MERGERS MODULE 1

## Mergers and Acquisition : Important terms.Merger: the share holders of two companies deciding to pool the resources of the companies under a common entity to do the business activity is called merger.

Two companies agree to go forward as a single company rather than separately owned and operated.

Both companies stocks are surrendered and new stock is issued in its place.

TATA-CORUS-$13 Billion

Daimler- Benz & Chrysler -> Daimler Chrysler.

It is also called as Amalgamation.##Mergers or amalgamation may take two forms

Merger through absorption: absorption is a combination of 2 or more companies into an existing co. All co’s except one lose their identity in a merger through absorption.

Ex: Absorption of Tata Fertilizer Ltd (TFL) by Tata Chemicals LTd (TCL)

TCL an acquiring co (buyer); survived after merger while TFL an acquired co ( a seller) ceased to exist.

TFL transferred its assets, liabilities and shares to TCL under the scheme of merger.

##Mergers through consolidationConsolidation:

two or more companies combine to form a new company. In this form of merger all companies are legally dissolved and a new entity is created.

In a consolidation, the acquired company transfers its assets, liabilities and shares to the new company for cash or exchange of share.

Ex : Merger or amalgamation of Hindustan Computers Ltd, Hindustan Instruments Ltd, Indian software co Ltd and Indian Reprographics ltd in 1986 to an entirely new co, called HCL ltd.

##Amalgamation: is used when two or more companies carries on similar business go into

liquidation and a new company is formed to take over their business.Takeover: a takeover generally involves the acquisition of a certain stake in the equity

capital of a company which enables the acquirer to exercise control over the affairs of the company.

Ex: HINDALCO took over INDAL by acquiring a 54% stake in INDAL from its overseas parent, Alcan. However, INDAL was merged into HINDALCO.

##WHAT IS CORPORATE RESTRUCTURINGCorporate restructuring refers to a broad array of activities that expand or contract a firm’s operations or substantially modify its financial structure or bring about a significant change in its organisational structure and internal functioning.

Inter alia, it includes activities such as mergers, purchases of business units, takeovers, slump sales, demergers, leveraged buyouts, organizational restructuring, and performance improvement initiatives. We will refer to these activities collectively as mergers, acquisitions, and restructuring (a widely used, though not a very accurate, term) or just corporate restructuring. Sacrificing some rigour, these activities may be classified as shown next##Top ten acquisition made by Indian companies.

Acquirer Target co Country targeted Deal value $ million Industries

Tata steel Corus group UK 12000 steel

Hindal co Novels Canada 5982 steel

Video con Daewoo elec co. Korea 729 steel

Dr. reddys labs

Beta pharmatical German 597 pharmatical

Suzlon energy

Hansen group Belgium 565 Energy

HPCL Kenya petroleum refinery Ltd

Kenya 500 Oil gas

Rambaxy labs

Terapia S A Romania 324 pharmatical

Tata steel Nat steel singapore 293 steel

Video con Thomson SA france 290 electronics

VSNL Teleg lobe canada 239 telecon

Near $4500 million. More than double the amount involved in US companies acquisition of Indian companies.

CorporateRestructuring

Acquisitions• Mergers• Purchase of a unit or

plant • Takeovers • Business alliances

Divestitures

• Sell offs• Demergers • Equity carve outs

Ownership Restructuring

• Going private • Leveraged

buyouts Organisational Restructuring

• Organisational redesign• Major performance

enhancement programmes

CORPORATE RESTRUCTURING ACTIVITIES

Financial Management-prasanna chandra

Categories of Mergers: 1. Horizontal . 3. Conglomerate.2. Vertical.

##Horizontal merger This is a combination of two or more firms in similar type of production,

distribution or area of business. Horizontal merger involves two firms operating and competing in the same

kind of business activity.MOTIVES:

1. Elimination or reduction in competition2. Putting an end to price cutting3. Economies of scale in production4. Research and development5. Marketing and management.

Ex: combining of book publishers or two mufg co’s to gain dominant mkt share. (Mittal’s Strategy) The acquisition of American Motors by Chrysler in 1987 represents a horizontal combination or merger.Horizontal merger increase monopoly power of the combined firm.##Vertical mergers

Vertical merger occurs when a firm acquires firms ‘Upstream’ from it or firms ‘downstream’ from it.

In case of an ‘Upstream’ merger it extends to the firms supplying raw materials and to those firms that sell eventually to the consumer in the event of a ‘down-stream’ merger.

when co combines with the supplier of materials it is called backward merger and when it combines with the customer it is known forward merger.

EX: Vertical Forward Integration – Buying a customer

Indian Rayon’s acquisition of Madura Garments along with brand rights

• Vertical Backward Integration – Buying a supplier IBM’s acquisition of Daksh

Merits:1. Low buying cost of materials2. Lower distribution costs3. Assured supplies and market4. Increasing or creating barriers to entry for potential competitors5. Placing them at a cost disadvantage.

##Carnegie Steel One of the earliest, largest and most famous examples of vertical integration

was the Carnegie Steel company. The company controlled not only the mills where the steel was manufactured but also the mines where the iron ore was extracted, the coal mines that supplied the coal, the ships that transported the iron ore and the railroads that transported the coal to the factory, the coke ovens where the coal was coked, etc. The company also focused heavily on developing talent internally from the bottom up, rather than importing it from other companies.

American Apparel American Apparel is a fashion retailer and manufacturer that actually

advertises itself as vertically integrated industrial company. The brand is based in downtown Los Angeles, where from a single building they control the dyeing, finishing, designing, sewing, cutting, marketing and distribution of the company's product. The company shoots and distributes its own advertisements, often using its own employees as subjects. It also owns and operates each of its retail locations as opposed to franchising. According to the management, the vertically integrated model allows the company to design, cut, distribute and sell an item globally in the span of a week. [9] Since the company controls both the production and distribution of its product, it is an example of a balanced vertically integrated corporation.

Oil industry Oil companies, both multinational (such as ExxonMobil, Royal Dutch Shell, or

BP) and national (e.g. Petronas) often adopt a vertically integrated structure. This means that they are active all the way along the supply chain from

locating crude oil deposits, drilling and extracting crude, transporting it around the world, refining it into petroleum products such as petrol/gasoline, to distributing the fuel to company-owned retail stations, where it is sold to consumers.

##Conglomerate merger Conglomerate merger represents a merger of firms engaged in unrelated

lines of business.Rationale for such merger:Diversification of risk3 types of Conglomerate merger a) Product-extension mergers broaden the product lines of firms. These are mergers between firms in related business activities and may also be called concentric mergers. Product Extension: New product in Present territory

P&G acquires Gillette to expand its product offering in the household sector and smooth out fluctuations in earning.

b) A geographic market-extension merger involves two firms whose operations have been conducted in non overlapping geographic areas.

Ex: Pizza Hut a fast food chain restaurant centered in USA, sought to wow Indian customers by opening their restaurant in all most all major urban centers of India. c) Pure conglomerate mergers involves unrelated business activities. These would not qualify as either product-extension or market extension.

• New product & New territories• Indian Rayon’s acquisition of PSI Data Systems.

##GENERAL ELECTRICALS. GE's divisions include GE Capital includes:

GE Commercial Finance and GE Money and GE Consumer Finance,2. GE Technology Infrastructure includes: GE Aviation , the former Smiths Aerospace and GE Healthcare and NBC

Universal, an entertainment company. Through these businesses, GE participates in a wide variety of markets

including the generation, transmission and distribution of electricity (eg. Nuclear, gas and solar), lighting, industrial automation, medical imaging equipment, motors, railway locomotives, aircraft jet engines, and aviation services. It was co-founder and is 80% owner (with Vivendi) of NBC Universal, the National Broadcasting Company.

Through GE Commercial Finance, GE Consumer Finance, GE Equipment Services, and GE Insurance it offers a range of financial services as well. It has a presence in over 100 countries.

Since over half of GE's revenue is derived from financial services, it is arguably a financial company with a manufacturing arm. It is also one of the largest lenders in countries other than the United States, such as Japan.

Tata Group:

Tata Chemicals · Tata Consultancy Services · Tata Elxsi · Tata Interactive Systems · Tata Motors · Tata Steel · Tata Power · Tata Tea · Tata Communications · Tata Technologies Limited · Tata Teleservices · Titan Industries · The Indian Hotels Company · Trent (Westside) · Voltas

Notable non-Indian Companies Corus Group · Tetley · Tata Daewoo Commercial Vehicle · VSNL International Canada · Jaguar Cars · Land Rover · Brunner Mond

BrandsGood Earth Teas · Tanishq · Taj Hotels · Tata Sky · Tata Indicom · Titan · Westside · Voltas

The Kirloskar Group consisting of: Kirloskar Brothers Limited , Kirloskar Oil Engines, Kirloskar Ferrous Industries, Kirloskar Pneumatic Company, Kirloskar Ebara Pumps Ltd., Kirloskar Construction And Engineering Ltd., SPP Pumps (UK), Gondwana Engineers Ltd, and The Kolhapur Steels Ltd) is India's largest Engineering and Construction Conglomerate with sales exceeding $2 Billion.##characteristics

A conglomerate firm controls range of activates in various industries that require different skills in the specific managerial functions of research, applied engineering, prdtn, mktg and so on.

Diversification is achieved mainly by external acquisitions and mergers, not by internal development.

FINANCIAL CONGLOMERATESConglomerate firms in which corporate mgt provides a flow of funds to operating segments, exercises control over strategic planning functions, and is the ultimate financial risk taker, but does not participate in operating decisions. Distinct economic functions are:

1. It improves risk/return ratios through diversification.2. It avoids “gambler’s ruin” (an adverse run of losses which might cause

bankruptcy)3. Establishing programs of financial planning control. These systems improves

the quality of general & functional managerial performance, there by resulting in more efficient operations & better resource allocation for the economy.

##Managerial conglomerates Conglomerate firms which provide managerial expertise, counsel &

interaction on decisions to operating units. Mgt conglomerate not only assume financial responsibility & control, but also play a role in operating decisions & provide staff expertise & staff services to the operating entities.

Generic mgt functions are:1. Planning, organizing, directing & controlling are readily transferable to all

types of business firms.

This theory argues for mgt transferability across a wide variety of industries & types of orgns including govt, nonprofit institutions and military and religious orgns.##CONCENTRIC COMPANIESA merger in which there is carry –over in specific mgt functions (ex: mktg) or complementarily in relative strengths among specific mgt functions rather than carry-over/complementarities in only generic mgt functions (eg: planning).Therefore, if the activities of the segments brought together are so related that there is carry over of specific mgt functions (mufg, finance, mktg, personnel, & so on) or complementarily in relative strengths among these specific mgt functions, the merger should be termed concentric rather than conglomerate.Ex: if one co., has competence in research, mufg., or mktg that can be applied to the pdt problems of another co., that lacks that particular competence, a merger will provide the opportunity to lower cost function. Firms seeking to diversify from advanced technology industries my be strong on research but weaker on pdtn., and mktg., capabilities firms in industries with less advanced technology.##Motives being merger (Reasons, logic, Benefits, Causes)

1. Limit competition2. Utilize under-utilized market power3. Achieve diversification4. Overcome the problem of slow growth & profitability of one’s own industry5. Utilize under utilized resources like, human, physical & managerial skills6. Reap speculative gains attendant upon new security issue/change in P/E

ratio.7. Achieve growth potentiality8. Achieve profitability9. Maximize the shareholders wealth10.Diversifying the risk of the company11.Gain economies of scale & increase income with proportionately less

investment12.Displace existing management.13.Circumvent government regulations.14.Establish a transnational bridgehead without excessive start-up costs to gain

access to a foreign market.##Motives behind M&A

The dominant rationale used to explain M&A activity is that acquiring firms seek improved financial performance. The following motives are considered to add shareholder value:

Synergy : This refers to the fact that the combined company can often reduce duplicate departments or operations, lowering the costs of the company relative to the same revenue stream, thus increasing profit.

Increased revenue/Increased Market Share: This motive assumes that the company will be absorbing a major competitor and thus increase its power (by capturing increased market share) to set prices.

Cross selling : For example, a bank buying a stock broker could then sell its banking products to the stock broker's customers, while the broker can sign up the bank's customers for brokerage accounts. Or, a manufacturer can acquire and sell complementary products.

Economies of Scale : For example, managerial economies such as the increased opportunity of managerial specialization. Another example are purchasing economies due to increased order size and associated bulk-buying discounts.

Taxes : A profitable company can buy a loss maker to use the target's loss as their advantage by reducing their tax liability. In the United States and many other countries, rules are in place to limit the ability of profitable companies to "shop" for loss making companies, limiting the tax motive of an acquiring company.

Geographical or other diversification: This is designed to smooth the earnings results of a company, which over the long term smoothens the stock price of a company, giving conservative investors more confidence in investing in the company. However, this does not always deliver value to shareholders (see below).

Resource transfer: resources are unevenly distributed across firms (Barney, 1991) and the interaction of target and acquiring firm resources can create value through either overcoming information asymmetry or by combining scarce resources [1].

Vertical integration : Vertical Integration occurs when an upstream and downstream firm merge (or one acquires the other). There are several reasons for this to occur. One reason is to internalize an externality problem. A common example is of such an externality is double marginalization. Double marginalization occurs when both the upstream and downstream firms have monopoly power, each firm reduces output from the competitive level to the monopoly level, creating two deadweight losses. By merging the vertically integrated firm can collect one deadweight loss by setting the upstream firm's output to the competitive level. This increases profits and consumer surplus. A merger that creates a vertically integrated firm can be profitable.

##Advantages of merger & acquisitions1. Maintaining or accelerating a co’s growth, particularly when the internal

growth is constrained due to paucity of resources.2. Enhancing profitability, through cost reduction resulting from economies of

scale, operating efficiency and synergy.3. Diversifying the risk of the co., particularly when it acquires those businesses

whose income streams are not correlated.

4. reducing tax liability because of the provision of setting-off accumulated losses and unabsorbed depreciation of one co., against the profit of another.

5. Limiting the severity of competition of increasing the companies market power.

##CHANGE FORCES CONTRIBUTING TO M&A ACTIVITIES1. Technological changes (technological requirements of firm has increased)2. Economies of scale and complimentary benefits (growth opportunities among

product areas are unequal)3. Opening up of economy or liberalization of economy4. Global economy (increase in competition)5. Deregulation6. New industries were created.7. Negative trends in some economies.8. Favorable economic & financial conditions (real time financial planning and

control information requirements have increases).9. Widening inequalities in income & wealth10.High valuation on equities.11.Requirement of human capital has grown relative to physical assets.12.Increase in new product line.13.Distribution and marketing methods have changed.

##THEORIES OF MERGEREfficiency theories A. Differential managerial efficiency B. Inefficient management C. Operating synergy D. Pure diversification E. Strategic realignment to changing environments F. UndervaluationII. Information and signalingIII. Agency problems and managerialism IV. Free cash flow hypothesisv. Market powerVI. TaxesVII. Redistribution.##EFFICIENCY THEORIES

• Efficiency theory of mergers suggest that M & A provide mechanism by which capital can be used more efficiently & that the productivity of the firm can be increased through economies of scale.

• It also states that mergers & other forms of asset redeployment have potential for social benefits.

• These theories can be further divided as:## A. DIFFERENTIAL MANAGERIAL EFFICIENCY

• It says that more efficient firm will acquire less efficient firm and realize gains by improving their efficiency. This implies excess managerial capabilities in the acquiring firm.

• Ex: if the mgt of firm A is more efficient than the mgt of firm B and if 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. This would be a social gain as well as a private gain.

FEATURES• This give rise for detecting below-average /less-than-full-potential

performance and have the managerial know-how for improving the performance of the acquired firm.

• The acquiring firm may be overoptimistic in their judgments of their impact on the performance of the acquired firms.

Consequence-pay too much /fail to improve its performance –acquired firm.

• The level of efficiency in the economy would be raised by such merger.• Differential efficiency theory is more likely to be a basis for horizontal

mergers. DIFFICULTIES

• It would result in only one firm in the economy, indeed in the world- the firm with a greatest managerial efficiency.

## Managerial efficiency• If a firm has an efficient mgt team whose capacity is in excess of its current

managerial input demand, the firm may be able to utilize the extra managerial resources by acquiring a firm that is inefficiently managed due to shortages of such resources.

• A merger b/w to 2 firms will be synergistic since it combines the nonmanagerial organization capital of the acquired firm with the excess managerial resources of the acquiring firm.

##INEFFICIENT MANAGEMENT THEORY• Inefficient mgt is simply not performing up to its potential. Another control

group might be able to manage the assets of this area of activity more effectively (i.e., mgt that is inept in an absolute sense).

• Inefficient management theory could be a basis even for mergers b/w firms with unrelated business.

OBSERVATIONS 1.The theory assumes that owners (shareholders) of acquired firms are unable to replace their own mgrs, and thus it is necessary to invoke costly mergers to replace inefficient mgrs.

• Merger for corporate control will principally be of the Horizontal and vertical types in which the acquiring firms mgt is familiar with the environment of the acquired firm’s activities.

• Merger do not imply the inability of the owners to replace their inefficient mgrs but the scarcity of able mgrs in the market.

• Merger with other firms can provide the necessary supply of managerial capabilities.

2. If the replacement of incompetent mgrs were the sole motive for mergers, it should be sufficient to operate the acquired firm as a subsidiary rather than to merge it into the acquirer.

3. The mgrs of the acquiring firm will be replaced after the merger. ( dissertation study of 28 conglomerate firms concludes that-they try to acquire companies with capable mgt that could be retained)

• Firm making multiple acquisitions in a relatively short period of time would face difficulties in managing the acquired firms efficiently if it used its own premerger managerial resources only or if it employed new managers after displacing the acquired firms’ mgrs.

##FINANCIAL SYNERGY Synergy refers to the type of reaction that occur when two substances or

factors combine to produce a greater effect together than that with the sum of the two operating independently could account for. It refers to the phenomenon 2+2=5.

FINANCIAL SYNERGY The impact of a corporate merger or acquisition on the costs of capital to the

acquiring or the combined firm refers to 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 and achieve lower cost of capital.

A firm in a declining industry will provide large cash flows since there are few attractive investment opportunities. A growth industry has more investment opportunities than cash with which to finance them.

##OPERATING SYNERGY• This theory assumes that economies of scale do exist in the industry and that

prior to the merger, the firms are operating at levels of activity that fall short of achieving the potentials for economies of scale.

• It can be achieved in horizontal, vertical and even in conglomerate mergers.

• Economies of scale arises because of indivisibilities, such as people, equipment, and overhead, which provides increasing returns if spread over a large no. of units of output.

• Ex: one firm might be strong in cash but weak in marketing while another has strong marketing department without the R&D capability. Merging the two firms would result in operating synergy.

• The R&D dept of chemical & pharmaceutical co’s often must have a large staff of highly competent scientists who, if given the opportunity, could develop & oversee a large no. of product areas.

• One problem in merging is- how to combine and coordinate the good parts of the organization and eliminate what is not required?

• vertical integration is one area in which operating economies may be achieved. Costs of communication, & various forms of bargaining , & opportunistic behaviour can be avoided by vertical integration.

• Combining firms at difft stages of an industry may achieve more efficient coordination of the difft levels.

##PURE DIVERSIFICATIONDiversification of shareholders wealth through mergers along with the employees & managers of the company is termed as the pure diversification.

Reasons: Demand for diversification by mgrs & other employees,

Preservation of orgnal and reputational capital,

Preservation of Financial and tax advantages.• Diversification of the firm provide managers and other employees with job

security & opportunities for promotion and, other things being equal, results in lower labour costs. i.e., Firm-specific investment.

• Firm-specific investment: knowledge acquired while working for the firm may be valuable to the firm but not to others .( employees are more productive in their current job than in other firms-specialized knowledge)

Information on employees is accumulated within the firm over time. Information is used for efficient matching of employees and jobs or of employees themselves for a particular job-managerial & other teams are formed in the firm.• Diversification ensure smooth & efficient transition of the firm’s activities &

the continuity of the teams and the orgn.3. Firm have reputational capital which customers, suppliers, & employees

utilize in establishing their r/s with the firm.• Reputation is acquired over time through firm-specific invts., in Advertising,

Research & development

Fixed assets,

Personnel training,

Orgnal devpt, & so on.• Diversification can help preserve the firm’s reputational capital which will

cease to exist if the firm is liquidated.4. With regard to financial synergy & tax effect, diversification can increase corporate debt capacity and decrease the present value of future tax liability. These effects are a result of the decrease in cash flow variability due to the merger.• Diversification can be achieved through internal growth as well as mergers.

##E. STRATEGIC REALIGNMENT TO CHANGING ENVIRONMENT• It says that mergers take place in response to the environmental changes.

External acquisitions of needed capabilities allow firms to adopt more quickly and with less risk than developing capabilities internally.

• Strategic planning is concerned with the firm’s environments and constituencies, not just operating decisions.

• The strategic planning approach to mergers implies either the possibilities of economies of scale or tapping an under used capacity in the firm’s present managerial capabilities.

• By external diversification the firms acquirers mgt skills form needed augmentation of its present capabilities.

• Competitive mkt for acquisitions implies that the NPV from M&A invts is likey to be small.

• If these invts, exploit synergy opportunities & can be used as a base for still additional invts, with +ve NPV, the strategy may succeed.

##F. UNDRVALUATION• It states that mergers occur when the market value of target firm stock for

some reason does not reflect its true or potential value or its value in the hands of an alternative mgt.

• One cause of under valuation may be that mgt is not operating the co up to its potential.

• Second possibility is that the acquirers have inside information. • If bidders possess information which the general mkt does not have, they

may place a higher value on the shares than currently prevails in the mkt.• Another aspect of under-valuation theory is the difference b/w the market

value of assets and their replacement costs.• Inflation had double-barreled impact.• Due to inflation in 1970’s the stock prices sere depressed & did not recovered

until the latter part of 1982, as the level of inflation dropped & business prospects improved.

• Current replacement costs of asset was substantially higher than their recorded historical book values.

• This twin effects resulted in a decline of the q-ratio.Q-ratio , defined as the ration of the market value of the firm shares to the replacement costs of the assets represented by these shares.##II. INFORMATION & SIGNALING

• It attempts to explain why target shares seem to be permanently revalued ---- in a tender offer whether or not it is successful.

• The information hypothesis says that the tender offer sends a signal to the market that the target shares are undervalued or alternatively the offer signals information to target mgt., which inspires them to implement a more efficient strategy on their own.

• Tender Offer: A method of effecting a takeover via a public offer to target firm shareholders to buy their shares.

• A hypothesis based on this empirical observation posits that New information is generated as a result of the tender offer and the

revaluation is permanent. a tender offer disseminates information that the target shares are

undervalued and the offer prompts the market to revalue those shares. No particular action by a target firm or any other is necessary to cause the revaluation . This has been called the “sitting on a gold mine”

The offer inspires target firm mgt to implement a more efficient business strategy on its own. This is the “kick in the pants”. No outside input other than the offer itself is required for the upward revaluation.

SIGNALING1. Signaling as per “Spence” is in connection with labor market: • Signaling states that particular actions may convey other significant forms of

information. • The level of education of a laborer was a signal not only of more training but

of higher innate abilities as well. • Lower –quality labor could not attempt to fool the mkt by substantial outlays

for obtaining more education and training. 2. Signaling as per “Ross”- connection with capital structure decisions.• He postulates that managers-insiders have information about their own firms

not possessed by outsiders. • Ross shows that the capital structure decision is not irrelevant and an optimal

capital structure may exist if : The nature of the firm’s invt., policy is signaled to the mket throught its

capital structure decision and The manager’s compensation is tied to the truth or falsity of the capital

structure signal.

##III AGENCY PROBLEMS AND MANAGERIALISMOverview:

• Agency problems in relationships arise whenever the two parties do not have exactly the same objective function.

• Then, benefits to one of the parties can come at the expense of another party.

• In the context of the differences between objectives of management and shareholders, agency problems can lead to inefficiencies, which inefficiencies may be resolve by means of the market’s discipline of managers through takeovers or the threat of takeovers.

Examples:Manager/employees vs. stockholder/owners

Managerial perks are paid for by shareholdersInefficiency is a form of managerial perk.

• Agency problem arises when mgrs own only a fraction of the ownership shares of the firm.

• This partial ownership may cause mgrs to work less vigorously than otherwise and /or to consume more perquisites (luxurious office, company cars, memberships in clubs) because the majority owners ear most of the cost.

• It may result from a conflict of the interest b/w managers & shareholders or b/w shareholders & debt holders.

• Agency problems arise basically because contracts b/w mgrs (decision or control agents) and owners (risk bearers) cannot be costlessly written and enforced. Returning agency cost includes:

Cost of structuring a set of contracts,

Cost of monitoring and controlling the behaviour of agents by principals,

Costs of bonding to guarantee that agents will make optima decisions or principals wil be compensated for the consequences of suboptimal decisions, and

The residual loss, that is, the welfare loss experienced by principals, arising from the divergence /w agents’

• A number of organization & market mechanisms serve to discipline self-serving managers & takeovers are viewed as the discipline of last resort.

1. Takeover/Merger as Solution to Agency Problems• Agency problems may be efficiently controlled by some orgnal and mkt

mechanisms.• If managers have created inefficiencies, then the stock price will not be as

high as possible had such inefficiencies not existed. • The presence of inefficiencies opens the opportunity for an outsider to buy

assets at a discount, resolve the inefficiencies, and bring the assets up to full value.

2. Mergers as an outcome of managerialism • Managers may have incentives to maximize the size of assets managed

rather than maximizing shareholder wealth if their incomes or economic power is more related to the size of their managerial scope.

• They are incented to add assets for their own purposes rather than to make shareholders better off.

• The discipline of a merger would strip inefficient or un-needed assets and reduce the firm to its proper size.

HUBRIS HYPOTHESIS• The theory explains that acquiring firm mgrs commit errors of over optimism

in evaluating merger opportunities (due to excessive pride, animal spirits), and end up paying too high a price for acquisitions.

• It is an explanation of why mergers may happen even if the current market value of the target firm reflects its true economic value.

• It implies that managers look for acquisition of firms for their own potential motives & that the economic gains are not the only motivation for the acquisition.

##IV FREE CASH FLOW HYPOTHESIS• Agency problems are heightened when management has financial flexibility

at its disposal in the form of the ability to generate cash from operations or in pools of liquid assets built up.

• Buildup of free cash flow in a) current assets b) pension fund c) borrowing capability can be used by managers to benefit themselves directly (higher salary) or indirectly (poor investments) at the expense of shareholders.

• Firms with good investment opportunities have greater need for financial slack (free cash flow) and are less likely to waste free cash. Firms with poor investment opportunities may be inclined to invest anyway simply because ample cash is available.

• • Example: Cash-rich oil companies with poor investment opportunities being

the subject of and the subject of takeover battles in the 1980’s. • Takeovers prevented oil companies from wasting cash in negative NPV

investment because of managerialism. • It says that takeover take place because of the conflicts b/w managers &

shareholders over the pay out of free cash flows. • Hypothesis assumes that free cash flow should be paid out to share holders

reducing the power of mgt & subjecting managers to the security of the public capital markets more frequently.

##V. MARKET POWER• a reason for Merger is that it will increase a firm’s market share.• Increasing market share really means increasing the size of the firm

relative to other firms in a industry.• But its not clear why increasing the firm’s relative size will provide

economies or other social gains.

Arguments:

Merger emphasizes economies of scale and vertical integration. Which could also be achieved by the internal expansion of the firm.

The reason for external acquisition – acquiring a larger volume of operations sooner.

If a firm expands its capacity either horizontally or vertically – leads to “tacit collusion”

As a result, the prices and profits of the firms will contain monopoly elements.

If not permitted firm results in “undue concentration” (conglomerate)So, It claims that merger gains are the result of increased concentration leading to collusion & monopoly effects.Herfindahl index

• The new merger guidelines adopted,in 1982, the Herfindahl Index (H index) which takes into consideration the market shares of all of the firms in the industry.

• The theory behind the H index is that if one or more firms have relatively high market shares, this if of even greater concern than the share of the largest 4 firms.

Example: In 1 market 4 firms each hold a 15% market share and the remaining 40% is held by 40 firms, each with a 1% market share. Its H index would be:

H= 4(15)2 + 40 (1) 2 =940In another market 1 firm has a 57% market share and the remaining 43% firms, each with a 1% market share. Like the first market, the 4 – firm concetration ratio here would be the same 60%. However, the H index would be:

H= (57) 2 + 43 (1)2 =3,292Thus, the H index registers a concern about inequality of firms as well as the degree of concentration of industry sales. The economic basis for either concern has not been well established. ##VI. TAX EFFECTS

• Some mergers are motivated by tax-minimizing opportunities.• when alternative methods of tax benefits are absent- tax consideration

induces merger.• Mergers for tax benefits have often been regarded as ZERO-SUM GAMES

against the treasury. • If these mergers involved use of real resources or caused distortions in the

tax system by increasing taxes on others in the economy, they would be socially undesirable.

• However, mergers for tax reasons may also facilitate more efficient behaviour of wiping out tax losses. Tax affect the merger process as well as merger incentives.

Carry-over of Net Operating Losses and Tax Credits• A firm with accumulated tax losses and tax credits can shelter the +ve

earnings of another firm with which it is joined (target firm).

• For the acquired firm to be able to inherit desirable tax attributes requires “continuity of interest”. This continuity is achieved when two conditions are met.

1. The majority of the target corporation should be acquired in exchange for the stock of the acquiring firm. This ensures investor continuity in which the target SH’s have an ownership interest in the merged firm.

2. The acquisition should have legitimate (genuine, valid) business purposes. The requirement is fulfilled when the target’s operations are continued. This amounts to corporate continuity. When continuity of interest is established, a merger becomes a tax-free reorganization in which the target shareholder’s capital gains or losses can be deferred( postponed) and the target’s tax attributes are inherited.

NET OPERATING LOSSES can be carried back 3 years and forward 15 years. The firm may deduct its losses up to the sum of taxes paid during the past 3 years. Any remaining losses can be taken against future profits, up to a limit of 15 years.Stepped-Up Asset Basis

• Transactions b/w corporations which involve cash and nonstock securities exceeding 50% of the total purchase price do not allow for continuity of interest. These are treated as taxale transactions.

• Following sale of its assets or stock to the buying corporation, the selling corporation distributes, within a 12-month period, all of its assets to its SH’s in complete liquidation.

• The S.H’s of the seller are liable for the tax on any gain. • The S.H’s gain ( or loss) equals the difference b/w the fair market value of the

distribution received and the adjusted basis of their stock.• The acquiring firm can increase or step-up the tax basis of the acquired firm’s

assets to their fair market value and take depreciation charges on this new basis.

• Thus, the increase in the tax basis of the acquired firm’s assets results in greater cash flows and may also reduce any gains realized on a premature disposition of assets.

• Another factor is that any excess of the purchase price paid over the fair market value of the acquirerd’s assets is recorded as good will on the acquirer’s B/S. Goodwill is amortized over a period not to exceed 40 yeas and is not tax deductible.

Substitution of capital Gains for Ordinary Income• A mature firm with few internal investment opportunities can acquire a

growth firm in order to substitute capital gains taxes for ordinary income taxes.

• A growth firm has no or a small dividend payout and requires continued capital and noncapital expenditures. ‘

• The acquiring firm provides the necessary funds which otherwise would have to be paid out as dividends taxable as ordinary income

• Later the acquiring firm may sell the acquired firm to realize capital gains. Similarly, when the growth of a firm has slowed so that earnings retention cannot be justified to the Internal Revenue Service, an incentive for sale to another firm is created. Rather than paying out future earning as dividends subject to the ordinary personal income tax, an owner can capitalize future earrings in a sale to another firm.The buyer will be a firm which welcomes additions to its internal cash flow for investment purposes. Usually the transaction is a tax-free exchange of securities. The owner of the selling firm is not subject to taxes utill he or she sells off the securities received; it will be a capital gain, and the owner can choose the time at which to recognize the gain. Carry over of net operating losses & tax credits, stepped-up asset basis & the substitution of capital gains for ordinary income are among the tax motivations.

##VII. REDISTRIBUTION A final theory of the value increases to shareholders in takeovers is that the

gains come at the expense of other stakeholders in the firm. Expropriated stakeholders under the redistribution hypothesis may include bondholders, the government ( in the case of tax savings ), and organized labor.

#COSTS AND BENEFITS OF A MERGER• When a Firm A acquires Firm B, it is making a capital invt decision &

firm B is making a capital divestment decision.• What is the net PV of this decision to Firm A?• What is the net PV of this decision to Firm B?

SOLUTION • To calculate the net PV to Co., A we have to identify the BENEFIT & the

COST of the merger.• The benefit of the merger is the difference b/w the PV of the Combined

entity PVAB & the PV of the 2 entities if they remain separate (PVA + PVB

). Hence, Benefit = PVAB – (PVA + PVB )

• The cost of the merger, from the point of view of firm A, assuming that compensation to firm B is paid in cash, is equal to the cash payment made for acquiring Firm B less the PV of Firm B as a separate entity. Thus,

Cost = Cash – PVB • The NPV of the merger from the point of view of Firm A is the

difference b/w the Benefit and the Cost as defined above. So , NPV to A = Benefit – Cost

• The NPV of the merger from the point of view of firm B is simply the cost of the merger from the point of view of Firm A. Hence,

NPV to B = (Cash - PVB )#Cash vs. Stock Compensation

Whether to pay for an acquisition in cash or in stock is an important decision. The choice depends on 4 factors, in the main.

1. overvaluation: if the acquiring firm’s stock is overvalued relative to the acquired company’s stock, paying in stock can be less costly than paying in cash.

2. Taxes: from the point of view of the shareholders of the acquired firm, cash compensation is a taxable transaction whereas stock compensation is not.

3. Sharing of risks and rewards: if cash compensation is paid, shareholders of the acquired company neither bear the risks nor enjoy the rewards of the merger. On the other hand, if stock compensation is paid, shareholders of the acquired company partake in the risks as well as the rewards of the merger.

4. Discipline :Empirical evidence suggests that acquisitions financed by cash tend to succeed more compared to acquisitions financed by stock. Because perhaps cash buyers are more disciplined, circumspect, and rigorous in their evaluation.

#Illustration1. Firm A has a value of Rs.20million and Firm B has a value of Rs.5

million. If the two firms merge, cost savings with the present value of Rs.5 million would occur. Firm A proposes to offer Rs.6 million cash compensation to acquire Firm B. Calculate the NPV of the merger to the two firms.

SOLUTIONGiven: PVA =Rs.20million, PVB =Rs 5million, PVAB = ?, Cash Rs.6 million. Therefore, Basic computation : PVAB = PVA + PVB +Benefit

= Rs.20million + Rs 5million + Rs 5 million = Rs.30million

i) Benefit = PVAB –(PVA + PVB ) = Rs.30million– (Rs.20million + Rs 5million )

Benefit = Rs. 5million ii) Cost = Cash – PVB

= Rs.6 million - Rs 5million = Rs. 1 million iii) NPV to A = Benefit – Cost

= Rs. 5 million – Rs.1million= Rs.4 million

iv) NPV to B = Cash – PVB = Rs.6 million - Rs 5million = Rs. 1 million

#COMPENSATION IN STOCK• In the above discussion we assumed that the acquiring firm pays cash

compensation to the acquired firm. • In practice, however, compensation is usually paid in the form of

stock.• When this happens, the cost component in the PV calculation needs to

be calculated with care. Illustration:

2. Firm A plans to acquire firm B. The relevant financial details of the two firms, prior to the merger announcement, are:

The merger is expected to bring gains which have a present value of Rs. 10 million.Firm A offer 2,50,000 shares in exchange for 5,00,000 shares to the shareholders of Firm B. Calculate the NPV of the merger to the two firms. You may state your assumptions, if any. #Given : PVA =50 million, PVB =Rs 10 million, PVAB =----Rs.million, stock: 2,50,000.

i) Cost = Stock/cash– PVB

= Rs. 2,50,000 X 50 - Rs 100,00,000= Rs. 25,00,000/ The true cost, however, is greater than Rs.25,00,000. While calculating the true cost we must recognize thatB’s shareholders end up owing a fraction of the share capital of the combined firm. The true cost, when B’sshareholders get a fraction of the share capital of the combined firm , is equal to:

ii) Cost = α PVAB – PVB α = 2,50,000

10,00,000 + 2,50,000 α = 0.2Assume that the market value of the two firms just before the merger announcement are equal to their PV as separate entities and the benefit of merger is Rs.10 milllion. Then, ii) PVAB = PVA + PVB +Benefit = Rs.50million + Rs 10million + Rs 10million

= Rs.70millioniii) Cost = α PVAB – PVB =0.2 X 70 million-10million = Rs.4 millioniv) NPV to A = Benefit – Cost = Rs. 10 million-4 million= Rs 6 milllion v) NPV to B = Cost= Rs 4 million

Clearly, there is an important difference b/w cash and stock compensation. If the compensation is paid in cash, the cost of the acquisition is independent of the gains of the acquisiion. On the other hand, if the compensation is paid in stock, the cost of the acquision is dependent on the gains of the acquisition

problem

3. The relevant financial details of 2 firms just prior to merger announcement are as follows:

• The merger is expected to bring gains which have a present value of Rs.1,20,00,000. Day ltd offers 2,46,000 shares in exchange for 5,00,000 share to the shareholders of firm night ltd. Assuming that the market value of 2 firms just before the merger announcement are equal to their present values as separate entities, calculate the NPV to Day ltd and Night ltd respectively.

PARTICULARS DAY LTD. NIGHT LTD.

Market price per share Rs 65 Rs 30

Number of shares 8,00,000 5,00,000

Market value of the firm Rs.5,20,00,000 Rs.1,50,00,000

• Given : PV A= 520lakh, PV B=Rs 150 lakh, PVAB =Rs ?, Stock 2,46,000. i) Cost = Stock/cash – PVB

= Rs. 2,46,000 X 65 -Rs 1,50,00,000= Rs. 1,59,90,000 -1,50,00,000= Rs. 9,90,000/

The true cost, when shareholders of Night Ltd get a fraction of the share capital of the combined entity will be; -

ii) Cost = αPVAB – PVB

α=total no of shares in Firm A/No. of shares offered to Firm BαPVAB =the value of what firm B’s S.H get in firm ABThe share of Night Ltd in the combined entity will be

α= 2,46,000/8,00,000 + 2,46,000α = 0.235

Assume that the market value of the two firms just before the merger announcement are equal to their PV as separate entities and the benefit of merger is Rs.120 lakh Then,

ii) PVAB = PVA+ PVB+Benefit= Rs.520lakh + Rs 150 lakh + Rs 120 lakh =Rs.790 lakh

iii) Cost = α PVAB – PVB =0.235 x 790 lakh - 150 lakh = Rs. 36 lakh iv) NPV to Day ltd = Benefit – Cost = Rs. 120 lakh – 36 lakh = Rs 84 lakh v) NPV to Night ltd = Cost = Rs 36 lakh.

Clearly, there is an important difference b/w cash and stock compensation. If the compensationis paid in cash, the cost of the acquisition is independent of the gains of the acquisition. On theother hand, if the compensation is paid in stock, the cost of the acquision is dependent on thegains of the acquisition

4. Calculation of true cost of firm for acquiring and NPV of merger firm.Firm Alpha is planning to acquire Firm Beta. The relevant financial details of the two firmsprior

to merger announcement are as follows:

The merger is expected to bring gains which have present value of Rs.1.50 crore . Firm Alpha offers 2,50,000 shares in exchange for Rs.5 lakh shares to the shareholders of Firm Beta.

You are required to calculate:i. True cost of Firm Alpha for acquiring Firm Beta; and ii. Net present value of the merger to Firm Beta.You may state your assumptions, if any.

PARTICULARS ALPHA LTD. BETA LTD.

Market price per share Rs 75 Rs 30

Number of shares 10,00,000 5,00,000

Market value of the firm Rs.7,50,00,000 Rs.1,50,00,000

SOLUTIONi) The true cost of Firm Alpha for acquiring Firm Beta is calculated by applying

the following formula: True cost = α PVAB – PVB α=total No. of shares in Firm Alpha/No. of Shares offered to Firm Beta=2,50,000/10,00,000+2,50,000 = 0.2One assumption of Firm Alphas and Firm Beta’s total mkt value before the proposal for merger is equal to the PV of both the firms & the total value is calculated below:PVAB = PVA + PVB = Rs.7,50,00,000+ Rs.1,50,00,000+Rs.1,50,00,000=Rs. 10,50,00,000/-Cost = α PVAB – PVB =(0.2 x Rs.10,50,00,000) – Rs 1,50,00,000= Rs. 60,00,000.ii) NPV of the merger to Firm Beta is calculated as below:

(a) NPV of Firm Alpha = Benefit – Cost = Rs.1,50,00,000 – Rs 60,00,000 = Rs. 90,00,000

(b)NPV of Firm Beta = Rs. 1,50,00,000 – Rs. 90,00,000

= Rs. 60,00,000NPV of merger to Firm Beta = Rs. 60,00,000/-

5 From the following data, calculate the cost of a merger:(i) When merger is financed by cash; and (ii) When merger is financed by stock.

Firm Cipla intends to pay Rs. 10,00,000 cash for Glenmark if Glenmark’s market price refelectsonly in value as a separate entity.

Solution: (i) Cost of merger when it is financed by cash:Cost of merger = (Cash – MVG+(MVG-PVG )Where, MVG= market value of Firm GlenmarkPVG= True/Intrinsic value of Firm Glenmark= (Rs.10,00,000 – Rs. 7,50,000) + ( Rs. 7,50,000 – Rs. 7,50,000)= Rs. 2,50,000 + 0 = Rs. 2,50,000If the cost of merger becomes negative, then the equity shareholders of Firm Cipla gain higher

by acquiring Firm Glenmark in terms of its market value.

PARTICULARS CIPLA GLENMARK

Market price per share Rs 60 Rs 15

Number of shares 1,00,000 50,000

Market value of the firm Rs.60,00,000 Rs.7,50,000

(ii) Cost of merger when it is financed by stock:

Cost of merger = α PVCG – PVG

Where, α PVCG =Value of Firm Cipla that Firm Glenmark’s shareholders get.

If Firm Cipla agrees to pay by way of 16,667 equity shares instead of cash of Rs.10,00,000 now the apparent cost would be as follows:

16,667 shares @ Rs. 60 10,00,000

Less: Market Value of Firm Glenmark 7,50,000

2,50,000

PVCG = PV + PV

= Rs. 60,00,000 + 7,50,000

= Rs. 67,50,000/-

Proportion that Firm Glenmark’s shareholders get in Firm Cipla’s capital structure will be:

α=16,667/1,00,000 + 16,667 = 0.143

True cost of merger = α PVCG – PVG

= (0.143 x Rs.67,50,000) – Rs7,50,000

= Rs. 9,65,250 – Rs. 7,50,000 = Rs. 2,10,250/-

The apparent cost as calculated above is Rs. 2,50,000 whereas true cost is Rs. 2,10,250 i.e., apparent cost is more than true cost and merger is beneficial to Firm Glenmark.

Calculation of net cost of acquisition and NPV after merger

The summarized balance sheet of R Co.Ltd. as on 31stDecember, 2006 is given below:

LIABILITIES AMOUNT ASSETS AMOUNT AMOUNT

Equity Share Capital (2,00,000@ Rs. 10 each)

20,00,000 Fixed assets 19,00,000

13% Preferenceshare capital 1,00,000 Investments 1,00,000

Retained earnings 4,00,000 CurrentAssets : Inventories 5,00,000

12% Debentures 3,00,000 Debtors 4,00,000

Current liabilities 2,00,000 Bank 1,00,000 10,00,000

TOTAL 30,00,000 TOTAL 30,00,000

Negotiations for takeover of R Ltd. result in its acquisition by A Ltd. The purchase consideration consists of

(i) Rs.3,30,000, 13% debentures of A Ltd. for redeeming the 12% deentures of R. Ltd.

(ii) Rs. 1,00,000, 12% convertible preference shares in A ltd. for the payment of the preference share capital of R Ltd.

(iii) 1,50,000 equity shares of A Ltd. to be issued at its current market price of Rs. 15; and

(iv) A ltd., would meet dissolution expenses of Rs. 30,000.

The break-up figures of eventual disposiion by A ltd. of unrequired assets and liabilities of R ltd. are investments – Rs.1,25,000; debtors – Rs.3,50,000; inventories – Rs. 4,25,000; and payment of current liailities – Rs.1,90,000.

The project is expected to generate yearly operating CFAT of Rs. 7,00,000 for 6 years. It is estimated (had fixed assets of R Ltd. would fetch Rs. 3,00,000 at the end of 6th year.

The firm’s cost of capital is 15%. As a company secretary, comment on the financial prudence of merger decision of A ltd. (PV at 15% rate of discount is- 1st

year: 0.870, 2nd :0.756; 3rd :0.658; 4th :0.572; 5th :0.496; and 6th : 0.432)

SolutionStatement showing cost of acquisition of R Ltd. to A ltd. under Breakup Value method.

PARTICULARS AMOUNT (Rs.)

Sale-proceedsof Assets: Investments 1,25,000

Debtors 3,50,000

Inventories 4,25,000

9,00,000

Add: bankbalance of R Ltd. 1,00,000

TOTAL (A) 10,00,000

ProposedPayments:

Dissolution Expenses 30,000

Current Liabilities 1,90,000

13% Debentures 3,30,000

12% Convertible Preference Shares 1,00,000

Equity Share Capital ( 1,50,000 x Rs. 15) 22,50,000

TOTAL (B) 29,00,000

Net cost of acquisition (B) – (A) 19,00,000

1. Explain the concept of horizontal, vertical and Conglomerate mergers. Illustrate your answer with suitable examples in the Indian context.

2. How does operating synergy differ from financial synergy?

3. Briefly explain the reasons for mergers.

4. What are the different motives behind merger? Discuss.

5. What are the managerial motives in acquisitions?

6. ‘the basic motive for mergers and acquisitions is growth and synergy’ Critically evaluate this statement.

7. What is merger?

8. Define the term merger.

9. Define the term amalgamation.

10.What is takeover?

11.What is synergy in merger?

12.Write a note on current scenario of mergers in India.

13.Explain the theories of merger.

MODULE-2

MODULE 2 (5 Hours)

• A strategic perspective• Industry life cycle and product life cycle• Analysis in M&A decision, • Strategic approaches to M&A • SWOT analysis,• BCG matrix,• Porter’s Five forces model

## M & A Strategic Perspective

Mergers and Acquisition activities should take place within the framework of long range planning by business firms. M & A are the most popular means of corporate restructuring or business combinations.

It is believed that M & A are strategic decisions leading to the maximization of the company’s growth by enhancing its production and marketing operations.

The reasons why M & A activities are considered to strategic in decision are:

It includes huge amount of investment and the benefits are long term in nature.

Maintaining or accelerating a company’s growth, particularly when the internal growth is constrained due to scarcity of resources.

Enhancing profitability, through cost reduction resulting from economies of scale, operating efficiency and synergy.

Diversifying the risk of the company, particularly when it acquires those businesses whose income streams are not correlated.

Limiting the severity of competition by increasing the company’s market power.

Reducing tax liability because of the provision of setting off accumulated losses and unabsorbed depreciation of one co., against the profits of another.

## INDUSTRY LIFE CYCLE

• It represents a useful concept for organizing ideas on business activity, if treated as suggestive rather than a set of fixed and established principles. The concept is used as a framework for indicating when different types of mergers may have an economic basis at difft stages of an industry’s devpt.

## I. THE DEVELOPMENT STAGE / INTRODUCTION STAGE

• It’s a start of a new product or industry• Time and money are needed to inform consumers of the nature and uses of

the new product.• Product development problems may also be involved.• Introduction stage of a new product may be associated with losses to the

innovating producers.• Growth rate 1% to 2%

Types of MERGER

• Newly created firms may sell to outside larger firms in a mature or declining industry, thereby enabling larger firms to enter a new growth industry.

• These result in related or conglomerate mergers.• The smaller firms may wish to sell because they want to convert personal

income to capital gain and because they do not want to place large invts in the hands of managers that do not have a long record of success.

• Horizontal mergers b/w smaller firms may also occur, enabling such firms to pool mgt and capital resources.

II. GROWTH STAGE / EXPLOITATION STAGE

• Sales expands rapidly (Increase in sales)-due to consumer acceptance.• Large Reservoir of demand can be drawn (Demand increases)• Growth rate is 8% to 20%• High profitability• Entry of competitors to obtain a share of the market.• Capacity in the industry expands with increasing momentum

TYPES OF MERGERS

• Mergers during the exploitation stage are similar to mergers during the introductory stage.

• The impetus for such mergers is reinforced by the more visible indications of prospective growth and profit and by the larger capital requirements of a higher growth rate.

• HORIZONTAL type of mergers is more suitable at this stage## III MATURITY STAGE

• The growth rate in sales declines further.• Profit margins experience greater pressures.• As the growth rate in the industry slows, the absolute level of sales in the

industry may be large.• The critical factor for profitable operations may be effective cost control of

large scale, mass-production operation.• The effective coordination of research, advertising, production, & mktg.,

required to reduce costs by a few cents per unit. • Accumulation of excess production capacity• Growth rate is 4% to 6%

Types of MERGER

• Mergers are undertaken to achieve economies of scale in research, production, and marketing in order to match the low cost and price performance of other firms, domestic or foreign.

• Some acquisition of smaller firms by larger firms takes place for the purposes of rounding out the management skills of the smaller firms and providing them with a broader financial base.

• Vertical type of mergers (forward integration) is more suitable under this type.

## IV DECLINE STAGE

• The development of substitute products- inception to new industry life cycles for the new products.

• Pressures are created for difft types of mergers:- Mergers for vertical integration, Horizontal mergers for survival, & mergers for diversification, Conglomerate mergers.• Profit margin declines due to unfavorable r/s b/w sales & capacity. • Strong pressures develop for changing the product mix of the firm.• Internal cash flow of the firm are not the profitable investment in the

declining product lines.• Increase in cost of production & Growth rate is at +2% to -10%.

Types of MERGER

• Horizontal mergers are undertaken to ensure survival.• Vertical mergers are carried out to increase efficiency and profit margins.• Concentric mergers (Conglomerate) involving firms in related industries

provide opportunities for synergy and carry-over. • Conglomerate acquisitions of firms in growth industries are undertaken to

utilize the accumulating cash position of mature firms in declining industries

whose internal flow of funds exceeds the investment requirements of their traditional lines of business.

• Conglomerate type of merger is suitable under this stage.## PRODUCT LIFE CYCLE & MERGER TYPES

Introduction and exploitation stage-

• New/small firms will become targets for related or conglomerate mergers initiated by larger firms in mature or declining industries.

• Horizontal mergers b/w smaller firms may occur to pool managerial & financial resources.

Maturity stage-

• Horizontal and related mergers may be undertaken to match the low cost & price performance of other firms, domestic/ foreign, by achieving economies of scale in research, marketing & production.

• Some horizontal acquisitions of smaller firms by larger firms take place to provide mgt skills & broader financial base.

Decline stage-

• Horizontal mergers to ensure survival take place.• Vertical mergers are carried out to increase efficiency and profit margins.• Concentric mergers- to obtain opportunities for synergy and carry-over of

managerial capabilities. • Conglomerate acquisitions of firms in growth industries are undertaken to

utilize financial slack of mature firms in declining industries.• The firms that had been acquired previously in conglomerate mergers may

now be divested. ## Analysis in M&A decision

• The issue of capability transference is also fundamental to the framework developed to explain horizontal and related industry mergers.

• The firm is viewed as a combination of orgn. Capital & invt. Opportunities.• Organization capital results from team effects & organization learning,

defined as the improvement in the capabilities of managers & other employees through experience.

• The 3 types of orgn learning vary in their transferability. • Generic mgt capabilities are generally obtainable on the open market, but it

is more difficult to obtain industry-specific mgt capabilities this way because of devpt time & team effects.

• Industry-specific mgt capabilities are transferable only in mergers within the same or a related industry.

• Firm-specific human capital develops through a long-term earning process and is otherwise obtainable only through mergers.

• From this basis, characteristics of bidder-& target-type firms are projected. • Target firms are likely to have high growth rates; in fact, they have grown so

fast there has not been time to develop needed mgt. capabilities.• As a result performance measures may be low.

• Bidder firms, in the other hand, are likely to have a long history in a mature industry, & over time have developed excess capabilities which can be used to complement the needs of target firms.

## Strategic approaches to M&A- SWOT analysis:

• A SWOT analysis is an instrumental framework in Value Based Management and Strategy Formulation to identify the Strengths, Weaknesses, Opportunities and Threats for a particular company.

• Strengths and Weaknesses are internal value creating (or destroying) factors such as assets, skills or resources a company has at its disposal relatively to its competitors. They can be measured using internal

assessments or external benchmarking.

• Opportunities and Threats are external value creating (or destroying) factors a company cannot control, but emerge from either the competitive dynamics of the industry/market or from demographic, economic, political, technical, social, legal or cultural factors.

• Typical examples of factors in a SWOT Analysis diagram: • Any organization must try to create a fit with its external environment. The

SWOT diagram is a very good tool for analyzing the (internal) strengths and weaknesses of a corporation and the (external) opportunities and threats. However, this analysis is just the first step. Actually creating alignment is often a more hazardous job, because in reality the two sides of the SWOT analysis often point in opposite directions, leaving strategists with the paradox of creating alignment either from the outside-in (market-driven strategy) or from the inside-out (resource driven strategy).

S trategic approaches to M &A- S W O T ana lys is :A n approach in fo rm ula ting firm s tra tegy via as s es s m ents o f firm capabilities in re la tion to the en vironm ent.

• Strengths- s pec ialis t m arketing expertis e- exc lus ive acc es s to natura l res ources- patents- new , inno vative prod uc t o r s ervice - location o f your bus ines s- cos t adva ntage throug h proprie tary kno w-how- qua lity proces s es and procedures - s trong brand or reputation

• W eaknes ses

- lack of m arketing e xpertis e

- und ifferen tiated produc ts and s ervic e (i.e . in re lation to you r c om petitors )

- loc ation of your bus ines s

- com petitors have s uperior acc es s to dis tribu tion channels

- poor qua lity goods or s ervic es

- - dam aged repu tation• O pportunities- deve lop ing m arket (C hina, the Internet)

- m ergers , jo int ventures or s trategic a llianc es

- m o ving into new attrac tive m arket

S egm ents

- a new international m arket- loos en ing of regulations

- rem oval of international trade barriers

- a m arket led by a w eak c ompetitor

• Threats- a new c om petitor in your hom e m arket

- pric e w ar

- com petitor has a new , innovative s ubs titute produc t or s ervic e

- new regulations

- inc reas ed trade barriers

- ta xation m ay be introduc ed on you r produc t or s ervic e

## EXAMPLESWal-Mart SWOT Analysis.

• Strengths - Wal-Mart is a powerful retail brand. It has a reputation for value for money, convenience and a wide range of products all in one store.

• Weaknesses - Wal-Mart is the World's largest grocery retailer and control of its empire, despite its IT advantages, could leave it weak in some areas due to the huge span of control.

• Opportunities - To take over, merge with, or form strategic alliances with other global retailers, focusing on specific markets such as Europe or the Greater China Region.

• Threats - Being number one means that you are the target of competition, locally and globally

Nike SWOT Analysis.

• Strengths - Nike is a very competitive organization. Phil Knight (Founder and CEO) is often quoted as saying that 'Business is war without bullets.

• 'Weaknesses - The organization does have a diversified range of sports products.

• Opportunities - Product development offers Nike many opportunities.• Threats - Nike is exposed to the international nature of trade.

## Strategic approaches to M&A- BCG matrix

• The BCG matrix or also called BCG model relates to marketing. The BCG model is a well-known portfolio management tool used in product life cycle theory. BCG matrix is often used to prioritize which products within company product mix get more funding and attention.

• The BCG matrix model is a portfolio planning model developed by Bruce Henderson of the Boston Consulting Group in the early 1970's.

• The BCG model is based on classification of products (and implicitly also company business units) into four categories based on combinations of market growth and market share relative to the largest competitor.

• When to use the BCG matrix model?

• Each product has its product life cycle, and each stage in product's life-cycle represents a different profile of risk and return. In general, a company should maintain a balanced portfolio of products. It includes both high-growth as well as low-growth products.

• A high-growth product is for example a new one that we are trying to get to some market. It takes some effort and resources to market it, to build distribution channels, and to build sales infrastructure, but it is a product that is expected to bring the gold in the future. An example of this product would be an iPod.

• A low-growth product is for example an established product known by the market. Characteristics of this product do not change much, customers know what they are getting, and the price does not change much either. This product has only limited budget for marketing. This is the milking cow that brings in the constant flow of cash. An example of this product would be a regular Colgate toothpaste.

• But the question is, how do we exactly find out what phase our product is in, and how do we classify what we sell? Furthermore, we also ask, where does each of our products fit into our product mix?

Should we promote one product more than the other one? The BCG matrix can help with this.

• Products and markets with low growth where the firm has a small market share are “DOGS” and the firm should discontinue such products, according to the simple product portfolio approach.

• The BCG matrix reaches further behind product mix. Knowing what we are selling helps managers to make decisions about what priorities to assign to not only products but also company departments and business units.

• Placing products in the BCG matrix results in 4 categories in a portfolio of a company:

1. Stars:- products for which the firm has a high mkt share in an industry with favorable growth rates are potential “Stars” with high profitaility. (=high growth, high market share)

- use large amounts of cash and are leaders in the business so they should also generate large amounts of cash.

- frequently roughly in balance on net cash flow. However if needed any attempt should be made to hold share, because the rewards will be a cash cow if market share is kept.

2. Cash Cows:- as industry matures, its growth slows, so that if a firm continues to have high mkt share, the attractive profits are available for invt in mkts with more favorable growth rates so the products becomes “cash cows” (=low growth, high market share)- profits and cash generation should be high , and because of the low growth, investments needed should be low. Keep profits high- Foundation of a company

3. Dogs Products and markets with low growth where the firm has a small market share and the firm should discontinue such products, according to the simple product portfolio approach. (=low growth, low market share)- avoid and minimize the number of dogs in a company.- beware of expensive ‘turn around plans’.- deliver cash, otherwise liquidate

4. Question Marks (= high growth, low market share)- have the worst cash characteristics of all, because high demands and low returns due to low market share- if nothing is done to change the market share, question marks will simply absorb great amounts of cash and later, as the growth stops, a dog.- either invest heavily or sell off or invest nothing and generate whatever cash it can. Increase market share or deliver cash

Portfolio balance seeks to combine attractive invt. Segments (stars) with cash-generating segments(cash cows), eliminating segments with unattractive prospects (dogs).

In such a scenario:

• A. Cash Cows Business Units will beat their profit target easily; their management have an easy job and are often praised anyhow. Even worse, they are often allowed to reinvest substantial cash amounts in their businesses which are mature and not growing anymore.

• B. Dogs Business Units fight an impossible battle and, even worse, investments are made now and then in hopeless attempts to 'turn the business around'.

• C. As a result (all) Question Marks and Stars Business Units get mediocre size investment funds. In this way they are unable to ever become cash cows. These inadequate invested sums of money are a waste of money. Either these SBUs should receive enough investment funds to enable them to achieve a real market dominance and become a cash cow (or star), or otherwise companies are advised to disinvest and try to get whatever possible cash out of the question marks that were not selected.

• Some limitations of the Boston Consulting Group Matrix include:• High market share is not the only success factor• Market growth is not the only indicator for attractiveness of a market• Sometimes Dogs can earn even more cash as Cash Cows

## Strategic approaches to M&A - Porter’s Five forces model

• Five Forces model of Michael Porter is a very elaborate concept for evaluating company's competitive position. Michael Porter provided a framework that models an industry and therefore implicitly also businesses as being influenced by five forces. Michael Porter's Five Forces model is often used in strategic planning.

• Porter's competitive five forces model is probably one of the most commonly used business strategy tools and has proven its usefulness in numerous situations.

need to use Porter's Five Forces model?

• In general, any CEO or a strategic business manager is trying to steer his or her business in a direction where the business will develop an edge over rival firms. Michael Porter's model of Five Forces can be used to better understand the industry context in which the firm operates. Porter's Five Forces model is a strategy tool that is used to analyze attractiveness of an industry structure.

• Basic ideology: find an attractive industry or industry segment, defined as an area in which large firms can collude behind entry barriers buttressed by credible deterrence.

• the model provides a simple perspective for assessing and analyzing the competitive strength and position of a corporation or business organization. it helps you understand both the strength of your current competitive position, and the strength of a position you're looking to move into.

Force 1: Barriers to entry

• Barriers to entry measure how easy or difficult it is for new entrants to enter into the industry. This can involve for example:

• Cost advantages (economies of scale, economies of scope) • Access to production inputs and financing, • Government policies and taxation • Production cycle and learning curve • Capital requirements • Access to distribution channels• Patents, branding, and image also fall into this category.

Force 2: Threat of substitutes

• Every top decision makes has to ask: How easy can our product or service be substituted? The following needs to be analyzed:

• How much does it cost the customer to switch to competing products or services?

• How likely are customers to switch? • What is the price-performance trade-off of substitutes?• If a product can be easily substituted, then it is a threat to the company

because it can compete with price only.

Force

3: Bargaining power of buyers

• Now the question is how strong the position of buyers is. For example, can your customers work together to order large volumes to squeeze your profit margins? examples:

• Buyer volume and concentration • What information buyers have • Can buyers corner you in negotiations about price • How loyal are customers to your brand • Price sensitivity • Threat of backward integration • How well differentiated your product is

• Availability of substitutes Having a customer that has the leverage to dictate your prices is not a good position.

Force 4: Bargaining power of suppliers

• This relates to what your suppliers can do in relationship with you.• How strong is the position of sellers? • Are there many or only few potential suppliers? • Is there a monopoly? • Do you take inputs from a single supplier or from a group? (concentration) • How much do you take from each of your suppliers? • Can you easily switch from one supplier to another one? (switching costs) • If you switch to another supplier, will it affect the cost and differentiation of

your product? • Are there other suppliers with the same inputs available? (substitute inputs)• The threat of forward integration is also an important factor here.

Force 5: Rivalry among the existing players

• Finally, we have to analyze the level of competition between existing players in the industry.

• Is one player very dominant or all equal in strength/size? • Are there exit barriers? • How fast does the industry grow? • Does the industry operate at surplus or shortage? • How is the industry concentrated? • How do customers identify themselves with your brand? • Is the product differentiated? • How well are rivals diversified?• Rivalry is the fifth factor in the Five Forces model but probably the one with

the most attention.

CORPORATE RESTRUCTURING- 3rd MODULE

CONTENTS

Corporate restructuring -different methods of restructuring -joint ventures -sell off and spin off -divestitures -equity carve out -leveraged buy outs (LBO) – management buy outs -master limited partnerships -employee stock ownership plans (ESOP)

# WHAT IS CORPORATE RESTRUCTURING

Corporate restructuring refers to a broad array of activities that expand or contract a firm’s operations or substantially modify its financial structure or bring about a

significant change in its organizational structure and internal functioning. Inter alia, it includes activities such as

mergers, purchases of business units, takeovers, slump sales, demergers, leveraged buyouts, organizational restructuring, and performance improvement initiatives.

We will refer to these activities collectively as mergers, acquisitions, and restructuring (a widely used, though not a very accurate, term) or just corporate restructuring.

Sacrificing some rigour, these activities may be classified as shown next.

#CORPORATE RESTRUCTURING

#categories of Corporate Restructuring

Corporate restructuring activities can be divided into 2 broad categories:

1. Operational Restructuring refers to:- a) outright or b) partial purchase or c) sale of companies or product lines or d) downsizing by closing unprofitable, non-strategic facilities.2. Financial Restructuring:

Corporate

Restructurin

Expansion

• Mergers & acquisition

Sell-offs

• Spin- offs• split-

Corporate Control

• Premium Buy-backs

Changes in Ownership Structure

• Exchange offers

refers to the actions taken by the firm to change its total debt & equity structuring.OR

Ownership restructuring Business restructuring Asset restructuring

#CHARACTERISTICS:

1. To improve the co., Balance sheet, (by selling unprofitable division from its core business).

2. To accomplish staff reduction ( by selling/closing of unprofitable portion)3. Changes in corporate mgt4. Sale of underutilized assets, such as patents/brands.5. Outsourcing of operations such as payroll and technical support to a more

efficient 3rd party.6. Moving of operations such as manufacturing to lower-cost locations.7. Reorganization of functions such as sales, mktg, & distribution8. Renegotiation of labor contracts to reduce overhead9. Refinancing of corporate debt to reduce interest payments.10.A major public relations campaign to reposition the co., with consumers.

#Need for restructuring:

1. To respond to particular business needs.2. To create friendly & comfortable working system3. To make organization more competent4. To make it as counter strategies5. Growth & globalization6. To have financial strength & synergy to compete.

#PURPOSE OF CORPORATE RESTRUCTURING:

To enhance the share holder value. The co., should continuously evaluate its:1. portfolio of businesses, 2. capital mix,3. ownership & 4. assets arrangements to find opportunities to increase the share holders’

value. To focus on asset utilization and profitable invt opportunities To reorganize or divest less profitable or loss making businesses/products The co., can also enhance value through capital Restructuring, it can

innovate securities that help to reduce cost of capital.

# A. JOINT VENTURE

Joint ventures are new enterprises owned by two or more participants. They are typically formed for special purposes for a limited duration.

It is a contract to work together for a period of time each participant expects to gain from the activity but also must make a contribution.

For Example:

GM-Toyota JV, GM hoped to gain new experience in the mgt techniques of the Japanese in building high-quality, low-cost compact & subcompact cars.

Whereas, Toyota was seeking to learn from the mgt traditions that had made GE the no. 1 auto producer in the world and

In addition to learn how to operate an auto co., in the environment under the conditions in the US, dealing with contractors, suppliers, and workers

#CHARACTERISTICS OF JOINT VENTURE

1. Contribution by partners of: a) Moneyb) Knowledgec) Propertyd) Skille) Effort or other assets to a common undertaking.

2. Joint property interest in the subject matter of the venture.

3. Right of mutual control or mgt of the enterprise.

4. Expectation of profit, or presence of “adventure”

5. Right to share in the profit.

6. Usual limitation of the objective to a single undertaking or ad hoc enterprise.

# Reasons for forming a joint venture

1. Internal reasons:

Build on company's strengths Spreading costs and risks Improving access to financial resources Economies of scale and advantages of size Access to new technologies and customers Access to innovative managerial practices

2. Competitive goals

Influencing structural evolution of the industry Defensive response to blurring industry boundaries Creation of stronger competitive units Speed to market Improved agility

3. Strategic goals

Synergies Transfer of technology/skills Diversification

# MOTIVES TO JOINT VENTURE

1. To share invt expenses or combine a large co.2. Learning-experience3. Sharing of risk4. Antitrust authorities permit Joint-venture than merger because it increases

the no., of firms.

#RATIONAL FOR JOINT VENTURES

1. To augment insufficient financial or technical ability to enter a particular line or business.

2. To share technology & generic mgt skills in orgn, planning & control.3. To diversify risk4. To obtain distribution channels or raw materials supply5. To achieve economies of scale6. To extend activities with smaller invt than if done independently7. To take advantage of favorable tax treatment or political incentives

( particularly in foreign ventures).

#International joint venture:

To reduce the risk of expanding into a foreign environment The contribution of the local conditions, which may be essential to the

success of the venture.

#TAX ASPECTS OF J.Vs.

if a corporation contributes a patent technology to a J.V., the tax consequences may be less than on royalties earned though a licensing arrangements.

Example:

1 partner contributes the technology While another contributes depreciable facilities. The depreciation offsets the revenues accruing to the technology. The J.V. may be taxed @ a lower rate than any of its partner & The partners pay a later capital gain tax on the returns realized by the J.V. if

and when it is sold. If the J.V. is organized as a corporation, only its assets are @ risk. The partners are liable only to the extent of their invt. This is particularly impt. in hazardous industries where the risk of workers,

production, or environmental liabilities is high.

# B. SELL OFF

Selling a part or allof the firm by any one of means: sale, liquidation, spin-off & so on. OR

General term for divestiture of part/all of a firm by any one of a no. of means: sale, liquidation, spin-off and so on.

PARTIAL SELL-OFF

A partial sell-off/slump sale, involves the sale of a business unit or plant of one firm to another.

It is the mirror image of a purchase of a business unit or plant. From the seller’s perspective, it is a form of contraction; from the buyer’s point of view it is a form of expansion. For example: when Coromandal Fertilizers Limited sold its cement division to India Cement

Limited, the size of Coromandal Fertilizers contracted whereas the size of India Cements Limited expanded.

#Motives for Sell off

• Raising capital • Curtailment of losses• Strategic realignment• Efficiency gain

# C DEMERGERS

A demerger results in the transfer by a company of one or more of its undertakings to another company. The company whose undertaking is transferred is called the demerged company and the company (or the companies) to which the undertaking is transferred is referred to as the resulting company.

A demerger may take the form of

• a spinoff or • a split-up.

Rationale for Demergers

• Sharper focus• Improved incentives and accountability

#Demergers STRUCTURE

Demergers are one type of spin-offs: (under/section 391) A = Demerging Company B = Resulting Company: may or may not have existed earlier A transfers undertaking to B B issues shares to shareholders of A

X Y Transfers undertaking Y

Y

Company ACompany B

Issues shares Shareholders

Of A

# Merger & Demerger PROCESS

Phase- I

Draft Scheme Notice to members of Board of both companies Determine swap ratio based on valuation report Board approval of both companies Prior NoCs from secured creditors and shareholders for exemption from

meeting: Reduce Time and Costs In ICICI Ltd. merger with ICICI Bank, meeting of preference

shareholders of ICICI Ltd. was dispensed with since sole preference shareholder furnished an NOC

Phase- II

Draft Application under s. 391(1) Application to HCs in respective jurisdictions of both companies for sanction /

direction to conduct meetings

Moving registered office to one jurisdiction: Reduce Time and Costs

Phase- III

Notice of EGM to members with statement of terms of merger, interests of directors and proxy forms: 21 days

Advertisement Notice in 2 newspapers: 21 days Affidavit certifying compliance with HC’s directions in respect of notice/

advertisement Meetings of creditors and/ or shareholders: agreed to by majority in number

representing ¾ of value present and voting Chairman of meetings to file report within 7 days of meeting Resolutions and Explanatory Statements to be filed with RoC

Phase- IV (Approval of the Scheme)

HC to be moved within 7 days of Chairman’s Report for second motion petition

10 days notice of hearing of petition in same newspapers Notice to Central Govt. (Regional Director), and OL (if applicable): Submit

reports Objections raised in 391 proceedings HC Sanction Certified copy of HC Order to be filed with RoC within 30 days of order.

#SPIN OFF’S

Spin-off is a transaction in which a co., distributes on a pro-rata basis all the shares it owns in a subsidiary to its own shareholders.

In a spinoff an undertaking or division of a company is spun off into an independent company.

After the spinoff, the parent company and the spun off company are separate corporate entities.

Feature

No cash exchange (money is not received by the original parent). subsidiaries assets are not revalued. The transactions is treated - stock dividend and a tax-free exchange.

Proportion of ownership:The existing stockholders have the same proportion of ownership in the new entity as in the original firm.

Separation of control The new entity exists as a separate decision-making unit. It may develop policies & strategies difft from those of the original parent.

so, spin-off represents a form of a dividend to existing shareholders.

#Spin-Offs STRUCTURE

X Y Y

Transfer of

undertaking Y

MODULE-4

MODULE 4 (7 Hours)

• Merger Process: Dynamics of M&A process-• Identification of targets-• Negotiation-• Closing the deal. • Five-stage model – • Due diligence (detailed discussion).

Process of merger integration

• Organizational and human aspects –• Managerial challenges of M & A

Steps in Merger

1.Screening and investigation of merger proposal:

When there is an intention of acquisition or merger, the primary step is that of screening. The motives and the needs are to be adjusted against three strategic criteria i.e., business fit, mgt and financial strength.

Once the proposal fits into the strategic motive of the acquirer, then the proposed acquirer will collect all relevant info., relating to the target co., about share price movements, earnings, dividends, market share, shareholding patterns, gearing, financial position, benefits from proposed acquisition etc.

This form of investigation will bring out the strengths and weaknesses of both one’s own co., and the prospective merger candidate.T he acquirer co., should not only consider the benefits to be obtained but also be careful about the attendant risks. If the proposal is viable after thorough analysis from all angles, then the matter will be carried further.

2. Negotiation stage:

It’s the stage in which the bargain is made in order to secure the highest price by the seller and the acquirer keep to limit the price of the bid.

Before the negotiations start, the seller needs to decide the minimum price acceptable and the buyer needs to decide the maximum he is prepared to pay.

After the consideration is decided then the payment terms and exchange ratio of shares will be decided, which has to be worked out by valuing the shares of both, as per norms and methods of valuation of shares.

Approved valuer or a firm of chartered accountants will evaluate the shares on the basis of audited accounts as on the transfer date

3. Approval of proposal by Board of Directors-

Deciding upon the considerations of the deal and terms of payments, the proposal will be put for the Board of Director’s approval.

4. Approval of share holders-

As per the provisions of the Companies Act 1956 the shareholders of both seller and the acquirer companies hold meeting under the directions of the National Company Law Tribunal and consider the scheme of amalgamation. A separate meeting for both preference and equity shareholder is convened for this purpose.

5. Approval of creditors/financial institutions/banks-

Approvals from all these are to be sought for as per the respective agreement with each of them and their interest are considered in drawing up the scheme of merger.

6. Tribunal’s approval:- Is required for confirming the scheme of amalgamation. The Tribunal shall issue orders for winding up of the amalgamating company

without dissolution on receipt of the reports from the official liquidator and Regional Director that the affairs of the amalgamating company have not been conducted in a manner prejudicial to the interest of its members or to public interest.

7. Approval of Central Government:- is required on the recommendation made by the specified authority under Sec 72A of the Income Tax Act, if applicable

8 Integration stage:

the structural and cultural aspects of the two organizations, if carefully integrated in the new organization, will lead to successful merger and ensure that expected benefits of the merger are realized.

DUE DILIGENCE

(WHAT IS DUE DILIGENCE?

An investigation into the financial and commercial activities of a business in connection with a proposed acquisition or disposal of an interest in that business. The due diligence process includes the gathering, analysis and interpretation of financial, commercial, legal and marketing information- finding out “skeletons in the cupboard”

A decision support tool Information gathering- data room, personal interviews, other sources Rule of Thumb - Caveat Emptor- Let the buyer beware. Duly diligent buyers and sellers

WHY A DUE DILIGENCE?

* For All Investors, It’s Primarily About Measuring and ManagingRisk

*To aid in:

- Determining the advisability of the transaction

-Minimizing the risk of exposure for the target client

-Formulating a proposal for the transaction

-Structuring, negotiating and drafting representations and

-warranties that do not expose the target to risks and

-exposure identified during the process

-Determining if closing conditions can/will be met

WHY DUE DILIGENCE IS SO IMPORTANT

Refines the price/value Identify potential "deal killer" defects in the target Mitigates legal (and other) risks Verification that the transaction complies with investment criteria Checking the compliance levels Identification of synergies in the target Ensures that post-deal plans will have best chance for success

DUE DILIGENCE – WHAT TO LOOK FOR …?

Deal making is glamorous – Due Diligence is not –

Why M&As fail even after Due Diligence?

Studies reveal that to succeed, answer to be found for

the following:

- What are we buying- What is the assets’ stand alone value?- What are the synergies and the skeletons?- What is our walk-away price?

Good Due Diligence will reveal all ……

Due Diligence Team should know :

the customers of the target, size, growth rate, geographical & product segment.

Check out :

Competition Verify cost Economics Take stock of capabilities

SELLER’S PERSPECTIVE

Provides the seller with a fresh and independent perspective into how well positioned they are to maximize value and present their business with a focus on its key differentiators.

Provides the seller with comfort that there are no surprises in the acquirers due diligence process

To be/or not to be firm in the negotiations Do not want to assume any risk of non-payment Do not want to carry any residual liabilities

MOVING TO A HOLISTIC DUE DILIGENCE PLAN

Strategic Due Diligence - Does the acquisition make sense? Operational Due Diligence - What you can do to realize improvements in

productivity and profitability?. How, where and when profits can get to? How we will get there and how much investment it take to achieve that?.

Legal Due Diligence – Analyses the contracts, IPs, Real Property, Assets, Ownership and prepare the ground work for negotiations, documentation and warranties.

Financial Due Diligence - To get a sense of earnings on a normalized basis. IT Due Diligence - Key component of merger and acquisition activity.

WHICH CATEGORY YOU BELONG TO?

Strategic Buyer- focus on what strategic value the target company will provide to it (for example, elimination of a competitor, access to new customers, or acquisition of a complimentary product line)

Financial Buyer- focus on the target company’s financial condition and operating history so as to satisfy itself that it will receive a reasonable rate of return on its investment.

KEY QUESTIONS

Is the motivation to our acquisition justifiable?

Add new products- Importance on Product portfolio of the target Absorbing a competitor- -the newly combined company to control more of the market share

- Is the revenue model or the market reach justifies the acquisition?

Taxes- Is tax breaks/benefits really available? Cross Selling- Is scalability achievable with out incurring substantial costs?

Whether we have strong growth opportunities or not?

HANDLING OF THE KEY FINDINGS

Explore more- Discovery aspect & Strategic aspect Analyze the effect in the deal- Is it a deal killer? Explore solutions/alternatives-

> indemnities

> reps & warranties

> escrow

> insurance

> reduction in the purchase price

> defer the payment or structure the payment schedule

> wait until the defects are rectified

> abandon.

Go ahead and implementDISCOVERING THROUGH DUE DILIGENCE AND VALUING SYNERGIES

Meaning of “synergy” – observing superior team work in sports “Boston Consulting Group” : Lose the acquisition game by failing to define

synergy Synergy assessment should be centre piece of M&A analysis –

- Value creation

- Assessing synergies – fall / rise in stock prices

- Valuing synergies can be helpful to communicate to the investors

- Valuing synergies will help in post merger integration

TYPES OF SYNERGIES

Revenue enhancement synergies Cost reduction synergies Asset reduction synergies Tax reduction synergies Financial synergies Reducing working capital costs

STAND ALONE VALUE OF THE TARGET

Find answers to the following:

Whether sales inflated? Over optimistic – projections? Treating recurring items as extraordinary items? Making cash flow look healthier by under funding costs

CULTURAL DUE DILIGENCE

Compatibility issues:– People management– Hierarchical relations– Decision making processes– Openness to change

Avoiding culture clash-Pharmacia-Upjohn: aggressive Americans merging with ‘lazy’ Swedes

DD- A TOOL FOR INTEGRATION

Shortening the learning curve Avoiding any surprises Identifying the key resources Providing ideas to reconcile the differences Helps in planning for redundancies, restructuring, placements etc.

RECENT INSTANCES

Kissan Acquisition by Brookebond Best & Crompton Acquisition by UB Group Jet Airways acquiring Sahara Tata Steel acquiring Corus Daiichi Sankyo Co. acquiring Ranbaxy Labs

CONCLUSION

Due Diligence is critical and a serious exercise. Plan it well in advance- Identify your team, talk to them and explain

the rationale for the transaction, Prepare questionnaire and send that in advance to the target, make sure you get all documents and information in the data room, document the documents, review, identify problem areas, discuss and decide.

Basic principle-attention to minute details at the planning stage and give importance to the important findings at the due diligence stage

For the decision makers, DD provides enough reasons to take that important decision as to whether to go ahead with the deal or not.

Effective Due Diligence is about Managerial Humility:

Testing every assumption and questioning every belief Never imagine that one can fix the problem after the event)

LET’S GIVE DILIGENCE ITS DUE

Due Diligence is nothing but a detailed evaluation. Once a proposal has passed through initial screening, it is subjected to a detailed evaluation or due diligence process.

There are 3 components of Due Diligence:-

• Legal Due Diligence• Financial Due Diligence• Strategic Due Diligence

1. Financial Due Diligence:-

financial evaluation is the most impt part of due diligence. It 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.

A merger is said to be at a premium when the offer price is higher than the target firm’s pre-merger market value.

The acquiring firm may pay the premium if it thinks that it can increase the target firm’s profits after merger by improving operations and due to synergy

Determination of Payment of Premium

• Earnings and cash flows• Areas of risk• Max price payable• Best way to finance merger

2 Legal Due Diligence:

Any M & A activity needs a lot of structuring such that they are within the tax and legal frame work. Any merger to happen successfully, has to be structured in such a way that they are tax efficient, compliant with SEBI, FDI, Capital Market and Government rules and regulations.

3. Strategic Due Diligence:

It tests the strategic rationale behind a proposed transaction with two broad questions:

A. Is the deal commercially attractive?B. Are we capable of realizing the targeted value?

Aspects of Due Diligence

1. A detailed examination of the preliminary information2. The firm should make sure that no problems with prospective partners

a. No legal problems are suit

b. no difficulties or complications regards to pension plans & provident fund.

c. no environmental problemsd. there are no other contingent liabilities

3. Reliability of accounting records.

4. Physical inspection of the property & assets possessed by the target company

5. Scope for product improvement & superiority

6. Merger should fill gaps in managerial capability & enhance it.

7. Integration b/w management.

8. The target should be more worth with the acquire

9. Integration of cultural factors

a. mgt by formal paper work v/s mgt by wondering around.

b. individual decisions v/s Group decisions

c. Risk taking is encouraged v/s one mistaking you are out

d. post performance evaluation v/s long-term relationship

10. Valuation

11. Negotiation

12. Implementation & Review

The basic function of due diligence is to assess the benefits & the costs of a proposed acquisition by including into all relevant aspects of the past, present & the predictable future of a business to be purchased.

Due diligence is of vital importance to prevent “unpleasant surprise” after completing the acquisition. The due diligence should be thorough & extensive. Both the parties to the transaction should conduct their own due diligence to get the accrual assessment of potential risks and rewards.

MERGER PROCESS: FIVE STAGE MODELMERGER PROCESS: FIVE STAGE MODEL

STAGE 1

ST

AG

E 2

STAGE 3

STAGE 4

STAGE 5

Corporate strategy

Organizing for Acquisitions

Deal Structuring

Post-AcquisitionIntegration

Post-AcquisitionAudit

1. CORPORATE STRATEGY DEVELOPMENT

Business strategy is concerned with ways of achieving, maintaining, or enhancing competitive advantage in product markets. Corporate strategy is concerned with ways of optimizing the portfolios of business that a firm currently owns & with how this portfolio can be changed to serve the interests of the corporation’s stakeholders. M & A is one such activity which achieves the objectives of both corporate and business strategies.

Corporate strategies are based on various models like:

Industry structure driven, Competition among strategic groups, Competence or resource based competition, etc. Firms make acquisitions to gain market power, gain economies of scale and

scope or internalize vertically linked operations to save on cost of dealing with markets, thus adding further cost savings.

Approaches to strategy formulation

I. BOSTEN CONSULTING GROUP APPROACH1. The Expensive Curve.2. The Product life cycle.3. The Portfolio balance.

II. PORTER APPROACH1. Selection of an attractive industry2. Developing a competitive advantage through cost leadership3. Developing attractive value chains.

2. ORGANISING FOR ACQUISITION

One of the major reasons for the observed failure of many acquisitions may be that firms lack the orgn resources and capabilities for making acquisitions.

It is also likely that the acquisition decision-making processes within firms are far from the models of economic rationality that one may assume.

Success for effective acquisition integration is determined at least partly by the thoroughness, clarity and forethought with which the value creation logic in blueprinted at the acquisition decision stage.

A pre-condition for a successful acquisition is that the firm organizes itself for effective acquisition making.

An understanding of the acquisition decision process is important, since it has a bearing on the quality of the acquisition decision and its value creation logic.

A frame work is developed for effective orgn of the M & A function. The aim of this frame work is to develop the acquisition function as an impt orgnal capability and as a core competence of the firm.

At this stage the firm lays down the criteria for potential targets of acquisitions consistent with the strategic objectives and value creation logic of the firm’s corporate strategy and business model.

Deal Structuring and Negotiating: This stage consists of

Valuing target companies, taking into account how the acquirer plans to leverage its own assets with those of the targets.

Choice of advisors to the deal such as investment bankers, lawyers etc. Performing due diligence Determining the range of negotiation parameters Negotiating the positions of senior mgt of both the firms in the post merger

firm Developing the appropriate bid and defense strategies and tactics within the

parameters set by relevant regulatory regime, etc.Negotiations are conducted in an atmosphere where the bidder & the target may have private information that the other party does not have. Each can use this information advantage to gain favorable terms during negotiation.

Post-Acquisition Integration

This is a very important stage, the objective of which is to put in place a merged organization that can deliver the strategic and value expectatons that drove the merger in the first place.

Integration has the characteristics of a change mgt programme but here three types of change may be involved:

Change of the target firms Change of the acquiring firms Change in the attitude and behavior of both to accommodate co-existence or

fusion of the two firms.The integration process also has to be viewed as a project & the firm must have the necessary project mgt. Capabilities & programme with well-defined goals, teams, communication plans, deadlines, performance benchmarks, reward for meeting deadlines, and benchmarks & sanction for failure etc.

Such a methodical process helps to analyze problems and provide solutions. So that integration achieves the strategic & value creation goals.

Post Acquisition Audit and Organization Learning

The importance of organizational learning to the success of future acquisitions needs much greater recognition, given the high failure rate of acquisitions.

Post merger audit by internal auditors can be acquisition specific as well as being part of an annual audit. Internal auditors have a significant role in ensuring organizational learning and its dissemination.