a compilation on mergers & acquisitions

8/9/2019 A Compilation on Mergers & Acquisitions

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Index

Chapter No. Chapter Name Page No.

1 Introduction 1

2 Concepts / Definitions 4

3 Theories of mergers 10

4 Strategies of Mergers & Acquisitions 15

5 Defence Mechanism 23

6 Acquisition & Takeover Regulations - SEBI 25

7 Valuation 34

8 Legal Issues Relating to Mergers 51

9 De-merger & Reverse merger 57

10 Post Merger Scenario 60

11 Post Merger Integration 64

Chapter One


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Introduction

Mergers, acquisitions and restructuring have become a major force in the financial andeconomic environment all over the world. Essentially an American phenomenon till themiddle of 1970s, they have become a dominant global business theme at present. On Indianscene too corporate are seriously making at mergers, acquisitions which has become order ofthe day.

Mergers and acquisitions (M&A) and corporate restructuring are a big part of the corporatefinance world. Every day, Wall Street investment bankers arrange M&A transactions, which

bring separate companies together to form larger ones. When they're not creating bigcompanies from smaller ones, corporate finance deals do the reverse and break up companiesthrough spin-offs, carve-outs or tracking stocks.

Not surprisingly, these actions often make the news. Deals can be worth hundreds of

millions, or even billions, of dollars. They can dictate the fortunes of the companies involvedfor years to come. For a CEO, leading an M&A can represent the highlight of a whole career.And it is no wonder we hear about so many of these transactions; they happen all the time.

Next time you flip open the newspapers business section, odds are good that at least oneheadline will announce some kind of M&A transaction.

Sure, M&A deals grab headlines, but what does this all mean to investors, it discusses theforces that drive companies to buy or merge with others, or to split-off or sell parts of theirown businesses. Once you know the different ways in which these deals are executed, you'llhave a better idea of whether you should cheer or weep when a company you own buysanother company - or is bought by one. You will also be aware of the tax consequences for

companies and for investors.

If one considers available statistics, one finds that M & A activity is taking place with a veryrapid pace:

Acquisitions

Years No. of Acquisitions Bids Amount (Rs. Crore)

2005 06 868 102904

2004 05 798 602842003 04 833 35319

2002 03 841 32696

2001 02 1048 35086

2000 01 1174 23113

Mergers

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Years No. of Merger Deals

2005 06 368

2004 05 272

2003 04 2842002 03 332

2001 02 319

2000 01 317

Industry-wise Trend of Number & Value of Acquisitions:

SectorNumber of

Acquisitions

Value of Acquisitions

(Rs. Crore)

Manufacturing 436 45106Food & Beverages 48 2528

Textiles 57 1946

Chemicals 115 21698

Non Metallic Mineral Products 41 6331

Metals & Metal Products 35 2091

Machinery 69 4309

Transport Equipments 39 5039

Miscellaneous Manufacturing 25 687

Diversified 7 475Mining 8 914

Coal & Lignite 2 58

Crude Oil & Natural Gas 3 844

Minerals 3 12

Electricity 9 3751

Electricity Generation 8 3751

Electricity Distribution 1 -

Services 356 51882

Financial Services 126 15884Other Services 230 35998

Hotels & Tourism 26 1859

Recreational Services 31 1993

Health Services 8 912

Trading 29 1086

Transport Services 12 3303

Communication Services 25 13677

Misc. Services 21 3513

Information Technology 78 9657Construction 52 5212

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Real Estate 41 4505

Construction & Allied Activities 11 706

Total 938 110240

Industry-wise Trend of Number of Mergers:

Sector Number of Mergers

Manufacturing 136

Food & Beverages 23

Textiles 24

Chemicals 39

Non Metallic Mineral Products 9

Metals & Metal Products 7

Machinery 20

Transport Equipments 2Miscellaneous Manufacturing 12

Diversified -

Mining 2

Coal & Lignite -

Crude Oil & Natural Gas -

Minerals 2

Electricity 2

Electricity Generation 2

Electricity Distribution -Services 159

Financial Services 90

Other Services 69

Hotels & Tourism 3

Recreational Services 6

Health Services 2

Trading 20

Transport Services 2

Communication Services 4Misc. Services 19

Information Technology 13

Construction 13

Real Estate 7

Construction & Allied Activities 6

Total 414

Chapter Two

CONCEPTS / DEFINITIONS:

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* Source for Statistical Data: CMIE


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Important terms used in the world of mergers & acquisition, & their brief explanation:

1) Merger:

Merger is defined as the combination of two or more companies into a single company whereone survives and the other loses its corporate existence. The survivor acquires the assets as

well as liabilities of the merged company or companies.

2) Amalgamation:

Halsburys Laws of England describe amalgamation as a blending of two or more existingundertakings onto one undertaking, the shareholders of each blending company becomingsubstantially the share holders in the company which is to carry on the blended undertaking.

Section 2 (a) of Income Tax Act defines: Amalgamation in relation to companies means themerger of two or more companies to form one company in such a manner that:

1. All the properties of the amalgamating company or companies just before theamalgamated company by virtue of amalgamation become the properties ofamalgamation.

2. All the liabilities of the amalgamating company or companies just before theamalgamation become the liabilities of the amalgamation; become the liabilities ofthe amalgamated company by virtue of amalgamation.

3. Shareholders holding not less than three-fourth in value of shares in the amalgamatingcompany or companies becomes the shareholders of the amalgamated company byvirtue of amalgamation.

The term amalgamation and merger are synonymous / Interchangeable

3) Consolidation:Technically speaking consolidation is the fusion of two existing companies into a newcompany in which both the existing companies extinguish. The small difference betweenconsolidation and merger is that in merger one of the two or more merging companies retainsits identity while in consolidation all the consolidating companies extinguish and an entirelynew company is born.

4) Acquisitions / Takeovers:

This refers to purchase of majority stake (controlling interest) in the share capital of anexisting company by another company. It may be noted that in the case of takeover although

there is change in management, both the companies retain their separate legal identity.

Terms Takeover & Acquisition are used interchangeably.

5) Leveraged Buyouts:

It means any takeover which is routed through a high degree of borrowings. In simple wordsa takeover with the help of debt.

6) Management Buyouts:

It refers to the purchase of the corporation part or whole of shareholding of the controlling /

dominant group of shareholders by the existing mangers of the company.7) Sell Off :

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General Term for divestiture of part or whole of the firm by any one or number of means:i.e. sale, spin off, split up etc.

8) Spin Off:

A transaction in which a company distributes all the shares it owns in a subsidiary to its ownshareholders on pro-rata basis & then creates a new company with the same proportional

shareholding pattern as in the parent company.

9) Split Off :

A transaction in which some, but not all, shareholders of the parent company receive sharesin a subsidiary, for relinquishing their parent company shares.

10) Split Up :

A transaction in which a company spins off, all of its subsidiaries to it shareholders andceases to exist.

11) Equity Carve Out :A transaction in which a parent company offers some common stock of one of itssubsidiaries to the general public, so as to bring in a cash infusion to the parent companywithout losing the control.

TYPES OF MERGERS & ACQUISITIONS:

Mergers & Acquisition can be classified into three categories:

a) On the basis of movement in the industries:

Horizontal Vertical Forward integration Backward integration Conglomerate

b) On the basis of method or approach:

Leveraged buyouts Management buyouts Takeover by workers

c) On the basis of response / relation:

Friendly Takeovers Hostile Takeovers

Explanation of the various types of mergers and acquisitions:

1. Horizontal Mergers:

Horizontal merger involves merger of two firms operating and competing in the sameline of business activity. It is performed with a view to form a larger firm, which may

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have economies of scale in production by eliminating duplication of competitions,increase in market segments and exercise of better control over the market. It alsohelps firms in industries like pharmaceuticals, automobiles where huge amount isspent on R&D to achieve a critical mass and reduce unit development costs.

Horizontal merger tend to be regulated by the Govt. in view of their potential for

creating monopoly power and negative effect on competition.

Example: India cements acquiring Raasi Cement.

2. Vertical Mergers :

Vertical Mergers take place between two or more firms engaged in different stages ofproduction. The main reason for vertical merger is to ensure ready take off of thematerials, gain control over scarce raw materials, gain control over productspecifications, increase in profitability by eliminating the margins of the previous

supplier/ distributor and in some cases to avoid sales tax.

Example: Tea Estate Ltd merging with Brooke Bond Ltd.

3. Conglomerate Mergers:

Conglomerate merger refers to the merger of two or more firms engaged in unrelatedline of business activity.

Two important characteristics of conglomerate mergers are:i. A conglomerate firm controls a range of activities in various industries that

require different skills in the specific managerial functions of research,applied engineering, production and marketing.

ii. The diversification is achieved mainly by external acquisitions and mergersand not by internal development.

Among conglomerate mergers three types may be distinguished:i. A product extension merger broadens the product line of firm.

ii. A geographic market extension merger involves firms whose operations areconducted in non overlapping geographic areas.

iii. Other conglomerate mergers involving unrelated business and do not qualify

for product extension or geographic extension.

Example: GNFC acquiring Gujarat Scooters.

Conglomerate mergers can be further classified as Financial Conglomerates &Managerial Conglomerates:

a) Financial Conglomerates:

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Financial Conglomerates provide a flow of funds to each segment of the operations,exercise controls and are the ultimate risk takers. In theory, financial conglomeratesundertake strategic planning but do not participate in operating decisions.

Financial conglomerates take care of five distinct economic functions:1. It improves risk / return ratios through diversifications

2. It avoids Gamblers Ruin. Financial Conglomerates maintain economicviability with long term value. Without this form of risk reduction, or bankruptcyavoidance, the assets of the operating entity might be shifted to less productiveareas.3. It establishes system of financial planning and control which improves thequality of general and functional managerial performance.

4. If the management does not improve performance, the management is changed.5. Better resource allocation. If management is competent but product market

potentials are inadequate, executives of financial conglomerate will seek to shiftresources from the unfavorable areas to areas more attractive from point of viewof growth and profitability.

b) Managerial Conglomerates:

Managerial conglomerates not only assume financial responsibility but also play arole in Operating decisions and provide staff expertise and staff service to theoperating entities. By providing managerial counsel and interactions on decisions, themanagerial conglomerates increase the potential for improving performance. Whenany two firms of unequal management competence are combined the performance ofcombined firm will benefit from the impact of the superior management and total

performance of combined firm will be greater that the sum of individual parts. Thisdefines synergy in most general form.

Concentric Companies

The difference between managerial conglomerates and the concentric company isbased on the distinction between the general and specific management functions.If the activities of the segments brought together are so correlated that there is carryover of specific management functions (research, manufacturing, finance, marketing,

personnel and so on) or complementarily in relative strengths among these specificmanagement functions, the merger should be called concentric rather than

conglomerate.

The concentric merger is also called product extension merger. In such a merger, inaddition to transfer of general management skills, there is transfer of specificmanagement skills, as in production, research, marketing etc. which have been neitherused in different line of business. A concentric merger brings all the advantages ofconglomeration without the side effects i.e, with concentric merger, it is possible toreduce the risk without venturing into areas that the management is not competent in.

4. Consolidation Mergers:

Consolidation merger involves a merger of a subsidiary company with parent company.

The reasons behind such mergers are to stabilize cash flows and to make fundsavailable for the subsidiary. In consolidation mergers, economic gains are not readily

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apparent as merging firms are under the same management. Still, Flow of fundsbetween parent and the subsidiary is obstructed by other consideration of laws such astaxation laws, Companies Act etc. Therefore, consolidation can make it easier for toinfuse funds for revival of subsidiaries.

MERGER MOTIVES:

The merger motives are as follows:(1) Growth Advantage / Combination Benefits:

The companies would always like to grow and best way to grow without much loss oftime and resources is to inorganically by acquisition and mergers.

E.g.: Merger of

SCICI with ICICI

ITC Classic with ICICIAcquisition of

Raasi cement by India cement

Dharani Cement and Digvijay cement by Grasim Modi cement by Gujarat Ambuja.

(2) Diversification:

The companies could diversify into different product lines by acquiring companieswith diverse products. The purpose is to diversify business risk by avoiding to put alleggs into one basket.

E.g.: All Multi-product companies

(3) Synergy:

When the companies combine their operations and realize results greater in value thanmere additions of their assets, the synergy is said to have been resulted.

Combined efforts produce better results on account ofi) Rationalization of operating assets of merged companies.ii) Sharing of sales outlets / distribution channels.iii) Cost reduction / savings.

E.g.: Merger of Ranabaxy and Crossland Laboratories.

(4) Market Dominance / Market Share/ Beat Competition:

The predominant market share or market dominance has always driven the executivesto look for acquiring competitive companies and create a huge market empire.

E.g.: Acquisition of Tomco by Hindustan LeverComputer Associates International - Acquired around twenty softwarecompanies.Consolidation in cement industry

Nicholas Piramal Ltd. has merged into itself.(5) Technological Considerations:

It refers to enhancing production capacities to derive economies of scale.

E.g.: Acquisition of Corus by Tata.

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(6) Asset Tripping:

When the companies are acquired for the hidden assets which are owned and theseassets can be separately developed or even sold off for profit.

E.g.: Textiles companies being taken over for the surplus land which could be

developed for real estate / malls

(7) Taxation Benefits / Revival Of Sick Units:

Section 72 A provides for revival of sick units by allowing accumulated losses of thesick unit to be absorbed by the healthy units subject to compliances to the conditionsof the provisions.

(8) Acquiring Platform:

When a company would like to expand beyond geographical limits and acquireplatform in the new place the best way would be to acquire the companies.

E.g.: Acquisition of Parle by Coke.

Chapter Three

Theories of Mergers

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Theories provide an explanation to any phenomenon, pattern and provide basis for furtheraction plan. The phenomenon of merger and acquisitions has been explained by differenttheories as under:

I. Efficiency Theories

a) Differential Managerial Efficiencyb) Inefficient Managementc) Operating Synergyd) Pure diversificatione) Strategic Realignment to changing environmentsf) Under Valuation

II. Information and Signaling

III. Agency Problems and managerialism

IV. Free Cash flow hypothesisV. Market Power

VI. Taxes

VII. Redistribution

The explanation of the various theories is as follows:

I. Efficiency Theories

a) Differential Efficiency:

If the management of firm A is more efficient than the management of firm B and if afterfirm A acquires firm B, the efficiency of firm B is brought up to the level of efficiency offirm A, efficiency is increased by merger.

Features:

- There would be social gain as well as private gain.- This may also be called managerial synergy hypothesis.

Limitations:

- If carried to its logical extreme, it would result in only one firm in the economy, the

firm with greatest managerial efficiency.- Over-optimization on the part of efficient firm about its impact on acquired firm may

result in excess payment of consideration or failure to improve its performance.- Inefficient / under performing firms could improve performance by employing

additional managerial input through direct employment / contracting.

b) Inefficient Management:

Inefficient Management refers to non performance up to its potential level. It may bemanaged by another group more efficiently.

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Features:

- Inefficient Management represents management which is inept in absolutesense.- Differential management theory is more likely to be basis for horizontalmerger; inefficient management theory could be basis for mergers between firms of

unrelated business.

Limitations:

- Difficult to differentiate differential management theory from inefficienttheory.- The theory suggests replacement of inefficient management. Howeverempirical evidence does not support this.- The theory also suggests that acquired firms are unable to replace their ownmanagers and thus it is necessary to invoke costly merger to replace inefficientmanagers- This is not convincing.

c) Operating Synergy:

Operating synergy or operating economies may be achieved in horizontal, vertical andeven conglomerate mergers.

Features:

- Theory is based on the assumption that economies of scale do exist in thisindustry and prior to merger, firms are operating at the levels of activity that fall shortof achieving the potential for economies of scale.- Economies of scale arise because of indivisibilities such as people, equipmentoverhead which provide increasing returns if spread over a large number of units of

output.

d) Pure Diversification:

Diversification of the firm can provide the managers and employees with job security andopportunity for promotion and other things being equal, results in lower costs. Even forowner manager diversification is valuable as risk premium for undiversified firm ishigher.

Diversification has value for many reasons:- Demand for diversification by managers, other employees

- Preservation of organizational and reputation capital- Financial and tax advantages- Diversification helps preserving reputational capital of the firm, which will belost if firm is liquidated.

Diversification can be achieved through internal growth as well as mergers. Howevermergers may be preferred in certain circumstances:

- Mergers can provide quick diversification.- Firm may lack internal growth opportunity for lack of requisite resources ordue to potential excess capacity in industry.

e) Strategic Realignment to Changing Environment:

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Strategic planning is concerned with firm's environment and constituencies, not justoperating decisions. The speed of adjustment through merger would be quicker thaninternal development.

Features:

- Strategic planning approach to mergers implies either the possibilities of

economies of scale or tapping an underused capacity in the firms present managerialcapabilities.- By external diversification the firm acquires management skills foraugmentation of its present capabilities.- A competitive market for acquisitions implies that the net present value frommerger and acquisition investment is likely to be small. Nonetheless if synergy can beused as a base for still additional investments with positive net present values, thestrategy may succeed.

f) Under Valuation:

Some studies have attributed merger motives to under valuation of target companies.- One cause of under valuation may be that management is not operating thecompany up to its potential (aspect of inefficient management theory.)- Second possibility is that acquirer has an inside information. Hence, its bidder

possesses information which general market does not have, they may place highervalue on the shares than currently prevailing in the market.- Another aspect of under valuation theory is the difference between the marketvalue of assets and their replacement costs. Hence entry into new product marketareas could be accomplished on a bargain basis.

II. Information and Signaling:

Shares of the target company in a tender offer experiences upward revaluation even ifoffer turns out to be unsuccessful. New information generated as a result of tender offerand the revaluation is permanent.

Two forms of information:i) The tender offer disseminates the information that the target shares are undervalued

and offer prompts the market to revalue the shares.ii) Offer inspires the target firm management to implement a more efficient business

strategy on its own.

Signaling may be involved in number of ways:- Tender offer gives a signal to the market that hither to unrecognized extravalues are possessed by the firm or that- Future cash flow streams are likely to rise.- When a bidder firm uses common stock on buying another firm, it is taken asa signal that common stock of bidder firm is overvalued.- When buyer firm repurchases their shares, the market may take this as signalthat the management has information that its shares are undervalued and favorablenew opportunities will be achieved.

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III. Agency problems and Managerialism :

Agency problem arises when a manager owns a fraction of ownership shares of the firm.This partial ownership may cause managers to work less vigorously than other wise and /or consume more perquisites, (luxurious offices, company cars, membership of clubs)

because majority owners bear most of the cost.

Agency costs include:

i) Cost of structuring a set of contractsii) Cost of monitoring and controlling the behavior of agents by principals.iii) Cost of bonding to guarantee that agents will make optimal decisions or principles

will be compensated for consequences of sub-optimal decisions.iv) Residual loss: i.e. welfare loss experienced, by the principals arising from the

divergence between agents decisions and decisions to maximize principalswarfare. This residual loss can arise because the cost of full enforcement ofcontracts exceeds the benefits.

Takeover as solution to Agency Problems:

o Agency problems can be controlled by organizational or market mechanism:

o A number of compensation arrangements and market for managers may

mitigate agency problems.o Stock market gives rise to external monitoring device, because stock prices

summaries the implications of decisions made by managers. Low stock prices exertpressure on managers to change their behavior and to stay in line with interest ofshareholders.o When these mechanisms are not sufficient, market for takeover provides an

external control device of last resort.o A takeover through a tender offer or proxy fight enables outside managers to

gain control of decision process of Target Company, while circumventing theexisting managers and Board of Directors.

Managerialism

In contrast to the view that mergers occur to control agency problem, some observersconsider merger as manifestation of agency problems rather than the solution.Mueller emphasizes that managers are motivated to increase the size of the firm ascompensation to manager is function of the size of the firm.

But empirical evidence shows that compensation is correlated with profit rate and notwith level of sales.

IV. Free Cash flow hypothesis

Jenson argues that pay out of free cash flow can play an important role in dealing withconflict between managers and shareholders.Payout of free cash flow reduces the amount under control of managers and reducestheir power. Further they are subject to monitoring in capital market when they seek tofinance additional investment with new capital.He states that such a free cash flow must be paid out to shareholders if firm is to be

efficient and to maximize share price.

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Chapter Four

Strategies of Mergers & Acquisitions

The various strategies are as follows:

I. Mergers and Acquisitions as Managerial Strategy.

Forms of Business Restructuring

ExpansionCorporate Control

Mergers Acquisitions Joint

Venture Premium standstill Anti takeover ProxyBuy Backs agreements Amendments contests

Spin offs Divestitures Equity Curve outs

Split SplitOffs Ups

Exchange Share Going LeveragedOffers repurchases Private Buyouts

II. Mergers and Acquisitions as Management Strategy:

The different views are as follows:

Strategy as concept

Strategy as Process

Concerned with most important decisions of an

enterprise. Strategic planning process- set of formal procedure- Informally in the mind managers

Individual strategies, plans, Policies or procedures areutilized.

Strategic planning as behavior A way of thinking- Requiring diverse inputs from all segments- Everyone must be involved

Responsibility resides with Top executive.

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The process of strategic planning:

1) Monitoring environments:A key to all approaches to strategic planning is continuous monitoring of the external

environments. The environments should encompass both domestic and internationaldimensions and include analysis of economic, technological, political, social and legalfactors.

Different organization may give different emphasis and weights to each of the categories.

2) Stakeholders:

Strategic planning process to take into account the diverse stakeholders of organization,which have interest in the organization i.e., customers, stockholders, creditors,employees, Government, Communities, Media, Political group, Educational institutions,financial community and international entity.

3) Essential elements in strategic planning processes:

i. Assessment of changes in the environment.ii. Evaluation of company capabilities and limitations.

iii. Assessment of expectations of stakeholders.iv. Analysis of company, competitors, industry, domestic economy, and international

economies.v. Formulation of missions, goals and policies for master strategy.

vi. Development of sensitivity to critical external environmental changes.vii. Formulation of Long-range strategy programmes.

viii. Formulation of internal organization performance measurements.ix. Formulation of mid-range and short run plans.x. Organization, Funding and other method to implement all preceding elements.

xi. Information flow and feedback systemxii. Review and evaluation process.

4) Organization cultures:How organization carries out the strategic thinking and planning processes will vary withit cultures.

i. Strong top leadership v/s Team appraisals.

ii. Management by formal paperwork v/s Management by wandering around.iii. Individual decisions v/s Group decisions.iv. Rapid evaluation based on performance v/s Long term relationship based on loyalty.v. Rapid feed back for change v/s Formal bureaucratic rules and procedures.

vi. Risk taking encouraged v/s one mistake and you are out.vii. Narrow responsibility v/s everyone in this is a salesman cost controller, product

quality manpower or so on.viii. Learn from customers v/s we know what is best for customers.

5) Alternative strategy methodologies:

i. SWOT or WOTS Up: Inventory and analysis of organization strength, weaknesses,environmental opportunities, and threats.

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ii. Gap Analysis: Assessment of goals v/s forecasts or projections.iii. Top down / Bottom up: Company forecasts v/s aggregation of segments.iv. Computer models: Opportunity for detail and complexity.v. Competitive Analysis: Assess customers, suppliers, new entrants, products andproduct substitutability.

vi. Synergy : Look for complementarily

vii. Logical incremental: Well supported moves from current bases.viii. Muddling through: Incremental changes selected from small no. of policy

alternatives.ix. Comparative histories: Learn from experience of others.x. Delphi Technique: Iterated opinion reactions.

xi. Discussion group technique: Simulating ideas by unstructured discussions aimed atconsensus.

xii. Adaptive Processes: Periodic reassessment of environmental opportunity andorganization capability adjustment required.

xiii. Environmental scanning: Continuous analysis of relevant environments.xiv. Intuition: Insights of brilliant managers.

xv. Entrepreneurship: Creative leadership.xvi. Discontinuities: Crafting strategy from recognition of trend shifts.

xvii. Brain storming: Free form repeated exchange of ideas.xviii. Game theory: Logical assessment of competitors actions and reactions.

xix. Game playing: Assign roles and simulate scenarios.

6) Alternative Analytical framework:

i. Product Life cycles: Introduction, Growth, maturity, and decline stages with changingopportunities and threats.

ii. Learning curve: Costs decline with cumulative volume experience resulting in firstmover competitive advantages.

iii. Competitive Analysis: Industry structure, rivals reactions, supplies and customerrelations, product positioning.

iv. Cost leadership : Low cost advantagesv. Product differentiation: Develop product configuration that achieve customer

preference.vi. Value chain Analysis: Controlled cost outlays to add product characteristics valued

by customers.vii. Niche opportunities: Specialize to needs or interest of customer groups.

viii. Product breadth: Carry over of organizational capabilities.

ix. Correlation's with profitability: Statistical studies of factors associated with highprofitability measures.x. Market share: High market share associated with competitive superiority.

xi. Product quality: Customer allegiance and price differentials for higher quality.xii. Technological leadership: Keep at frontiers of knowledge.

xiii. Relatedness matrix: Unfamiliar markets and products involve greatest risk.xiv. Focus matrix : Narrow v/s Broadxv. Growth / share matrix: Aim for high market share in high growth markets.

xvi. Attractiveness matrix : aim to be strong in attractive industriesxvii. Global matrix: Aim for competitive strength in attractive countries.

7) Approaches to formulating Mergers and Acquisitions strategy:i. Boston Consulting Group

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ii. The Porter Approachiii. Adaptive Processes

i. Boston Consulting Group:The three important concepts of BCG are as follows:

Experience curve

Product life cycle Portfolio balance

o Experience curve:

It represents a volume-cost relationship. It is argued that as the cumulativehistorical volume of output increases, unit cost will fall at a geometric rate. Thiswill result from specialization, standardization, learning and scale effects.The firm with target cumulative output will have lower costs, suggesting astrategy of early entry and price policy to develop volume.

o

Product life cycle:Every product or a line of business proceeds through four places:

DevelopmentGrowthMaturity

And decline

During first two stages, sales and growth is rapid and entry is easy. As individualfirms gain experience and as growth slows in last 2 stages, entry becomesdifficult, because of cost advantages of incumbents.

In declining stage of product line, (as other substitutes emerge) sales and pricesdecline, firms which have not achieved a favorable position on the experiencecurve become unprofitable and either merge or exit from the Industry.

o Portfolio Approach:

Rapid growth may require substantial investments. As requirements for growthdiminish, profits may generate more funds than required for investments.Portfolio balances seeks to combine

Attractive investment segments ( stars)

Cash generating segments (cash cows)

Eliminating segments with unattractive prospects (Dogs)

Overall, total cash inflows will balance and corporate investments.

ii. The Porter Approach:

Michael Porter suggests the following:

Select an attractive industry.

Develop competitive advantage through cost leadership and productdifferentiation.

Develop attractive value chain.

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o Attractive Industry in which:

Entry barriers are high.

Suppliers and buyers have only modest bargaining power. Substitute products or services are few.

Rivalry among 'competitors' is stable.

o Unattractive Industry will have:

Structural flows

including plethora of substitute materials

Powerful and price sensitive buyers.

Excessive rivalry caused by high fixed costs and large group ofcompetitors, many of whom are state supported.

E.g.: Steel Industry.

o Competitive Advantage:

It may be based on cost leadership, product differentiation. Cost advantage isachieved by consideration of wide range of checklist factors including BCG's learningcurve theory.

o Value chain:

A matrix that relates the support activities of:

Infrastructure

Human Resource Management

Technology development

Procurement

Operations

Marketing / Sales / Service

Aim is to minimize outlays in adding characteristics valued by customers.

iii. Adaptive Processes:Adaptive processes orientation involves marketing resources to investmentopportunities under environmental uncertainty compounded with uncertain

competitors actions and reactions. It involves ways of thinking which assesscompetitors actions and reactions in relation to changing environments.

8) Factors favoring external growth and diversification through Mergers andAcquisitions:

i. Some goals and objectives may be achieved more speedily through an externalacquisition.

ii. The cost of Building an organization internally may exceed cost of an acquisition.iii. There may be fewer risks, lower costs, or shorter time requirements involved in

achieving an economically feasible market share by the external route.

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iv. The firm may not be utilizing their assets or arrangement as effectively as they could beutilized by the acquiring firm.

v. The firm may be able to use securities in obtaining other companies, where as it mightnot be able to finance the acquisition of equivalent assets and capabilities internally.

vi. There may be tax advantages.vii. There may be opportunities to complement capabilities of other firms.

9) Gains and Pains of Merger and Acquisition:

Gains Pains

Financial Returns/Profitability i. Expenses / Drain on Profitability

Aligned Org Structure.ii. Time and resource required to

manager / transition.

iii. New approaches to conductingwork.

iii. Reduced work productivity andquality.

Motivated and capable talent.iv. Unintended consequences for

employees attitudes and behavior.

Desired culture. v. Culture clash.

Cost Savings. vi. Customer concerns.

10) Planning for Merger and Acquisition:

i. Search for acquisition of Target Company based on objectives of the acquirer company.

ii. Services of Intermediaries a) Finding a Target companya) Consultants b) Negotiation

b) Merchant bankers c) Compliance of legalformalitiesc) Financial Institutions d) Completion of Financial arrangement

e) Closing the deals.

iii. Primary investigation about Target Company.

a) Industry Analysis Competition

Growth Rate / Future projectionsBarriers to entry / ExitMergers and acquisitions in industry and results

b) Financial Analysis Balance sheet and Profit and loss forpast years

Budgets and forecastsFinancial ratios - Return on Assets

- Return on Net worth- GP / NP

- D/ E Ratio- Expense Ratio

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Replacement cost dataValuation of Assets / Liabilities

c) Management Analysis Assessment of Senior Management

Business Experience

Union Contract / Strike HistoryLabour Relations / AgreementsPersonnel SchemesProfile of permanent employees

d) Marketing Analysis Data on Past SalesCustomer profileMajor sales agreementsTrendsDistribution channelsProduct ProfileDevelopment / Disclosure

e) Manufacturing LocationTechnologyManufacturing processQualityR & D

iv. Other Information- Inventory valuation, obsolescence, over valuation.- Litigation- Doubtful debts- Unrealized / Unrealizable Assets / Investments- Tax status / Assessments / Outstanding dues

v. Economic Analysis- Business Cycles- Public Interest- Government Prices / Incentives- Condition of securities market

vi. Comparison of Alternative Target companies and Arrival of decision as regards target

company.vii. Strategy for takeover - method to be employed.- Friendly take over through negotiations- Hostile

viii. Valuation of Assets and arriving at Purchase consideration.ix. Mode of Payment- Cash- Share Exchange Ratio

x. Legal formalities

- Takeover code- Company law

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- Income tax / SICA / IDR / MRTP

xi. Post Merger Integration.

Additional Information

When are Mergers and Acquisitions Successful?

If one plus one equals three - Mergers and acquisitions is successful.

Do Mergers and Acquisitions always succeed?

International studies suggest: 75% of all mergers fail only 25% succeed.

Some findings of International Studies:

(1) About 15% of Mergers and Acquisitions in USA achieve their financial objectives asmeasured by share value, return on Investment and Post combination profitability.[Course in Mergers and Acquisitions, American Management Association,1997]

(2) Up to 75% of European Mergers end in failure.[Harper J and Cormeraic S. Journal of European Inds. Training 1995]

(3) Separate studies by McKinsey & Co. and Coopers & Lybrand report that about 70%alliances fail or fall short of expectations.

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Chapter Five

Defence Mechanism

Defene mechanisms are the tools used by a company to prevent its takeover. In order to wardoff take over bid, the companies may adopt:

I. Preventive MeasuresII. Defence strategies in the wake of take over bid.

These defensive measures are elaborated below:

I. Advance / Preventive Measures:

a) Joint holding / Agreements between major shareholders

b) Interlocking / Cross holding of shares.c) Issue of block of shares to friends and Associates.d) Defensive merger with own group company.e) Non-voting shares / Preference sharesf) Convertible debenturesg) Maintaining part of capital uncalled for making emergency requirements.h) Long term service agreements.

II. Defence in the wake of takeover bid :

a) Commercial Strategies

i) Dissemination of favourable information to keep shareholders abreast oflatest developments.

- Market coverage- Product demand- Industries outlook and resultant profit.

ii) Step up dividend and update share priceiii) Revaluation of Assetsiv) Capital structure Re-organizationv) Unsuitability of offertory to be highlighted while communicating with

shareholders.

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b) Tactical, defense strategies

i) Friendly purchase of sharesii) Emotional attachment loyalty / participationiii) Recourse to legal actioniv) Operation white Knight.

White Knight enters the fray when the target company is raided by

hostile suitor. White Knight offers bid to target company higher than theoffer of the predator that may not remain interested in the bid.

v) Disposing of Golden jewels :Precious assets of the company are called cream jewels which attract

the raider. Hence as a defence strategy, company sells these assets at its owninitiative leaving rest of the company intact. Raider may not remaininterested thereafter.

vi) Pac-Man Strategy:In this strategy, the target company attempts to take over the

raider. This happens when Target Company is higher than the predator.

vii) Compensation Packages:Golden parachutes or First class passenger strategy termination

package for senior executives is used as protection for Directors.

viii) Shark Repellants:Companies change and amend their bye laws to make it less

attractive for corporate raider.

ix) Ancillary Poison Pills:Issue of convertible debentures - which when converted dilutes

holding percentage of raider and makes it less attractive.

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Chapter Six

Acquisition and Takeover Regulations

(SEBI Regulations)

Securities Exchange Board of India (SEBI) is a market regulator and has issued takeoverguidelines popularly called takeover code as under:

I. Exempted Categories:

a) Allotment in pursuance of an application made in public issue.b) Allotment in pursuance of Rights Issuec) Preferential Allotment made in pursuance of Sec. 81 (1A)d) Allotment in pursuance of an underwriting agreement.e) Intense transfer of shares amongst

Group companies Relatives

Promoters / Indian promoters and foreign promoters who are shareholders

f) Acquisition of shares in ordinary course of business by

Registered stock broker of stock exchange on behalf of clients

Registered market maker of a Stock Exchange

Public financial institution on their own account

Banks / Financial Institutions as pledge

g) Acquisition of shares by way of transmission or succession or inheritance.h) Acquisition of shares by government companiesi) Transfer of shares from state level financial institutions including subsidiaries pursuant to

agreement between such FIS and Promoters.j) Transfer of shares venture capital funds to promoters.k) Under BIFR schemel) Acquisition of shares of companies not listed other cases as may be exempted by SEBI.m) In respect of exempted cases for acquisition exceeding 15%

Application to be made to SEBI within 21 days

Giving details / reasons seeking exemption

Payment of fee to SEBI Rs. 10,000/-

n) In respect of notification for information to public, it should be made in case of acquisitionexceeding 5% of voting rights.

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II. Disclosure required to be made in respect of acquisition of shares / Voting rights.

a) Existing shareholders holding more than 5% of shareholding / voting rights

Disclosure to be made to the company within 2 months from the date of SEBIRegulations.

b) Acquisition of 5% and 10% of voting rights

Disclosure to be made to company within 4 working days of

Receipt of intimation of allotment of shares

Acquisition of shares

c) Company to disclose to all stock exchanges where shares are listed

Within 7 days of receipt of information.

d) Continual disclosure by those who held more than 15%

Within 21 days from the close of financial year

e) Company to make annual disclosure

Within 30 days from the close of financial year

III. Substantial Acquisition / Public Announcement

a) Acquisition of 15% or more shares / voting rights

Public announcement

b) Consolidation of holding from 15% to 75% In any year acquisition should not be more than 10% unless announcement ismade.

c) Conditions precedent to public announcement

Appointment of Merchant Banker

Timing of Announcement, within 4 working days of entering into agreementfor acquisition of shares

Publications of announcement : In all editions of the English daily, one Hindidaily, one Regional language daily where registered office of company islocated.

Copy to be submitted to: SEBI, Stock Exchange and Target Company

IV. Contents of Public Announcement Offer

a) Target company

Existing paid up capital

No. of fully paid shares

No. of partly paid shares

b) Total number of percentage shares of the target company to be acquired from thepublic by the acquirer subject to minimum of 20% of voting capital of the company.

c) Minimum offer price

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d) Mode of payment of consideration.e) Identity of acquirer / acquirersf) Existing holdingg) Agreement to acquire shares

Date of Agreement

Name of the seller

Price of which shares are to be acquired.No. of percentage of shares to be acquired.

h) Price paid by acquirer and persons acting in concert with him, during last 12 months.

The highest price

The average price

i) Object and purpose of acquisition and future plans.j) Date of opening of offer / closing of offerk) Date by which purchase consideration would be paid

l) Disclosure to the effect that firm financial arrangement required to implement hasbeen made.m) Other statutory approvals if any;n) Approval of Banks / Institutionso) Minimum level of acceptances from the shareholders

p) Such other information as is essential for the shareholders to make informal decision.

Submission of letter of offer to SEBI within 14 days from the date of publicannouncement made.

Letter of offer not to be dispatched to shareholders. Therefore not earlier than21 days from its submission to SEBI.

V. Specified date

Acquirer to specify a date for the purpose of determining the names of the shareholdersof the target company to who letter of offers have been sent. Specified date shall not belater than 30th day from the date of public announcement.

VI. Minimum number of shares to be acquired:

a) 20% of voting capital; b) Acquirer may take more than 20% if he so desires but in that case 50% of

consideration is to be deposited in escrow account.

c) Reduction of public holding below 10% The acquirer within 3 months to acquire remaining shares (Resulting intodelisting of shares)

Or

Disinvest through an offer for sale or by public issue within a period of 6months.

d) If the shares offered are more than the shares agreed to be acquired.

Pro-rata Acquisition

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VII. Offer Price:

Acquirer is required to make a minimum offer price which may be payable in

a) Cashb) By exchange / transfer of shares of the acquirer companyc) Exchange / transfer of instruments with minimum 'A' grade rating from rating agency

d) Combination of (a), (b) and (c).

Minimum offer price shall be highest of

(For frequently traded shares)a) The negotiated price under agreement for acquisition

b) Highest price paid by the acquirer the concert - including public or right issue during26 weeks prior to public announcement.

c) Price paid by acquirer under preferential allotment made to him.d) Average of weekly high low during last 26 weeks.

If shares are not frequently traded:

Minimum price will be in consultation with Merchant Bankers based on the followingfactors:a) Negotiated price

b) Highest price paid in past 26 weeks

VIII. Directors Obligations:

a) Responsibilities of Acquirer company's Directors:

Directors of the company to accept responsibility for offer brochure, circulars,letter of offer or any advertising material.

b) Exemption from the Liability:

If any director exemption, such director to issue statement to that effecttogether with reasons thereof.

c) Prohibition to become a Director:

During the offer period, the acquirer or person acting in concert with him shallnot be entitled to be appointed on the Board of Directors of Target Company.

d) Offer Conditional upon minimum level of acceptances:Where an offer is conditional upon minimum level of acceptances theAcquirer-

Shall acquire shares from the public to the minimum extent of 20%irrespective of public response to the minimum level of acceptance (Notapplicable if 50% amount payable is deposited in escrow account)

Shall not acquire, during the offer period, shares in the target company exceptby way of fresh issue of shares of the target company.

Shall be liable for penalty of forfeiture of entire escrow amount for non-

fulfillment of obligations under the regulations.

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e) Restrictions on existing Directors:

Existing Director is an insider within the meaning of SEBI Regulations andsuch a person shall refuse himself / and not participate in any matters concurringor relating to the offer including any preparatory steps leading to the offer.

f) Other Duties

i. Open escrow account on or before the date of issue of public announcement ofoffer.

ii. Make financial arrangements for fulfilling obligation.iii. To complete the procedures relating to offer within 30 days from the date of

closure.iv. Prohibition of further offer of shares

If acquirer has withdrawn the offer, he shall not make further offer foracquisition for a period of six months.

And if he has violated SEBI rules, he cannot make offer for any listedcompany for a period of 12 months.

v. Disclosure of acquisition within 24 hours to

Stock exchanges

Merchant banks

Details: No. of shares, Price paid, mode of acquisition.

vi. Prohibition of disposed or encumbrance of shares acquired, for 2 years unlessspecifically stated.

IX. General Obligations of Target Company

During the period offer Target Company could

sell, transfer or dispose of the assets of the company

issue any authorized but un-issued securities

enter into material contracts

List of shareholders to be furnished as required by the Acquirer:

Within seven days of the request or specified date whichever is later.

Once public offer is made, cannot appoint may additional director or fill inany casual vacancy by any person representing or having interest in theacquirer company.

Director can send unbiased comments on the offer to shareholders butMisstatement / concealment of material information will make them liable foraction.

Facilitate the acquirer in verification of securities tendered for acceptances

Transfer of securities in favour of the acquirer in certification of merchantbankers.

X. General Obligations of Merchant Bankers

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a) Merchant Bankers to ensure that

Acquirer is able to implement the offer made in terms of public announcementof offer.

Provisions relating to escrow account is made

Firm arrangement of funds / money for payment through verifiable means tofulfill SEBI regulations.

b) Contents of public announcement of offer and offer letter are true, fair and adequateand based on reliable sources.

Filing of letter of offer with SEBI, Target company and also Stock Exchangewhere shares are listed.

Issue of due diligence certificate

Compliance with SEBI regulations

Directions to Bank for release of escrow account.

Report to SEBI: Within 45 days of closure of offer

XI. Competitive bids

a) Public announcement of competitive bid to be made

within 21 days of first announcement of offer

by any person

b) Quantum of Competitive bid should be atleast equal to the number of shares, whichwas made under first offer.

i. Option to First Acquirer:

Revise his offer

Withdraw his offer with SEBI approval

ii. Upward Revision of offer price

Any time upto 7 working days prior to the date of closure of offer.

Acquirer shall not have the option to change other items.

Increase escrow amount upto 10% of consideration payable on revision.

Public announcement in all newspapers in which original offer was made.

Inform : SEBI

Stock ExchangeTarget Company

iii. Closure of offer:

When there is a competitive bid, the date of closure of original bid as well asdate of closure of all subsequent bids shall be the date of closure of public offerand the last subsisting competitive bid.

iv. Withdrawal of offer:Once acquirer has made an announcement of public offer he can not withdraw

unless:

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Withdrawal is consequent upon competitive bid by another.

Statutory approvals required have been refused.

The sole acquirer being natural person dies.

Such circumstances which SEBI may permit.

Withdrawal by -o Public announcement in all publications when offer was made

o Inform : SEBI, Stock Exchange and Target company

XII. Other Aspects - Escrow Account:

The acquirer shall on the date of public announcement of offer create escrow account byway of security for performance obligations under SEBI rules:

a) Amount :

For consideration upto Rs. 100 crores 25%Above Rs. 100 crores 25% upto Rs. 100 crores

and 10% thereafter

For offers which are subject to minimum level of acceptances and the acquirerdoes not want to acquire more than 20% 50% of consideration

Total consideration to be calculated for highest price.

b) Escrow Account to consist of

Cash deposit with scheduled bank

Bank guarantee

Deposit of acceptable securities with appropriate managing with MerchantBanker.

c) Conditions to be fulfilled

i. Cash deposit with scheduled bank: Acquirer to empower merchant banker to issuecheque / DD as per SEBI rules.

ii. Bank GuaranteeTo be in favour of Merchant Banker

Valid for a period of public announcement plus 30 days from the

closure of offer

d) Escrow with Security:

Empower merchant banker to dispose of security by sale or otherwise.

The guarantee / Securities shall not be returned till all the obligations underSEBI Regulations are complied with.

e) Increase in value of Escrow:

i. Upon upward revision of offer:

Additional value of 10% of consideration payable on such revision

Additional deposit of 10% of value increases in consideration.

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ii. When Bank guarantees have been given as securities:

Acquirer to give at least 1% of consideration payable by way of security

f) Release of Escrow Account

i. The entire amount to the acquirer upon withdrawal of offer with certificate ofmerchant banker.

ii. Transfer of 90% to Special account opened.iii. To the acquirer, balance 10% of cash on completion of all this formalities.iv. Entire amount to Merchant Banker in the event of forfeiture due to non fulfillment

of SEBI Regulations.v. In the event of forfeiture :

Merchant Banker will distributeo 1/3 rd of the amount to Target company

o 1/3 rd to Stock Exchange

o 1/3 rd to be distributed pro-rata among shareholders who accepted the

offer

g) Forfeiture of Escrow Account

In case of non fulfillment of obligations under SEBI regulations, SEBI shallforfeit escrow account in full or part.

The merchant banker shall ensure realization of escrow account byo foreclosure of deposit

o Invoking bank guarantee

o Sale of security

h) Payment of Consideration :

Consideration payable in cash: within 21 days from the closure of offer.

Open a special account with Banker to the Issue.

Consideration payable in exchange of security: Acquirer to ensure thatsecurities are actually issued and dispatched.

Unclaimed balance: To be transferred to Investors Protection fund after 3years of date of deposit.

XIII. Bailout Takeover

a) What is bailout takeover?

Bail out take over of financially weak but not sick unit.

Financially weak: Erosion of 50% of its net worth but less than 100%

Responsibility: Lead Institution to e responsible to ensure compliance of SEBIRegulations.

b) Approval by Lead Institution:

Taking into account financial viability

Assessing requirement of funds for revival

Drawing up revival package

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c) Scheme may provide for:

Change in management

Exchange of shares

Combination of both

d) Manner of Acquisition:

Invitation of offer

Information to offerorso Management

o Technology

o Range of products

o Shareholding pattern

o Financial holding

o Past performance

e) Selection of the Party:

Management competence

Adequacy of Financial Resources

Technical Capability

f) Manner of evaluating bid:

Purchase Price

Track Record

Financial Resources

Reputation of management

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Chapter Seven

Valuation of Shares

I. Introduction to Valuation:

The process of determining the current worth of an asset or a company is calledvaluation. There are many techniques that can be used to determine value, some aresubjective and others are objective. For example, an analyst valuing a company may lookat the company's management, the composition of its capital structure, prospect of future

earnings, and market value of assets. Judging the contributions of acompany's management would be more of a subjective valuation technique, whilecalculating intrinsic value based on future earnings would be an objective technique.

Every asset, financial as well as real, has a value. The key to successfully investing inand managing these assets lies in understanding not only what the value is but also thesources of the value. Any asset can be valued, but some assets are easier to value thanothers and the details of valuation will vary from case to case. Thus, the valuation of ashare of a real estate property will require different information and follow a differentformat than the valuation of a publicly traded stock. What is surprising, however is notthe difference in valuation techniques across assets, but the degree of similarity in basic

principles. There is undeniably uncertainty associated with valuation. Often thatuncertainty comes from the asset being valued, though the valuation model may add tothat uncertainty.

A postulate of sound investing is that an investor does not pay more for an asset thanits worth. This statement may seem logical and obvious, but it is forgotten andrediscovered at some time in every generation and in every market. There are those whoare disingenuous enough to argue that value is in the eyes of the beholder, and that any

price can be justified if there are other investors willing to pay that price. That is patentlyabsurd. Perceptions may be all that matter when the asset is a painting or a sculpture, butinvestors do not (and should not) buy most assets for aesthetic or emotional reasons

financial assets are acquired for the cash flows expected on them. Consequently,perceptions of value have to be backed up by reality, which implies that the price paid for

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any asset should reflect the cash flows that it is expected to generate. The models ofvaluation described here attempt to relate value to the level and expected growth in thesecash flows.

II. Role of Valuation in Acquisition Analysis:

Valuation should play a central part of acquisition analysis. The bidding firm orindividual has to decide on a fair value for the target firm before making a bid, and thetarget firm has to determine a reasonable value for itself before deciding to accept orreject the offer.

There are also special factors to consider in takeover valuation. First, the effects ofsynergy on the combined value of the two firms (target plus bidding firm) have to beconsidered before a decision is made on the bid. Those who suggest that synergy isimpossible to value and should not be considered in quantitative terms are wrong.Second, the effects on value, of changing management and restructuring the target firm,will have to be taken into account in deciding on a fair price. This is of particular concern

in hostile takeovers.

Finally, there is a significant problem with bias in takeover valuations. Target firmsmay be over-optimistic in estimating value, especially when the takeover is hostile, andthey are trying to convince their stockholders that the offer price is too low. Similarly, ifthe bidding firm has decided, for strategic reasons, to do an acquisition, there may bestrong pressure on the analyst to come up with an estimate of value that backs up theacquisition.

III. Need for Valuation of Shares:

i. Assessment under estate duty, wealth tax, gift tax.ii. Purchase of block of shares including acquisition of controlling interest in the

company.iii. Formulations of schemes of amalgamation.iv. Acquisition of interest of dissenting shareholders under reconstruction scheme.v. Conversion of preference shares into equity

vi. Advancing loans against security of sharesvii. Compensating shareholders on the acquisition of their shares by the government

under a scheme of nationalization.

IV. Factors Affecting Valuation:

Internal Factors:Rate of dividend declaredMarket / Current values of assets / liabilitiesGoodwillMarket for the productsIndustrial relations with employees

Nature of plant / machineryNature of plant / machineryExpansion policies of the companyReputation of Management

External Factors:

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CompetitionRelations with Govt. AgenciesTechnological developmentTaxation partiesImport / Export policyStability of economy

Stability of government in powerPolitical climate in country

V. Basis of Valuation:

1) Assets Value2) Capitalized Earning Power3) Market value4) Book Value5) Cost: Historical, Replacement / Substitution / Opportunity cost.

VI. Methods of Valuation:Analysts use a wide range of models to value assets in practice, ranging from the

simple to the sophisticated. These models often make very different assumptions aboutpricing, but they do share some common characteristics and can be classified in broaderterms. There are several advantages to such a classification -- it makes it easier tounderstand where individual models fit into the big picture, why they provide differentresults and when they have fundamental errors in logic.

Thus methods of valuation of shares are classified into two parts i.e.:

Historical Perspective

Modern Perspective

Historical Perspective:

In historical perspective we use the following methods:

Net Asset Method

Yield Method

1) Net Asset Method:Also termed as Balance Sheet Method, Asset Backing Method or Break up valuemethod.

For instance: If assets total Rs. 50,000 and liabilities Rs. 10,000.No. of shares 20,000Net Asset value: Rs. 2

Points to be considered:

a) Proper value to be placed for Goodwill after business.b) Fictitious Assets such as Preliminary expenses, debit balance in profit and loss

account etc to be excluded.c) All other assets (including non-trading assets such as investments) should be taken

at market value. In absence of information about market value --

Book valuesmay be taken.

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d) Liabilities payable to third parties and preference share capital should be deductedfrom total assets.

e) It should be noted that item constituting part of the equity shareholders funds(E.g. General Reserves; Profit and loss account credit balance, DebentureRedemption Fund, Dividend Equalisation fund, Contingency Reserves should not

be deducted.

f) Net Assets so arrived at should be divided by no. of equity shares.

Illustration:

Balance Sheet of M/s Prosperous Ltd. As on 31. 3. 97

Liabilities Rs. Assets Rs.

Share Capital:

Authorized & Issued Land and Building 2,70,000

6000 shares of

Rs. 100 each 6,00,000 Plant and machinery 1,00,000

Profit and loss account 40,000 Stock 3,60,000

Bank overdraft 10,000 Sundry debtors 1,60,000

Creditors 80,000

Provision for taxation 1,00,000

Proposed dividend 60,000

8,90,000 8,90,000

Additional information: Profit before depreciation and taxation during last five years:

1992.93 1,70,000

1993.94 2,10,0001994.95 1,80,000

1995.96 2,20,0001995.97 2,00,000

- On 31st March, 1997 Land and Building were valued at Rs. 2,80,000 and Plantand Machinery Rs. 1,20,000, Sundry debtors included Rs. 4,000 which wereirrecoverable.

- Having regard to the nature of business, a 10% return on net tangible capitalemployed is considered reasonable.

- You are required to value the shares of the company

- Valuation of Goodwill may be based on five years purchase of annual superprofits.

- Tax rate to be assumed at 50%.

Solution:

Statement showing valuation of shares

Goodwill (see working note) 1,44,500Land and Building 2,80,000

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Plant and Machinery 1,20,000Sundry Debtors 1,56,000Stock 3,60,000

10, 60,500Less: Liabilities:

Bank Overdraft 10,000Creditors 80,000Provision for taxation 1,00,000Proposed dividend 60,000

2,50,000

Total 8,10,500

Value per share 8,10,500 / 6000 = 135.08

Working note:

i) Tangible capital employed:

Assets at their present value:Land and Building 2,80,000Plant and Machinery 1,20,000Stock 3,60,000Sundry debtors 1,56,000

9,16,000Less: Liabilities

Bank Overdraft 10,000Creditors 80,000Provision for tax 1,00,000

1,90,000

Net tangible capital employed 7,26,000Less: 50% of Profits (after tax) 50,000Average capital employed 6,76,000

ii) Goodwill:

Total profits for five years 9,80,000Less: Bad debts 4,000

Average 9,76,000Less: Adjustment for change inDepreciation in value of assets 1,95,000Land and Bldg. 2% on 10,000 200Plant and Mach. 10% on 200000 2000

1,93,000Less: Taxation @ 50% 96,500Average Annual profit 96,500Less: 10% Return on Annual average

Capital employed 67,600

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Average Annual super profit 28,9005 years purchase of super profits 1,44,500

2) Yield Method

The yield basis of valuation may take any of the following two forms

a) Valuation based on Rate of Returnb) Valuation based on Productivity factor

a) Valuation based on Rate of Return

The rate of return refers to the return which a shareholder earns on hisinvestment. It may further be classified into:

- Rate of dividend- Rate of earnings

i. Valuation based on Rate of dividend:

Paid up value of share x Profitable rate of dividend

Normal rate of dividend

E.g.:Paid up value : Rs. 80Normal dividend : Rs. 10Possible Dividend : Rs. 12

Hence value 80 x 12 / 10 = Rs. 96.

ii. Valuation based on Rate of EarningsRate of earnings of company explains the effective utilization of companysassets. In case the company does not distribute 100% of its earnings amongits shareholders, it is a matter of fact strengthens the financial position of thecompany.

Paid up value of shares x Possible earnings Rate

Normal earnings Rate

E.g.:Paid up value : Rs. 80Past earning Rate : Rs. 16Expected earning rate : Rs. 20

Value: 80 x 20 = 100

16

iii. Valuation based on Price Earning Ratio:

Earning per share x Price Earning Ratio

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Earning Per share = Profit available for Equity shareholders

No. of Equity Shares

Price Earning Ratio = Market value of a share

Earning per share

E.g.:Earning per share 10Market value 40Price Earning Ratio 04In case EPS goes up 12

Value of share will be 12 x 4 = 48

iv. Capitalization FactorThe value of share can also be found out by finding capitalization factor ormultiplication

If yield expected in the market is 8%

The capitalization factor is 100 / 8 i.e. 12.5%

Hence if a company earns profit of Rs. 4 lakhs

Total value of Business will be Rs. 50 lakhs 4 x 12.5

v. Value of equity share:

Capitalized value of Business

No. of Shares

b) Valuation based on Productivity Factor:

- Productivity factor represents earning power of the company in relation to value ofthe assets employed for such earning.

- The factor is applied to net worth of company on the valuation data to arrive atprojected earnings of the company.

- Projected earnings after necessary adjustments are multiplied by the appropriatecapitalization factor to arrive at the value of companys business.

- Maturity value is divided by no. of shares to ascertain value of each share.

Procedure:

1) Ascertain average net worth of the business for relevant years2) Ascertain the value of Net worth of business on valuation date3) Average profit earned for the relevant years4) Productivity factor = Average profit x 100

Average net worth

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5) Productivity factor so obtained is applied to net worth of the business on valuationdate to ascertain projected income of business in future.

6) Projected income so calculated is further adjusted by making appropriations ofreplacement / tax, etc. hence profit available to shareholders is arrived at.

7) The Normal rate of return for the company is ascertained by keeping in view natureand size of the undertaking.

8) Appropriate capitalization factor or multiplier based on normal rate of return isascertained.

9) Capitalization factor is applied to projected profits to ascertain value of theundertaking.

10) Capitalized value is divided by no. of shares.

Illustration:

The following figures relate to a company which has Rs. 10,00,000 in equity shares and

Rs. 3,00,000 in 9% Preference shares all @ Rs. 100 each.

Year Average Networth Adjusted Taxed Profit

(excluding investments)

1995 Rs. 18,60,000 Rs. 1,90,0001996 Rs. 21,50,000 Rs. 2,10,0001997 Rs. 21,90,000 Rs. 2,50,000

The company has investments worth Rs. 2,80,000 (at market value). On the valuationdate, the yield in respect of which has been excluded in arriving at adjusted taxed profitfigures. It is customary to similar types of the companys to set aside 25% of taxed profitsfor rehabilitation and replacement purposes. On valuation date, the net worth (excludinginvestments) amounts to Rs. 22,50,000. The normal rate of return expected is 9%. Thecompany has paid dividends consistently within range of 8% to 10% on equity sharesover past 7 years and expects to maintain the same.

Required: Ascertain value of each equity share on the basis of productivity factorapplying suitable weighted averaging.

Solution:

Computation of Productivity Factor

Year Avg. N.W. Adjustedtaxed Profits

Weight Weighted N.W. Weighted adjustedtaxed Profits

1995

18,60,000 1,90,000 1 18,60,000 1,90,000

1996

21,50,000 2,10,000 2 43,00,000 4,20,000

1997

21,90,000 2,50,000 3 65,70,000 7,50,000

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Productivity factor: 2,26,667 x 100 = 10.68%21,21,667

Maintainable profit: 10.68% on 22,50,000 2,40,000Less: Rehabilitation / Replacement Reserve @ 25% 60,075

1,80,225

Less: Preference dividend 27,000Profit available for shareholders 1,53,225

Capitalized value of profit @ 9% 17,02,500Add: Value of Investments 2,80,000Total value of Assets 19,82,500

Value of Equity shares: 19,82,500 = Rs. 198.2510,000

B. CCI Guidelines

Fair Value

Guidelines formed in 1977 / 78 made public on 13-7-1990Valuation of shares according to the guidelines is computed after taking into accountfollowing 3 elements:

1. Net Asset Value (NAV)2. Profit Earning Capacity value (PECV)3. Fair value (FV)

1. Net Asset Value:

Total Assets xx Shareholders FundsDeduct: all liabilities i) Equity xx1) Pref. Capital x ii) Free Reserves xx2) Secured / unsecured creditors x Total xx3) Current liabilities x Deduct: Contingent liability4) Contingent liabilities x 1. x

2. x3. x

4. x

Net worth xxx Net worth xxx

Add: Fresh Capital Issue Face value xTotal xxx

NAV Per share: M.V. / No. of shares

2. Profit Earning Capacity Value (PECV)

Years Profit Before tax Profit after tax Dividend declared12

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345

Average Profit before tax (on basic or simple or weighted average basis) :______Deduct provision for tax _________%

Average profit after taxDeduct Preference dividend

Net Profit after taxAdd: Contribution to profits by fresh issueTotal profits after tax

No. of equity shares including fresh / bonus sharesEPS Capitalized EPS by Capitalization rate.

Capitalization Rate

15% in the case of manufacturing companys (which may be modified / liberalized inexceptional cases upto 12%

20% in case of trading companies

17.5% In case of intermediate companies i.e. company whose turnover from tradingactivity is more than 40% but less than 60% of total turnover.

Contribution of Fresh Issue of Capital

x Fresh Capital x Existing Profit after taxExisting networth

Market value: Average Market priceYear High Low Remarks123 latest4 Month-wise

In preceding 12 months average market price on the above basis:

3. Fair Value:Fair value is worked out by averaging NAV and PECV.Market value is not taken as direct element in calculating fair value.

But if fair value arrived at by averaging NAV and PECV, is less than MV, Weightageis given for higher MV in the following manner:

If market value is higher or more byi) 20% to 50% of F.V, Capitalisation rate is reduced to 12%.ii) 50% to 75% Capitalisation rate is reduced to 10%.

iii) 75% and above of FV, capitalisation rate is reduced to 8%.

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Valuation of Shares and Exchange Ratio

When two or more companies are combined / merged, financial consideration,generally in the form of exchange of shares is involved. This requires relative value ofeach companys shares to determine a particular exchange ratio.

Three Approaches:

o Earnings Approacho Market value Approach

o Book Value Approach

1) Earnings Approach

EPS of Acquired Company

EPS of Acquiring Company

E.g. Earning per share of Acquiring Company is Rs. 5.Earning per share of Acquired Company is Rs. 2.Exchange ratio: 2 / 5 i.e. 4 or 4 shares of acquiring company will be given for 10shares of acquired company or 2 shares of acquiring company for 5 shares ofacquired company.

2) Market value Approach

Market price per share of acquired company

Market price per share of acquiring company

For example:Market value of share of Company A: Rs. 50Market value of share of Company B: Rs. 25 and if A is acquiring BExchange Ratio : 25 / 50 = 0.5i.e. A Ltd. will issue 1 share for 2 shares of B Ltd.

3) Capitalized Value of EPSSteps: 1) Determining Average future earnings

2) Determining Capitalisation Rate

3) Determining of market valueEPS

Capitalisation Rate

EPS 30 Capitalisation Rate 15%

Market value 30 / 50 x 100 = 200

4) Exchange Ratio

Market Price per share of Acquired Company

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Market price per share of the acquiring company

5) Book value per share

Book value = Shareholders fundsNo. of shares

= Net worthNo. of shares

Exchange Ratio = Book value per share of the acquired Co.

Book value per share of Acquiring Co.

Modern Perspective:

1) Dividend Discount Models :

Basis : The value of the stock is the present value of expected dividends on it.

Rationale: The value of any asset is the present value of expected future cash flows,discounted at a rate appropriate to the riskiness of cash flows being discounted.

General Model:

When investors buy stock, they expect to get two types of cash flows:i) Dividends during the period they hold stockii) Expected price at the end of holding period

Since expected price is itself determined by future dividends, the value of stock is thepresent value of dividends through infinity.

t =

Value per share of stock DPStt = 1 (1 + r) t

DPSt = Expected dividend per share

r = required rate of return on stock

Two inputs: Expected dividendsRequired rate of return

Since dividend projections cannot be made through infinity, several versions of thedividend discount model have been developed upon different assumptions aboutfuture growth.

The Gordon Growth Model:

Model: The Gordon Growth Model can be used to value a firm that is in Steady ratewith dividends growing at a rate that is expected to stay stable in the long term.

Value of stock = DPS1

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(r g)

Where DPS1 = Expected dividends one year from now

r = Required rate of return for equity investors

g = Growth rate in dividends for ever

Stable Growth Rate

Expected normal Growth rate in economy:Expected inflation + Expected real growth

In U.S. 4% + 2% = 6%

In India 8% + 6% = 14%In practical terms, the stable growth rate can not be higher than the normal growthrate in the economy in which firm operates, if valuation is done in nominal (real)terms.

If the firms operations are domestic, this will be the expected growth rate in domesticeconomy. (For multi nationals, the relevant information will be the growth rate inworld economy).

Limitations: Highly sensitive to growth rate

Example: Expected dividend per share : US $ 2.50Discount rate: 15%

Expected growth rate: 8%

Value of stock: 2.50 (0.15 0.08) = $ 35. 71

Two Stage Dividend Model

This model allows for 2 stages of growth

Initial phase when growth rate is high

Subsequent steady rate: Where growth rate is stable and expected to remain sofor a long term.

Value of stock: PV of dividends during growth period + PV of terminal pricet= n

P0 = DPSt + Pnt = 1 (1 + r) t (1 + r) n

Where Pn = DPSn + 1(rn - gn) (1 + r)

n

Limitations of two stage dividend discount model:

i. Practical problem is in defining the length of extra ordinary growth periodii. This model assumes that growth rate is high during initial period and is

transformed overnight to a lower stable rate at the end of the period. While these

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sudden transformations in growth can happen, it is more realistic to assume thatshift from high growth to stable growth happen gradually over time.

iii. Overestimating or underestimating growth rate can lead to significant errors invalue.

Further modifications: H model for valuing growth:

i. This model is based on the assumptions that:Equity growth rate starts at a high initial rate (g a) declines linearly over extra-ordinary growth period (which is assumed to last 2

ii. H periods) to a stable growth rate (gn)Dividend payout ratio is constant over time and is not affected by the shiftinggrowth rates.

P0 = DPS0 ( 1 + gn ) + DPS x H ( ga - gn )r - gn r - gn

Stable growth Extra ordinary growth

Where P0 = Value of firm now per share

DPSt = Dividend per share in year t

r = Required return to equity investor

ga = Growth rate initially

gn = Growth rate at the end of 2H years applied for ever after that.

Limitations:

i. Growth rate is assumed to follow a structure laid out in the model deviationsfrom the structure can cause problem.

ii. Assumption of pay out ratio remaining constant in consistent.

Three Stage Discount Model:

This model assumes on initial period of stable high growth, second period of

declining growth and a third period of stable low growth that lasts forever.

t =n1 t = n2

P0 = EPS0 ( 1 + ga)t x IIa + DPSt + EPSn2 (1+gn) x IIn

t = 1 t = n1 +1 (1 + r) t (r gn) (1 + r)n

High growth Transition Stable growth

EPSt : Earnings per share in year t

DPSt : Dividends per share in year t

ga : Growth rate in high-growth phase ( lasts n1 years)

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gn : Growth rate in stable growth phase

IIa : Payout ratio in high growth phase

IIn : Payout ratio in stable growth phase.

2) Free Cash flows to equity discount models:

Free Cash flows to Equity:The FCFE is the residual cash flows left after meeting interest and principal paymentsand providing for capital expenditures to both maintain existing assets and createnew assets for future growth.

FCFE = Net Income + Depreciation Capital spending - Working capital Principal repayments + New Debt Issues.

In a special case where capital expenditures and working capital are expected to be

financed at the target debt equity ratio and principal repayments are made fromnew debt issues.

FCFE = Net Income + (1 - ) (Capital Exp. Depreciation) + (1 - ) Working capital.

Why are Dividends different from FCFE?

The FCFE is a measure of what a firm can afford to payout as dividends.a) Desire for stability

b) Future investment needsc) Tax factorsd) Signaling prerogatives: Increase in dividends is viewed as positive signals anddecreases as negative signal.

FCFE Models:

The stable-growth FCFE Model:The value of equity, under the stable-growth model, is a function of expected FCFEin the next period, the stable growth rate, and the required rate of return.

P0 = FCFE1r - gn

P0 = Value of stock today

FCFE1 = Expected FCFE next year

r = Cost of equity of the firm

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gn = Growth rate in FCFE for the firm forever.

Illustration:

Earnings per share : $ 3.15Capital Exp. per share : $ 3.15

Depreciation per share : $ 2.78Change in working capital per share : $ 0.50Debt financing ratio : 25%Earnings, Capital expenditure, Depreciation, Working capital are all expected to growat 6% per year.The beta for stock is 0.90. Treasury bond rate is 7.5%.Calculate value of stock.

Solution:

Estimating value

Long term bond rate 7.5%Cost of equity = 7.5% + (0.90 x 5.50%) = 12.45%Expected growth rate 6%

Base year FCFE = Earning per share (Capital Exp. Dep.)(1 D /E Ratio) Change in working capital(1 D / E Ratio)

= 3.15 (3.15 2.78) (1 0.25) 0.50 (1 0.25)

= 2.49

Value per share = 2.49 x 1.06 (0.1245 0.06) = $ 41.

3) Further modification in FCFE model

Two stage FCFE model :

The value of any stock is the present value of the FCFE per year for the extraordinary growth period plus the present value of the terminal price at the end of the

period.

Value = PV of FCFE + PV of Terminal pricet =n

= FCFEt (1 + r)t + Pn (1 + r) n

t = 1

Where FCFEt = FCFE in year t

Pn = Price at

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