MF0002-Unit-02-Mergers & Acquisition – A

strategic perspective
Unit 2 Mergers & Acquisition – A strategic perspective

Structure

2.1 Introduction

Objectives

2.2 Merger Process

Formulation of the Vision

Pre-Merger planning

Post-Merger Planning

2.3 Basic steps in Strategic planning in Merger

Self Assessment Questions

2.4 The Five-stage Model

Corporate strategy development

Organizing for acquisitions

Deal structuring and negotiation

Post-acquisition integration

Post acquisition audit and organizational learning

2.5 Methods of Financing Mergers – Cash offer, Share Exchange ratio

Cash Offer

Equity Share Financing

Debt and Preference Shares Financing

Hybrids
Self Assessment Questions

2.6 Mergers as a capital Budgeting decision

2.7 Summary

2.8 Terminal Questions

2.9 Answers to SAQ’s & TQ’s

2.1 Introduction

This unit explains the various processes involved in mergers. This unit also describes the
financial framework of a merger decision. In this unit you will also able to understand the three
inter-related aspects of merger. It covers, determining the firm’s value, financing techniques and
analysis of the mergers as a capital budgeting decision. This unit also helps you to understand
financial models used in decision making.

Objectives

After studying this unit, you should be able to

· Understand the process involved in mergers

· Discuss the technique of evaluation of merger proposals

· Describe the methods of financing merger

2.2 Merger Process

Mergers and acquisition activity should take place within the framework of long-range planning
by business firms. The merger decisions involve the future of the firm. Hence, it is useful to
understand the planning process involved in mergers. The planning processes can utilize formal
procedures or develop through informal communications throughout the organization. The
strategies, plans, policies and procedures are developed in the process of mergers. The strategic
planning in merger is behaviour and a way of thinking that requires diverse inputs from all
segments of the organization. For profitable and smooth flow of mergers, the entire process can
be divided into three phases as explained below:

2.2.1 Formulation of the Vision

The acquiring company must formulate the future vision of merger move in advance. The
following vision should be identified while planning for mergers and acquisitions.
· Growth – The vision for an organization defines its purpose, where it is heading, and what it
intends to do once it gets there. The vision includes a well-defined set of core values and beliefs
that define a company’s culture and purpose.

· Competition – The vision should identify the distinct set of competencies that will enable the
organization to deliver the unique value required to remain competitive as it moves forward. It
should describe clearly the expectations for what the company will look like and how it will
operate over time. Targets should be identified and evaluated in a manner consistent with the
company’s vision.

2.2.2 Pre-Merger planning

A coherent pre-merger planning process should target companies with the desired capabilities,
get the deal done, and lay the groundwork for a successful integration through rigorous planning
and building of trust among the players.

2.2.3 Post-Merger Process

The post-merger process should be focused on cultural integration, retention of key people, and
capturing well defined sources of value as quickly and efficiently as possible.

2.3 Basic steps in Strategic planning in Merger

Any merger and acquisition involves the following critical activities in strategic planning
processes. Some of the essential elements in strategic planning processes of mergers and
acquisitions are as listed here below.

1. Assessment of changes in the organization environment

2. Evaluation of company capacities and limitations

3. Assessment of expectations of stakeholders

4. Analysis of company, competitors, industry, domestic economy and international economies

5. Formulation of the missions, goals and polices

6. Development of sensitivity to critical external environmental changes

7. Formulation of internal organizational performance measurements

8. Formulation of long range strategy programs

9. Formulation of mid-range programmes and short-run plans

10. Organization, funding and other methods to implement all of the proceeding elements
11. Information flow and feedback system for continued repetition of all essential elements and
for adjustment and changes at each stage

12. Review and evaluation of all the processes

In each of these activities, staff and line personnel have important responsibilities in the strategic
decision making processes. The scope of mergers and acquisition sets the tone for the nature of
mergers and acquisition activities and in turn affects the factors which have significant influence
over these activities. This can be seen by observing the factors considered during the different
stages of mergers and acquisition activities. Proper identification of different phases and related
activities smoothens the process involved in merger.

I. Self Assessment Questions

1. Merger decision involves the future of the firm – Yes or No

2. What are the visions that should be identified while planning for mergers and acquisition?

_________________________________________________________

_________________________________________________________

3. State the critical activities in strategic planning processes.

_________________________________________________________

_________________________________________________________

_________________________________________________________

2.3 The Five-Stage (5-S) model

Mergers and acquisitions are transactions of great significance not only to the companies
themselves, but also to many other constituencies such as workers, managers, competitor
communities and economies. Hence, the mergers and acquisition process needs to be viewed as a
multi-stage process, with each stage giving rise to distinct problems and challenges to companies
understating such transactions. To understand the nature and sources of these problems, we need
a good understanding of the external context in which merger and acquisition take place. This
context is not purely economic but includes political, sociological and technological contexts as
well. The context is also ever-changing. Thus merger and acquisition could be regarded as a
dynamic response to these changes.

The five-stage model conceptualizes the merger and acquisition process as being driven by a
variety of impulses, not all of them reducible to rational economic paradigms. Both economic
and non-economic factors affect the merger and acquisition process. The five stages of merger
and acquisition process under 5-S model can be divided as below.
1. Corporate strategy development

2. Organizing for acquisitions

3. Deal structuring and negotiation

4. Post-acquisition integration

5. Post acquisition audit and organizational learning

The brief explanation of the above stages of merger is given below:

2.4.1 Stage 1: Corporate strategy development

Corporate strategy is concerned with the ways of optimizing the portfolios of businesses that a
firm currently owns and with how this portfolio can be changed to serve the interests of the
corporation’s stakeholders. Merger and acquisition can serve the objectives of both corporate and
business strategies, despite their being the only one of several instruments. Effectiveness of
merger and acquisition in achieving these objectives depends on the conceptual and empirical
validity of the models upon which corporate strategy is based. Given an inappropriate corporate
strategy model, mergers and acquisitions are likely to fail to serve the interest of the
stakeholders. With an unsustainable business strategy model, merger and acquisition is likely to
fail to deliver sustainable competitive advantage. Corporate strategy analysis has evolved in
recent years through several paradigms- industry structure –driven strategy, competition among
strategic group, competence or resource based competition etc.

2.4.2 Organizing for acquisitions

One of the major reasons for the observed failure of many acquisitions may be that firms lack the
organizational 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. Thus, a pre-condition for a successful acquisition is that the
firm organises 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. 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.

2.4.3 Stage 3: Deal structuring and negotiation

This stage consists of:

· Valuing target companies

· Choice of advisers (investment banker, lawyers, accountants etc) to the deal

· Performing due diligence

· Determining the range of negotiation parameters

· Negotiating the positions of senior management of both firms in the post-merger dispensation

· Developing the appropriate bid and defence strategies and tactics within the parameters set by
the relevant regulatory regime etc.

2.4.4 Post-acquisition integration

At this stage, the objective is to put in place a managed organization that can deliver the strategic
and value expectations that drove the merger in the first place. The integration process also has
to be viewed as a project and the firm must have the necessary project management capabilities
and programme with well defined goals, teams, deadlines, performance benchmarks etc. Such a
methodical process can unearth problems and provide solutions so that integration achieves the
strategic and value creation goals. One of the major problems in post-merger integration is the
integration of the merging firm’s information systems. This is particularly important in mergers
that seek to leverage each company’s information on customers, markets or processes with that
of the other company.

2.4.5 Post acquisition audit and organizational learning

The importance of organization 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 auditor has a significant
role in ensuring organizational learning and its dissemination.

2.5 Methods of financing Mergers – Cash offer, Share Exchange ratio

Financing of merger and acquisition involves payment of consideration money to the acquiree
for acquiring the undertaking, assets and controlling voting power of the shareholders as per
valuation done and the exchange ratio arrived at. Cash or exchange of shares of shares or a
combination of cash, shares and debt can finance a merger and acquisition. The choice of
financial instruments and techniques of acquiring a firm usually have an effect on the purchasing
agreement. The means of financing may change the debt-equity mix of the combined or the
acquiring firm after the merger. The cost of capital shall differ as per different debt-equity mix to
be selected.

2.5.1 Cash Offer

A cash offer is straightforward means of financing a merger. Main considerations for selecting
cash payment are as under:
a) Agreeableness of acquiree

b) Ability of the acquirer to raise additional funds needed

c) Easy accounting system for the acquirer as assets are written up for tax purposes creating more
cash flow

d) It does not cause any dilution in the earnings per share and the ownership of the existing
shareholders of the acquiring company

e) The share holders of the target company get immediate cash rather than blocking their money
in investments in securities of the acquirer

A company acquiring another will frequently pay for the other company by cash. Such
transactions are usually termed acquisitions rather than mergers because the shareholders of the
target company are removed from the picture and the target comes under the (indirect) control of
the bidder’s shareholders alone.

Let us assume that the net worth of XYZ Company is Rs. 500 crore and it has 25 crore
outstanding equity shares. The net asset value per share is Rs 20 (Rs, 500 crore / 25 crore). If
ABC Company decides to acquire XYX Company, it has to offer a price of Rs. 20 per share. If
ABC wants to pay cash for the shares of XYZ, it would need Rs. 500 crore in cash. Current
market price of the share can also be considered as purchase consideration instead of net asset
value for the purpose of acquisition.

The cash can be raised in a number of ways. The company may have sufficient cash available in
its account, but this is unlikely. More often the cash will be borrowed from a bank, or raised by
an issue of bonds. Acquisitions financed through debt are known as leveraged buyouts, and the
debt will often be moved down onto the balance sheet of the acquired company.

2.5.2 Equity Share Financing

A merger is often financed by an all stock deal (a stock swap), known as an all share deal. Such
deals are considered mergers rather than acquisitions because neither of the companies pays
money and the shareholders of each company end up as the combined shareholders of the
merged company. There are two methods of merging companies in this way:

· one company takes ownership of the other, issuing new shares in itself to the shareholders of
the company being acquired as payment, or

· a third company is created which takes ownership of both companies (or their assets) in
exchange for shares in itself issued to the shareholders of the two merging companies.

Where one company is notably larger than the other, people may nevertheless be wary of calling
the deal a merger, as the shareholders of the larger company will still dominate the merged
company.
It is easier for the acquirer to make payment of the consideration money of acquisition in the
form of its own equity shares, in the ratio arrived at through valuation process. A share exchange
offer will result into the sharing of ownership of the acquiring company between its existing
shareholders and new shareholders. The only disadvantage to the shareholders of the acquirer is
dilution of Earning per Share and possibility of fall in share price due to issuance of additional
shares. At times, acquiree’s shareholders are also interested in obtaining payments in equity
shares rather in cash for reasons of tax liability immediately devolving upon them in receipt of
cash consideration, where as in the case of equity; capital gain tax is deferred till realization of
the share in cash. In simple words, exchange of shares is tax-free, as recipient pays no tax on
equity shares received.

The earnings and benefits would be shared between the shareholders of acquirer and acquired
company. The precise extent of net benefits that accrue to each group depends on the exchange
ratio in terms of market prices of the shares of the acquiring and the acquired companies.

Instead of paying cash, ABC company could acquire XYZ through exchange of shares on the
basis of either net asset value or current market price of shares. Let us assume that the current
market price of ABC is Rs. 100 and XYZ is Rs. 50 per share. The market value of every 2 shares
of XYZ company is equal to one share of ABC company. Hence, the exchange ratio will be 1:2.
That is ABC company will issue 12.5 crore shares to XYZ company as purchase consideration.
The additionally issued 12.5 crore share would be added to the total number of existing equity
shares to get the post merger outstanding share of the acquirer.

When a company is considering the use of equity shares to finance a merger, the relative price-
earning ratios of two firms are an important consideration. For example, for a firm having a high
price-earning ratio, equity shares represent an ideal method for financing mergers and
acquisitions. Similarly, ordinary shares are more advantageous for both companies when the firm
to be acquired has a low price-earning ratio.

2.5.3 Debt and Preference Shares Financing

Investors who seek dividend or interest income in contrast with capital appreciation, convertible
debentures and preference shares might be used for finance mergers. The use of such sources of
financing has several advantages.

· Potential earning dilution may be partially minimized by issuing a convertible security.

· A convertible issue might serve the income objectives of the shareholders of the target firm,
without changing the dividend policy of the acquiring firm.

· Convertible security represents a possible way of lowering the voting power of the target
company.

In a nutshell, fixed income securities are compatible with the needs and purposes of mergers and
acquisitions. The need for changing the financing leverage and the need for a variety of securities
is partly resolved by the use of senior securities.
2.5.4 Hybrids

An acquisition can involve a cash and debt combination, or a combination of cash and stock of
the purchasing entity, or just stock. The Sears-Kmart acquisition is an example of a cash deal.

II. Self Assessment Questions

1. The five stages of merger and acquisition process under 5-S model are:

_________________________________________________________

_________________________________________________________

2. The various means of financing mergers are:

_________________________________________________________

_________________________________________________________

3. The main considerations for selecting cash payment are:

_________________________________________________________

_________________________________________________________

2.6 Merger as a Capital Budgeting Decision

Merger should be evaluated as a capital budgeting decision. The target firm should be valued in
terms of its potential to generate incremental future cash flows. Such cash flows should be
incremental future free cash flows likely to accrue due to the acquisition of the target firm. Free
cash flows in context of a merger are equal to after-tax expected operating earnings plus non-
cash expenses (depreciation, amortization etc) less additional investments expected to be made in
the long-term assets and working capital of the acquired firm. These cash flows are then to be
discounted at an appropriate rate that reflects the friskiness of target firm’s business. The present
value of the expected benefits from the merger is to be compared with the cost of the acquisition
of the target firm. Here, acquisition costs include:

· the payment made to the target firm’s shareholders and debenture-holders,

· the payment made to discharge the external liabilities,

· estimated value of the obligations assumed,

· Liquidation expenses to be met by the acquiring firm and so on less cash proceeds expected to
be realized by the acquiring firm from the sale of certain assets of the target firm.
If the net present value is positive, accept the merger proposal otherwise reject the proposal.

Steps used to evaluate merger decision

· Determination of projected incremental free cash flows

· Determination of terminal value

=>Terminal value is the present value of free cash flows after the forecast period. Its value can
be determined as per the following equations:

- When free cash flows are likely to be constant till infinity:

–TV = FCF (t+1) / Ko

- When free cash flows are likely to grow at a constant rate:

–TV= FCF (t+1) (1 +g) / (Ko – g)

-When free cash flows likely to decline at a constant rate:

–TV = FCF (t+1) (1-g) /(Ko + g)

· Determination of appropriate discount rate

· Determination of present value of free cash flows

· Determination of cost of acquisition

· Determination of net present value of the merger proposal

Example

XYZ Ltd is contemplating taking over the business of ABC Ltd. The balance sheet of ABC Ltd
as on 30th June was as follows:

Additional information:
1. XYZ Limited agrees to takeover all the current assets at their book value but the fixed assets
were to be re-valued as under:

Land and buildings: Rs. 500 lakh

Plant and Machinery Rs. 500 lakh

In addition to the above, XYZ Ltd is required to pay Rs. 50 lakh for goodwill

2. Purchase consideration is to be paid as Rs. 130 lakh in cash to pay 13% debenture and other
liabilities and the balance to be paid in terms of shares of XYZ Ltd.

3. Expected benefits accruing to XYZ Ltd are as follows:

Year 1 2 3 4 5
Expected Benefits (Cash 200 300 260 200 100
Flows) Rs.

Further, it is estimated that the cash flows are expected to grow at 5 per cent per annum after 5
years

4. Cost of capital for the purpose of analysis is to be 15 percent

Suggest whether the above merger proposal is likely to benefit to XYZ Ltd.

Solution:

1. Calculation of cost of acquisition

(Rs. lakhs)

Fixed Assets: 500 1050

Land & Buildings 500

Plant & Machinery 50

Goodwill
Current Assets: 70 120

Inventories 35

Debtors 15

Bank
Total 1170

1. Mode of Payments:

Rs. 1170 lakh is payable as follows:

Cash payment to pay 13% Debentures and current liabilities 130

Shares of XYZ Ltd (Rs. 1170 lakh – Rs. 130 lakh) 1040

1. Calculation of present value of expected benefits:

1. Present Value of expected benefit after the forecast period

TV5 = FCF 5 (1 +g)/(K –g)

Rs. 100 (1.05)/(0.15 – 0.05) = Rs. 1050 lakh

Present Value = Rs. 1050 lakh X 0.497 = Rs. 521.85

5. Calculation of Net Present Value (Rs. lakh)

Present Value of Expected benefit (years 1 – 5) Rs. 735.98

Present value of Expected benefit after the forecast period Rs. 521.85

Total Present Value of Expected Benefits Rs. 1257.83

Less: Cost of Acquisition Rs. 1170.00

Net Present Value Rs. 87.83