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MERGER BASICS

LEARNING OBJECTIVE

After reading this chapter you should be able to:

Understand the basics merger as a form of corporate restructuring Define and conceptualize the concept of Merger Understand the different Types of Mergers Understand the Merger Movements in India and abroad Spot out the Factors Affecting Merger Narrate the of Theories of Merger Point out the Impact of Mergers on Stakeholders

2

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In this chapter Introduction, Definition of merger and acquisition, history of merger andacquisition, Types of merger, difference between merger and acquisition, differencebetween acquisition and takeover,Merger and Acquisition Process, Significance of merger and acquisition,Requirement of merger and acquisition, Motives behind merger and acquisition,

Benefits of merger and acquisition, Limitations of merger, Impact of mergerand acquisition, Financial accounting for merger and acquisition, Merger andacquisition strategies, Merger and acquisition laws, Merger and acquisition in

India, Merger and acquisition in world have been included

2.1 INTRODUCTION

As discussed in the previous chapter, a business firm may expand its business by eitherinternally or externally. In internal expansion, the firm grows gradually over time innormal course of business through acquisition of new assets, replacement of thetechnologically obsolete equipments and the establishment of new lines of products. It

is otherwise known as organic growth, the essential feature of which is thereinvestment of the previous years retained profit in the existing business, togetherwith finance provided by shareholders. An organic growth provides more corporatecontrol, encourages internal entrepreneurship and protects organisational cultures andcore values. It also provides managers with a better understanding of their own firmand assets, and internal investment is likely to be better planned and efficient. However,this type of growth is a slower as compared its counterpart inorganic growth. Inexternal expansion or inorganic growth, a firm acquires a running business and growsovernight through corporate combinations. These combinations are in the form ofmergers, acquisitions, amalgamations and takeovers; which have now become

important features of corporate restructuring. They have been playing an importantrole in the external growth of a number of leading companies the world over. They havebecome popular because of the enhanced competition, breaking of trade barriers, freeflow of capital across countries and globalization of businesses. In the wake of economicreforms, Indian industries have also started restructuring their operations around theircore business activities through merger, acquisition and takeovers because of theirincreasing exposure to competition both domestically and internationally.

The present era is known as the era of competition and in this era, companies go formerger to avoid the competition and to enjoy sometimes monopoly. Mergers andacquisitions (M & As) have been a very important strategy for entry into a new marketas well as for expansion. Corporate India is waking up to the new millenniumimperative of mergers and acquisitions in a desperate search for a panacea for facingthe global competition. This is hardly surprising as stiff competition is, in a sense,implicit in any bid to integrate the national economy with the global economy. Theongoing process of liberalization has exposed the unproductive use of capital by theIndian corporate both in public and private sectors. Consolidation through mergers andacquisitions (M & As) is considered as one of the best way of restructuring structure ofcorporate units.

The concept of mergers and acquisitions has become very much popular after 1990s,when India entered in to the Liberalization, Privatization and Globalization (LPG) era.

The winds of LPG are blowing over all the sectors of the Indian economy but itsmaximum impact is seen in the industrial sector. It caused the market to become hyper-

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competitive. As competition increased in the economy, so to avoid unhealthycompetition and to face international and multinational companies, Indian companiesare going for mergers and acquisitions.

2.2 CONCEPT AND DEFINITION

Both the terms merger and acquisition mean a corporate combination of twoseparate companies to form one company and they are often used synonymously inpractice, but there are slightly different meanings between them.

MERGER

In a merger activity, it usually takes place when two separate firms which have similarsize agree to form a new single company. Then both companies stocks will cease to

exist and the newly created companys stock will be issued in its place. This kind of

activity is often referred as a merger of equals (www.investopedia.com). A typicalexample of a major merger is the merger between AOL and Time Warner in 2000.

In India, the term Merger is not defined under any Indian law neither under theCompanies Act 1956 nor under the Income Tax Act 1961 even. Simply put, a merger is acombination of two or more distinct entities into one; the desired effect being not justthe accumulation of assets and liabilities of the distinct entities, but to achieve severalother benefits such as, economies of scale, acquisition of cutting edge technologies,obtaining access into sectors /markets with established players, etc. Generally, in amerger, the merging entities would cease to be in existence and would merge into asingle surviving entity.

Very often, the two expressions Merger and Amalgamation are used synonymously.

But there is, in fact, a difference. Merger generally refers to a circumstance in which theassets and liabilities of a company (merging company) are vested in another company(the merged company). The merging entity loses its identity and its shareholdersbecome shareholders of the merged company. On the other hand, an amalgamation is anarrangement, whereby the assets and liabilities of two or more companies(amalgamating companies) become vested in another company (the amalgamatedcompany). The amalgamating companies all lose their identity and emerge as theamalgamated company; though in certain transaction structures the amalgamatedcompany may or may not be one of the original companies. The shareholders of theamalgamating companies become shareholders of the amalgamated company.According to the Oxford Dictionary the expression merger or amalgamation means

Combining of two commercial companies into one and Merging of two or morebusiness concerns into one respectively.A merger is just one type of acquisition. Onecompany can acquire another in several other ways including purchasing some or all ofthe companys assets or buying up itsoutstanding share of stock.

ACQUISITION

While in the case of an acquisition, one company is purchased by another one and nonew company is formed subsequently. From a legal point of view, the target companyceases to exist, the acquirer occupies the business of the target firm and the acquirer'sstock continues to be traded. In addition, the acquiring firm collects all asset and gainsof the target company as well as the liability (www.investopedia.com). An example of a

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major acquisition is Manulife Financial Corporation's acquisition of John HancockFinancial Services Inc in 2004 (www.investopedia.com).

2.3 TYPES OF MERGERS AND ACQUISITIONS

MERGERS

There are mainly four types of mergers based on the competitive relationships betweenthe merging parties:

1) Horizontal Mergers2) Vertical Mergers3) Conglomerate Mergers

(1) Horizontal Merger

Horizontal mergers refer to combination of two or more firms that operate and competein a similar kind of business and are in same stage of industrial process. Horizontalmergers raise three basic competitive issues. The firstis the elimination of competitionbetween the merging firms, which, depending on their size, may be significant. Thesecond is that the unification of the merging firms operations may create substantialmarket power and could enable the merged entity to raise prices by reducing outputunilaterally. The third problem is that by increasing concentration in the relevantmarket, the transaction may strengthen the ability of the markets remainingparticipants to co-ordinate their pricing and output decisions. The fear is not that theentities will engage in secret collaboration but that the reduction in the number ofindustry members will enhance co-ordination of behaviour.

Horizontal merger provides economies of scale from the larger combined unit;eliminates competition, thereby putting an end to price cutting wars, possibility ofstarting R&D, effective marketing and management. For example in the Aerospaceindustry, Boeing merged with McDonald Douglass to create the Worlds largestaerospace company. Another Compaq acquired Digital Equipment and then itself wasacquired by Hewlett Packard (hp). Glaxo Wellcome Plc. and SmithKline Beecham Plc.Mega merger resulted in the largest drug manufacturing company globally. The mergercreated a company valued at $182.4 billion and with a 7.3 per cent share of the globalpharmaceutical market. The two companies have complementary drug portfolios, andthe merger helped them pool their research and development funds and the mergedcompany a bigger sales and marketing force.

2) Vertical Mergers

Vertical merger is a combination of two or more firms involved in different stages ofproduction or distribution of the same product. For example, the merger of a companyengaged in the construction business with a company engaged in production of brick orsteel would lead to vertical integration. Companies stand to gain on account of lowertransaction costs and synchronization of demand and supply. Moreover, vertical mergerhelps a company to move towards greater independence and self-sufficiency. Thedownside of a vertical merger involves large investments in technology in order tocompete effectively.

Vertical merger may take the form of forward or backward merger. When a companycombines with the supplier of material, it is called Backward Merger and when itcombines with the customer; it is known as Forward Merger. And there are two

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benefits: first, the vertical merger internalizes all transactions between manufacturerand its supplier or dealer thus converting a potentially adversarial relationship intosomething more like a partnership. Second, internalization can give the managementmore effective ways to monitor and improve performance. Vertical mergers may also beanticompetitive because their entrenched market power may impede new business

from entering the market.

Unlike horizontal mergers, which have no specific timing, vertical mergers take placewhen both firms plan to integrate the production process and capitalise on the demandfor the product. Forward integration takes place when a raw material supplier finds aregular procurer of its products; while backward integration takes place when amanufacturer finds a cheap source of raw material supplier. For example, merger ofUsha Martin and Usha Beltron enhanced shareholder value, through business synergies.The merger also enabled both the companies to pool their resources and to streamlinebusiness and finance with operational efficiencies and cost reduction and also helped indevelopment of new products that require synergies.

3) Conglomerate Merger

A conglomerate merger is a merger between firms that are involved in totally unrelatedbusiness activities. One example of conglomerate merger would be Phillip Morris, atobacco company which acquired General Foods in 1985.

There are two types of conglomerate mergers: pure and mixed. Pure conglomeratemergers involve companies with nothing in common, while mixed conglomeratemergers involve companies that are looking for product extensions or marketextensions. A conglomerate merger occurs when the companies are not competitors anddo not have a buyer seller relationship and is made up of a number of different,

seemingly unconnected businesses. In a conglomerate, one company owns a controllingstake in a number of smaller companies, which conduct business separately. Each of aconglomerate's subsidiary businesses runs independently of the other businessdivisions, but the subsidiaries' management reports to senior management at the parentcompany. The largest conglomerates diversify business risk by participating in anumber of different markets, although some conglomerates elect to participate in asingle industry - for example, mining. These are the two philosophies guiding manyconglomerates:

a) By participating in a number of unrelated businesses, the parent corporation isable to reduce costs by using fewer resources.

b) By diversifying business interests, the risks inherent in operating in a singlemarket are mitigated.

History has shown that conglomerates can become so diversified and complicated thatthey are too difficult to manage efficiently. Since the height of their popularity in theperiod between the 1960s and the 1980s, many conglomerates have reduced thenumber of businesses under their management to a few choice subsidiaries throughdivestiture and spin-offs.

Conglomerate transactions take many forms, ranging from short term joint ventures tocomplete mergers. Whether a conglomerate merger is pure, geographical or a productline extension, it involves firms that operate in separate market. Conglomerate

transactions ordinarily have no direct effect on competition. This type of diversificationcan be achieved mainly by external acquisition and mergers and is not generally

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possible through internal development. The basic purpose of such merger is theeffective utilization of unutilized financial resources and enlarging debt capacitythrough re-organising their financial structure so as to maximize shareholders earningsper share (EPS), lowering the cost of capital and thereby raising maximizing value of thefirm and the share price.

4] Other types

Apart from the above-discussed three (Horizontal, Vertical and Conglomerate) types ofmergers, the following are the few other forms of mergers:

a) Within Stream Mergers: This type of mergers takes place when a subsidiarycompany merges with parent company or parent company merges with subsidiarycompany. The former type of merger is known as Downstream merger, whereasthe latter is known as Upstream merger. For example, recently, ICICI Ltd., a parentcompany has merged with its subsidiary ICICI Bank signifying downstream merger.Instance of upstream merger is the merger of Bhadrachelam Paper Board,

subsidiary company with the parent ITC Ltd., and like.b) Circular Combination: Companies producing distinct products seek amalgamation

to share common distribution and R&D facilities to obtain economies byelimination of cost on duplication and promoting market enlargement. Theacquiring company obtains benefits in the form of economies of resource sharingand diversification.

c) Cross Boarder Mergers: It refers to mergers across the national boundariesinvolving substantial cash flow into other countries. It seems that cross-bordermergers have an increasing trend over the past few years due to the globalizationand the development of the internet. With the advent of globalization, companies

prefer to seek a competitive area that is worldwide in scale in order to havecustomers worldwide through cross- border mergers. The typical example is thebiggest cross-border M & A at the beginning of 21st century -Vodafone (UK)acquired Mannesmann AG (Germany) and it has a record of worth $203 billion.

However, regardless of which type of mergers, the main goal is to create the value of thecombined companies greater than the value of the two single entities and the successrelies on the synergy effect of the new company (www.investopedia.com).

TYPES OF ACQUISITIONS

An acquisition or takeover may be of two types: friendly and hostile depending onOfferor Companys approach.

a) Friendly takeover: Also commonly referred to as negotiated takeover, a friendly

takeover involves an acquisition of the target company through negotiations

between the existing promoters and prospective investors. This kind of takeover is

resorted to further some common objectives of both the parties.

b) Hostile takeover: A hostile takeover can happen by way of any of the following

actions: if the target companys board rejects the offer, but the bidder continues to

pursue it or the bidder makes the offer without informing the board beforehand.

The acquisition of one company (called the target company) by another (called the

acquirer) that is accomplished not by coming to an agreement with the target

company's management, but by going directly to the companys shareholders or

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fighting to replace management in order to get the acquisition approved. A hostile

takeover can be accomplished through either a tender offer or a proxy fight.

c) Leveraged Buyouts: These are a form of takeovers where the acquisition is funded

by borrowed money. Often the assets of the target company are used as collateral

for the loan. This is a common structure when acquirers wish to make largeacquisitions without having to commit too much capital, and hope to make the

acquired business service the debt so raised.

d) Bailout Takeovers: Another form of takeover is a bail out takeover in which a

profit making company acquires a sick company. This kind of takeover is usually

pursuant to a scheme of reconstruction/rehabilitation with the approval of lender

banks/financial institutions. One of the primary motives for a profit making

company to acquire a sick/loss making company would be to set off of the losses of

the sick company against the profits of the acquirer, thereby reducing the tax

payable by the acquirer. This would be true in the case of a merger between such

companies as well.

2.4 DISTINCTION BETWEEN MERGER AND ACQUISITION

Difference between Merger and Acquisition is delicate. It is true that the terms Mergersand Acquisitions are used in a way that it seems, both are synonymous. But, the fact isthat, there is a slight difference in the two concepts.

In case of a Merger, two firms, together, form a new company. After merger, theseparately owned companies become jointly owned and get a new single identity. Whentwo firms get merged, stocks of both the concerns are surrendered and new stocks inthe name of new merged company are issued.

Generally, Mergers take place between two companies of more or less of same size. Inthese cases, the process is called Merger of Equals. But, in case of Acquisition, one firmtakes over another and establishes its power as the single owner. Here, generally, thefirm which takes over is the bigger and stronger one. The relatively less powerfulsmaller firm loses its existence after Acquisition and the firm which takes over, runs thewhole business by its' own identity. Unlike Merger, in case of Acquisition, the stocks ofthe acquired firm are not surrendered. The stocks of the firm that are bought by thepublic earlier continue to be traded in the stock market. But, often Mergers andAcquisitions become synonymous, because in many cases, the big firm may buy out arelatively less powerful one and thus compels the acquired firm to announce theprocess as a Merger. Although, in reality an Acquisition takes place, the firms declare itas a Merger to avoid any negative impression.

Another difference between Merger and Acquisition is that, when a deal is madebetween two companies in friendly terms, it is proclaimed as Merger, even in case of abuyout. But, if it is an unfriendly deal, where the stronger firm swallows the target firm,even when the target company is not willing to be purchased, then it is called anAcquisition.

2.5 DISTINCTION BETWEEN ACQUISITION AND TAKEOVER

An acquisition may be defined as an act of acquiring effective control by one company

over assets or management of another company without any combination of companies.Thus, in an acquisition two or more companies may remain independent, separate legal

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entities, but there may be a change in control of the companies. When an acquisition is'forced' or 'unwilling', it is called a takeover. In an unwilling acquisition, themanagement of the 'target' company would oppose a move of being taken over. But,when managements of acquiring and target companies mutually and willingly agree forthe takeover, it is called acquisition or friendly takeover.

Under the Indian Monopolies and Restrictive Practices Act, takeover means acquisitionof not less than 25 percent of the voting power in a company. While in the CompaniesAct (Section 372), a company's investment in the shares of another company in excessof 10 percent of the subscribed capital can result in takeovers. An acquisition ortakeover does not necessarily entail full legal control. A company can also have effectivecontrol over another company by holding a minority ownership.

2.6 EVOLUTION MERGERS AND ACQUISITIONS / MERGER MOVEMENTS

The history of merger waves spans the twentieth century during which time there havebeen several merger waves in the US, and UK each of which has been distinctly different

from the others.

2.6.1 MERGER WAVES IN UNITED STATES (USA)

Historians refer to five waves of mergers in the U.S. starting from 1890s. The startingdate and duration of each of these waves are not specific, although the ending dates forthose ended in wars or in panics, crashes or other financial disasters. Indeed, it may bemore accurate to say that mergers are an integral part of market capitalism and therewere continuous merger activities since the evolution of the industrial economy in thelate 19thCentury, with short interruptions when fundamental forces turned exogenousmerger factors negative.

The First Merger Wave (1897 -1904)

The first US merger wave began at the end of thenineteenth century and continued until 1904. It isgenerally thought to have been triggered by thecombination of a rising stock market and theintroduction of the Sherman Antitrust Act (1890), whichwas designed to prohibit any contract that would limittrade between different states and countries, but was notdesigned specifically to deal with the growingphenomenon of merger and acquisition activity. It was

also unable to prohibit any merger or acquisition thatwas organized using a stock for stock exchange. Worse yet, the Sherman Act made itpossible for companies to form near monopolies without any regulatory interference.Naturally, many companies sought to take advantage of this situation and the first USmerger wave began as a result. During this time 1800 firms disappeared in this mergerwave and approximately 71 formerly competitive industries were converted into virtualmonopolies during this wave; a massive reorganization of the industrial landscape ofthe United States.

The merger activity peaked in 1899, began its downturn in 1901 (Table1) as somecombinations failed to realize their expectations and almost ended in 1903, whensevere economic recession set in. The turn of the century was a period of rapid

Table1

First Merger Wave

YearNo. of

Mergers

1897 691898 3031899 12081900 3401901 4231902 3791903 142

1904 79

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economic expansion in the US economy. The first merger wave during 1897 to 1904was characterized by Horizontal Mergers, which increased concentration in a number ofindustries. This merger period is known for its role in creating large monopolies. Themain motivational factors attributed to the first merger movement are:

-Obtaining economies of scale

-Merging for monopoly, and-Promotion of failing firms

The distinguishing feature of first wave is that some of todays industrial giants like,General Electric, Navistar International, Du-Pont Inc., Standard Oil, Eastman Kodak andAmerican Tobacco Inc. were originated during this wave. Another notable feature of thiswave was investment bankers seeking to establish monopoly control over certainindustries created huge holding companies or trusts. Examples of the trusts formedduring this period are J. P. Morgans, U.S. Steel Corporation and other giant firms such asStandard Oil, American Sugar Refining Company, and the American Tobacco Company.By 1904 more than 300 such trusts had been formed, and they controlled more than

40% of the nations industrial capital.The Second Merger Wave (1922-29)

The second period of business combination activity, fostered by the federal governmentduring World War I, continued through the 1920s. Like the first one, the second mergerwave also began with upturn in the business activity in 1922 and ended with the onsetof a severe economic slowdown in 1929. In an effort to sustain the war effort, thegovernment encouraged business combinations to obtain greater standardization ofmaterials and parts and to discourage price competition. After the war, it was difficult toreverse this trend, and business combinations continued.

These combinations were efforts to obtain better integration of operations, reducecosts, and improve competitive positions rather than attempts to establish monopolycontrol over an industry. This type of combination is called vertical integration becauseit involves the combination of a company with its suppliers or customers. For example,Ford Motor Company expanded by acquiring a glass company, rubber plantations,cement plant, a steel mill, and other businesses that supplied its automobilemanufacturing business. From 1925 to 1929, more than 1,200 combinations took place,and about 7,000 companies disappeared in the process. The difference between thesetwo periods (first and second merger waves) can bedescribed as "mergers for monopoly" and "mergers for

oligopoly".

The Merger Wave during 1940s

The level of merger and acquisition activity fluctuatedthroughout the 1940s and 1950s without ever rising to theextreme levels that characterize a wave. In 1950 the Celler-Kefauver Act was introduced which extended the ClaytonAct and prohibited any merger or acquisition that wasdesigned to give one firm a substantial degree of marketpower. As a result the number of horizontal deals was

reduced to the bare minimum. This Act marked the firststep towards merger regulations as they exist worldwide

Table 2

Third Merger Wave

Year No. of Mergers

1963 13611964 19501965 2125

1966 23771967 29751968 44621969 6107

1970 5152

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today with the emphasis on maintaining consumer choice in the market place.

The Third Merger Wave (1963-1970)

The next US wave activity began at the end of the 1950s and lasted until the middle ofthe 1970s as the US economy underwent a strong period and the stock market againrose markedly. This resulted in the third US merger wave of the last century asprofitable companies found them with large cash flows, which they were unwilling topay out to shareholders in the form of dividends, and so turned to the market forcorporate control as a way of utilizing these funds.

Throughout this period, the majority of deals were friendly arrangements and stock wasthe primary medium of exchange. The most notable feature of this merger wave was the

predominance of conglomerate deals as companiesactively sought to expand into new markets and areas.The strength of this trend is illustrated by the fact that the

number of conglomerate firms increased from 8.3% ofFortune 500 firms in 1959 to 18.7% in 1969. This changeis almost certainly due to the provisions of the Celler-Kefauver Act, which made horizontal mergers unpopular.The oil crisis of 1973 resulted in a sharp increase ininflation and a worldwide economic downturn, whichmarked the end of this merger wave. Around 6000mergers took place in the US economy during this periodand lead to disappearance of around 25,000 firms.

The Fourth Merger Wave (1981-1989)

The fourth US merger wave took place in the 1980s and exceeded all of the precedingwaves in both the volume of transactions and in the size of the deals. Another notablecharacteristic of this wave was the much higher degree ofhostility as companies that were previously considereduntouchable, as their sheer size would make them safe,became the targets of unwelcome acquisition bids andfought vigorously to defend themselves. Almost half of allmajor US companies were the recipients of an unsolicitedtakeover bid in the 1980s which is a clear indicator of thevolume of transactions taking place during this particular

wave.

This period was featured several unique and interestingfeatures. Firstly, it was a period of mega-mergers. Some ofthe largest firms in the world (Fortune 500 firms) becamethe target of acquirers. Secondly, Investment bankersplayed an aggressive role in M&As activities by providingspecialized advisory services to the concerned firms.Thirdly, the concept of using debts to finance acquisitions(Leveraged Buy Out) was emerged during this period. Moreover this merger wave alsofeatured innovations in acquisition techniques and investment vehicles. The investmentbank, Drexel Burnham Lambert pioneered the growth of the junk bond market.

Table 3Fourth Merger Wave

Year No. of Mergers

1981 2395

1982 2346

1983 25331984 25431985 30011986 3336

1987 2032

1988 2258

1989 2366

Table 4Fifth Merger Wave

Year No. of Mergers

1990 20741991 18771992 25741993 2663

1994 29971995 35101996 58481997 78001998 78091999 92782000 95662001 7528

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acquisition activity previously unseen in the UK and imported from the US; increasedhostility, the use of leverage and a large number of buy-outs all of which took place inthis wave but had not previously been notable features of the market for corporate

control in the UK. The London Stock Exchange suffered a major crash in 1987 but thiswas not enough to stop the wave, however, which had sufficient momentum to keepgoing until 1989.

The most recent merger wave in the UK took place in the 1990s and was again spurredon by deregulation of more British industries coupled with the policy of privatizingGovernment owned assets which took place through the last years of the 1980s and theearly 1990s, as typified by the sales of British Telecom (1984), British Gas (1986) andBritish Rail (1993). These changes resulted in the need for extensive restructuring onmany difference levels of British industry and prompted the merger wave. Unlike the1980s there was relatively little hostility during this period and many companieschanged their perspective on mergers and acquisitions to take a more balancedapproach when compared to the excesses of the previous decade.

In the UK, horizontal mergers were the dominant form between 1954 and 1965 andsince then there has been a trend towards diversified merger. The value of assetsacquired through diversified merger rose to 33 percent in 1972 from 5 percent in 1966.The merger wave since 1980s witnessed divestments on a large scale. In 1992 it wasaccounted for 31 percent of all acquisitions and mergers.

2.6.3 MERGER WAVES: THE INDIAN EXPERIENCE

In earlier years, India was a highly regulated economy. To set-up an industry variouslicenses and registration under various enactments were required. The scope and modeof corporate restructuring was, therefore, very limited due to restrictive government

policies and rigid regulatory framework.

Consequent upon the raid of DCM Limited and Escorts Limited launched by Swaraj Paul,the role of the financial institutions became quite important. In fact, Swaraj Pauls bidswere a fore-runner and constituted a watershed in the corporate history of India. TheSwaraj Paul episode also gave rise to a whole new trend. Financially strongentrepreneurs made their presence felt as industrialists Ram Prasad Goenka, M.R.Chabria, Sudarshan Birla, Srichand Hinduja, Vijay Mallya and Dhirubhai Ambani andwere instrumental in corporate restructuring.

The real opening up of the economy started with the Industrial Policy, 1991 wherebycontinuity with change was emphasized and main thrust was on relaxations inindustrial licensing, foreign investments, and transfer of foreign technology etc. Forinstance, amendments were made in MRTP Act, within all restrictive sectionsdiscouraging growth of industrial sector. With the economic liberalization, globalizationand opening up of economies, the Indian corporate sector started restructuring to meetthe opportunities and challenged of competition.

The unleashing of Indian economy has opened up lucrative and dependableopportunities to business community as a whole. The absence of strict regulationsabout the size and volume of business encouraged the enterprises to opt for mergersand amalgamations so as to produce on a massive scale, reduce costs of production,make prices internationally competitive etc. Today despite the sluggish economic

scenario in India, merger and amalgamation deals have been on the increase. Theobvious reason is as the size of the market shrinks, it becomes extremely difficult for

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all the companies to survive, unless they cut costs and maintain prices. In such asituation, merger eliminates duplication of administrative and marketing expenses. Theother important reason is that it prevents price war in a shrinking market. Companies,by merging, reduce the number of competitors and increase their market share.

Table-5 exhibits a sharp rise in the overall merger and acquisition activity in the Indiancorporate sector. While there were 58 mergers and takeover from 1988 to 1990, thenumber rose to 71 in 1991 and 730 in 1998. There was a jump in the number of mergerand takeover activities in India from 1988 to 1993, the average rate of increase beingaround 89 percent for the five-year period. Since then the rate of rise had maintained anaverage of 20.5 per cent. After 2001 year the M&A trend has shown declining. But therewas substantial growth in the year 2000-01, with the total number of M&As deals 1177which is 54 percent higher than the previous year total deals.

2.7 MOTIVES/BENEFITS OF MERGERS & ACQUISITIONS

Mergers and acquisitions are resorted to by the corporate entities due to more than one

reason. Some of the significant motives for mergers include the following:

(a) Faster Growth

Broadly there are two alternatives available for growth of a corporate entity as long asinvestment opportunities exist. Organic route of growth takes time. Organizations needplace, people, regulatory approval and other resources to expand into newer productcategories or geographical territories. On the other hand, inorganic route, acquisition ofanother organization with complementary products or geographic spread provides allthese resources in a much shorter time, enabling faster growth.

(b)Synergy

It is regarded as the most popular motive for M & A. Synergy occurs when the whole isgreater than sum of its parts. For example, in terms of math it could be represented as1+1=3 or as 2+2=5. Within the context of mergers, synergy means the performanceof firms after a merger (in certain areas and overall) will be better than the sum of theirperformances before the merger. For example, a larger merged company may be able toorder larger quantities from suppliers and obtain greater discounts due to the size ofthe order. In this context, there can be three types of synergy: operating, financial, andmanagerial.

Illustration:There are two firms Bharat Ltd and Hindustan Ltd are planning tomerge, whose per-merger values are Rs.420 lakhs, and Rs. 200 lakhs. They are

merging with the objective of savings with present value of Rs.50 lakhs. Foracquiring Hindustan Ltd. Firm Bharat Ltd will be required to pay Rs.220 lakhs

(consisting of Rs. 180 lakhs in the form of equity shares and Rs.40 lakhs in the

form of cash). Besides the purchase consideration the Bharath Ltd. need to incur

acquisition cost of Rs. 10 lakhs. Determine the value of the gain, costs, and net

gain from merger.

Solution:

Cost = Purchase Value + Acquisition cost Pre-merger value of Hindustan Ltd.

Cost = Rs. 220 lakhs + Rs.10 lakhs Rs.200 lakhs = Rs. 30 lakhs.

Net Gain = Expected savings Cost = Rs.40 lakhs Rs.30 lakhs; = Rs.10 lakhs.

Operating Synergy

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It arises from the combination of the acquirer and targets operations.

Increased revenue and/or market share: This would typically occur when the buyertakes over a major competitor, reducing its competition and thus building up its marketpower by capturing increased market share. If it has a dominant enough position, itcould then exercise greater power in setting prices as well.

Economy of scale: A combined company can usually cut its fixed costs by removingduplicate departments, teams and operations, thus lowering the companys costs

relative to the same revenue stream, which would result in increasing profit margins.

Economies of Scope: When two or more business units in different industries shareresources such as manufacturing facilities, distribution channels, advertisingcampaigns, R&D cost, they may be able to realize economies of scope: the costreductions associated with sharing resources across businesses. For example Procter &Gamble can enjoy economies of scope if it acquire a consumer product company thatbenefits from its highly regarded marketing skills and also helps in obtaining thebenefits of economies of scale.

Cross-selling:This refers to the complementary products an acquiring company can sellto the customers of its acquired company. As an example, a bank buying a stock brokercould sell its banking products to the stock broker's customers. At the same time, thebroker could poach the bank's customers for brokerage accounts.

Geographical, product, or other diversification: Diversification of any kind can usuallysmooth the earnings results of a company. This, in turn, helps in smoothing the stockprice of a company, giving conservative investors more confidence in investing in thecompany.

Financial synergy

The following are the financial synergy available in the case of mergers:Better credit worthiness: This helps the combined company to purchase the goods oncredit, obtain bank loan and raise capital in the market easily.

Lower cost of capital: The investors consider big firms as safe from their investmentpoint of view and expect lower rate of return for the capital supplied by them. So thecost of capital reduces after the merger.

Enhancement of the debt capacity:After the merger the earnings and cash flows of thecombined entity become more stable than before. This increases the capacity of thecompany to borrow more funds.

Increase in P/E ratio and value per share:The liquidity and marketability of the securityincreases after the merger. The growth rate as well as earnings of the firm will alsoincrease due to various economies after the merged company. All these factors help thecompany to enjoy higher P/E in the market.

Low floatation cost: Small companies have to spend higher percentage of the issuedcapital as floatation cost when compared to a big firm.

Raising of capital:After the merger due to increase in the size of the company and bettercredit worthiness and reputation, the company can easily raise the capital at any time.

Managerial synergy

There are cases where firms interested to merge with another company with the idea of

getting benefit through managerial effectiveness. This is one of the potential gains ofmergers is an increase in managerial effectiveness. This may happen if a more effective

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management team replaces the existing management team, which is performing poorly.Often, a company, with managerial inadequacies, can gain immensely from the superiormanagement that is likely to emerge as a consequence to the merger. Having greatersimilarity between the interests of managers and the shareholders is another benefit ofmerger.

(c)Diversification of risk

Diversification is another major motive in the case of conglomerate mergers. Mergerbetween two companies, which are unrelated businesses, would be able to reduce therisk, increase rate of return on investment, and thereby increase market value of thefirm. In other words, conglomerate mergers helps in stabilizing or smoothen overallcorporate income, which would otherwise fluctuate due to seasonal or economic cyclesor product life cycle stages. In operational terms, the greater the combination ofstatistically independent, or negatively correlated businesses or income streams of themerged companies, the higher will be the reduction in the business risk and greater willbe the benefit of diversification or vice versa.

An example of diversification through mergers to reduce total risk and improveprofitability is that RPG Enterprises of Goenka Group. The group started its takeoveractivity in 1979. It comprises of a large number of companies, most of which have beentakeover. The strategy has been to look out for any foreign disinvestments, or any casesof sick companies, which could prove right targets at low takeover prices. In 1988, RPGtook over ICIM and Harrisons Malayalam Limited. Acquiring ICIM hasprovided an easyaccess to the electronics industry.

(d) Limiting or Elimination of Competition

Acquisitions, especially horizontal mergers are undertaken to destroy competition and

establish a critical mass. This might increase the bargaining power of the company withits suppliers and customers. Economies of scale may also be generated in the process.Example of this could be VIPs takeover of Universal Luggage and its thereafter puttingan end to Universals massive price discounting, which was eating their profits. The HP

and Compaq merger also created the largest personal computers company in India.Internationally, as well this move was supposed to put IBM under immense pressure.

(e)Protection against a hostile takeover

Defensive acquisition is one of the strategiesto avoidhostile takeover. It makes itselfless attractive to the acquiring company. In such a situation, the target company willacquire another company as a defensive acquisition and finance such an acquisitionthrough adding substantial debt. Due to the increased debt of the target company, theacquiring company, which planned the hostile takeover, will likely lose interest inacquiring the now highly leveraged target company. Before a defensive acquisition isundertaken, it is important to make sure that such action is better for shareholderswealth than a merger with the acquiring company which started off the whole processby proposing a hostile takeover.

(f) Tax Benefits

Certain mergers take place just to get the benefit of tax shields. Tax benefits areavailable for a firm, which acquires a firm that is running with cumulative losses or

unabsorbed depreciation. The firm with accumulated losses or unabsorbed depreciationmay not be able to get the benefit of tax shield. Section 72A of Income Tax Act, 1961

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provides tax shield incentive for reverse mergers for the survival of sick units. However,when it merges with a profit-making firm, its accumulated losses can be set off againstthe profits of the profit-making firm and tax benefits can be quickly realized. Anexample of a merger to reduce tax liability is the absorption of Ahmedabad Cotton MillsLimited (ACML) by Arbind Mills in 1979. ACML was closed in August 1977 due to labor

problem. At the time of merger in April 1979, saved about Rs.2 crore in tax liability forthe next two years after the merger because it could set-off ACMLs accumulated lossagainst its profits.

Illustration: Dream well Company acquires Well Do Company. At the date ofacquisition the accumulated losses of Well Do Company are Rs.500 lakhs. DreamWell Company is running with a profit record due to the well experiencedmanagement. The expected earnings before tax of Dream Well Company overthree year period are Rs.150 lakhs, Rs.250 lakhs, and Rs.350 lakhs for the years1,2, and 3 respectively. Determine the present value of tax gains to accrue onaccount of merger to Dream Well Company, if the company is in the tax bracket

of 35 per cent and 12 per cent discount rate.Solution:Present Value of Tax Gain

ParticularsYears (Rs. in lakhs)

1 2 3

Earnings Before Tax 150 250 350

Less: Recovery of Loss 150 250 100*

Tax Benefit (Recovery of Loss x Tax Rate) 52.5 87.5 35.0

Present Value Factor at 12 per cent 0.893 0.797 0.712

Present Value of Tax Shield 46.8825 69.7375 24.92

Total Present Value of Tax benefit to Dream Well Company 144.54* (Rs.500 lakhs accumulated loss of firm Well Do Company Rs.150 lakhs, Rs.250lakhs loss adjusted in the year 1 and 2 respectively).

3.2.7 IMPACT OF MERGERS

The word restructure particularly M&A has been symbolic with conflict, dislocation andeconomic and financial pain or gain. It is largely perceived in terms of its externalconsequences for investors, employees, competitors, suppliers, and host communities.The impact of mergers on general public could be viewed as aspects of benefits and

costs to (1) Shareholders (2) Organisation Culture (3) Consumers, (4) Workers orEmployees, and (5) General Public.

1.Shareholders

Increasing the shareholders value is generally a prime objective of most of M&As. Thevalue to shareholders through M&As could be increased either by cutting the costs bycombining similar assets in the merging concerns or by enhancing the revenue byfocusing on enhancing capabilities and revenues, and combining complementarycompetencies. However most of the studies on the impact of M&As on shareholderswealth reveal that on an average, M&As consistently benefit the target companys

shareholders, but not the acquirers shareholders. Various consulting firms have also

estimated that from one-half to two-thirds of M&As do not come up to the expectationsof those transacting them, and many resulted in divestitures.

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market, which will help to consumers to substitute the alternative products. ThereforeM&As costly to the public when it creates monopoly.

Put in simple M&As are dangerous, when there is elimination of healthy competition;concentration of economic power; and adverse effects on national economy. However,mergers are essential for the fast growth of the organisations. At the same time thedangers of mergers are more than off-set by advantages of mergers. This is possibleonly when every M&A proposal must be examined keeping in view the advantages anddangers, thereby allowing mergers or acquisitions that help to a group of stakeholders.

WHY DO MERGERS FAIL?

It's no secret that plenty ofmergers don't work. Those who advocate mergers will arguethat the merger will cut costs or boost revenues by more than enough to justify the pricepremium. It can sound so simple: just combine computer systems, merge a fewdepartments, use sheer size to force down the price of supplies and the merged giant

should be more profitable than its parts. In theory, 1+1 = 3 sounds great, but in practice,things can go awry.

Statistics show that roughly half of acquisitions are not successful. Mergers fail quiteoften and fail to create value for shareholders of the acquirers. A definite answer as towhy mergers fail to generate value for acquiring shareholders cannot be providedbecause mergers fail for a host of reasons. Some of the important reasons for failures ofmergers are discussed below:

Excessive premium

In a competitive bidding situation, a company may tend to pay more. Often highestbidder is one who overestimates value out of ignorance. Though he emerges as thewinner, he happens to be in a way the unfortunate winner. This is called WinnersCurse hypothesis. When the acquirer fails to achieve the synergies requiredcompensating the price, the M&A fails. More you pay for a company, the harder you willhave to work to make it worthwhile for your shareholders. When the price paid is toomuch, how well the deal may be executed, the deal may not create value.

Acquisition indigestion

A mismatch in the size between acquirer and target has been found to lead to pooracquisition performance. Many acquisitions fail either because of 'acquisitionindigestion' by buying too big targets or failed to give the smaller acquisitions the time

and attention it required.Lack of research

Acquisition requires gathering a lot of data and information and analyzing it. It requiresextensive research. A carelessly carried out research about the acquisition causes thedestruction of acquirer's wealth.

Diversification

Very few firms have the ability to successfully manage the diversified businesses.Unrelated diversification has been associated with lower financial performance, lowercapital productivity and a higher degree of variance in performance for a variety of

reasons including a lack of industry or geographic knowledge, a lack of focus as well as

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perceived inability to gain meaningful synergies. Unrelated acquisitions, which mayappear to be very promising, may turn out to be big disappointment in reality.

Previous Acquisition Experience

While previous acquisition experience is not necessarily a requirement for future

acquisition success, many unsuccessful acquirers usually have little previous acquisitionexperience. Previous experience will help the acquirers to learn from the previousacquisition mistakes and help them to make successful acquisitions in future. It mayalso help them by taking advice in order to maximize chances of acquisition success.Those serial acquirers, who possess the in house skills necessary to promote acquisitionsuccess as well trained and competent implementation team, are more likely to makesuccessful acquisitions.

Unwieldy and Inefficient

Conglomerate mergers proliferated in 1960s and 1970. Many conglomerates provedunwieldy and inefficient and were wound up in 1980s and 1990s. The unmanageable

conglomerates contributed to the rise of various types of divestitures in the 1980s and1990s.

Poor Cultural Fits

Cultural fit between an acquirer and a target is one of the most neglected areas ofanalysis prior to the closing of a deal. However, cultural due diligence is every bit asimportant as careful financial analysis. Without it, the chances are great that mergerswill quickly amount to misunderstanding, confusion and conflict. Cultural due diligenceinvolve steps like determining the importance of culture, assessing the culture of bothtarget and acquirer. It is useful to know the target management behaviour with respectto dimensions such as centralized versus decentralized decision making, speed indecision making, time horizon for decisions, level of team work, management of conflict,risk orientation, openness to change, etc. It is necessary to assess the cultural fitbetween the acquirer and target based on cultural profile. Potential sources of clashmust be managed. It is necessary to identify the impact of cultural gap, and develop andexecute strategies to use the information in the cultural profile to assess the impact thatthe differences have.

Poor Strategic Fit

A Merger will yield the desired result only if there is strategic fit between the mergingcompanies. Mergers with strategic fit can improve profitability through reduction in

overheads, effective utilization of facilities, the ability to raise funds at a lower cost, anddeployment of surplus cash for expanding business with higher returns. But many atime lack of strategic fit between two merging companies especially lack of synergiesresults in merger failure. Strategic fit can also include the business philosophies of thetwo entities (return on investment v/s market share), the time frame for achievingthese goals (short-term v/s long term) and the way in which assets are utilized. Forexample, P&G Gillette merger in consumer goods industry is a unique case ofacquisition by an innovative company to expand its product line by acquiring anotherinnovative company, which was, described analysts as a perfect merger.

Striving for Bigness

Size no doubt is an important element for success in any business. Therefore there is astrong tendency among managers whose compensation is significantly influenced by

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size to build big empires. Size maximizing firms may engage in activities, which havenegative net present value. Therefore when evaluating an acquisition it is necessary tokeep the attention focused on how it will create value for shareholders and not on howit will increase the size of the company.

Faulty evaluation:At times acquirers do not carry out the detailed diligence of the targetcompany. They make a wrong assessment of the benefits from the acquisition and landup paying a higher price.

Poorly Managed Integration: Integration of the companies requires a high qualitymanagement. Integration is very often poorly managed with little planning and design.As a result implementation fails. The key variable for success is managing the companybetter after the acquisition than it was managed before. Even good deals fail if they arepoorly managed after the merger.

Failure to Take Immediate Control:Control of the new unit should be taken immediatelyafter signing of the agreement. ITC did so when they took over the BILT unit even

though the consideration was to be paid in 5 yearly instalments. ABB put newmanagement in place on day one and reporting systems in place by three weeks.

Failure to Set the Pace for Integration:The important task in the merger is to integratethe target with acquiring company in every respect. All function such as marketing,commercial; finance, production, design and personnel should be put in place. Inaddition to the prominent persons of acquiring company the key persons from theacquired company should be retained and given sufficient prominence opportunities inthe combined organization. Delay in integration leads to delay in product shipment,development and slow down in the company's road map. Acquisition of Scientific DataCorporation by Xerox in 1969 and AT&T's acquisition of computer maker NCR

Corporation in 1991 were troubled deals, which resulted in large write offs. The speedof integration is extremely important because uncertainty and ambiguity for longerperiods destabilizes the normal organizational life.

Incomplete and Inadequate Due Diligence : Lack of due diligence is lack of detailedanalysis of all important features like finance, management, capability, physical assetsas well as intangible assets results in failure. ISPAT Steel is a corporate acquirer thatconducts M&A activities after elaborate due diligence.

Ego Clash: Ego clash between the top management and subsequently lack ofcoordination may lead to collapse of company after merger. The problem is moreprominent in cases of mergers between equals.

Merger between Equals:Merger between two equals may not work. The Dunlop Pirellimerger in 1964, which created the world's second largest tier company, ended in anexpensive divorce. Manufacturing plants can be integrated easily, human beings cannot.Merger of equals may also create ego clash.

Over Leverage: Cash acquisitions results in the acquirer assuming too much debt. Futureinterest cost consumes too great a portion of the acquired company's earnings(Business India 2005).

Incompatibility of Partners:Alliance between two strong companies is a safer bet thanbetween two weak partners. Frequently many strong companies actually seek small

partners in order to gain control while weak companies look for stronger companies tobail them out. But experience shows that the weak link becomes a drag and causes

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Inadequate Attention to People Issues: Not giving sufficient attention to people issuesduring due diligence process may prove costly later on. While lot of focus is placed onthe financial and customer capital aspects, not enough attention is given to aspects ofhuman capital and cultural audit. Well conducted HR due diligence can provide veryaccurate estimates and can be very critical to strategy formulation and implementation.

Strategic Alliance as an Alternative Strategy:Another feature of 1990s is the growth instrategic alliances as a cheaper, less risky route to a strategic goal than takeovers.

Loss of Identity: Merger should not result in loss of identity, which is a major strengthfor the acquiring company. Jaguar's car image dropped drastically after its merger withBritish Leyland.

Diverging from Core Activity: In some cases it reduces buyer's efficiency by diverting itfrom its core activity and too much time is spent on new activity neglecting the coreactivity.

Expecting Results too quickly: Immediate results can never be expected except those

recorded in red ink. Whirlpool ran up a loss $100 million in its Philips white goodspurchase. R.P. Goenka's takeovers of Gramophone Company and Manu Chhabria'stakeover of Gordon Woodroffe and Dunlops fall under this category.

Assessment Questions

1. Why do Firms Merge?

2. Why do Mergers and Acquisitions quite often fail? List the important reasons forfailures of mergers.

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Acquisitions

LEARNING OBJECTIVE

After reading this chapter you should be able to:

Know the background on acquisitions Define and conceptualize the concept of acquisitions Understand the process of an acquisition Narrate the Steps in an acquisition Know the Prerequisites for success Know the procedure of Valuing a target firm

Narrate the Methods of Payment for the target firm

4

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This section the historical background of acquisition, process of acquisition, how todevelop acquisition strategy, the matters relating to the valuation of the synergies,amount paid to the target firm, and the accounting consideration involved in mergerand acquisition.

Firms are acquired for a number of reasons. In the 1960s and 1970s, firms such as Gulfand Western and ITT built themselves into conglomerates by acquiring firms in otherlines of business. In the 1980s, corporate giants like Time, Beatrice and RJR Nabiscowere acquired by other firms, their own management or wealthy raiders, who sawpotential value in restructuring or breaking up these firms. In the 1990s, we saw a waveof consolidation in the media business as telecommunications firms acquiredentertainment firms and entertainment firms acquired cable businesses. Through time,firms have also acquired or merged with other firms to gain the benefits of synergy, inthe form of either higher growth, as in the Disney acquisition of Capital Cities, or lowercosts.

Acquisitions seem to offer firms a short cut to their strategic objectives, but the processhas its costs. In this chapter, we examine the four basic steps in an acquisition, startingwith establishing an acquisition motive, continuing with the identification and valuationof a target firm, and following up with structuring and paying for the deal. The final andoften the most difficult step is making the acquisition work after the deal isconsummated.

Background on Acquisitions

When we talk about acquisitions or takeovers, we are talking about a number ofdifferent transactions. These transactions can range from one firm merging withanother firm to create a new firm to managers of a firm acquiring the firm from its

stockholders and creating a private firm. We begin this section by looking at thedifferent forms taken by acquisitions, continue the section by providing an overview onthe acquisition process and conclude by examining the history of the acquisitions in theUnited States.

The Process of an Acquisition

Acquisitions can be friendly or hostile events. In a friendly acquisition, the managers ofthe target firm welcome the acquisition and, in some cases, seek it out. In a hostileacquisition, the target firms management does notwant to be acquired. The acquiringfirm offers a price higher than the target firms market price prior to the acquisition andinvites stockholders in the target firm to tender their shares for the price.

In either friendly or hostile acquisitions, the difference between the acquisition priceand the market price prior to the acquisition is called the acquisition premium. Theacquisition price, in the context of mergers and consolidations, is the price that will bepaid by the acquiring firm for each of the target firms shares. This price is usually basedupon negotiations between the acquiring firm and the target firms managers. In atender offer, it is the price at which the acquiring firm receives enough shares to gaincontrol of the target firm. This price may be higher than the initial price offered by theacquirer, if there are other firms bidding for the same target firm or if an insufficientnumber of stockholders tender at that initial price. For instance, in 1991, AT&T initiallyoffered to buy NCR for $80 per share, a premium of $ 25 over the stock price at the timeof the offer. AT&T ultimately paid $110 per share to complete the acquisition.

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changing existing management policy or practices, should make these firms morevaluable, allowing the acquirer to claim the increase in value. This value increase isoften termed the value of control.

Prerequisites for Success

While this corporate control story can be used to justify large premiums over themarket price, the potential for its success rests on the following.

a) The poor performance of the firm being acquired should be attributable tothe incumbent management of the firm, rather than to market or industryfactors that are not under management control.

b) The acquisition has to be followed by a change in management practices, andthe change has to increase value. As noted in the last chapter, actions thatenhance value increase cash flows from existing assets, increase expectedgrowth rates, increase the length of the growth period, or reduce the cost ofcapital.

c)

The market price of the acquisition should reflect the status quo, i.e., thecurrent management of the firm and their poor business practices. If themarket price already has the control premium built into it, there is littlepotential for the acquirer to earn the premium. In the last two decades,corporate control has been increasingly cited as a reason for hostileacquisitions.

Choosing a Target firm and valuing control/synergy

Once a firm has an acquisition motive, there are two key questions that need to beanswered. The first relates to how to best identify a potential target firm for anacquisition, given the motives. The second is the more concrete question of how to valuea target firm.

Choosing a target firm

Once a firm has identified the reason for its acquisition program, it has to find theappropriate target firm.

a) If the motive for acquisitions is under valuation, the target firm must be undervalued. How such a firm will be identified depends upon the valuationapproach and model used. With relative valuation, an under valued stock is onethat trades at a multiple (of earnings, book value or sales) well below that ofthe rest of the industry, after controlling for significant differences onfundamentals. Thus, a bank with a price to book value ratio of 1.2 would be anundervalued bank, if other banks have similar fundamentals (return on equity,growth, and risk) but trade at much higher price to book value ratios. Indiscounted cash flow valuation approaches, an under valued stock is one thattrades at a price well below the estimated discounted cash flow value.

b) If the motive for acquisitions is diversification, the most likely target firms willbe in businesses that are unrelated to and uncorrelated with the business ofthe acquiring firm. Thus, a cyclical firm should try to acquire counter-cyclicalor, at least, non-cyclical firms to get the fullest benefit from diversification.

c)vary depending upon the source of the synergy. For economies of scale, thetarget firm should be in the same business as the acquiring firm. Thus, theacquisition of Security Pacific by Bank of America was motivated by potentialcost savings from economies of scale. For functional synergy, the target firm

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should be strongest in those functional areas where the acquiring firm is weak.For financial synergy, the target firm will be chosen to reflect the likely sourceof the synergy a risky firm with limited or no standalone capacity forborrowing, if the motive is increased debt capacity, or a firm with significantnet operating losses carried forward, if the motive is tax benefits.

d) If the motive for the merger is control, the target firm will be a poorly managedfirm in an industry where there is potential for excess returns. In addition, itsstock holdings will be widely dispersed (making it easier to carry out thehostile acquisition) and the current market price will be based on thepresumption that incumbent management will continue to run the firm.

e) If the motive is managerial self-interest, the choice of a target firm will reflectmanagerial interests rather than economic reasons.

Valuing the Target Firm

The valuation of an acquisition is not fundamentally different from the valuation of anyfirm, although the existence of control and synergy premiums introduces somecomplexity into the valuation process. Given the inter-relationship between synergy andcontrol, the safest way to value a target firm is in steps, starting with a status quovaluation of the firm, and following up with a value for control and a value for synergy.

a. Status Quo Valuation

We start our valuation of the target firm by estimating the firm value with existinginvesting, financing and dividend policies. This valuation, which we term the status quovaluation, provides a base from which we can estimate control and synergy premiums.In particular, the value of the firm is a function of its cash flows from existing assets, theexpected growth in these cash flows during a high growth period, the length of the highgrowth period and the firms cost of capital.

b. The Value of Corporate Control

Many hostile takeovers are justified on the basis of the existence of a market forcorporate control. Investors and firms are willing to pay large premiums over themarket price to control the management of firms, especially those that they perceive tobe poorly run. This section explores the determinants of the value of corporate controland attempts to value it in the context of an acquisition.

Determinants of the Value of Corporate Control

The value of wresting control of a firm from incumbent management is inverselyproportional to the perceived quality of that management and its capacity to maximizefirm value. In general, the value of control will be much greater for a poorly managedfirm that operates at below optimum capacity than for a well managed firm. The valueof controlling a firm comes from changes made to existing management policy that canincrease the firm value. Assets can be acquired or liquidated, the financing mix can bechanged and the dividend policy reevaluated, and the firm can be restructured tomaximize value. If we can identify the changes that we would make to the target firm,we can value control. The value of control can then be written as:

Value of Control = [Value of firm, optimally managed -Value of firm with currentmanagement]

The value of control is negligible for firms that are operating at or close to their optimalvalue, since a restructuring will yield little additional value. It can be substantial forfirms operating at well below optimal, since a restructuring can lead to a significantincrease in value.

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c. Valuing Operating Synergy

There is a potential for operating synergy, in one form or the other, in many takeovers.Some disagreement exists, however, over whether synergy can be valued and, if so,what that value should be. One school of thought argues that synergy is too nebulous tobe valued and that any systematic attempt to do so requires so many assumptions that

it is pointless. If this is true, a firm should not be willing to pay large premiums forsynergy if it cannot attach a value to it.

While valuing synergy requires us to make assumptions about future cash flows andgrowth, the lack of precision in the process does not mean we cannot obtain anunbiased estimate of value. Thus we maintain that synergy can be valued by answeringtwo fundamental questions.

(1) What form is the synergy expected to take? Will it reduce costs as a percentage ofsales and increase profit margins (e.g., when there are economies of scale)? Will itincrease future growth (e.g., when there is increased market power) or the length of thegrowth period? Synergy, to have an effect on value, has to influence one of the four

inputs into the valuation process cash flows from existing assets, higher expectedgrowth rates (market power, higher growth potential), a longer growth period (fromincreased competitive advantages), or a lower cost of capital (higher debt capacity).

(2) When will the synergy start affecting cash flows? Synergies can show upinstantaneously, but they are more likely to show up over time. Since the value ofsynergy is the present value of the cash flows created by it, the longer it takes for it toshow up, the lesser its value.

Once we answer these questions, we can estimate the value of synergy using anextension of discounted cash flow techniques. First, we value the firms involved in themerger independently, by discounting expected cash flows to each firm at the weighted

average cost of capital for that firm. Second, we estimate the value of the combined firm,with no synergy, by adding the values obtained for each firm in the first step. Third, webuild in the effects of synergy into expected growth rates and cash flows and we valuethe combined firm with synergy. The difference between the value of the combined firmwith synergy and the value of the combined firm without synergy provides a value forsynergy.

d. Valuing Financial Synergy

Synergy can also be created from purely financial factors. We will consider threelegitimate sources of financial synergy - a greater tax benefit from accumulated lossesor tax deductions, an increase in debt capacity and therefore firm value and better use

for excess cash or cash slack. We will begin the discussion, however, withdiversification, which though a widely used rationale for mergers, is not a source ofincreased value by itself.

Structuring the Acquisition

Once the target firm has been identified and valued, the acquisition moves forward intothe structuring phase. There are three interrelated steps in this phase. The first is thedecision on how much to pay for the target firm, synergy and control built into thevaluation. The second is the determination of how to pay for the deal, i.e., whether touse stock, cash or some combination of the two, and whether to borrow any of the fundsneeded. The final step is the choice of the accounting treatment of the deal because it

can affect both taxes paid by stockholders in the target firm and how the purchase isaccounted for in the acquiring firms income statement and balance sheets.

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Deciding on an Acquisition Price

The value determined in consideration of synergy and control represents a ceiling onthe price that the acquirer can pay on the acquisition rather than a floor. If the acquirerpays the full value, there is no surplus value to claim for the acquirers stockholders andthe target firms stockholders get the entire value of the synergy and control premiums.

This division of value is unfair, if the acquiring firm plays an indispensable role increating the synergy and control premiums.

Consequently, the acquiring firm should try to keep as much of the premium as it canfor its stockholders. Several factors, however, will act as constraints. They include:

1. The market price of the target firm, if it is publicly traded, prior to the acquisition:

Since acquisitions have to base on the current market price, the greater the currentmarket value of equity, the lower the potential for gain to the acquiring firmsstockholders. For instance, if the market price of a poorly managed firm already reflectsa high probability that the management of the firm will be changed, there is likely to belittle or no value gained from control.

2. The relative scarcity of the specialized resources that the target and the acquiring firmbring to the merger: Since the bidding firm and the target firm are both contributors tothe creation of synergy, the sharing of the benefits of synergy among the two partieswill depend in large part on whether the bidding firm's contribution to the creation ofthe synergy is unique or easily replaced. If it can be easily replaced, the bulk of thesynergy benefits will accrue to the target firm. If it is unique, the benefits will be sharedmuch more equitably. Thus, when a firm with cash slack acquires a firm with manyhigh-return projects, value is created. If there are a large number of firms with cashslack and relatively few firms with high-return projects, the bulk of the value of thesynergy will accrue to the latter.

3. The presence of other bidders for the target firm: When there is more than one bidderfor a firm, the odds are likely to favor the target firms stockholders. Bradley, Desai, andKim (1988) examined an extensive sample of 236 tender offers made between 1963 and1984 and concluded that the benefits of synergy accrue primarily to the target firmswhen multiple bidders are involved in the takeover. They estimated the market-adjusted stock returns around the announcement of the takeover for the successfulbidder to be 2% in single bidder takeovers and -1.33% in contested takeovers.

Payment for the Target Firm

Once a firm has decided to pay a given price for a target firm, it has to follow up bydeciding how it is going to pay for this acquisition. In particular, a decision has to be

made about the following aspects of the deal.1. Debt versus Equity:A firm can raise the funds for an acquisition from either debt orequity. The mix will generally depend upon both the excess debt capacities of theacquiring and the target firm. Thus, the acquisition of a target firm that is significantlyunder levered may be carried out with a larger proportion of debt than the acquisitionof one that is already at its optimal debt ratio. This, of course, is reflected in the value ofthe firm through the cost of capital. It is also possible that the acquiring firm has excessdebt capacity and that it uses its ability to borrow money to carry out the acquisition.Although the mechanics of raising the money may look the same in this case, it isimportant that the value of the target firm not reflect this additional debt. The

additional debt has nothing to do with the target firm and building it into the value will

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only result in the acquiring firm paying a premium for a value enhancement thatrightfully belongs to its own stockholders.

2. Cash versus Stock: There are three ways in which a firm can use equity in atransaction. The first is to use cash balances that have been built up over time to financethe acquisition. The second is to issue stock to the public, raise cash and use the cash to

pay for the acquisition. The third is to offer stock as payment for the target firm, wherethe payment is structured in terms of a stock swap shares in the acquiring firm inexchange for shares in the target firm. The question of which of these approaches is bestutilized by a firm cannot be answered without looking at the following factors.

The availability of cash on hand: Clearly, the option of using cash on hand isavailable only to those firms that have accumulated substantial amounts of

The perceived value of the stock: When stock is issued to the public toraise new funds or when it is offered as payment on acquisitions, the acquiringfirms managers are making a judgment about what the perceived value of thestock is. In other words, managers who believe that their stock is trading at a

price significantly below value should not use stock as currency onacquisitions, since what they gain on the acquisitions can be more than whatthey lost in the stock issue. On the other hand, firms that believe their stocksare overvalued are much more likely to use stock as currency in transactions.The stockholders in the target firm are also aware of this and may demand alarger premium when the payment is made entirely in the form of theacquiring firms stock.

Tax factors; when an acquisition is a stock swap, the stockholders in the targetfirm may be able to defer capital gains taxes on the exchanged shares. Sincethis benefit can be significant in an acquisition, the potential tax gains from a

stock swap may be large enough to offset any perceived disadvantages.The final aspect of a stock swap is the setting of the terms of the stock swap, i.e., thenumber of shares of the acquired firm that will be offered per share of the acquiringfirm. While this amount is generally based upon the market price at the time of theacquisition, the ratio that results may be skewed by the relative mis-pricing of the twofirms securities, with the more overpriced firm gaining at the expense of the moreunder priced (or at least, less overpriced) firm. A fairer ratio would be based upon therelative values of the two firms shares.

Summary

Acquisition refers to the acquiring of ownership right in the property and asset withoutany combination of companies. Thus in acquisition two or more companies may remainindependent, separate legal entity, but there may be change in control of companies.Acquisition results when one company purchase the controlling interest in the sharecapital of another existing company in any of the following ways:

a) Controlling interest in the other company. By entering into an agreement with aperson or persons holding

b) By subscribing new shares being issued by the other company.c) By purchasing shares of the other company at a stock exchange, andd) By making an offer to buy the shares of other company, to the existing

shareholders of that company.

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There are four basic and not necessarily sequential steps, in acquiring a target firm. Thefirst is the development of a rationale and a strategy for doing acquisitions, and theunderstanding of what the strategy requires in terms of resources. The second is thechoice of a target for the acquisition and the valuation of the target firm, with premiumsfor the value of control and any synergy. The third is the determination of how much to

pay on the acquisition, how best to raise funds to do it, and whether to use stock or cash.This decision has significant implications for the choice of accounting treatment for theacquisition. The final step in the acquisition, and perhaps the most challenging one, is tomake the acquisition work after the deal is complete.

Once a firm has an acquisition motive, there are two key questions that need to beanswered. The first relates to how to best identify a potential target firm for anacquisition, given the motives. The second is the more concrete question of how to valuea target firm.

The valuation of an acquisition is not fundamentally different from the valuation of anyfirm, although the existence of control and synergy premiums introduces somecomplexity into the valuation process. Given the inter-relationship between synergy andcontrol, the safest way to value a target firm is in steps, starting with a status quovaluation of the firm, and following up with a value for control and a value for synergy.

Assessment Questions

1. What do you mean by acquisition? Discuss different steps involved in the processof acquisition.

2. How a target firm is valued?

3. Enumerate different methods of payment to a target firm under acquisition.