain, as do speculators and insiders who buy/sell on anticipation of merger activity. E. Mergers tend to improve real productivity. F. While mergers may reward selling stockholders, the LBO movement of the 1980s tended to reward these selling stockholders and “professionals” at the expense of bondholders, government tax revenues, and perhaps employees at takeover firms. G. The possibility of takeovers provides incentives for firm managers to manage efficiently, but are there other less costly incentives for increasing business productivity? 23.11 SUMMARY PEDAGOGICAL IDEAS General Teaching Note - This is an excellent chapter for discussing one of the more challenging ethical issues of financial management. LBOs, MBOs, and takeovers have likely affected many of the students and their families in your class. This is a 23-11 good time to talk about the negatives and positives of corporate takeovers. From providing an ability to channel resources to more effective rates of returns to wrecking the economic viability of a community, takeovers usually bring forth heated opinions. The Globe and Mail and The National Post are always reporting a current takeover. Using the chapter examples—such as the RJR Nabisco case or the section entitled “Barbarians at the Gate” (a book title)—provides good fodder for pulling even your worst wallflower into the conversation. Do it! Bring a little passion to business finance! Student Career Planning - When I mention a sales job opportunity to my students, all but a few curl up their nose. Those who move forward on their seats to listen are tuned in to this next century! It is all sales out there! With competition heating up in the world, there are few situations where customers will knock the door down for your product or service. Students must broaden their focus as to the value of persuasive skills and the need to develop them while in the protection of the college walls. In most businesses the rewards go to the greatest value contributor. Today it is production or sales. Sales experience is best gained during the college years when little is at stake. Many financial service firms employ and train part-time employees. Encourage students to find the best sales training program in the community and sign up. Even if they end up miles away from company sales, there is still plenty of opportunity to sell ideas, projects, and their kid’s Girl Scout cookies. Let the damnation of sales now cease! Internet Exercises - Over the previous chapters, the sites selected were intended to provide students with the breadth of finance as well as the depth of managerial finance. http://www.crosbieco.com/index.html The Crosbie & Company is in the investment banking industry. It has a page of M&A press releases and M&A report. http://fool.com One “breadth” finance sites with excellent educational materials is The Motley Fool. It has excellent presentations on investment fundamentals and personal finance advisories as well as news, company research, and many related links. A class orientation to this site would provide excellent bookmarks for continued education. Be sure to “sell” the investments course offered by your department. Most students will be “managers” of their defined contribution pension plans in the future, and the concepts provided by a structured investment course and information from this site should prepare them for continued learning in this area. 23-12 Instructor Manual for Fundamentals of Corporate Finance Richard A. Brealey, Stewart C. Myers, Alan J. Marcus, Elizabeth Maynes, Devashis Mitra 9780071320573, 9781259272011