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Chapter 10 Corporate Financial Structure

Module IV – Corporate Finance. Chapter 10 Corporate Financial Structure. Bar exam. Corporate practice. Capitalizing the corporation Equity: common and preferred Debt: compare to equity (D/E ratio) Tax attributes Leverage: risk of insolvency Debt-equity mix Legal capital

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Chapter 10 Corporate Financial Structure

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  1. Module IV – Corporate Finance Chapter 10Corporate Financial Structure Bar exam Corporate practice Capitalizing the corporation Equity: common and preferred Debt: compare to equity (D/E ratio) Tax attributes Leverage: risk of insolvency Debt-equity mix Legal capital Money in : legal “consideration” Money out: illegal “distributions” Dividend policy Board discretion CHC vs PHC Law profession Citizen of world Chapter 10 Corporate Financial Structure

  2. Capital (money in) Chapter 10 Corporate Financial Structure

  3. Capital - attributes Return Risk Tax Common stock • Variable dividends • from earnings • board’s discretion • High • growth potential • voting rights Double corporate tax Preferred stock • Fixed dividends • from earnings • before pay common • Moderate / high • participating (growth) • cumulative (certain) • contingent voting Double corporate tax Bonds (LT debt) • Principal + interest • from future ops • K – not discretionary • Moderate / low • no growth potential • sometimes secured • personal guarantees Interest deductible Notes (ST debt) • Principal + interest • from current ops • K - not discretionary • Low • no growth potential • not secured Interest deductible Chapter 10 Corporate Financial Structure

  4. Financing an acquisition(recapitalizing a business) Chapter 10 Corporate Financial Structure

  5. Justin (buyer) Kathy (buyer) Lorenzo (buyer) Widget Bros (sellers) Widget, Inc. JKL Corporation ACQUIRES First National Bank Chapter 10 Corporate Financial Structure

  6. Widget Bros agree to sell their business for $2.0 million. The buyers don’t have enough cash (and also want some extra cash for expansion). Terms: $1.25 million in cash + $750,000 (10-year note @ 12% (with acceleration upon default). Is their debt a kind of “contingent ownership”? Seller financing Chapter 10 Corporate Financial Structure

  7. First National Bank will lend $500,000 to finance the acquisition and help recapitalize. Terms: 10-yr note (12% interest / $100,000 repayment of principal in years 6-10) Bank financing Chapter 10 Corporate Financial Structure

  8. Justin lacks cash, but wants some control. Terms: 40% common for $100,000 in cash and $100,000 note (escrow shares) Kathy has more cash, and wants control Terms: pays $200,000 for 40% common Lorenzo is less worried about control, but wants steady income Terms: Pays $600,000 in cash for 20% common + $500,000 preferred (10% dividend rate, cumulative, non-participating, convertible – like VC) Owner financing Chapter 10 Corporate Financial Structure

  9. Sources / uses of financing Chapter 10 Corporate Financial Structure

  10. Balance Sheet(JKL Corporation - as of acquisition date) ASSETS LIABILITIES Widget pre-acquisition Widget pre-acquisition assets $5,260 liabilities $3,750 New assets New liabilities Note receivable 100 New note (sellers) 750 New cash (expansion) 150 New note (bank) 500 Acquisition goodwill 490 Total liabilities 5,000 Equity Preferred stock 500 Common stock Paid-in 500 Total equity 1,000 Total assets $6,000 Total Liab + Equity $6,000 Chapter 10 Corporate Financial Structure

  11. Outside debt Financial returns Effect on business Inside debt Tax Bankruptcy What is leverage? “Equity is soft, debt is hard” Chapter 10 Corporate Financial Structure

  12. Leveraged (D/E = 4/1) All Equity Compare two capital structures … Owners Owners Debt $1,000,000 equity $200,000 equity $800,000 debt (10% interest) Corporation Corporation Chapter 10 Corporate Financial Structure

  13. Chapter 10 Corporate Financial Structure

  14. Chapter 10 Corporate Financial Structure

  15. Chapter 10 Corporate Financial Structure

  16. Effect of outside leverage Chapter 10 Corporate Financial Structure

  17. What if owners take on debt … Leveraged (D/E = 9/1) All Equity Owners Owners $500,000 equity $50,000 equity $450,000 debt (20% interest) Corporation Corporation Corporations: A Contemporary Approach Chapter 10 Corporate Financial Structure Slide 17 of 93

  18. Tax advantage of inside debt All equity (no leverage) ($500,000 invested) Leveraged (D/E = 90/10) (D$450,000 / E$50,000) Operating income $200,000 $200,000 Interest -- $90,000 (20% interest on $450,000) Income before taxes $200,000 $110,000 Corporate tax (15% rate) $30,000 $16,500 Net income (pay dividends) $170,000 $93,500 Total return (interest + div) $170,000 $183,500 Return on investment (equity + inside debt) 34% ($500,000 invested) 36.7% ($500,000 invested) Chapter 10 Corporate Financial Structure

  19. (1) IRS recharacterizes Inside debt treated as equity Remedy: interest not deductible • (2) Bankruptcy court recharacterizes • Inside debt treated as equity • “equitably subordinated” • Remedy: outside creditors reclaim place in line • Deep Rock doctrine Too much inside debt …(IRS and bankruptcy) Chapter 10 Corporate Financial Structure

  20. Tension in capital structure … Corporations: A Contemporary Approach Chapter 10 Corporate Financial Structure Slide 20 of 93

  21. Equity-Linked Investors, LP v Adams (Del Ch 1997) • Facts • Company in dire straights • Preferred vs common (BoD) • Preferred doesn’t want new debt • Issue • Duties of board when on “lip of insolvency”? • BJR or special duty to preferred/debt? • Holding • Judicial review: Until “point corporation must be liquidated is …BJR” • Analysis • Short-term interests of preferred vs long-term of common • “no duty owed to preferred … protections contractual in nature” Corporations: A Contemporary Approach Chapter 10 Corporate Financial Structure Slide 21 of 93

  22. Legal Capital “Validly issued, fully paid and non-assessable”(money in) Legal distributions(money out) Chapter 10 Corporate Financial Structure

  23. Issue equity securities (money in) Chapter 10 Corporate Financial Structure

  24. Hypothetical JKL Corporation has 1,000 no-par common shares that are authorized, and were issued to Justin, Kathy and Lorenzo. If the company wants to issue new common stock, what must it do? What are treasury shares? Can they be issued? At what price must the company sell the stock? Issuance of equity securities Chapter 10 Corporate Financial Structure

  25. Hypothetical JKL Corporation shares are held as follows: Justin (400), Kathy (400) and Lorenzo (200). Kathy and Lorenzo, a majority shareholders and a majority of the board, decide to authorize and issue 600 new shares – 400 to Kathy and 200 to Lorenzo. Can they do this without offering Justin his proportionate share? What protection does Justin have against dilution? Preemptive rights What are they? shareholder right to purchase newly issued shares proportionate voting and financial rights How create? Once mandatory, then default, now opt-in MBCA: No preemptive rights unless in articles Needed? Issuance at fair price Voting agreements Protect proportionality Chapter 10 Corporate Financial Structure

  26. Hypothetical Remember that Justin paid $100,000 cash and gave a $100,000 personal note for his JKL shares. Kathy and Lorenzo paid cash for theirs. Was Justin’s note lawful consideration? What protection do creditors have if JKL Corporation becomes insolvent? Del. GCL § 152 (old) … cash, services rendered, personal property, real property, leases of real property or a combination thereof .... * * * Del. GCL § 152 (as of 2004) … cash, any tangible or intangible property or any benefit to the corporation … Assure equity cushion Chapter 10 Corporate Financial Structure

  27. Hypothetical Justin, Kathy and Lorenzo want some assurance that once they’ve paid for their shares, there will be no further payment obligations. What legal opinion can you give them? What documents will you use in giving your opinion? MBCA § 6.21 Before the corporation issues shares, the board of directors must determine that the consideration received or to be received for shares to be issued is adequate. The determination by the board of directors as to the adequacy of consideration is conclusive as to whether the shares are validly issued, fully paid, and nonassessable. “Validly issued, fully paid and non-assessable” Chapter 10 Corporate Financial Structure

  28. Hypothetical Since the acquisition 3 years ago, JKL Corporation has had some success. This year there were $90,000 in net profits. Justin, Kathy and Lorenzo would like to take some cash out. Can they declare a dividend of $200,000? Delaware? MBCA? Pay dividends (money out) Chapter 10 Corporate Financial Structure

  29. Assets Cash  $   200 Accts receivable $1,400 Inventories $1,300 Prepaid expenses $   600 Total current assets  $3,500    Fixed assets   Land  $   600 Buildings  $1,700 Machinery  $1,000 Total PP&E  $3,300   Notes receivable  $   100 Goodwill $   100   Total Assets $7,000 Liabilities & Equity Current liabilities $2,650 Long-term liabilities  Note (old one) $2,000 Note (sellers) $   750 Note (bank) $   500 Debentures (Bernie) $   500 Total liabilities $6,400   Common stock (5000 shs) $   500 Retained earnings $   100 Total equity $   600   Liabilities & Equity $7,000 Legal distribution Chapter 10 Corporate Financial Structure

  30. Del GCL § 170   (a)  The directors of every corporation ... may declare and pay dividends ... either (1) out of its surplus ..., or (2) in case there shall be no such surplus, out of its net profits for the fiscal year in which the dividend is declared and/or the preceding fiscal year. Del GCL § 154  ... The excess, if any, at any given time of the net asset of the corporation over the amount so determined to be capital shall be surplus.  Net assets means the amount by which total assets exceed total liabilities. Del GCL § 154 [paraphrased]Capital is – (1) "the aggregate of par value of shares issued having par value" (2) "that part of consideration [in dollars] specified by the board to be capital, for shares issued without par value"If the board does not specify, "the capital ... shall be ... the amount of the consideration for such shares without par value.“ Chapter 10 Corporate Financial Structure

  31. Assets Cash  $   200 Accts receivable $1,400 Inventories $1,300 Prepaid expenses $   600 Total current assets  $3,500    Fixed assets   Land  $   600 Buildings  $1,700 Machinery  $1,000 Total PP&E  $3,300   Notes receivable  $   100 Goodwill $   100   Total Assets $7,000 Liabilities & Equity Current liabilities $2,650 Long-term liabilities  Note (old one) $2,000 Note (sellers) $   750 Note (bank) $   500 Debentures (Bernie) $   500 Total liabilities $6,400   Common (5000 shs) $   500 Retained earnings $   100 Total equity $   600   Liabilities & Equity $7,000 Legal distribution (Delaware) Chapter 10 Corporate Financial Structure

  32. Assets Cash  $   200 Accts receivable $1,400 Inventories $1,300 Prepaid expenses $   600 Total current assets  $3,500    Fixed assets   Land  $   600 Buildings  $1,700 Machinery  $1,000 Total PP&E  $3,300   Notes receivable  $   100 Goodwill $   100   Total Assets $7,000 Liabilities & Equity Current liabilities $2,650 Long-term liabilities  Note (old one) $2,000 Note (sellers) $   750 Note (bank) $   500 Debentures (Bernie) $   500 Total liabilities $6,400   Common (5000 shs) $   500 Retained earnings $   100 Total equity $   600   Liabilities & Equity $7,000 Legal distribution (Delaware) Common stock Stated capital (5000 shs @100/sh) $ 500 Capital surplus $   -- Retained earnings $   100 Chapter 10 Corporate Financial Structure

  33. Assets Cash  $   200 Accts receivable $1,400 Inventories $1,300 Prepaid expenses $   600 Total current assets  $3,500    Fixed assets   Land  $   600 Buildings  $1,700 Machinery  $1,000 Total PP&E  $3,300   Notes receivable  $   100 Goodwill $   100   Total Assets $7,000 Liabilities & Equity Current liabilities $2,650 Long-term liabilities  Note (old one) $2,000 Note (sellers) $   750 Note (bank) $   500 Debentures (Bernie) $   500 Total liabilities $6,400   Common (5000 shs) $   500 Retained earnings $   100 Total equity $   600   Liabilities & Equity $7,000 Legal distribution (Delaware) Common stock Stated capital (5000 shs @1/sh) $ 5 Capital surplus $   495 Retained earnings $   100 Chapter 10 Corporate Financial Structure

  34. Assets Cash  $   200 Accts receivable $1,400 Inventories $1,300 Prepaid expenses $   600 Total current assets  $3,500    Fixed assets   Land  $   600 Buildings  $1,700 Machinery  $1,000 Total PP&E  $3,300   Notes receivable  $   100 Goodwill $   100   Total Assets $7,000 Liabilities & Equity Current liabilities $2,650 Long-term liabilities  Note (old one) $2,000 Note (sellers) $   750 Note (bank) $   500 Debentures (Bernie) $   500 Total liabilities $6,400   Common (5000 shs) $   500 Retained earnings $   100 Total equity $   600   Liabilities & Equity $7,000 Legal distribution (Delaware) Common stock Stated capital (5000 shs no par) $ -- Capital surplus $   500 Retained earnings $   100 Chapter 10 Corporate Financial Structure

  35. MBCA § 55-6-40 Distributions to shareholders. (a) A board of directors may authorize and the corporation may make distributions to its shareholders subject to restriction by the articles of incorporation and the limitation in subsection (c). (c) No distribution may be made if, after giving it effect:   (1) The corporation would not be able to pay its debts as they become due in the usual course of business; or   (2) The corporation's total assets would be less than the sum of its total liabilities … Chapter 10 Corporate Financial Structure

  36. Assets Cash  $   200 Accts receivable $1,400 Inventories $1,300 Prepaid expenses $   600 Total current assets  $3,500    Fixed assets   Land  $   600 Buildings  $1,700 Machinery  $1,000 Total PP&E  $3,300   Notes receivable  $   100 Goodwill $   100   Total Assets $7,000 Liabilities & Equity Current liabilities $2,650 Long-term liabilities  Note (old one) $2,000 Note (sellers) $   750 Note (bank) $   500 Debentures (Bernie) $   500 Total liabilities $6,400   Common (5000 shs) $   500 Retained earnings $   100 Total equity $   600   Liabilities & Equity $7,000 Payment of dividends Chapter 10 Corporate Financial Structure

  37. Repurchase shares … Chapter 10 Corporate Financial Structure

  38. Hypothetical Since the acquisition 3 years ago, JKL Corporation has had some success. Lorenzo wants out, and Justin and Kathy agree. A bank will lend $300,000 to finance the buyout. Can the corporation buy Lorenzo’s shares for $500,000? Delaware? MBCA? Repurchase of shares Chapter 10 Corporate Financial Structure

  39. Del GCL § 160. Corporation's powers respecting ... redemption.  (a)  Every corporation may purchase, redeem, ... or otherwise acquire its ... own shares; provided, however, that no corporation shall:  (1) Purchase or redeem its own shares of capital stock for cash or other property when the capital of the corporation is impaired or when such purchase or redemption would cause any impairment of the capital of the corporation, MBCA § 1.40. ACT DEFINITIONS In this Act: …(6) "Distribution" means a direct or indirect transfer of money or other property (except its own shares) or incurrence of  indebtedness by a corporation to or for the benefit of its shareholders in respect of any of its shares. A distribution may be in the form of a declaration or payment of a dividend; a purchase, redemption, or other acquisition of shares; a distribution of indebtedness; or otherwise. Chapter 10 Corporate Financial Structure

  40. Assets Cash  $   200 Accts receivable $1,400 Inventories $1,300 Prepaid expenses $   600 Total current assets  $3,500    Fixed assets   Land  $   600 Buildings  $1,700 Machinery  $1,000 Total PP&E  $3,300   Notes receivable $   100 Goodwill $   100   Total Assets $7,000 Liabilities & Equity Current liabilities $2,650 Long-term liabilities  Note (old one) $2,000 Note (sellers) $   750 Note (bank) $   500 Debentures (Bernie) $   500 Total liabilities $6,400   Common stock (5000 shs) $   500 Retained earnings $   100 Total equity $   600   Liabilities & Equity $7,000 Repurchase shares Borrow $300 from Bank Chapter 10 Corporate Financial Structure

  41. Assets Cash  $   500 Accts receivable $1,400 Inventories $1,300 Prepaid expenses $   600 Total current assets  $3,500    Fixed assets   Land  $   600 Buildings  $1,700 Machinery  $1,000 Total PP&E  $3,300   Notes receivable $   100 Goodwill $   100   Total Assets $7,300 Liabilities & Equity Current liabilities $2,650 Long-term liabilities  Note (old one) $2,000 Note (sellers) $   750 Note (bank) $   800 Debentures (Bernie) $   500 Total liabilities $6,700 Common stock (5000 shs) $   500 Retained earnings $   100 Total equity $   600   Liabilities & Equity $7,300 Repurchase shares Chapter 10 Corporate Financial Structure

  42. Revaluation of assets … Chapter 10 Corporate Financial Structure

  43. Assets Cash  $   500 Accts receivable $1,400 Inventories $1,300 Prepaid expenses $   600 Total current assets  $3,500    Fixed assets   Land  $   600 Buildings  $1,700 Machinery  $1,000 Total PP&E  $3,300   Notes receivable $   100 Goodwill $   100   Total Assets $7,300 Liabilities & Equity Current liabilities $2,650 Long-term liabilities  Note (old one) $2,000 Note (sellers) $   750 Note (bank) $   800 Debentures (Bernie) $   500 Total liabilities $6,700   Common stock (5000 shs) $   500 Retained earnings $   100 Total equity $   600   Liabilities & Equity $7,300 Revaluation of assets Chapter 10 Corporate Financial Structure

  44. Revaluation of assets Assets Cash  $   500 Accts receivable $1,400 Inventories $1,300 Prepaid expenses $   600 Total current assets  $3,500    Fixed assets   Land  $1,200 Buildings  $1,700 Machinery  $1,000 Total PP&E  $3,300   Notes receivable $   100 Goodwill $   100   Total Assets $7,300 Liabilities & Equity Current liabilities $2,650 Long-term liabilities  Note (old one) $2,000 Note (sellers) $   750 Note (bank) $   800 Debentures (Bernie) $   500 Total liabilities $6,700   Common stock (5000 shs) $   500 Retained earnings $   100 Revaluation surplus $ 600 Total equity $   600   Liabilities & Equity $7,300 Corporations: A Contemporary Approach Chapter 10 Corporate Financial Structure Slide 44 of 93

  45. Klang v. Smith’s Food & Drug Centers, Inc. Chapter 10 Corporate Financial Structure

  46. Legal capital? Public shareholders • Plaintiff (an SFD public shareholder) claims SFD does not have enough “surplus” for repurchase • SFD would have a “negative net worth” after repurchase • Pro forma balance sheet in proxy statement (filed with the SEC) shows negative “capital surplus” of more than $121.6 million repurchase 50% stock (6.3mm shares) Smith’s Food & Drug Centers Yucaipa Companies Cactus Acquisition Smitty’s Merger 3.0mm shares Chapter 10 Corporate Financial Structure

  47. PRO FORMA (DOLLARS IN MILLIONS) Current portion of long-term debt: New Term Loans..........………………………………........................ $ 12.3 Other indebtedness...............…………………………………................ 1.4 ---------------------------------------------------------------------------------------------------------------- Total current portion of long-term debt...…………………………..... $ 13.7 ============================================================= Long-term debt: New Term Loans (a)...............……………………………................ $ 792.7 New Revolving Facility (a)(b).........…………………………….............. – New Senior Notes.............................………………………………..... 150.0 New Senior Subordinated Notes...............………………………....... 350.0 Other indebtedness.....................…………………………………......... 50.4 -------------------------------------------------------------------------------------------------- Total long-term debt...............………………………………............. 1,343.1 ============================================================= Redeemable preferred stock, $.01 par value..……………………………...... 3.3 New Preferred Stock, $.01 par value.............……………………………..... 71.2 Common stockholders' equity: Common Stock, $.01 par value (c)...…........ 0.2 Additional paid-in capital.................……………………………………….... 164.9 Retained earnings (deficit)...................……………………………….…..... (286.7) --------------------------------------------------------------------------------------------------------- Total common stockholders' equity (deficit).……………………………….. (121.6) --------------------------------------------------------------------------------------------------------- Total capitalization.................…………………………………………...... $1,296.0 ============================================================= Chapter 10 Corporate Financial Structure

  48. DGCL § 160(a): No corporation shall purchase … its own shares … when such purchase … would cause any impairment of the capital of the corporation DGCL § 154: [The board may] determine that consideration … received by the corporation for … its capital stock … shall be capital... The excess … of the net assets of the corporation over the amount so determined to be capital shall be surplus. Net assets means the amount by which total assets exceed total liabilities. Chapter 10 Corporate Financial Structure

  49. Revaluation of assets “Market” Balance Sheet SFD hires investment firm – Houlihan - to render solvency opinion • compares SFD's "Total Invested Capital" of $1.8 billion -- valued under the "market multiple" approach -- with SFD's long-term debt of $1.46 billion. • SFD's "concluded equity value" equals $346 million, more than outstanding par value of SFD's stock Houlihan gives opinion to SFD Board that transactions would not impair SFD's capital Assets $1.8 B Liabilities $1.4 B Equity $346 M “Figures never lie” Chapter 10 Corporate Financial Structure

  50. Delaware Supreme Court: “We understand that the books of a corporation do not necessarily reflect the current values of its assets and liabilities.” * * * “Market multiple” approach (FMV of assets minus liabilities) is OK to value company’s solvency. Holding: Recapitalization does not violate DGCL §160! Chief Justice Norman Veasey (1992-2004) Chapter 10 Corporate Financial Structure

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