joint ventures, minority investments, acquisitions, and mergers. The choice among these alternatives is driven by at least three considerations: the benefits from relatedness of the target business to the core of the acquirer, the need for control, and the need to manage risk.
Restructuring activity is a significant source of M&A activity: one-quarter to one-third of all deals annually are divestitures by other firms. But divestiture is only one of the tactical instruments of a strategy of restructuring. This chapter outlines other alternatives, including liquidations, minority investments, spin-offs, carve-outs, split-offs, and tracking stock. (Financial restructurings are reserved for discussion in Chapter 13.) The selection among the various tactical alternatives will be driven by the relatedness of the unit to the core of the parent, the need for control, and whether the unit can survive as an independent entity.
The survey of research in this chapter suggests that restructuring creates value: Divestiture, spin-offs, carve-outs, and tracking stock are associated with significant positive returns at the announcement of those transactions.
However, the costs and benefits of a strategy of diversification remain unsettled. That diversification destroys value is the conventional wisdom in 2003, but the latest research challenges its certainty. This suggests that the practitioner should think critically about blanket assertions about the value of a strategy of diversification or focus. Future research will likely give a more contingent explanation, such as “diversification pays in these circumstances.” In the interim, it is too early to tell.
APPENDIX 6.1 A Critical Look at the Self-Sustainable Rate of Growth Concept and Formulas
The self-sustainable growth rate (SSGR) is the maximum rate at which a firm can grow without sales of new common equity. A firm that has a high SSGR relative to its targeted growth rate can execute its business strategy without having to dilute the interests of existing shareholders, submit its plans and intentions to the scrutiny of a stock offering, and incur the relatively high costs of stock issuance. Also, a firm that has a high SSGR relative to its competitors is bound to have some strategic advantage in exploiting the random flow of growth opportunities that come to every industry. Regardless of the popularity of this concept, the financial adviser and analyst must understand its possible application and limitations in order to put it to best use.
BEGINNINGS: A FOCUS ON VALUE
The interest in self-sustainable growth had its origins in the work of two academicians, Merton Miller and Franco Modigliani (1961) (M&M), who asked the question: At what rate will the market value of the firm grow? They argued that the only kind of growth on which operating managers should focus is growth of value because any of the other bases of growth (e.g., sales or assets) are flawed guides16 for corporate policy; only growth of market value was consistent with an interest in value creation. M&M showed that the growth rate in market value is simply the product of two variables: the internal rate of return (IRR) of expected future cash flows, and the rate of reinvestment of that cash flow back into the firm.
(1)
Here K is the reinvestment rate of the cash flows, and ρ (or “rho,” a Greek letter) is the IRR of cash flows. The virtue of the M&M growth rate model is that it is economically correct: (1) it focuses on cash flow; and (2) it takes into account the time value of an entire stream of cash. The formula is deceptively simple: Whether the firm can reinvest in the same activities that produce a given IRR depends on a wide range of strategic assumptions such as the rate of technological change, the length of a product life cycle, or the persistence of competitive advantage. In short, the application of this model takes careful thought.
THE POPULAR MODEL FOR ASSET GROWTH
As a shorthand for estimating the self-sustainable growth rate, many analysts use the model shown in equation (2) and its variants, equations (3 and 4):
In the formulas, ROE is the accounting return on equity, ROTC is return on total capital17, Kd is the after-tax cost of debt, and DPO is the dividend payout ratio.18 Equation (2) is simply an accrual-accounting version of M&M’s formula: (1 – DPO) is equivalent to M&M’s K. For ROE, many analysts use the expected return for the next few years. A less sensible assumption is to use the past few years’ average ROE.
Equation (3) expands the preceding equation by inserting a well-known formula for the ROE of a levered firm. The virtue of this form of the model is that it allows the analyst to tinker with a possible interdependence between the firm’s mix of capital and its cost of debt. For instance, the firm’s cost of debt might be supposed to rise as the firm increased its debt/equity ratio past some moderate level.
Equation (4) also expands equation (2) by inserting the well-known DuPont system of ratios for ROE. This version is appealing to operating managers since it decomposes ROE into a measure of margin profitability (net income/sales), a measure of asset turnover (sales/assets), and a measure of leverage (assets/equity). With the aid of this model, one can see more directly the effects of price or cost improvements and better asset utilization.
INSIGHTS TO BE GAINED FROM THE POPULAR ASSET GROWTH MODEL
Comparisons across Firms
The popular self-sustainable growth model can yield insights into the comparative strategic robustness of competitors within an industry. For instance, Exhibit 6A.1 gives the calculations for the self-sustainable growth rates for five retailers competing in selling women’s apparel. The data, drawn from Value Line,19 are forecasts of the variables for each firm in early 1991 for the period through 1995. Consider each firm’s strategic ability to grow and the sources of that strength.
EXHIBIT 6A.1 Self-Sustainable Growth Rates for Five Retailers
| Name | Self-Sustainable Growth Rate | Dividend Payout Ratio | Return on Total Capital |
Hypothetical Bond Rating and After-Tax Cost of
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