SOLUTION TO END TERM EXAMINATION

THIRD SEMESTER MBA(F.M)

MERGERS ACQUISITIONS AND CORPORATE RESTRUCTURING

Q1Discuss the treatment of goodwill and capital reserve in context of mergers and
amalgamations. Explore the considerations involved in inter-companies' holdings
accounting and the related tax aspects.
Ans
Goodwill is the excess of purchase consideration over the fair value of net assets acquired. If
the goodwill is not separable from the acquiring company’s business, it is recognized as an
intangible asset. On the other hand, if it is separable, it is recognized as goodwill.

Capital reserve is the excess of the fair value of net assets acquired over the purchase
consideration. It is recognized in the financial statements as a separate line item.

Accounting Treatment of Goodwill and Capital Reserve

Treatment of Reserves in context of Mergers and Amalgamation If the amalgamation is an

‘amalgamation in the nature of merger’ If the amalgamation is an ‘amalgamation in the nature of
merger’, the identity of the reserves is preserved and they appear in the financial statements of
the transferee company in the same form in which they appeared in the financial statements of
the transferor company. Thus, for example, the General Reserve of the transferor company
becomes the General Reserve of the transferee company, the Capital Reserve of the transferor
company becomes the Capital Reserve of the transferee company and the Revaluation Reserve
of the transferor company becomes the Revaluation Reserve of the transferee company. As a
result of preserving the identity, reserves which are available for distribution as dividend before
the amalgamation would also be available for distribution as dividend after the amalgamation.
The difference between the amount recorded as share capital issued (plus any additional
consideration in the form of cash or other assets) and the amount of share capital of the
transferor company is adjusted in reserves in the financial statements of the transferee
company

If the amalgamation is an ‘amalgamation in the nature of purchase’ If the amalgamation is

an ‘amalgamation in the nature of purchase’, the identity of the reserves, other than the
statutory reserves is not preserved, dealt within the certain circumstances mentioned below.
Certain reserves may have been created by the transferor company pursuant to the
requirements of, or to avail of the benefits under, the Income-tax Act, 1961; for example,
Development Allowance Reserve, or Investment Allowance Reserve. The Act requires that the
identity of the reserves should be preserved for a specified period. Likewise, certain other
reserves may have been created in the financial statements of the transferor company in terms
of the requirements of other statutes. Though, normally, in an amalgamation in the nature of
purchase, the identity of reserves is not preserved, an exception is made in respect of reserves
of the aforesaid nature (referred to hereinafter as ‘statutory reserves’) and such reserves retain
their identity in the financial statements of the transferee company in the same form in which
they appeared in the financial statements of the transferor company, so long as their identity is
required to be maintained to comply with the relevant statute. This exception is made only in
those amalgamations where the requirements of the relevant statute for recording the statutory
reserves in the books of the transferee company are complied with. In such cases the statutory
reserves are recorded in the financial statements of the transferee company by a corresponding
debit to a suitable account head (e.g., ‘Amalgamation Adjustment Account’) which is disclosed
as a part of ‘miscellaneous expenditure’ or other similar category in the balance sheet. When
the identity of the statutory reserves is no longer required to be maintained, both the reserves
and the aforesaid account are reversed. The amount of the consideration is deducted from the
value of the net assets of the transferor company acquired by the transferee company. If the
result of the computation is negative, the difference is debited to goodwill arising on
amalgamation and dealt with in the manner stated below ‘under‘ treatment of goodwill on
amalgamation, . If the result of the computation is positive, the difference is credited to Capital
Reserve.

Treatment of Goodwill in context of Mergers and Amalgamation Goodwill arising on

amalgamation represents a payment made in anticipation of future income and it is appropriate
to treat it as an asset to be amortised to income on a systematic basis over its useful life. Due to
nature of goodwill, it is difficult to estimate its useful life, but estimation is done on a prudent
basis. Accordingly, it should be appropriate to amortise goodwill over a period not exceeding five
years unless a somewhat longer period can be justified. The following factors are to be taken
into account in estimating the useful life of goodwill: (i) the forceable life of the business or
industry; (ii) the effects of product obsolescence, changes in demand and other economic
factors; (iii) the service life expectancies of key individuals or groups of employees; (iv)
expected actions by competitors or potential competitors; and (v) legal, regulatory or contractual
provisions affecting the useful life.

Q2 Define Merger and Amalgamation. Explain Accounting Standard 14 (AS 14) and its
relevance to the accounting treatment of mergers. Differentiate between the pooling of
interest method and the purchase method.
Ans
M&As are means of corporate expansion and growth. They are not the only means of corporate
growth, but are an alternative to organic growth. From time to time, companies have preferred
the external growth through M&As than organic growth due to some strategic objectives.
These strategic objectives may be growth and expansion of the firm, reduction of cost
through economies of scale, gaining competitive advantage in existing product markets,
market product extension, or risk reduction. Further, like all other strategic decisions,
acquisitions should also satisfy the criterion of value addition. A horizontal merger takes
place A horizontal merger takes place between two or more companies that compete in the
same business and geographical market. A vertical merger integrates the operations of a
supplier and a customer. In a backward vertical merger, the customer acquires the supplier,
while, in a forward vertical merger, the supplier acquires the customer. A market extension
merger or marketing/technology related concentric merger takes place between two
companies in a similar field whose sales do not overlap but may expand the acquiring firm’s
geographical or product market owing to related marketing/ technology. A conglomerate
merger is one between firms in totally unrelated business. A consolidation merger takes place
between two or more firms, generally engaged in same or similar business under the control
of the same management.
Q3.Define Corporate Restructuring and discuss its needs and scope. Provide examples
of various modes of restructuring in the Indian and global scenarios.
Ans
Corporate restructuring is defined as the process involved in changing the organization of a
business. Corporate restructuring can involve making dramatic changes to a business by cutting
out or merging departments. It implies rearranging the business for increased efficiency and
profitability. In other words, it is a comprehensive process, by which a company can consolidate
its business operations and strengthen its position for achieving corporate objectives-synergies
and continuing as competitive and successful entity.
Corporate Restructuring as a Business Strategy Corporate restructuring is the process of
significantly changing a company's business model, management team or financial structure to
address challenges and increase shareholder value. Restructuring may involve major layoffs or
bankruptcy, though restructuring is usually designed to minimize the impact on employees, if
possible. Restructuring may involve the company's sale or a merger with another company.
Companies use restructuring as a business strategy to ensure their long-term viability.
Shareholders or creditors might force a restructuring if they observe the company's current
business strategies as insufficient to prevent a loss on their investments. The nature of these
threats can vary, but common catalysts for restructuring involve a loss of market share, the
reduction of profit margins or declines in the power of their corporate brand. Other motivators of
restructuring include the inability to retain talented professionals and major changes to the
marketplace that directly impact the corporation's business model. Corporate restructuring is the
process of significantly changing a company's business model, management team or financial
structure to address challenges and increase shareholder value. Corporate restructuring is an
inorganic growth strategy.
NEED AND SCOPE OF CORPORATE RESTRUCTURING
Corporate Restructuring is concerned with arranging the business activities of the corporate as
a whole so as to achieve certain predetermined objectives at corporate level. Such objectives
include the following: — orderly redirection of the firm's activities; — deploying surplus cash
from one business to finance profitable growth in another; — exploiting inter-dependence
among present or prospective businesses within the corporate portfolio; — risk reduction; and
— development of core competencies.
When we say corporate level it may mean a single company engaged in single activity or an
enterprise engaged in multi activities. It could also mean a group having many companies
engaged in related or unrelated activities. When such enterprises consider an exercise for
restructuring their activities they have to take a wholesome view of the entire activities so as to
introduce a scheme of restructuring at all levels. However such a scheme could be introduced
and implemented in a phased manner. Corporate Restructuring also aims at improving the
competitive position of an individual business and maximizing it's contribution to corporate
objectives. It also aims at exploiting the strategic assets accumulated by a business i.e. natural
monopolies, goodwill, exclusivity through licensing etc. to enhance the competitive advantages.
Thus restructuring would help bringing an edge over competitors. Competition drives
technological development. Competition from within a country is different from crosscountry
competition. Innovations and inventions do not take place merely because human beings would
like to be creative or simply because human beings tend to get bored with existing facilities.
Innovations and inventions do happen out of necessity to meet the challenges of competition.
Cost cutting and value addition are two mantras that get highlighted in a highly competitive
world. Monies flow into the stream of production in order to be able to face competition and
deliver the best possible goods at the convenience and affordability of the consumers. Global
Competition drives people to think big and it makes them fit to face global challenges. In other
words, global competition drives enterprises and entrepreneurs to become fit globally. Thus,
competitive forces play an important role. In order to become a competitive force, Corporate
Restructuring exercise could be taken up. Also, in order to drive competitive forces, Corporate
Restructuring exercise could be taken up. The scope of Corporate Restructuring encompasses
enhancing economy (cost reduction) and improving efficiency (profitability). When a company
wants to grow or survive in a competitive environment, it needs to restructure itself and focus on
its competitive advantage. The survival and growth of companies in this environment depends
on their ability to pool all their resources and put them to optimum use. A larger company,
resulting from merger of smaller ones, can achieve economies of scale. If the size is bigger, it
enjoys a higher corporate status. The status allows it to leverage the same to its own advantage
by being able to raise larger funds at lower costs. Reducing the cost of capital translates into
profits. Availability of funds allows the enterprise to grow in all levels and thereby become more
and more competitive.

Corporate Restructuring aims at different things at different times for different companies and
the single common objective in every restructuring exercise is to eliminate the disadvantages
and combine the advantages. The various needs for undertaking a Corporate Restructuring
exercise are as follows: (i) to focus on core strengths, operational synergy and efficient
allocation of managerial capabilities and infrastructure. (ii) consolidation and economies of scale
by expansion and diversion to exploit extended domestic and global markets. (iii) revival and
rehabilitation of a sick unit by adjusting losses of the sick unit with profits of a healthy company.
(iv) acquiring constant supply of raw materials and access to scientific research and
technological developments. (v) capital restructuring by appropriate mix of loan and equity funds
to reduce the cost of servicing and improve return on capital employed. (vi) Improve corporate
performance to bring it at par with competitors by adopting the radical changes brought out by
information technology

Various types of corporate restructuring strategies include: 1. Merger 2. Demerger 3. Reverse

Mergers 4. Disinvestment 5. Takeovers 6. Joint venture 7. Strategic alliance 8. Slump Sale 9.
Franchising 10. Strategic alliance etc.

1. Merger Merger is the combination of two or more companies which can be merged together
either by way of amalgamation or absorption. The combining of two or more companies, is
generally by offering the stockholders of one company securities in the acquiring company in
exchange for the surrender of their stock. Mergers may be
(i) Horizontal Merger: It is a merger of two or more companies that compete in the same
industry. It is a merger with a direct competitor and hence expands as the firm's operations in
the same industry. Horizontal mergers are designed to achieve economies of scale and result in
reduce the number of competitors in the industry.
(ii) Vertical Merger: It is a merger which takes place upon the combination of two companies
which are operating in the same industry but at different stages of production or distribution
system. If a company takes over its supplier/producers of raw material, then it may result in
backward integration of its activities. On the other hand, Forward integration may result if a
company decides to take over the retailer or Customer Company. Vertical merger provides a
way for total integration to those firms which are striving for owning of all phases of the
production schedule together with the marketing network
(iii) Co generic Merger: It is the type of merger, where two companies are in the same or related
industries but do not offer the same products, but related products and may share similar
distribution channels, providing synergies for the merger. The potential benefit from these
mergers is high because these transactions offer opportunities to diversify around a common
case of strategic resources.
(iv) Conglomerate Merger: These mergers involve firms engaged in unrelated type of activities
i.e. the business of two companies are not related to each other horizontally nor vertically. In a
pure conglomerate, there are no important common factors between the companies in
production, marketing, research and development and technology. Conglomerate mergers are
merger of different kinds of businesses under one flagship company. The purpose of merger
remains utilization of financial resources enlarged debt capacity and also synergy of managerial
functions. It does not have direct impact on acquisition of monopoly power and is thus favoured
throughout the world as a means of diversification.
2. Demerger It is a form of corporate restructuring in which the entity's business operations are
segregated into one or more components. A demerger is often done to help each of the
segments operate more smoothly, as they can focus on a more specific task after demerger.
3. Reverse Merger Reverse merger is the opportunity for the unlisted companies to become
public listed company, without opting for Initial Public offer (IPO).In this process the private
company acquires the majority shares of public company, with its own name.

4. Disinvestment Disinvestment means the action of an organization or government selling or

liquidating an asset or subsidiary. It is also known as "divestiture".

5. Takeover/Acquisition Takeover means an acquirer takes over the control of the target
company. It is also known as acquisition. Normally this type of acquisition is undertaken to
achieve market supremacy. It may be friendly or hostile takeover. Friendly takeover: In this type,
one company takes over the management of the target company with the permission of the
board. Hostile takeover: In this type, one company takes over the management of the target
company without its knowledge and against the wish of their management.

6. Joint Venture (JV) A joint venture is an entity formed by two or more companies to undertake
financial activity together. The parties agree to contribute equity to form a new entity and share
the revenues, expenses, and control of the company. It may be Project based joint venture or
Functional based joint venture. Project based Joint venture: The joint venture entered into by
the companies in order to achieve a specific task is known as project based JV. Functional
based Joint venture: The joint venture entered into by the companies in order to achieve mutual
benefit is known as functional based JV.

7. Strategic Alliance Any agreement between two or more parties to collaborate with each
other, in order to achieve certain objectives while continuing to remain independent
organizations is called strategic alliance. 8. Franchising Franchising may be defined as an
arrangement where one party (franchiser) grants another party (franchisee) the right to use
trade name as well as certain business systems and process, to produce and market goods or
services according to certain specifications.

Q4 Examine the legal aspects of mergers and amalgamations, including the provisions
of the Companies Act. Discuss the regulatory framework governing mergers and
amalgamations.

Ans

The restructuring process does not only involve strategic decision making based on the market
study, competitor analysis, forecasting of synergies on various respects, mutual benefits,
expected social impact etc, but also the technical and legal aspects such as valuation of
organizations involved in restructuring process, swap ratio of shares if any, legal and procedural
aspects with regulators such as Registrar of Companies, High Court etc., optimum tax benefits
after merger, human and cultural integration, stamp duty cost involved etc. It involves a team of
professionals including business experts, Company Secretaries, Chartered Accountants, HR
professionals, etc., who have a role to play in various stages of restructuring process. The
Company Secretaries being the vital link between the management and stakeholders are
involved in the restructuring process through out as co-coordinator, in addition to their
responsibility for legal and regulatory compliances. The restructuring deals are increasing day
by day to be in line with business dynamics and international demands. It necessitates the
expanded role of professionals in terms of maximum quality in optimum time. Companies Act,
2013 The Companies Act, 2013 has brought many enabling provisions with regard to mergers,
compromise or arrangements, especially with respect to cross border mergers, time bound and
single window clearances, enhanced disclosures, disclosures to various regulators, simplified
procedure for smaller companies etc. It may be noted that Section 230-240 of the Companies
Act, 2013 and the rules made thereunder are yet to be notified. Salient Features of Companies
Act, 2013 relating to Corporate Restructuring (Section 230-240)

• National Company Law Tribunal to assume jurisdiction of High Court.

• Section 230(2) – Application for compromise or arrangement to be accompanied by an

affidavit, disclosing 1. All material facts relating to the company. 2. Reduction of capital if any
included in the compromise or arrangement; 3. Any scheme of corporate debt restructuring
consented to by not less than 75% of the secured creditors in value along with creditors
responsibility statement, report of the auditor as to the funds requirement after CDR and the
conformity to liquidity test etc.

• Proviso to Section 230(3) – Notice relating to compromise or arrangement and other

documents to be placed on the website of the company.

• Section 230(5) – Notice of meeting for approval of the scheme of compromise or arrangement
be sent to various regulators including:

1. The Central Government;

2. Income-tax Authorities;

3. Reserve Bank of India (`RBI’);

4. Securities Exchange Board of India (`SEBI’);

5. The Registrar;

6. Respective Stock Exchange;

8. The Competition Commission of India; if necessary; and

9. Other Sectoral regulators which could likely be affected by the scheme. Representation, if
any, by the above authorities will have to be made within a period of 30 days from receipt of
notice.

• Proviso to Section 230(4) – Persons holding not less than 10% of the shareholdings or
persons having outstanding debt amounting to not less than 5% of the total outstanding debt as
per the latest audited financial statement, entitled to object the scheme of compromise or
arrangement.
• Proviso to Section 230(7) – No sanction for Compromise or arrangement if accounting
treatment is no AS compliant.

• Section 234 – Cross border Merger permitted. The 1956 act permits merger of foreign
company wit h Indian company and not vice versa.

• Section 233 (10) – Abolishing the practice of companies holding their own shares through a
trust (Treasury Stock) in case of merger of holding and subsidiary companies. Ultimately the
shares are to be cancelled.

• Section 233 – Fast track mergers introduced. – The new Act enables fast track merger without
the approval of NCLT, between: 1. Two or more small companies. Small company is defined
under the Act. 2. Holding and wholly owned subsidiary company 3. Other class of companies as
may be prescribed

• Section 230(6) – Approval of scheme by postal ballot thereby involving wider participation;

• Section 230(11) – Any compromise or arrangement may also include takeover offer made in
prescribed manner. In case of listed companies, takeover offer shall be as per the regulations
framed by SEBI.

Q5 Explore the challenges and considerations involved in valuing firms with negative
earnings. Discuss the approaches to valuing start-up firms.
Ans
Negative Earnings: Consequences and Causes A firm with negative earnings or abnormally low earnings is
more difficult to value than a firm with positive earnings. In this section, we look at why such firms create
problems for analysts in the first place and then follow up by examining the reasons for negative earnings.
The Consequences of Negative or Abnormally Low Earnings Firms that are losing money currently create
several problems for the analysts who are attempting to value them. While none of these problems are
conceptual, they are significant from a measurement standpoint.
1. Earnings growth rates cannot be estimated or used in valuation: The first and most obvious
problem is that we can no longer estimate an expected growth rate to earnings and apply it to
current earnings to estimate future earnings. When current earnings are negative, applying a
growth rate will just make it more negative
2. Tax computation becomes more complicated: The standard approach to estimating taxes is to
apply the marginal tax rate on the pre-tax operating income to arrive at the after-tax operating
income.
3. The Going Concern Assumption: The final problem associated with valuing companies that have
negative earnings is the very real possibility that these firms will go bankrupt if earnings stay
negative.

Startup valuation is a process of identifying the true worth of the firm and giving a crucial insight into a
company's potential that reveals its ability to use the new capital to grow and hit the next milestone.
It considers numerous factors, including the team's expertise, product's validity and value, inside and outside
assets, business model, target market and its current needs and expectations, competitor performance,
present and future opportunities, goodwill, and investor expectations.

Valuation analyzes current and past performance and operates with financial data and statistics. Not only
does it provide an average pre money valuation, but most importantly, it gives an understanding of the
fundamental value of the startup and its idea, brand value on the market, team and product's potential, and
the context of fundraising. It undermines an excellent starting point and solid foundation to build a strong
business.

Importance of Accurate Valuation of Startup

To understand the importance of a startup's valuation, especially at an early stage, consider what it does:

 Assess the company's worth.

 Determine the weaknesses and strengths of the team.
 Analyze the startup's capital structure.
 Predict future earnings prospects.
 Provide financial opinions on matters of litigation.
 Plan exit strategy.
All these functions are crucial for early stage startups because they clarify the overall situation around the
company and eliminate the majority of delusions and biases. On top of that, using financial metrics and
analyzing competition and market needs, the valuation process gives insights into future sales and the
company's profit.

Another reason why valuation is important is that it secures funding. Investors are interested not only in
business models and products but also well-researched and accurate valuation of the brand itself.
According to statistics, whatever exciting business idea is, the estimated company always gets more
investments. There is more. Companies should also remember that pre money and post money valuation
methods give directions for creating an effective financial plan. On top of that, the process does these tasks:

 define the potential of a startup and idea,

 assist businesses in getting tax benefits and exemptions,
 spot trends and opportunities,
 highlight common financial problems and traps,
 provide essential applications for a company at a given point in time,
 set a fair market value for the product and company.
Many successful businesses believe in a company's valuation done at all stages during life because it
indicates risks and returns and creates a clear picture of what is happening with the startup company and
what matters now. This helps to choose the right strategy for the next period, avoid degradation and
stagnation, and secure new investors.
Although there is no exact science for figuring out how much money precisely a company will need to reach
the next milestone, still there are patterns and methods to predict that and provide the business owner with a
relatively solid ground. Let's consider the popular startup valuation methods.

Methods of Startup Valuations

So, how to get the current company value and average pre money valuation?

The precise valuation of a startup is almost impossible because many factors may distort the picture.
However, it still does lots of good, even with relative numbers.

Another good news is the business sector has different startup valuation methods. Some go for valuation by
stage model, while others rely on the Berkus method. They may provide great valuation results depending
on the niche, competition, product, market, and current development stage. Therefore, it is possible to do an
average valuation that can be pretty accurate. Let's consider some of the most reliable methods.

Discounted Cash Flow Analysis

Discounted cash flow method is a financial analysis model that is highly popular among stakeholders and
future investors who need to assess the potential value of returns on their investments and make the right
strategic decisions. On the other hand, it helps improve startups' financial qualifications and advance in their
niche. The central pillar of this solution lies in discounting the estimated projected cash flow. It determines
the discount percentage rate by analyzing certain factors, including:

 capital,
 cost of equity,
 the capital cost of the debt,
 costs on purchasing equipment and hiring new employees, etc.
The formula has three main components:

 The total amount of cash flow a company has in a given year.

 The targeted rate of return on the investment based on the weighted average cost of capital.
 A number of years a company is reporting.
Taking these components and inserting them into the mathematical formula, this method estimates the
investment's future value, determines the discount rate and defines future cash flows.

Comparable Company Analysis

Comparable company analysis is a popular pre money valuation method used in investment banking niche
to compare different companies' values by assessing the entire value of the enterprise. This includes
shareholder stakes, the company's debt, and all assets, including current and non-current, tangible and non-
tangible, and operating and non-operating. At some point, it reminds scorecard method, but it goes much
deeper into examining the competition. The main goal of this method is to estimate how much a startup
should be worth based on how it compares to other startup companies. This is done in several steps:
  Defining the right group of competitors. As a rule, these companies are similar according to these
factors: industry, size, revenue, growth rates, assets, and even geographic location and number of
employees.
 Gathering financial data about each one. This includes share price, market capitalization, earnings
before interest, taxes, revenue, and the company's worth.
 Calculating several ratios to compare and contrast. For instance, get the ratio of enterprise value
versus revenue.
The main advantage of this method is that it works great for pre revenue startups because it is based on pre
revenue valuations of the same companies.

Precedent Transaction Analysis

Precedent transaction analysis is a valuation method that uses past performance results. This cannot be
easy with pre revenue startups because some do not have any previous financial data. Nevertheless, it still
gives valuable estimations and results that can be used as a baseline valuation of a company that should be
improved with other intricate and thorough analyses.

It primarily relies on publicly available information and looks at the type of investors that have purchased
similar companies. Using a comparable transactions method, it identifies the most relevant transactions. On
top of that, it analyses competitors not just in the same niche but, most importantly, with similar financial
characteristics.

In short, it does these steps:

 Seek relevant transactions.

 Analyze available transactions.
 Determine a range of valuation and revenue multiples.
 Apply the valuation multiples to the company in question.
The most significant advantage of this method is that it provides a general assessment of the market's
demand for a particular asset. This routine underlies an approximate valuation of the asset.

Q6.A Ltd. is considering a takeover of B Ltd. and C Ltd. The financial data for the three
companies are as follows:

Particulars A Ltd B Ltd C Ltd

Equity Share Capital of 450 180

Rs. 10 each (Rs. crores) 90

Earnings (Rs. crores) 90 18 18

Market price of each share 60 37 46

 (Rs.)

Calculate:
i) Price-earnings ratios
ii) Earnings per share of A Ltd. after the acquisition of B Ltd. and C Ltd. separately.
Will you recommend the merger of either/both companies? Justify your answer.

Ans

Analysis: After merger of C Ltd. with A Ltd’s. EPS is higher than A Ltd. (Rs. 2.08). Hence
merger with only C Ltd. is suggested to increase the value to the shareholders of A Ltd.

Q7 How to evaluate a business before going for the merger? Explain different methods
of valuation of a business firm.
Ans
Business Valuation is the process of determining the financial value of a business. Business
valuation is performed because it is helpful information during litigation; it helps develop your
business' exit strategy for buying and selling a business, acquiring funding, and strategic
planning.
While there are several valuation methods used to determine the worth of a business,
appraisers typically choose one of these three M&A valuation methods:
Cost approach: The most straightforward approach, a cost-based valuation estimates what it
would cost to replicate the business from scratch. This approach works best with businesses
that are physical or tangible in nature. For example, you could gauge the cost of replicating an
e-commerce business by summing the total of assets for the business.
Cost approaches to company valuations work less well for businesses that rely on intellectual
capital. To give an example, it's difficult to objectively value an employee's talents or skills in a
service-based businesses, so these companies are less likely to be valued with a cost
approach.
Market approach: A market-based approach looks at similar business that sold recently to
estimate the value of a company. This method is frequently used when there are other
businesses, such as the seller's company in the same niche and geographic area. After all, a
business that recently sold in another state or country does not provide useful data. This
method isn't likely to be used with companies run by individuals or maverick companies in
hybrid niches, since direct competitors are scarce.
Discounted cash flow approach: The discounted cash flow approach to a business
valuation compares the potential future value of the business with its present-day cash flow
perspective. If a business is projected to be worth a hefty sum in a given period — say, five
years from now — an appraiser will work backward from the future valuation to determine its
present-day worth. This estimate then becomes the company valuation now, even though the
potential future income is hypothetical.
Understanding Which Factors Contribute to a Company Valuation in an M&A
After selecting the most relevant appraisal method, an appraiser will then look at these factors
to come up with the valuation:

Assets: Adding the material worth of a company's assets and subtracting liabilities is a simple
yet effective way to gauge value.
Earnings before interest, tax, depreciation & amortization (EBITDA): Taking EBITDA allows
buyers to compare the seller's company with competitors by taking out these four factors.
Revenue multiple: This determines the value of a business proportionate to its revenue and
can be used to determine whether the seller's company is “cheap” or expensive to acquire.
Real option analysis: “Real options” are simply asset-based choices, such as machinery or
business property, rather than intangible assets such as IP. Enticing or valuable real options
can sweeten a deal.
P/E (price earnings) ratio: The ratio expresses a company's share price divided by after-tax
profits, and can help buyers and sellers compare a company to competitors.
Dividend yield: Similar to discounted cash flow, this gauges the present value of a future
dividend to “prove” worth.
Entry cost: The entry cost sums up the cost from scratch to start an equivalent business; it
helps the buyer weigh the pros and cons of the M&A terms.
Precedent analysis: Comparable to the cost valuation method, this gauges the precedent
price paid in similar M&A deals.
Q8 What is pooling interest and method of amalgamation? Also, explain the operating,
financial and managerial synergy of mergers.

Ans Pooling of Interests refers to the process of accounting where the assets and liabilities or
balance sheets of two companies are combined at their historical cost during an acquisition
or merger.Intangible assets are not included in the Pooling of Interests. When combining the
balance sheets, the assets and liabilities are incorporated in each category and entered into
the financial statements after making relevant adjustments.The intangible assets are included
only when recognized in the financial statements of either of the firms. Similarly, the firms'
comprehensive income statements will include any expenses incurred during amalgamation.

It is essential to combine the separate financial statements of pooled companies to form a single
set of messages. On the effective date of the pooling of interests, all the financial data of
different companies should be available on a combined basis to ensure comparability.

Financial statements for at least a year before the effective date and the current year must be
combined in the Pooling of Interests.
Advantages Of The Pooling Of Interests Method

This method has certain advantages in a merger between two companies. These advantages
include the benefits related to technology, increased market presence, goodwill, and so on, but
not limited to just these.This simple technique makes the company's earnings appear higher
than the actual figures and contributes towards inflated accounting ratios. Various technology
firms also use it to avoid acquisition costs.

Some of the advantages include:

1. Technology Sector: The method is extensively used in the technology sector. It is

generally used to avoid recording any expenses arising from the acquisition of
companies.
2. Goodwill: Under this method, excess or deficit of purchase consideration over share
capital is not reflected as goodwill. As a result, no write-downs for goodwill make the
company's earnings look stronger.
3. Accounting Ratios: The mathematical representation of the company's solvency,
liquidity, and profitability is based on its financial statements. This method helps improve
financial ratios such as Return on Equity (ROE) and Return on Assets (ROA).
4. Simplicity: This method is simple and less burdensome because assets and liabilities of
the merged company are recorded, which needs one set of books to be maintained for
both income and expenses.
Synergy implies a situation where the combined firm is more valuable than the sum of the
individual combining firms. It is defined as ‘two plus two equal to five’ (2+2>4) phenomenon.
Synergy refers to benefits other than those related to economies of scale. Operating economies
are one form of synergy benefits. But apart from operating economies, synergy may also arise
from enhanced managerial capabilities, creativity, innovativeness, R&D and market coverage
capacity due to the complementarily of resources and skills and a widened horizon of
opportunities.

An under valued firm will be a target for acquisition by other firms. However, the fundamental
motive for the acquiring firm to takeover a target firm may be the desire to increase the wealth of
the shareholders of the acquiring firm. This is possible only if the value of the new firm is
expected to be more than the sum of individual value of the target firm and the acquiring firm.
For example, if A Ltd. and B Ltd. decide to merge into AB Ltd. Then the merger is beneficial if;

V (AB)> V (A) +V (B)

Where;

V (AB) = Value of the merged entity

V (A) = Independent value of company A

V (B) = Independent value of company B

A merger which results in meeting the test of increasing the wealth of the shareholders is said to
contain synergistic properties. Synergy is the increase in the value of the firm combining two
firms into one entity i.e., it is the difference value between the combined firm and the sum of the
value of the individual firms. Igor Ansoff (1998) classified four different types of synergies.
These are:

1. Operating Synergy:The key to the existence of synergy is that the target firm controls a
specialized resource that becomes more valuable when combined with the bidding firm’s
resources. The sources of synergy of specialized resources will vary depending upon the
merger. In case of horizontal merger, the synergy comes from some form of economies of scale
which reduce the cost or from increase market power which increases profit margins and sales.
There are several ways in which the merger may generate operating economies. The firm might
be able to reduce the cost of production by eliminating some fixed costs. The research and
development expenditures will also be substantially reduced in the new set up by eliminating
similar research efforts and repetition of work already done by the target firm. The management
expenses may also come down substantially as a result of corporate reconstruction.

The selling, marketing and advertisement department can be streamlined. The marketing
economies may be produced through savings in advertising (by reducing the need to attract
each other’s customers), and also from the advantage of offering a more complete product line
(if the merged firms produce different but complementary goods), since a wider product line may
provide larger sales per unit of sales efforts and per sales person. When a firm having strength
in one functional area acquires another firm with strength in a different functional area, synergy
may be gained by exploiting the strength in these areas. A firm with a good distribution network
may acquire a firm with a promising product line, and thereby can gain by combining these two
strength. The argument is that both firms will be better off after the merger. A major saving may
arise from the consolidation of departments involved with financial activities e.g., accounting,
credit monitoring, billing, purchasing etc.

Thus, when two firms combine their resources and efforts, they will be able to produce better
results than they were producing as separate entities because of savings various types of
operating costs. These resultant economies are known as synergistic operating economies.

In a vertical merger, a firm may either combine with its supplier of input (backward
integration) and/or with its customers (forward integration). Such merger facilitates better
coordination and administration of the different stages of business stages of business
operations-purchasing, manufacturing and marketing —eliminates the need for bargaining (with
suppliers and/or customers), and minimizes uncertainty of supply of inputs and demand for
product and saves costs of communication.

An example of a merger resulting in operating economies is the merger of Sundaram Clayton

Ltd. (SCL) with TVS-Suzuki Ltd. (TSL). By this merger, TSL became the second largest
producer of two-wheelers after Bajaj. The main objective motivation for the takeover was TSL’s
need to tide over its different market situation through increased volume of production. It needed
a large manufacturing base to reduce its production costs. Large amount of funds would have
been required for creating additional production capacity. SCL also needed to upgrade its
technology and increase its production. SCL’s and TCL’s plants were closely located which
added to their advantages. The combined company has also been enabled to share the
common R&D facilities.

2. Financial Synergy:Financial synergy refers to increase in the value of the firm that accrues
to the combined firm from financial factors. There are many ways in which a merger can result
into financial synergy and benefit. A merger may help in:

 Eliminating financial constraint

 Deployment surplus cash
 Enhancing debt capacity
 Lowering the financial costs
 Better credit worthiness

Financial Constraint: A company may be constrained to grow through internal development

due to shortage of funds. The company can grow externally by acquiring another company by
the exchange of shares and thus, release the financing constraint.

Deployment of surplus cash: A different situation may be faced by a cash rich company. It
may not have enough internal opportunities to invest its surplus cash. It may either distribute its
surplus cash to its shareholders or use it to acquire some other company. The shareholders
may not really benefit much if surplus cash is returned to them since they would have to pay tax
at ordinary income tax rate. Their wealth may increase through an increase in the market value
of their shares if surplus cash is used to acquire another company. If they sell their shares, they
would pay tax at a lower, capital gains tax rate. The company would also be enabled to keep
surplus funds and grow through acquisition.

Debt Capacity: A merger of two companies, with fluctuating, but negatively correlated, cash
flows, can bring stability of cash flows of the combined company. The stability of cash flows
reduces the risk of insolvency and enhances the capacity of the new entity to service a larger
amount of debt. The increased borrowing allows a higher interest tax shield which adds to the
shareholders wealth.

Financing Cost: The enhanced debt capacity of the merged firm reduces its cost of capital.
Since the probability of insolvency is reduced due to financial stability and increased protection
to lenders, the merged firm should be able to borrow at a lower rate of interest. This advantage
may, however, be taken off partially or completely by increase in the shareholders risk on
account of providing better protection to lenders. Another aspect of the financing costs is issue
costs. A merged firm is able to realize economies of scale in flotation and transaction costs
related to an issue of capital. Issue costs are saved when the merged firm makes a larger
security issue.

Better credit worthiness: This helps the company to purchase the goods on credit, obtain
bank loan and raise capital in the market easily.

RP Goenka’s Ceat Tyres sold off its type cord division to Shriram Fibers Ltd. in 1996 and also
transfer’s its fiber glass division to FGL Ltd., another group company to achieve financial
synergies.

3. Managerial Synergy:One of the potential gains of merger is an increase in managerial

effectiveness. This may occur if the existing management team, which is performing poorly, is
replaced by a more effective management team. Often a firm, plagued with managerial
inadequacies, can gain immensely from the superior management that is likely to emerge as a
sequel to the merger. Another allied benefit of a merger may be in the form of greater
congruence between the interests of the managers and the shareholders.

A common argument for creating a favorable environment for mergers is that it imposes a
certain discipline on the management. If lackluster performance renders a firm more vulnerable
to potential acquisition, existing managers will strive continually to improve their performance.

4. Sales Synergy:These synergies occurs when merged organization can benefit from common
distribution channels, sales administration, advertising, sales promotion and warehousing.

The Industrial Credit and Investment Corporation of India Ltd. (ICICI) acquired Tobaco
Company, ITC. Classic and Anagram Finance to obtain quick access to a well dispersed
distribution network.