CAPITAL STRUCTURE ISSUES

Table of Contents

I. ASSESSING LONG-TERM DEBT EQUITY AND

CAPITAL STRUCTURE……………………………………
I.1 Capital Structure…….
I.2 Debt vs. Equity………
I.3 Factors Affecting Capital Structure……
I.4 Why Capital Structure Changes Over Time….
I.5 Capital Structure Theory……
I.6 Business and Financial Risk……
I.7 Capital Structure Policy;

II. SOURCES OF LONG-TERM FINANCING…….

II.1 Sources of Long-Term Financing……
II.1.1 Shares……
II.1.2 Debentures……
II.1.3 Bank Term Loans……
II.1.4 Retained Earnings…….
II.1.5 Loans from Financial Institutions…….
II.1.6 Public Deposits…….
II.2 Why Firms Engage in Long-Term Financing…….
II.3 Purpose of Long-Term Financing……..

III. SHARING FIRM WEALTH, DIVIDENDS………

IV. SHARES AND OTHER PAYOUTS…………..

V. MERGERS, ACQUISITION, DIVESTITURES………

VI. V.1 Mergers and Acquisitions Definition and Differences
V.2 Synergy
V.3 Philippines Tax Applications on M&A
V.4 Application for tax treaty relief
V.5 Break-Up Value
V.6 Divestitures
ASSESSING LONG-TERM DEBT EQUITY AND CAPITAL
STRUCTURE

Assessing Long-Term Debt, Equity and Capital Structure

Capital Structure

From a technical perspective, the capital structure is the careful balance

between equity and debt that a business uses to finance its assets, day-to-day
operations, and future growth. Capital Structure is the mix between owner’s funds
and borrowed funds.

 FUNDS = Owner’s funds + Borrowed funds.

 Owner’s funds = Equity share capital + Preference share capital + reserves
and surpluses + retained earnings = EQUITY
 Borrowed funds = Loans + Debentures + Public deposits = DEBT

In short, Capital Structure is the mixture of long-term sources of funds. Capital

Structure is optimal when the proportion of debt and equity maximizes the value
of the equity share of the company. However, a company heavily funded by debt has
an aggressive capital structure and poses a greater risk to investors. This risk,
however, may be the primary source of the firm’s growth.

source: sentika

- A firm mobilizes funds which, depending upon their maturity period can be
- The financial manager's objective in making capital structure decisions is to find the
financing mix that maximizes the value of the firm. This structure is called the optimal
capital structure.

- Changes in the market value of a debt/equity capital could result in large changes in its
measured capital structure.

Debt vs Equity

Cost of Debt is lower than the cost of equity but Debt is riskier than equity. The reasons for
this are

 Lender earns an assured interest and repayment of capital.

 Interest on debt is a tax-deductible expense so brings down the tax liability for a
business whereas dividends are paid out of profit after tax.
Debt is more dangerous for the business as it adds to the financial risk faced by a business.
Any failure with reference to the payment of interest or repayment of principal amount may
lead to the liquidation of the company.

FACTORS AFFECTING CAPITAL STRUCTURE

1] Cash Flow Position

A firm’s ability to pay expenses and loans determines debt capacity. Some firms
operate in volatile financial environments affecting their ability to meet financial obligations.
The company may raise funds by issuing debts if it has a fluent cash flow position, as they are
to be paid back after some time.

It must cover fixed payment obligations with regards to,

 Normal business operations

 Investment in fixed assets
 Meeting debt services commitments as well as provide a sufficient buffer period

2] Interest Coverage Ratio

Interest Coverage Ratio is the number of times earnings before interest and taxes of a
company covers the interest obligation. High-Interest coverage ratio indicates that company
can have more of borrowed funds.

Interest Coverage Ratio (ICR) = Earnings Before Interest and Tax (EBIT) / Interest.
3] Control

Public issues damage the reputation of the firm and make it vulnerable to takeovers.
Debt generally does not cost dilution of control. To have control, the firm must issue debt. So
there is a constant struggle over whether to give up control or pay more for capital.

4] Return on Investment

It will be beneficial for a firm to raise finance through borrowed funds if the return on
investment is higher than the rate of interest on the debt. But if the return is uncertain and the
company is not sure if it can cover the fixed cost of interest, they should opt for equity.

5] Floatation Cost

Flotation cost must be understood while selecting the sources of finance.  Cost of the
Public issue is more than the floatation cost of taking a loan. The cost of issuing securities,
brokers’ commission, underwriter’s fee, cost of prospectus etc is the flotation cost.

6] Flexibility

Issuing debenture and preference shares introduce flexibility. A good financial structure

is flexible and sound enough to have scope for expansion or contraction of capitalization
whenever the need arises.

7] Stock Market Conditions

Conditions of the stock market influence the determination of securities. During the
depression, people do not like to take a risk and do not take interest in the equity shares.
During the boom, investors are ready to take a risk and invest in equity shares.

8] Tax Rate

Interest on debt is allowed as a deduction; thus in case of the high tax rate, debts are
preferred over equity but in case of low tax rate more preference is given to equity.

WHY CAPITAL STRUCTURE CHANGES OVER TIME

1. Deliberate Management Actions

- If a firm is not currently at its target, it may deliberately raise new money

in a manner that moves the actual structure towards the target.

2. Market Actions
CAPITAL STRUCTURE THEORY
There are numerous theories that attempt to explain how changes in financial
leverage, or the use of debt, affect the value of a firm and its cost of capital.

1. The Traditional Approach

- suggests that a firm can lower its weighted average cost of capital and increase its market
value by the judicious use of financial leverage.

The total market value of the firm can be determined as follows:

2. The Modigliani and Miller (Perfect World) Approach

- The firm's value is determined by its real assets, not by the securities it issues. Thus capital
structure is irrelevant and all capital structures are equally desirable. This theory assumes no
taxes, no chance of bankruptcy, and no brokerage caused investors borrow up the same
rate as corporations.

3. The Contemporary Approach

- Capital structure asserts that there is an optimal capital structure are at least an optimal
range of structures of every firm.

a. Corporate Income taxes - the use of debt capital structure of a corporation reduces its
cause of raising capital because interest on debt is tax deductible.

b. Financial Distress and Related Costs - allows the possibility that the firm may go bankrupt.

Trade -off Theory of Leverage states that firm's trade off the tax benefits of debt financing
against problems caused by potential bankruptcy.

Value of the Value of the Present Value of Present Value

Levered levered firm with Net Tax Savings Of Financial
Firm,With taxes, taxes Distress And
Financial Related Costs
distress, and
= costs
related + -

BUSINESS AND FINANCIAL RISK

1. Business risk, which is the riskiness of the firm's assets if no debt is used; and

2. Financial risk which is the additional risk placed on the ordinary equity shareholders as a
result of using debt.
 Business Risk is the single most important determinant of capital structure and it
represents the amount of risk that is inherent of the firm's operations even it uses no debt
financing.

FINANCIAL RISK is the additional risk placed on the ordinary equity shareholders as a
result of the decision to finance the debt. Conceptually, shareholders face a certain amount
that is inherent in the firm's operations - this is its business risk which is the uncertainty
inherent in projections of future operating income.

CAPITAL STRUCTURE POLICY

- The capital structure that maximizes the value of the firm is also the one that minimizes
the cost of capital. Capital structure involves a choice between risk and expected returns
associated with the firm's financing mix.

- The capital structure that balances risk and return to maximize the value of the firm is the
"optimal structure policy".

- The determination of a firm's optimal capital structure is theoretically possible but financial
managers cannot determine with precision the percentage of debt that will maximize the
market value of the firm.

EBIT - EPS ANALYSIS

One commonly used analytical technique used to evaluate various capital structures
in order to select the one that maximizes a firm's earnings per share is the EBIT - EPS
Analysis. This approach measures the impact of financing alternatives on EPS at different
levels of EBIT.

Another objective of EBIT - EPS analysis is to determine the EBIT - EPS indifference or
breakdown points between the various financing choices. An indifference point is the level
of EBIT where EBS of a firm is the same, regardless of which alternative capital structures
are employed.

SOURCES OF LONG-TERM FINANCING

Finance is the top priority of any firm. Under the basis time period, we have 3
sources of financing a business, they are: short-term, medium-term and long-term financing.

Long-term finance is any financial instrument with a maturity exceeding one year. It
is raising capital to meet financial requirements of a firm for a period of 5 years and above.

Sources of Long-Term Financing are:

 Shares
 Debentures/ Bonds
 Term loans from banks
 Retained Earnings
 Loan from financial Institutions
  Public Deposits

1. Shares – Capital obtained by issuance of shares. A company divides the capital into
units called shares and has a definite face value. available to the general public. Shares
are classified into two types: (a)Equity shares (a.k.a. common shares) and (b)Preference
Shares.

Characteristics of Shares:

 There is a definite face value per share.

 A shareholder is given a stock certificate indicating the shares and the
amount.
 Each share has a distinct nominal value.
 The different face value of shares indicate the interest of a certain
shareholder in the company and the extent of his liability.
 Shares are transferrable units.
Different investors have different risk appetites, some are risk averse and
others believe in investing more allows them to gain better returns. A firm
offers may issue two types of shares to cater to the risk anticipations of
shareholders.
(a)Equity Shares:

The most important source of raising long-term capital of a firm. Equity

shares depict ownership of a firm thus the funds raised through issuance of
shares is known as ownership capital. No fixed rate of dividends in equity
shares. It is dependent on surplus earnings of the firm. It is riskier compared
to preference shares.

Liability of equity shareholders is only to the extent of their capital

contribution. Equity shareholders enjoy the rewards as well as the risk of
ownership.

Merits:
1. In case the company has good profit, equity shareholders willing to
assume greater risks are payed dividends at a higher rate.
2. Permanent capital of a firm. Repaid only at the time of a firm’s
liquidation.
3. Giving dividends for equity shareholders is not compulsory.
4. Equity shares gives credit worthiness of a company and confidence to a
prospective loan creditors and investors.
5. Funds can be raised without any charge on the fixed assets of a company.
6. Equity shareholders are given participation in management decisions and
the right to vote.

Limitations:
 1. Risk averse shareholders may not want equity shares since the return of
funds fluctuate.
2. There is always speculation on the prices of equity shares especially if the
firm is experiencing a highly lucrative year and dividends paid by the
company are high
3. Issuing additional equity shares dilutes the voting power of existing equity
shareholders.
4. More procedures and paperwork are required in issuance of equity
shares.
5. Equity shareholders are given dividends only after dividends of
preference shareholders are given.
6. In theory, equity shareholders manage and control the company,
however in reality, only a handful of members control and manage votes.

(b) Preference Shares:

Have preferential rights over equity shares. Shareholders receive a fixed

dividend rate out of net profit. In case of the company’s liquidation, preferred
shareholders are given priority claim over earnings and assets. The capital is
returned to its shareholders.

Merits:
 A steady form of investment, receiving a steady flow of income.
 Lower risk of return rate than equity shares
 Does not affect the control of equity shareholders; preference shareholders
have no right to vote.
 In case of good profit fixed rate of dividends of preference shares enable a
firm to declare higher dividend rates for equity shareholders.
 In the event of liquidation of a firm, preferential rights of repayment for
preference shareholders are favored over equity shareholders
 Preference capital does not create change over assets of a firm.

Limitations:

 Not suitable for investors who want to assume more risk for higher returns.
 Claim of equity shareholders over assets of a company are diluted by
preference capital.
 Dividends are only paid when the company earns profit. There is no assured
return for the investor.

Types of Preference Shares:

(i.) Cumulative or Non-Cumulative

 Cumulative shares are preference shares that have the right to enjoy unpaid
accumulated dividends, it requires that any unpaid dividends must be paid to
preference shareholders before any dividends can be paid to equity
 shareholders. Cumulative shares protect the investor in case of low revenue
of a company since a company may be unable to afford paying dividends.
 Non-cumulative shares are dividends that are not accumulated if it is not
paid in a certain period.

(ii.) Participating and Non-Participating

 Participating shares enjoy rights in terms of surpluses of earnings of a
company after dividends have been paid to equity shares. If an issuing firm
meets its financial goals, this type of share guarantees additional dividends. If
a firm is experiencing a very profitable year, the dividends received for
participatory shares may yield above normal fixed rates.
 Non-participating shares do not enjoy these rights of participating in surplus
of earnings of a company.

(iii.) Convertible and Non-Convertible

 Convertible shares can be exchanged for equity shares at a certain period of
time at a fixed rate. It can be profitable for shareholders if the market value of
equity shares increases. If preference shares are converted to common
shares, the shareholder will lose the benefit of fixed dividend and cannot
exchange it back to preference shares.

 Non-Convertible shares are shares that cannot be converted to equity shares

(iv.) Redeemable and Non-Redeemable


Redeemable shares are issued by a firm and then claims them on the
after a fixed period, known as buying back shares at a later date.
 Non-Redeemable shares are issued by the firm although cannot be
claimed during the lifetime of the firm. It can only be obtained when a
there is liquidation of assets.
(v.) Callable
 Can be redeemed by the issuer at a defined date, set at a certain
price. Callable by the discretion of the company, the shares is bought
back by the company
2. Bonds – Also known as debentures. A corporation or the government can raise funds
through the issuance of bonds. A proof of indebtedness that a firm borrows a large
amount of money promising to pay back the creditor a fixed interest until such time
known as the maturity comes when the company has repaid the debt. It also specifies
the terms and conditions such as rate of interest, time repayment, and security offered.
The total amount to be borrowed is divided into units of fixed amounts.

Characteristics of Bonds:

 Creditors who purchase bonds are known as bond holders. Entitling them to
periodic payments of interest at a fixed rate stated in the terms and
conditions.
  Bonds are repayable after a fixed period of time stated in the terms of
conditions. (e.g. 5 years, 8 years, etc.)

 Bonds do not partake in voting or management participation.

 In case a company fails to pay the interest and principal amount to its
creditors, bond holders can recover it from the sale of assets of a company.

Merits:
 For the management of a firm, funds can be raised without allowing
control over the company.
 It helps long term planning since bonds are issued at a fixed period.
 Interest paid to creditors are treated as expense and is charged to the
profit of the company (part of non-operating expense, shown as interest
expense in an Income Statement) The company saves income tax.
 For creditors, bonds are mostly secure. In case of liquidation of a firm, it is
the first to be repaid before any payments are given to shareholders.
Interest is issued whether the firm is gaining or losing revenue.

Limits:
 For the firm, it can be a burden to pay off debenture interest to creditors
when it is undergoing profit loss.
 Debentures are charged to the company’s assets in favor of debentures
holders. A company which does not own sufficient fixed assets cannot
issue debentures. Moreover, the assets of a company that has been
mortgaged cannot be used for further borrowing.
 Too much of this form of financing leaves little gain for shareholders,
when most profits are required to pay interest on debentures.
 In times of depression, a company experiences profit decline. If interest
of a firm piles up, it can lead to the closure of a company due to difficulty
in paying interest.

Nature of Bonds:

(i.) Redeemable Debentures and Irredeemable Bonds:

 Redeemable bonds are payable at a pre-determined date. It can also be

paid off any time prior to the maturity date.
 Irredeemable bonds, also known as perpetual bonds, are bonds without a
maturity date. The major feature of this kind of debenture is it pays a
steady stream of interest to its creditor forever. The principal is not paid
back.

(ii.) Convertible and Non-Convertible Bonds:

 Convertible Debentures have the option of converting their debentures

into equity shares at a time and ratio decided by a firm.
  Non-Convertible Debentures cannot be converted into shares.

(iii.) Secured and Unsecured Bonds:

 Secured Bonds carry a charge on some of the assets of the issuing firm. In
case of failure to pay back the debt, assets of the company will be
mortgaged to repay creditors. Holders have the right to recover their
money from the sales of assets of a company
 Unsecured Bonds do not carry this security towards its creditors more so,
assets of a company are not sold off to repay debt to its investors.

(iv.) Registered and Bearer Bonds:

 Only bond holders can redeem these bonds since it is the details of the
bond holder that is registered in a company’s records. Not freely
transferable
 Bearer Bonds do not register details of the bond holder and anyone
owning the bond certificate can redeem it. Freely transferable.

(v.) First and Second Mortgage Bonds:

 First Mortgage Debenture means companies repay these bonds first

before all others.
 Second Mortgage Debentures are paid after first mortgage bonds are
satisfied.

3. Bank Term Loan – Commercial banks offer loans with a maturity of more than one
year. Giving priority in financing MSMEs for a long period.

Secured Loan – Banks usually require a form of collateral assets such as real
estate, equipment. In case the borrower defaults on the loan, the collateral is fully
claimed by the creditor

Unsecured Loan – Risker for creditors to issue this type of lone and more difficult to
qualify since creditors are reliant on the good name of the borrower. Higher interest
rates and shorter maturity of loans.

Merits: Limits:

Offering easy and flexible term loans and To the borrowing firm: Banks have very
modes of payment. Loan can be repaid as strict requirements namely, good credit
soon as the need is met. line, collateral of assets or a personal
guarantee.

Low interest rates especially for SMEs. Application process is time-consuming.

Approval may take months to complete.
 Management maintains control over the
company since banks do not interfere
with internal operations.

4. Retained Earnings – Also called internal accruals. Appropriated retained

earnings reserves part of the profit of a firm to over the years to meet financial
requirements such as factory construction, purchase of fixed assets, marketing, etc.

While Unappropriated retained earnings are not assigned to a specific

business purpose. Unappropriated earnings help to determine the portion of
dividends to be issued to shareholders. The higher unappropriated earnings, the
possibility of higher dividends can be paid. Unappropriated earnings can also
mean that the company is not reinvesting enough.

Merits:
 Cheap source of Capital - No expenses are incurred when a company has
this source of finance. No interest, dividend, or capital to be paid back.
Safe to use for business expansion.
 Financial Stability - Enough reserves of retained earnings means a
company can be resilient in the firm’s capacity to absorb unexpected loss.
 Benefits to shareholders- Reserves of retained earnings can lead to an
increase in the market price of equity shares.
 Internal Financing - Since funds are generated internally there is a higher
degree of operational flexibility and freedom.

Limits:
 Huge Profit - This method of financing is possible only with huge profits to be
acquired for a long period of time.
 Dissatisfaction among shareholders - Excessive ploughing back may cause
dissatisfaction amongst shareholders
 Fear of Monopoly -Growth of a firm’s financial strength may result to
eliminating their competitors from the market and monopolizing their
position.
 Mismanagement of Funds - Excessive retained earnings may lead to the
management of a firm to spend carelessly.

5. Loans from financial institutions – Similar to commercial banks term loans.

Offering loans with a maturity of one year or more. It aims to promote industrial
development (hence the name development bank) by increasing entrepreneur’s
awareness of financial sources available from the government and private sector
institutions. Granting access to funds based on the capabilities of the firm. This type of
financing is considered when large funds are required for expansion, and modernization
of an enterprise.

Merits: Limits:
 Aside from financial assistance, Rigid application process
financial institutions provide,
managerial, technical, and business
consultation to business firms.

Repayment of loans are in Time – consuming application and

instalments, not much of a burden to approval
a firm.

Funds are available even in periods of Restrictions are imposed (e.g.

depression of the economy while restriction of dividend payments)
other sources are not

A borrowing firm increases the

goodwill of the Capital Market1

6. Public Deposits – A firm receiving deposits as unsecured debt from the general
public to finance the working capital needs. The firm issues a deposit receipt that serves
as an acknowledgement of debt to its depositor. The rate of interest depends on the
period of deposit.

For the depositor, it is an unsecured source of investment since it does not create a
charge over a company’s assets. In case of company failure depositors have no
assurance of getting their investment back.

Characteristics of Public Deposits:

 Public deposits cannot exceed 25% of its shares capital and free reserves.
 Interest rate of public deposits are higher than bank deposits.
 Companies make advertisements through newspapers to invite the public to
deposit.
 A company can invite public deposits from a period of 6 months to 3 years
 Public deposits are cheaper than paying interest of bank loans.

Merits:
 Simple – no legal formalities. Invitation involve putting up an advertisement and
issue a receipt to the depositor
 Economical – Interest paid to depositors is lower compared to interest paid to
debentures and bank loans. Interest paid is tax deductible and reduces tax liability.
 Safe assets – Does not create a charge or mortgage on company assets.
 Flexible – It is renewable from time to time. Can be raised for a certain period to buy
raw materials in bulk and returned when the need is over. It is flexible towards the
financial structure of a firm

1
Capital Market is a financial market offering different financial securities where long-term debt or securities
are bought and sold. Philippine Securities and Exchange Commission oversees the capital market.
  Trading on Equity – Fixed rate of interest paid to depositors. Allows a company to
declare higher rates to shareholders in times of good profit.
 No Interference – Depositors do not have the right to vote and do not participate in
management affairs.

Limits:
 Uncertainty – depositors can withdraw their investments when they doubt the
financial health of a firm. Making it an unreliable source of finance. Large numbers of
withdrawals from depositors become burdensome for a company to pay a huge sum
at once. Giving Public Deposits the association of “fair weather friends”
 Temporary – the maturity of public deposits is short. The firm cannot solely and
frequently depend on public deposits for long-term financial needs.
 Unsuitable for start-ups – The public is not confident with depositing in firms lacking
good credit standing or an established reputation, therefore firms that are on the
start-up phase cannot depend on this form of financing.
 Hindrance to the growth of the Capital Market as widespread usage of public
deposits results to shortages of industrial securities.

Why firms engage in Long-term Financing

Firms engage in long-term financing to align its capital structure to meet long-term
goals. It affords the business more time to realize a return of an investment.

It is an approach of managing financial risks by matching the maturity of their assets

and liabilities; companies do not finance short-term assets to a long-term liability.

Long-term financing offers longer maturities at a fixed rate over the course of the
debt. Allowing more time to pay the financing. It minimizes the refinancing risk 2that comes
with short-term debt maturities. It limits a firm’s exposure to interest rate risks 3should
interest rates rise.

A firm can benefit from a long financial relationship with the same investor. With the
right investor, a firm gains ongoing support and less of a burden in bringing in new investors
who may not understand the business well which happens often in short-term financing.

Finally, firms can diversify their capital portfolio through various resources to fund
business purposes and not be solely dependent on one capital source. It allows a firm to
spread its debt maturities.

Purpose of Long-term Financing:

2
Refinancing risks – at a critical time, a firm cannot borrow funds to repay an existing debt.
3
Interest rate risks a potential for investment to loss due to change in interest rates. The higher interest rate
means more expense for the firm since they have to pay more interest to investors. The value of bond or fixed
income investments will decline.
 1. Purchase of fixed assets- Fixed capital for acquiring fixed assets such as buildings,
land, plants, and equipment are invested in the firm for a long period of time. These
fixed assets are regarded as the foundation of a business.

2. Financing permanent part working capital – Long term fund supports a firms’
continued activities it must have a certain amount of working capital utilized over
and over again. This nature of working capital is considered permanent

3. Financing growth and expansion – Huge amounts of investment for the long-term is
required to expand a business.

SHARING FIRM WEALTH DIVIDENDS

DIVIDENDS
 Is a distribution of profits by a corporation to its shareholders.

 When a corporation earns profit or surplus. It is able to pay a proportion of the profit
as a dividend to shareholders. Any amount not distributed is taken to be re-invested
in the business (called retained earnings).

DIVIDEND PROCESS
1. Investor purchases one or more shares in a dividend-paying company.
2. Company evaluates performance at the end of the quarter.
3. Company may declares and announce a dividend payment.
4. Company announces the dividend amount and dividend date.
5. Investor is paid the stated dividend for each share they own.

Dividends are given so as:

1. To increase the faith of retail investors in the company.

2. To send a signal to investors about companies optimism towards future earnings.

These are the following types of dividend options.

 Cash dividend
 Stock dividend
 Property dividend
 Liquidating dividend

HOW TO MEASURES DIVIDEND RATIOS

DIVIDEND YIELD RATIO

 Is a financial ratio used to measure the percentage return received from dividend
relative to its market price.
DIVIDEND PAYOUT RATIO
 Is the amount of dividend that a company gives out to its shareholders out of its
current earnings.
ADVANTAGES
 Of course, when you receive a dividend the benefit is immediately clear.
 You get something in return for your capital. Your investment increases not only
through the appreciation of the stock price, but also with the dividend that you
receive.
 It is also used as an indicator that the business is doing well because it can afford to
distribute part of its profit to shareholders.
DISADVANTAGES
 Tax. Upon receiving dividends, you would be taxed at 10%.

 Non-guaranteed. They also vary depending on the income of the company. The

schedule of distribution—that is, the date when it is going to be issued—is also not
guaranteed. So they may not be as reliable as interest earned in savings
account, time deposit, bonds or long term negotiable certficate of deposit (LTNCD).

 Non-compounding. Cash dividend is money that is deposited to your account, and

it’s not going to earn any interest or help in getting compounding return from your
investment.
 Less business capital. Dividends take away money that could’ve been reinvested
back to the business. This is the reason some investors would prefer to not receive
dividend at all. They might want the company to use all the profits in a way that
would improve the business like pouring funds into research and development,
purchasing state-of-the-art technology, expanding in new markets, hiring great
talents, etc. All of these would translate to more value for shareholders, which in the
long run is reflected on the increase of the price of the stock.
 Hype. Another factor to look into is that a struggling company might announce a
huge dividend pay-out to attract investors and inflate its stock price. After the hype,
you may be left with a company stock that has little fundamental worth.
 Liquidity. Some stocks might have liquidity issue. It might be difficult to buy or sell
them should you choose to.

SHARES REPURCHASE AND OTHER PAYOUTS

Share Repurchases
  Is a transaction whereby a company buys back its own shares from the market place.

 Refers to the repurchase of the company’s own outstanding shares from the open
market using the accumulated funds of the company to decrease the outstanding
shares in the company’s balance sheet thereby raising the worth of remaining
outstanding shares or to block the control of various shareholders on the company.

Dividends
 Is part of profit paid out to shareholders.

 A share of profits that a company pays at regular intervals to its shareholders.

 As part of company net profit to be paid out per one share, passed in the resolution
of the General Meeting of Shareholders.

Methods of Share Repurchase

 Open Market Repurchases

 Self-Tender Offer Repurchases

 Fixed Price Self-Tender Offer

 Dutch Auction Self-Tender Offer

 Repurchase by Direct Negotiation

Share Repurchases vs Dividends

Share Repurchases Dividends

 Represents an uncertain future  Represents a definite return in the

return on which tax is deferred until current timeframe that will be
the shares are sold. taxed.

Impact of Share Repurchases

 Generally, it’s a positive sign because it means that the company believes its stock is
undervalued and is confident about its future earnings.

Advantages of Share Repurchase

 Reduce Equity Financing Cost

 Capitalize on Undervalued Shares

Disadvantages of Share Repurchase

  Poor Predictions

 Sinking Dividends

 Poor Use of Capital

 Management Self-Interest

 Cover for Stock Handouts

MERGERS, ACQUISITIONS & DIVESTITURES

MERGERS & ACQUISITIONS:

Mergers and acquisitions (M&A) is a general term used to describe the

consolidation of companies or assets through various types of financial transactions,
including mergers, acquisitions, consolidations, tender offers, purchase of assets,
and management acquisitions.

Merger in business terms - to combine two separate businesses into a single

new legal entity. True mergers are uncommon because it's rare for two equal
companies to mutually benefit from combining resources and staff, including their
CEOs. Unlike mergers, acquisitions do not result in the formation of a new
company.
Acquisition - is when one company purchases most or all of another company's
shares to gain control of that company. Purchasing more than 50% of a target
firm's stock and other assets allows the acquirer to make decisions about the newly
acquired assets without the approval of the company’s shareholders. Acquisitions,
which are very common in business, may occur with the target company's approval,
or in spite of its disapproval. With approval, there is often a no-shop clause during
the process.
Divesture - A divesture is the partial or full disposal of a business unit
through sale, exchange, closure, or bankruptcy. A divestiture most commonly results
from a management decision to cease operating a business unit because it is not
part of a core competency.

A divesture may also occur if a business unit is deemed to be redundant after

a merger or acquisition, if the disposal of a unit increases the sale value of the firm,
or if a court requires the sale of a business unit to improve market competition.

Differences Between Mergers & Acquisitions:

A merger occurs when two separate entities combine forces to create a new, joint
organization. Meanwhile, an acquisition refers to the takeover of one entity by
another. Mergers and acquisitions may be completed to expand a company’s reach
or gain market share in an attempt to create shareholder value.

 A merger occurs when two separate entities combine forces to create a new,
joint organization.
  An acquisition refers to the takeover of one entity by another.
 The two terms have become increasingly blended and used in conjunction
with one another.

Mergers:
Legally speaking, a merger requires two companies to consolidate into a new
entity with a new ownership and management structure (ostensibly with members of
each firm). The more common distinction to differentiating a deal is whether the
purchase is friendly (merger) or hostile (acquisition). Mergers require no cash to
complete but dilute each company's individual power.

In practice, friendly mergers of equals do not take place very frequently. It's
uncommon that two companies would benefit from combining forces with two
different CEOs agreeing to give up some authority to realize those benefits. When
this does happen, the stocks of both companies are surrendered, and new stocks
are issued under the name of the new business identity.

Typically, mergers are done to reduce operational costs, expand into new
markets, boost revenue and profits. Mergers are usually voluntary and involve
companies that are roughly the same size and scope.

Acquisitions
In an acquisition, a new company does not emerge. Instead, the smaller
company is often consumed and ceases to exist with its assets becoming part of the
larger company. Acquisitions, sometimes called takeovers, generally carry a more
negative connotation than mergers. As a result, acquiring companies may refer to an
acquisition as a merger even though it's clearly a takeover. An acquisition takes
place when one company takes over all of the operational management decisions of
another company. Acquisitions require large amounts of cash, but the buyer's power
is absolute.

Companies may acquire another company to purchase their supplier and

improve economies of scale–which lowers the costs per unit as production
increases. Companies might look to improve their market share, reduce costs, and
expand into new product lines. Companies engage in acquisitions to obtain the
technologies of the target company, which can help save years of capital investment
costs and research and development.

Since mergers are so uncommon and takeovers are viewed in a negative

light, the two terms have become increasingly blended and used in conjunction with
one another. Contemporary corporate restructurings are usually referred to as
merger and acquisition (M&A) transactions rather than simply a merger or
acquisition. The practical differences between the two terms are slowly being eroded
by the new definition of M&A deals.

Scopes:

MERGERS & ACQUISITIONS:

 The primary goal of these deals is to expand the market share, diversify the
market presence and to buy technology, and the mergers and acquisitions lawyers
are working on the deals to prove their efficiency in the long run. Apart from this, the
deals also act as a powerful tool for the companies to close the mismatches and the
gaps such as the growth gap, market gap, gap in the outlook of growth between the
partners and the business cycles, gap in succession planning, and the resource gap.
For instance, the acquiring of an active pharmaceutical ingredient manufacturing
company by a pharmaceutical company shows the effort to reduce the resource gap
thus saving money, effort and even time in terms of decision making, logistics and
processes.

Synergy: Value Of The Whole Exceeds Sum Of The Parts

These factors could arise from the following perspectives

1. Operating Economies – refer to the reductions in costs per unit thanks to the
increase in a company's operations both in terms of size and scale. In this
sense, operating economies include both economies of scale and
economics of scope. Operating economies is another term
for operating synergy.
2. Financial Economies – An economy of scale is where average cost falls as
production increases. Economies of scale come about because larger firms
are able to lower their unit costs. A financial economy of scale results from the
ability of large firms to borrow money on better terms than smaller firms which
makes the cost of financing investment lower. This may be because they are
seen as a better risk by the financial institution or perhaps because they have
access to more efficient ways of raising capital.
3. Differential Management Efficiency - According to the differential efficiency
theory of mergers, if the management of firm A is more efficient than the
management of firm B and if after firm A acquires firm B, the efficiency of firm
B is brought up to the level of firm A, then this increase in efficiency is
attributed to the merger.
According to this theory, some firms operate below their potential and
consequently have low efficiency. Such firms are likely to be acquired by
other, more efficient firms in the same industry. This is because, firms with
greater efficiency would be able to identify firms with good potential operating
at lower efficiency. They would also have the managerial ability to improve the
latter’s performance.
However, a difficulty would arise when the acquiring firm overestimates its
impact on improving the performance of the acquired firm. This may result in
the acquirer paying too much for the acquired firm. Alternatively, the acquirer
may not be able to improve the acquired firm’s performance up to the level of
the acquisition value given to it. The managerial synergy hypothesis is an
extension of the differential efficiency theory. It states that a firm, whose
management team has greater competency than is required by the current
tasks in the firm, may seek to employ the surplus resources by acquiring and
improving the efficiency of a firm, which is less efficient due to lack of
adequate managerial resources. Thus, the merger will create a synergy, since
 the surplus managerial resources of the acquirer combine with the non-
managerial organizational capital of the firm. When these surplus resources
are indivisible and cannot be released, a merger enables them to be optimally
utilized. Even if the firm has no opportunity to expand within its industry, it can
diversify and enter into new areas. However, since it does not possess the
relevant skills related to that business, it will attempt to gain a ‘toehold entry’
by acquiring a firm in that industry, which has organizational capital alongwith
inadequate managerial capabilities.
4. Increased Market / Pricing Power - Market power refers to a company's
relative ability to manipulate the price of an item in the marketplace by
manipulating the level of supply, demand or both. A company with substantial
market power has the ability to manipulate the market price and thereby
control its profit margin, and possibly the ability to increase obstacles to
potential new entrants into the market. Firms that have market power are
often described as "price makers" because they can establish or adjust the
marketplace price of an item without relinquishing market share.
5. Taxes / Savings (Use Of Accumulated Losses) - Starting a business has
become rather easy, however, growing it is usually harder once a company
has reached a certain point. One of the best ways of growing an existing
company is through mergers and acquisitions. It is also worth noting that
mergers and acquisitions are regulated in countries all over the globe and
they come with many advantages. Let’s find out below the seven most
important advantages of merging with or acquiring another company. Many
governments offer tax cuts or reductions when a merger or acquisition is
completed. Among these, Singapore is one of the best Asian countries where
a merger or acquisition could take place in. Opening a business in
Singapore by merging or acquiring a smaller existing company can attract
substantial tax advantages in this country.

Philippines Tax Applications on M&A

Republic Act 10667

In 2015, one major law was enacted affecting M&A in the Philippines.
Republic Act No. 10667, also known as the Philippine Competition Act, was signed
into law on 21 July 2015. It provides for the creation of an independent, quasi-
judicial body called the Philippine Competition Commission.

The law grants the commission the power to review M&As based on factors
the commission deems relevant. M&A agreements that substantially prevent, restrict
or lessen competition in the relevant market or in the market for goods or services,
as the commission may determine, are prohibited, subject to certain exemptions.

Parties to a merger or acquisition agreement with a transaction value

exceeding 1 billion Philippine pesos (PHP) are barred from entering their agreement
until 30 days after providing notification to the commission in the form and containing
the information specified in the commission’s regulations. An agreement entered in
violation of this notification requirement would be considered void and subject the
parties to an administrative fine of 1–5 percent of the transaction’s value.

The law also provides that the commission shall promulgate other criteria,
such as increased market share in the relevant market in excess of minimum
thresholds, which may be applied specifically to a sector or across some or all
sectors in determining whether parties to a merger or acquisition should notify the
commission.

If the commission determines that such agreement is prohibited and does not
qualify for exemption, the commission may:

 prohibit the agreement’s implementation

 prohibit the agreement’s implementation until changes specified by the
commission are made
 prohibit the agreement’s implementation unless and until the relevant party or
parties enter into legally enforceable agreements specified by the
commission.
The Commission published Memorandum Circulars (MC) Nos. 16-001 and 16-
002 on 22 February 2016, and they will take effect on 8 March 2016. MC 16-001
provides transitional rules for M&As executed and implemented after the effective
date of the Philippine Competition Law and before the effective date of its
Implementing Rules and Regulations (IRR). Similarly, MC
16-002 provides transitional rules for M&As of companies listed with the Philippine
Stock Exchange.

Application for tax treaty relief

On 28 March 2017, the Bureau of Internal Revenue (BIR) issued Revenue
Memorandum Order (RMO) No. 08-2017 effective 26 June 2017 regarding the
procedures for claiming tax treaty benefits for dividend, interest and royalty income
of non-resident income earners. The RMO dispensed with the mandatory tax treaty
relief application (TTRA) for dividends, interests and royalties. Instead, preferential
treaty rates for dividends, interests and royalties may now be applied by Philippine
withholding tax agents on submission of a Certificate of Residence for Tax Treaty
Relief (CORTT) Form.

RMO No. 08-2017 does not apply to other types of income such as business
profits and gains from alienation of property. In these cases, RMO No. 72-2010, as
discussed below, applies and obtaining a ruling is still required.

On 25 August 2010, the BIR issued RMO No. 72-2010, which mandates the
filing of a TTRA for entitlement to preferred tax treaty rates or exemptions. Under
current regulations, this is now limited to income other than dividends, interests and
royalties as covered by RMO No. 08-2017. The TTRA must be filed before the
occurrence of the first taxable event (i.e. the activity that triggers the imposition of the
tax).

The BIR relaxed the TTRA filing deadline after a Philippine Supreme Court
ruling in August 2013. In that case, the BIR denied a TTRA because the taxpayer
failed to file their TTRAs before the occurrence of the first taxable event. The court
held that the obligation to comply with a tax treaty takes precedence over a BIR
revenue memorandum.

Break-up Value : Assets would be more valuable if sold to some other

company

The breakup value of a corporation is the worth of each of its main business
segments if they were spun off from the parent company. It is also called the sum-of-
parts value.

Key Takeaways:

 Breakup value is an analysis of the worth of each of a large corporation's

distinct lines of business.
 If the breakup value is greater than its market capitalization, investors may
press for a spinoff of one or more divisions.
 Investors would be rewarded with stock in the newly-formed companies, or
cash, or both.

If a major corporation has a market capitalization that is less than its breakup
value for a prolonged period of time, major investors may press for the company to
be split apart in order to maximize shareholder profits.

Understanding Breakup Value

Breakup value is applicable to large-cap stocks that operate in several distinct
markets or industries.

If a company's stock has not kept up with the perceived level of its full
value, investors may call for the company to be split apart, with proceeds returned to
investors as cash, new shares in the spinoff companies, or a combination of both.

Breakup Value and Business Valuation:

The end result is a breakup value analysis for each business segment of the
corporation. One way to do this is by relative valuation, which measures the
performance of each segment against its industry peers. Using multiples such as
price-to-earnings (P/E), forward P/E, price-to-sales (P/S), price-to-book (P/B), and
price to free cash flow, analysts evaluate how the business segment is performing
compared to its peers.

Analysts may also use an intrinsic valuation model such as discounted cash
flows or a DCF model. In this scenario, analysts use the business segment’s future
free cash flow projections and discounts them, using a required annual rate, to arrive
at a present value estimate.

A DCF is calculated as:

DCF = [CF1 / (1+r)1] + [CF2 / (1+r)2] + ... + [CFn / (1+r)n]

CF = Cash Flow

r = discount rate (WACC)

Other Valuation Methods

Other business valuation methods include market capitalization, a

straightforward calculation of in which a company’s share price is multiplied by its
total number of shares outstanding.

The times revenue method relies on a stream of revenues generated over a

period of time, to which an analyst applies a specific multiplier, derived from the
industry and economic environment. For example, a tech company in a high growth
industry may be valued at 3x revenue, while a less hyped service firm may be valued
at 0.5x revenue.

QUESTIONABLE REASONS FOR MERGERS:

 Diversification: Whereas the intent of companies to engage in M&A is leaning

towards extreme tax reduction or in some cases monopoly or price control
from one entity.

 Purchase of assets at below replacement costs

 Get bigger using debt-financed mergers to help fight off takeovers

TYPES OF M&A:

1. Friendly merger:

 The merger is supported by the managements of both firms

2. Hostile merger:

 Target firm’s management resists the merger.

 Acquirer must go directly to the target firm’s stockholders try to get

51% to tender their shares.

 Often, mergers that start out hostile end up as friendly when offer price
is raised.

Reasons why alliances can make more sense than acquisitions:

 Access to new markets and technologies

 Multiple parties share risks and expenses
 Rivals can often work together harmoniously
  Antitrust laws can shelter cooperative R&D activities

DIVESTITURES:

A divestiture is the partial or full disposal of a business unit through  sale,

exchange, closure, or bankruptcy. A divestiture most commonly results from a
management decision to cease operating a business unit because it is not part of
a core competency.
A divestiture may also occur if a business unit is deemed to be redundant
after a merger or acquisition, if the disposal of a unit increases the sale value of the
firm, or if a court requires the sale of a business unit to improve market competition.

In its simplest form, a divestiture is the disposition or sale of an asset by a

company, a way to manage its portfolio of assets. As companies grow, they may find
they are in too many lines of business and they must close some operational units to
focus on more profitable lines. Many conglomerates face this problem.

Companies may also sell off business lines if they are under financial duress.
For example, an automobile manufacturer that sees a significant and prolonged drop
in competitiveness may sell off its financing division to pay for the development of a
new line of vehicles.

Divested business units may be spun off into their own companies rather than
closed in bankruptcy or a similar outcome. Companies may be required to divest
some of their assets as part of the terms of a merger. Governments may divest some
of their interests in order to give the private sector a chance to profit.

By divesting some of its assets, a company may be able to cut its costs, repay
its outstanding debt, reinvest, focus on its core business(es), and streamline its
operations. This, in turn, can enhance shareholder value. This is especially important
when there is volatility in the markets or if the company experiences unstable
conditions.

KEY TAKEAWAYS:

 Divestitures happen when a company disposes of all or some of its assets by

selling, exchanging or closing them down, or through bankruptcy.
 As companies grow, they may decide that they are involved too many
business lines, so divestiture is the way to stay focused and remain profitable.
 Divestiture allows companies to cut costs, repay their debts, focus on their
core businesses, and enhance shareholder value.

Advantages & Disadvantages of Mergers & Acquisitions:

Pros

 Economies of scale – bigger firms more efficient

 More profit enables more research and development.
 Struggling firms can benefit from new management.
 Consolidation in departments
  Maximised workforce

Cons

 Increased market share can lead to monopoly power and higher prices for
consumers
 A larger firm may experience diseconomies of scale – e.g. harder to
communicate and coordinate.
 Job losses (Redundancy, Force Retirement & Retrenchment)
 Lesser product range options
 Diseconomies of scale

Advantages & Disadvantages of Divestitures:

Pros
 Right-sizing the business
 Cutting costs for efficiency
 Save a dying business
 Enable focus on the change or the strength
Cons
 Issues from hesitance of lenders
 Potential revenue risk
 Job losses

Opting to divest from your company is not an easy decision. After all, it’s hard to
decide what to cut, sell, or part with when you own your own business. Shuttering a
store means laying off staff; giving up on a product line means sacrificing the costs
involved in getting it off the ground. If your market conditions and business activities
make it such that divestiture is your best way to cover expenses or right-size your
business, it can be the right (if still painful) decision to make. Alternatively, if
divestiture means selling your business and taking advantage of the hard work you
put in to make it successful, then divesting can mean the realization of a dream
come true. It all comes down to your own scenario and perspectives.