Corporate Finance Study Session 8 p2?

The Herfindahl-Hirschman Index p1

The Herfindahl-Hirschman Index (HHI) is a measure of market power based on the sum of the squared market shares for each company in an industry. Higher index values or combinations that result in a large jump in the index are more likely to meet regulatory challenges.

post-offer defenses

"Just Say No" Defense Litigation (anti-trust) Greenmail - repo own shares from acquirer at premium Share Repurchase (increase cost of remaining stocks) Leveraged Recapitalization - A post-offer takeover defense mechanism that involves the assumption of a large amount of debt that is then used to finance share repurchases; the effect is to dramatically change the company's capital structure while attempting to deliver a value to target shareholders in excess of a hostile bid. Crown Jewel Defense - a target may decide to sell off a subsidiary or asset to a third party. Pac-Man Defense - making a counteroffer White Knight Defense - Often the best outcome for target shareholders is for the target company's board to seek a third party to purchase the company in lieu of the hostile bidder. White Squire Defense - the target seeks a friendly party to buy a substantial minority stake in the target—enough to block the hostile takeover without selling the entire company.

Friedman Doctrine

"There is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say that it engages in open and free competition without deception or fraud." Basically, just make profits without violating rules (laws) of the game. shareholders figure out the rest.

Board Self Review

- an assessment of the board's effectiveness as a whole; - evaluations of the performance of individual board members, including assessments of the participation of each member, with regard to both attendance and the number and relevance of contributions made, and an assessment of the member's willingness to think independently of management and address challenging or controversial issues; - a review of board committee activities; - an assessment of the board's effectiveness in monitoring and overseeing their specific functions; - an evaluation of the qualities the company will need in its board in the future, along with a comparison of the qualities current board members currently have; and - a report of the board self-assessment, typically prepared by the nominations committee, and included in the proxy in the United States and in the corporate governance report in Europe.

The responsibilities of board members, both individually and as a group

- establish corporate values and governance structures for the company to ensure that the business is conducted in an ethical, competent, fair, and professional manner - ensure that all legal and regulatory requirements are met and complied with fully and in a timely fashion - establish long-term strategic objectives for the company with a goal of ensuring that the best interests of shareholders come first and that the company's obligations to others are met in a timely and complete manner - establish clear lines of responsibility and a strong system of accountability and performance measurement in all phases of a company's operations - hire the chief executive officer, determine the compensation package, and periodically evaluate the officer's performance - ensure that management has supplied the board with sufficient information for it to be fully informed and prepared to make the decisions that are its responsibility, and to be able to adequately monitor and oversee the company's management - meet regularly to perform its duties and in extraordinary session as required by events - acquire adequate training so that members are able to adequately perform their duties

The primary responsibility for overseeing the design, maintenance, and continuing development of the control and compliance systems rests with this committee. At a minimum the audit committee must:

- include only independent directors; - have sufficient expertise in financial, accounting, auditing, and legal matters to be able to adequately oversee and evaluate the control, risk management, and compliance systems, and the quality of the company's financial disclosure to shareholders and others. It is advisable for at least two members of the committee to have relevant accounting and auditing expertise; - oversee the internal audit function; the internal audit staff should report directly and routinely to this committee of the board, and, when necessary report any concerns regarding the quality of controls or compliance issues; - have sufficient resources to be able to properly fulfill their responsibilities; - have full access to and the cooperation of management; - have authority to investigate fully any matters within its purview; - have the authority for the hiring of auditors, including the setting of contractual provisions, review of the cost-effectiveness of the audit, approving of non-audit services provided by the auditor, and assessing the auditors' independence; - meet with auditors independently of management or other company interest parties periodically but at least once annually; and - have the full authority to review the audit and financial statements, question auditors regarding audit findings, including the review of the system of internal controls, and to determine the quality and transparency of financial reporting choices.

Qualifications of directors

- independence (see factors to consider in Section 5.1.1); - relevant expertise in the industry, including the principal technologies used in the business and in financial operations, legal matters, accounting and auditing; and managerial considerations such as the success of companies with which the director has been associated in the past; - indications of ethical soundness, including public statements or writings of the director, problems in companies with which the director has been associated in the past such as legal or other regulatory violations involving ethical lapses; - experience in strategic planning and risk management; - other board experience with companies regarded as having sound governance practices and that are effective stewards of investors' capital as compared to serving management's interests; - dedication and commitment to serving the board and investors' interests (board members with such qualities will not serve on more than a few boards, have an excellent record of attendance at board meetings, and will limit other business commitments that require large amounts of time) - commitment to the needs of investors as shown, for example, by significant personal investments in this or other companies for which he or she serves as a director, and by an absence of conflicts of interest.

Several different types of compensation awards are in common use today:

- salary, generally set by contractual commitments between the company and the executive or director - perquisites, additional compensation in the form of benefits, such as insurance, use of company planes, cars, and apartments, services, ranging from investment advice, tax assistance, and financial planning advice to household services; - bonus awards, normally based on performance as compared to company goals and objectives; - stock options, options on future awards of company stock - stock awards or restricted stock.

HHI p2

Example: To calculate the pre-merger HHI, first square the market share for each company. Then add together the squared market shares to obtain an HHI of 1,450, which indicates that this is a moderately concentrated industry. If Companies 2 and 3 were to merge, the HHI would jump 400 points to 1,850. The large change in the HHI combined with the high post-merger HHI value indicates that this merger would likely evoke antitrust objections. If Companies 9 and 10 were to merge instead of Companies 2 and 3, the HHI would climb only 50 points to 1,500. Although the post-merger HHI indicates a moderately concentrated industry, the combination is unlikely to raise antitrust concerns because the post-merger HHI is only 50 points higher than the pre-merger HHI.

Valuation

Net operating profit less adjusted taxes (NOPLAT) - A company's operating profit with adjustments to normalize the effects of capital structure. 1. Unlevered net income = Net income Net interest after tax Adding back net interest after tax to remove the debt-holder tax shield associated with that capital structure Companies typically report depreciation for property, plant, and equipment at a faster rate for tax purposes (higher depreciation shields more income from taxes) than for financial reporting purposes (lower depreciation results in higher net income). The differences in depreciation result in different taxes. This difference is accounted for as a liability on the balance sheet—deferred income taxes. To account for this impact on cash flow, we add the change in deferred taxes to unlevered net income (an increase in deferred taxes increases cash flow; a decrease in deferred taxes reduces cash flow). 2. Net interest after tax = (Interest expense − Interest income) × (1 − Tax rate) 3. NOPLAT = Unlevered net income + Change in deferred taxes Change in deferred taxes has a POSITIVE relationship with FCF (more deferred taxes means more free cash available; source of cash) At this point, NOPLAT is adjusted to add back net noncash charges (NCC), which prominently include depreciation (of tangible assets) and amortization and impairment (of intangible assets); noncash charges affect net income but do not represent cash expenditures. To estimate free cash flow, we then subtract the value of necessary or otherwise planned investments in working capital and property, plant, and equipment. They are recorded as the change in net working capital and capital expenditures (capex), respectively. 4. FCF = NOPLAT + NCC - Change in net working capital - Capex Takeover premium = (Deal Price - Stock Price) / Stock Price (note that this is as a percentage of the current stock price)

Pre-offer defenses

shark repellent - A pre-offer takeover defense mechanism involving the corporate charter (e.g., staggered boards of directors and supermajority provisions). Flip-in pill - A poison pill takeover defense that dilutes an acquirer's ownership in a target by giving other existing target company shareholders the right to buy additional target company shares at a discount. Flip-over pill - A poison pill takeover defense that gives target company shareholders the right to purchase shares of the acquirer at a significant discount to the market price, which has the effect of causing dilution to all existing acquiring company shareholders. Dead-hand provision - A poison pill provision that allows for the redemption or cancellation of a poison pill provision only by a vote of continuing directors (generally directors who were on the target company's board prior to the takeover attempt). Poison Puts - A pre-offer takeover defense mechanism that gives target company bondholders the right to sell their bonds back to the target at a pre-specified redemption price, typically at or above par value; this defense increases the need for cash and raises the cost of the acquisition. Incorporation in a State with Restrictive Takeover Laws (United States) Staggered Board of Directors Restricted Voting Rights Supermajority Voting Provisions Fair Price Amendments - are changes to the corporate charter and bylaws that disallow mergers for which the offer is below some threshold. Golden Parachutes - allow the executives to receive lucrative payouts, usually several years' worth of salary, if they leave the target company following a change in corporate control. In practice, golden parachutes do not offer much deterrent, especially for large deals where the managers' compensation is small relative to the overall takeover price. One reason they persist is that they help alleviate target management's concerns about job loss.