2023 Curriculum CFA Program Level II Corporate Finance
Corporate RestructuringDownload the full reading (PDF)
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Corporate issuers change over time. Although many changes are evolutionary, such as launching new products and expanding capacity, others involve more revolutionary changes to the legal and accounting structure of the issuer. The most well-known among these structural changes is acquisitions, in which one company buys another. Other well-known changes include divestitures and spin-offs, in which an issuer sells or separates a segment of its business. Common features among these changes are that they tend to attract significant press and analyst attention and their announcement is associated with increased securities trading volume.
This reading explains how to evaluate corporate restructurings from the perspective of an independent investment analyst. The discussion begins in Section 2 with an overview of corporate restructurings, including putting these events in the context of the corporate life cycle, and corporate issuers’ motivations for pursuing them. Sections 3 and 4 feature a three-step process for evaluating corporate restructurings as an investment analyst. Sections 5–7 demonstrate the evaluation process with case studies for each major type of corporate restructuring. The reading concludes with a summary and practice problems.
The member should be able to:
- explain types of corporate restructurings and issuers’ motivations for pursuing them;
- explain the initial evaluation of a corporate restructuring;
- demonstrate valuation methods for, and interpret valuations of, companies involved in corporate restructurings;
- demonstrate how corporate restructurings affect an issuer’s earnings per share (EPS); net debt to earnings before interest, taxes, depreciation, and amortization (EBITDA) ratio; and weighted average cost of capital;
- evaluate corporate investment actions, including equity investments, joint ventures, and acquisitions;
- evaluate corporate divestment actions, including sales and spin-offs; and
- evaluate cost and balance sheet restructurings.
- Corporate issuers seek to alter their destiny, as described by the corporate life cycle, by taking actions known as restructurings.
- Restructurings include investment actions that increase the size and scope of an issuer’s business, divestment actions that decrease size or scope, and restructuring actions that do not affect scope but improve performance.
- Investment actions include equity investments, joint ventures, and acquisitions. Investment actions are often made by issuers seeking growth, synergies, or undervalued targets.
- Divestment actions include sales and spin-offs and are made by issuers seeking to increase growth or profitability or reduce risk by shedding certain divisions and assets.
- Restructuring actions, including cost cutting, balance sheet restructurings, and reorganizations, do not change the size or scope of issuers but are aimed at improving returns on capital to historical or peer levels.
- The evaluation of a corporate restructuring is composed of four phases: initial evaluation, preliminary evaluation, modeling, and updating the investment thesis. The entire evaluation generally is done only for material restructurings.
- The initial evaluation of a corporate restructuring answers the following questions: What is happening? When is it happening? Is it material? And why is it happening?
- Materiality is defined by both size and fit. One rule of thumb for size is that large actions are those that are greater than 10% of an issuer’s enterprise value (e.g., for an acquisition, consideration in excess of 10% of the acquirer’s preannouncement enterprise value). Fit refers to the alignment between the action and an analyst’s expectations for the issuer.
- The three common valuation methods for companies involved in corporate restructurings, during the preliminary valuation phase of the evaluation, are comparable company, comparable transaction, and premium paid analysis.
- Corporate restructurings must be modeled on the financial statements based on the situational specifics. Estimated financial statements that include the effect of a restructuring are known as pro forma financial statements.
- The weighted average cost of capital for an issuer is determined by the weights of different capital types and the constituent costs of capital. The costs of capital are influenced by both bottom-up and top-down drivers. Bottom-up drivers include stability, profitability, leverage, and asset specificity. Corporate restructurings affect the cost of capital by affecting these drivers.