UNIT- IV

MERGER STRATEGY

MERGER STRATEGY (Financial Management by Prasanna Chandra, Page No: 824-831)

Corporate restructuring includes mergers and acquisitions, amalgamations, takeover-spinoffs

leveraged buy-offs, buy back of shares, sale of business units and assets etc. Mergers and
Acquisitions are the most popular means of corporate restructuring or business combinations.
They have played an important role in the external growth of a number leading companies in
the world over in USA the first merger was emerged between 1890 & 1904 and the second
merger began at the end of the 1st world war. In India, in legal sense merges is known as
Amalgamation.

Merger meaning

 I.M.Pandey emphasizes that a merger is the end result of two companies combining
into one company.
 Merger is a combination of two companies in which eventually only one survives as
the merged company loses its existence.
 A merger refers to a combination of two or more companies into one company .it may
involve through absorption or consolidation.

Merger through Absorption: Two or more companies merge to form one existing company.

Example: Tata consultancy Ltd and Tata fertilizers

Merger through Consolidation: Two or more companies merge to form a new company

Example:

Hindustan instruments Ltd

Indian software company Ltd HCL Limited

Indian reprographics Ltd

Characteristics of merger (Strategic Financial Management by Rajni Sofat, Page No:

335-336)

 Merging of companies by purchase of assets or stock

 Loss of entity of the merging company
 A friendly deal
 Mutual benefit
 Pooling the resources
 Impact on the value of the firm
 Compensation to shareholders

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Reasons for Merger/Motives for Merger (Strategic Financial Management by Rajni
Sofat, Page No: 337-339)

 Growth objects of an organization

 Expansion

 To compete better in intense competition

 Synergies and economies of scale

 A safeguard against future takeovers

 Value chain optimization

 Surplus resources

 Survival

 Turnaround strategy

 Innovation for a mature company

 Risk management

 Retention of talented human capital

 Tax planning

 Revival and reconstruction benefits

 As a logical natural process

TYPES OF MERGERS / FORMS OF MERGER (Strategic Financial Management by

Rajni Sofat, Page No: 341-342)

 Horizontal Merger: A horizontal merger is the combination of two or more firms

that produce the same goods or service. This merger may help reduce rivalry among
the firms and bring harmony in the relevant industry.
Example: Chrysler and Daimler-Benz merger in the automotive industry. The new
company became DaimlerChryslar.
 Vertical Merger: The vertical merger relates to the combining of firms that are
forward or backwards on the supply chain. So, a merger between a firm and its
supplier of raw material or the distributor of its products is best explained as vertical
merger.
Example: Disney Pixar merger in the animation entertainment industry. This merger
created a win-win situation, as Disney distributed Pixar firlms and Pixar offered
creative animation.
 Congeneric/ Concentric merger: A merger between firms of related industry. It is
also known as concentric merger. This means the firms are of similar nature, but do
not manufacture the same products or provide the same service. The industry is

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 similar, but it must be noted that, there does not exist a buyer-seller connection
between the merging companies, and also that, they may have different functional and
operational lines within the same industry.
Example: The Prudential Insurance Company of America (an insurance company)
with Bache & Co. (stock brokerage and investment banking) is an appropriate
example, as both the firms operate in the financial services sector, but have their
different area of operations.
 Conglomerate Merger: A conglomerate merger is the merger of two firms from
different industries. Conglomerate mergers help to reduce business risk and promote
diversification. There can be of the two types.
- Pure and Mixed conglomerate merger: It involves entirely non-related
industries, these firms have no similarity in their product or service offering.
While a mixed conglomerate merger may have some degree of relatedness.

Example: Merger between the General Motors (car manufacturing firm) and DuPont
(a chemical manufacturing company) with the purpose of gaining managerial
expertise from DuPont to survive competition.

 Reverse merger: It is one when a smaller company initiates and sends the merger
proposal to a larger or more influential company. Also, in a reverse merger, one of the
non-listed company proposes to merge with a listed company in order to surpass the
complications of opting for IPO and issue management and directly merging with an
already listed company. And, it helps private company to bypass lengthy and complex
process required to be followed in case it is interested in going public.

THEORIES OF MERGERS

 Differential Efficiency: It is also called managerial synergy or managerial efficiency.

According to this theory.
- If the management of firm A is more efficient than the management of firm B and
after firm A acquires firm B the efficiency of firm B is brought up to the level of
efficiency of firm A . Efficiency is increased by merger.
- Basis for horizontal merger
- It may be social gain as well as private gain.
 Inefficient Management Theory: This is similar to the concept of managerial
efficiency but it is different in that inefficient management.
- Basis for mergers between firms when unrelated business i.e., conglomerate
merger.
- The management in control is not able to manage asset efficiently, mergers with
another firm can provide the necessary supply of managerial capabilities.
- In this replacement of incompetent managers were the sole motive for mergers
and also manager of the target company will be replaced.
 Synergy: Synergy refers to the type of reactions that occur when two substances or
factors combine to produce a greater effect together than that which the sum of the
two operating independently could account for. The ability of a combination of two
firms to be more profitable than the two firms individually. In this company can

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 create great shareholders value than if they are operated separately. There are two
types of synergy:
- Operating synergy: Operating synergy is improved by Economies of scale and
economies of scope.
 Economies of scale: It means reduction of average cost with increase in
volume or production. Because of fixed overhead expenses such as steel,
pharmaceutical, chemical and aircraft manufacturing. In that merging of
company in same line of business such as horizontal Merger it eliminates
duplication and concentrates a great volume of activity in a available
facility. In vertical mergers com expands forward towards the customer or
backward towards the source of raw material (suppliers). By acquiring
com control over the distribution and purchasing bring in economies of
scale.
 Economies of scope: Using a specific set of skill or an asset currently
employed in producing a specific product or service. Operating synergy
arises from improving operating efficiency through economies of scale and
scope by acquiring a customers, suppliers, and competitors.
- Financial synergy: Impact of merger on cost of capital of acquiring firms or the
newly formed firm. Cost of capital can be reduced with financial synergy.
 Financial synergy occurs as a result of the lower costs of internal financing
versus external financing. A combination of firms with different cash flow
positions and investment opportunities may produce a financial synergy
effect and achieve lower cost of capital.
 Tax saving is another consideration. When the two firms merge, their
combined debt capacity may be greater than the sum of their individual
capacities before the merger.
 The financial synergy theory also states that when the cash flow rate of the
acquirer is greater than that of the acquired firm, capital is relocated to the
acquired firm and its investment opportunities improve.

 Pure Diversification: Diversification through mergers is commonly preferred to

diversification through internal growth, given that the firm may lack internal
resources or capabilities requires.
- It may be done including demand for diversification by managers and other
employees, preservation of organizational and reputational capital, financial and
tax advantage.
- It is undertaken to shift from the acquiring com core product line or market into
those that have higher growth prospect.
- Research reveals that investors do not benefited from diversification. Investors
perceive com diversified in unrelated areas as riskier because they are difficult for
management to understand.
 Strategic realignment to changing environment: It suggests that the firms use the
strategy of M&As as ways to rapidly adjust to changes in their external environments
in regulatory framework and technological innovation. When a company has an
opportunity of growth available only for a limited period of time slow internal growth
may not be sufficient.

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 - Technical change contributes to new products, industries, market.
- The use of IT technology is likely to encourage mergers which are less expensive
and faster way to acquire new technology and owner knows that how to fill a gap
in current offering or to entering new business .
 Hubris Hypothesis: Hubris hypothesis implies that manager’s look for acquisition of
firms for their own potential motives and that the economic gains are not the only
motivation for the acquisitions. This theory is particularly evident in case of
competitive tender offer to acquire a target. The urge to win the game often results in
the winners curse refers to the ironic hypothesis that states that the firm which over
estimates the value of the target mostly wins the contest.
 Q-ratio: The ratio relates the market value of shares to replacement value of asset.
- Inflation and high interest rate can depress share price will below the book value
of the firm; high inflation may also raise replacement cost above the book value of
asset.
- Mergers are undertaken when market value of company is less than replacement
cost of its asset.
 Information and signaling: The announcement of mergers negotiation or a tender
offer may convey information or signals to market participants that future cash flows
are likely to increase and that future will increase in future values.
 Agency problem: When it takes place where there is a divergence between the goals
of management and owners. Takeover and mergers would be a threat because of
inefficiency or agency problem.
 Market power /share: Increase in the size of the firm is expected to result in market
share. The decrease in the number of firm will increase recognized interdependence.
Mainly mergers are undertaken to improve ability to set and maintain prices above
competitive level.
 Managerialism: Managers may increase the size of the firm through mergers in the
beliefs that their compensation is determined by size but in practice management
compensation is determined by profitability.
 Tax consideration: Unused net operating loss of the target com and the revaluation
or writing up of acquired asset and the tax free status of the deal influence M&A Tax
consideration & Loss carry forward can be set off against the combined firm taxable
income.

MERGERS AND ACQUISITION PROCEDURE (Palanisamy Saravana, Jayaprakash Sugavanam

Page No: 291-293), (I.M.Pandey, Page No: 695-696)

Mergers and acquisitions involve a series of process and are governed by statutory
requirements as per various acts. The companies act, 1956, lays down the various procedures
for M&A. Mergers and acquisitions has been permitted by the memorandum of association.
In case of listed companies, the notification has to be given to the stock exchange where the
shares of the company are listed. The board of director’s approval has to be obtained. After
that, the same amalgamation proposal should be filed with the high court. The shareholders
should get the approval of more than 75 percent of the shareholders for the scheme of the
merger. The court will approve the merger/ acquisition and this shall be published in two
news papers.

The companies Act, 1956, lays down the legal procedures for mergers and acquisitions.
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  Permission for merger: Two or more companies can amalgamate only when the
amalgamation is permitted under their memorandum of association. Also, the
acquiring company should have the permission in its object clause to carry on the
business of the acquired company. In the absence of these provisions in the
memorandum of association, it is necessary to seek the permission of the
shareholders, board of directors and the company law board before affecting the
merger.
 Information to the stock exchange: The acquiring and the acquired companies
should inform the stock exchanges (where they are listed) about the merger.
 Approval of board of directors: The board of directors of the individual companies
should approve the draft proposal for amalgamation and authorize the managements
of the companies to further pursue the proposal.
 Application in the high court: An application for approving the draft amalgamation
proposal duly approved by the board of directors of the individual companies should
be made to the high court.
 Shareholder’s and creator’s meetings: Individual companies should hold separate
meetings of their shareholders and creditors for approving the amalgamation scheme.
At least, 75 percent of shareholders and creditors in separate meeting, voting in
person or by proxy, must accord their approval to the scheme.
 Sanction by the high court: After the approval of the shareholders and creditors, on
the petitions of the companies, the high court will pass an order, sanctioning the
amalgamation scheme after it is satisfied that the scheme id fair and reasonable. The
date of the court’s hearing will be published in two news papers, and, also, the
regional director of the company law board will be intimated.
 Filing of the court order: After that court order, its certified true copies will be filed
with the registrar of companies.
 Transfer of assets and liabilities: The assets and liabilities of the acquired company
will be transferred to the acquiring company in accordance with the approved scheme
with effect from the specified date.
 Payment by cash or securities: As per the proposal, the acquiring company will
exchange shares and debentures and/ or cash for the shares and debentures of the
acquired company. These securities will be listed on the stock exchange.

The competition Act, 2002

The competition Act, 2002, will allow the merger and acquisition if it does not cause any
adverse effect on the competition in the market the companies are operating. The Act
prescribes the threshold limits for the assets and turnover criteria for scrutiny by the
commission for checking the adverse effects.

The competition commission will look into the following factors while regulating the
combinations.

 Potential and actual competition through imports

 The extent of barriers to entry into the market
 The possibility of increase in profits/prices
 The market share of the merger and acquisition parties individually and as a joint
entity.

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  Innovation and its impact on the market
 Are there any adverse effects of the merger and acquisition
 Will this merger and acquisition remove competition form market

The other regulations provided are the Foreign Exchange Management Act, 1999, and the
Income Tax Act, 1961. Besides, the Securities Exchange Board of India (SEBI) has issued
guidelines to regulate mergers and acquisitions.

FINANCIAL EVALUTION OF MERGER (Financial Management by M Y Khan and P K Jain,

Page No: 32.6-32.22) (Strategic Financial Management by Rajni Sofat, Page No: 344-347)

Financial evolution of a merger is needed to determine the earnings and cash flows, areas of
risk, the maximum price payable to the target company and the best way to finance the
merger. The acquiring firm must pay a fair consideration to the target firm for acquiring its
business. Simply whether merger is financially advisable or not.

Approaches/ Methods

 Asset-Based valuation approach/Valuation based on Assets: This approach rates

the value of the firm on the basis of asset its own and its worth. In this approach, the
physical assets may be taken only at their monetary quantification values or
sometimes the qualitative assets, like goodwill, patents, innovative research. There is
another concept in which the asset value is calculated as if at a point of time, the firm
is liquidated, in that situation what will be the value of the assets. This method
provides an appropriate value that the company holds in the quantitative and
qualitative form.
Net assets = Total assets – Total external liabilities
The value of net assets is also known as net worth or equity/ordinary shareholders’
funds. Assuming the figure of net assets to be positive, it implies the value available
to equity shareholders after the payment of all external liabilities.
Net asset per share = Net assets/ Number of equity shares issued and outstanding.
Limitations of Asset based approach
- It ignores the firm’s prospects of future earnings and
- It also ignores the firm ability to generate cash in business valuation.
 Earnings based approach to valuation/Valuation based on earnings: The earnings
based approach is essentially guided by the economic proposition that business
valuation should be related to the firm’s potential of future earnings or cash flow
generating capacity. This approach overcomes the limitation of assets based approach,
which ignores the firm’s prospects of future earnings and ability to generate cash in
business valuation. There are two major types of this approach:
- Earnings measure based on accounting-capitalization method : As per this
method, the earnings approach of business valuation is based on two major
components, that is, the earnings of the firm and the capitalization rate applicable
to such earnings (given the level of risk) in the market. Earnings normally
expected annual profits.
- Earnings measure on cash flow (Financial management) basis (DCF
approach): The P/E ratio approach, as a measure of valuation of equity

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 shareholders wealth, is essentially based on accounting profits/ earnings.
Normally such earnings are either of the current year or prospective earnings of
the next year.

 Market value based approach to valuation: This method attempts to value the firm
on the basis of its stock performance in the stock markets. The value is derived on the
basis of the price of company security in open market, based on its demand and
supply will be the best determining factor. The market value of securities used for the
purpose can be either (i) twelve months average of the stock exchange prices or (ii)
the average of the high and low values of securities during a year. Alternatively, some
other fair and equitable method of averaging (on the basis of the number of
months/years) can be worked out.
Limitations of market value based approach
- The main problem with this method is that the market value of firm is influenced
Not only financial fundamentals but also by speculative factors like market
sentiments, investors expectations etc.
This approach cannot be applied if the shares are unlisted or are not actively
traded.

FINANCING A MERGER/ PAYMENT OPTIONS AVAILABLE IN A MERGER

(Financial Management by I.M.Pandey, Page No: 681-681)

Cash or exchange of shares or a combination of cash, shares and debt can finance a merger,
or an acquisition. The means of financing may change the debt-equity mix of the combined or
the acquiring firm after the merger. When a large merger takes place, the desired capital
structure is difficult to be maintained, and it makes the calculation of the cost of capital a
formidable task. The other important factors are the financial condition and liquidity position
of the acquiring firm, the capital market conditions, the availability of long-term debt etc.

 Cash offer: A cash offer is a straight forward means of financing a merger. It does
not cause any dilution in the earning per share and the ownership of the existing
shareholders of the acquiring company. It is also unlikely to cause wide fluctuations
in the share prices of the merging companies. The shareholders of the target company
get cash for selling their shares to the acquiring company. This may involve tax
liability of them. In simple payment made to selling company by purchasing company
for acquiring stock and assets for cash.
 Ordinary shares/ Share exchange: The exchange of ordinary shares of merging
company for the amount of shares in the new company.
 Convertible loan stock: The share holders of one company exchange their shares for
convertible loan stock, i.e. loan or debt which can be later converted into equity after
a certain period of time.

MERGE AND DILUTION EFFECT ON EARNING PER SHARE (Financial

Management by I.M.Pandey, Page No: 682-682)

A merger usually involves combining two companies into a single larger company. The
combination of the two companies involves a transfer of ownership, either through

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a stock swap or a cash payment between the two companies. In practice, both companies
surrender their stock and issue new stock as a new company.

Dilution

Dilution occurs when a company issues additional shares of stock, and as a result the earnings
per share and the book valueper share decline.This happens because earnings per share and
book value per share are calculated by dividing the total earnings or bookvalue by the number
of existing shares.

The larger the number of shares, the lower the value of each share. Lower earnings per share
may trigger a selloff in thestock, lowering its price. That's one reason a company may choose
to issue bonds rather than new stock to raise additional capital.

Similarly, if companies merge or one buys another, earnings may be diluted if they don't incr
ease proportionately with the combined number of shares in the newly created company.

Example: Summarizes the effect of the merger of Excel with SFC’s on EPS, market value
and Price-earnings ratio with an exchange ratio.

Merger of EXCEL with SFC: Impact on EPS, Book value, Market value and P/E ratio

S.No Particulars SFC (before merger) Excel SFC (after merger)

1 Profit after tax 403 83 486
(Rs in crore)
2 Number of shares (crore) 157.50 25 175.84
3 EPS (Rs) 2.56 3.32 2.76
4 Market value per share (Rs) 57.86 24.90 57.80
5 Price-earnings ratio (times) 22.60 7.50 20.94
6 Total Market Capitalisation 9104 1060 10.164
(Rs in Crores)

Incremental adjustments

These are additional value items that are created when the two firms combine, which impact
on earnings per share:

 Incremental after-tax interest expenses that come from new debt financing.
 After-tax synergies (gains in assets).
 After-tax depreciation and amortization expense (from write-ups).
 Lost opportunity cost of cash balances if used to finance the acquisition.
 Saved after-tax interest expense from the liquidation of Target’s debt.
 Saved preferred stock dividend payment from liquidation or conversion of Target’s
preferred stock.

For example, a manufacturing company merges with a transportation firm. Due to this merge,
the manufacturing firm can save on their original distribution costs, which were initially paid
out to a third party. Because they can now use the assets of the transportation, they realize

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after-tax savings of $50M. The incremental adjustment here is an after-tax synergy arising
from those savings of $50M, which did not originally exist when the firms were separate.

Note

 Memorandum of Association (MOA): A Memorandum of Association (MOA) is a

legal document prepared in the formation and registration process of a limited liability
company to define its relationship with shareholders. The MOA is accessible to the
public and describes the company’s name, physical address of registered office,
names of shareholders and the distribution of shares. The MOA and the Articles of
Association serve as the constitution of the company. The MOA is not applied in the
U.S. but is a legal requirement for limited liability companies in European countries
including the United Kingdom, France and Netherlands, as well as some
Commonwealth nations.

 Demerger: Demerger is a form of corporate restructuring in which the entity's

business operations are segregated into one or more components. A demerger can take
place through a spin-off by distributed or transferring the shares in a subsidiary
holding the business to company shareholders carrying out the demerger.

 Equity carve-out: Equity carve-out, also known as a split-off IPO or a partial spin-
off, is a type of corporate reorganization, in which a company creates a new
subsidiary and subsequently IPOs it, while retaining management control. Only parts
of the shares are offered to the public, so the parent company retains an equity stake
in the subsidiary. Typically, up to 20% of subsidiary shares are offered to the public .
In simple disinvestment of a business unit, issuing the equity shares to public through
initial public offer (IPO). The parent company also maintains a controlling stake n
the company. Only a minority stock is issued while control rests with the parent
company.

 Earnings per Share (EPS) formula

EPS = (Acquirer firm Net Income + Target or acquired firm Net Income +/-
Incremental Adjustments) / (Acquirer outstanding shares + Target company
outstanding shares)

 No of shares outstanding formula

No of shares outstanding = PAT of Acquiring firm+ PAT of acquired firm/ EPS

 Market price per share formula

Market price per share = EPS * P/E ratio

 P/E ratio formula

P/E ratio = Market price per share / EPS

 Market capitalization: Calculated as the market value per share multiply with total
number of shares outstanding.

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  Market value per share: Calculated as the total market value of the business, divided
by the total number of shares outstanding.
 P/E ratio: The price to earnings ratio indicates the expected price of a share based on
its earnings. A company with a high P/E ratio usually indicated positive future
performance and investors are willing to pay more for this company's shares. It shows
how much investors are willing to pay per Rupee of earnings.

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