MF0002

MF0002-Unit-03-Corporate Restructuring Unit 3 Corporate Restructuring

Structure

3.1 Introduction

Objectives

3.2 Background

3.3 Meaning

3.4 Characteristics

3.5 Need and rationale of restructuring

Self Assessment Questions

3.6 Different methods of restructuring

Sell-off

Spin off

Divestitures


Equity Carved out

Leveraged buy outs (LBO)

Management buy outs

Master limited partnerships

Employee stock ownership plans (ESOP)


Joint Ventures

3.7 Summary

3.8 Terminal Questions

3.9 Answers to SAQ’s & TQ’s

3.1 Introduction

This unit introduces the basic concept and characteristic of corporate restructuring. It will help you to understand how corporate restructuring is carried out internally in the firm for making it more profitable and viable. You will also be able to understand about the various forms of corporate restructuring in this unit.

Objectives

After studying this unit, you should be able to:

· Define the concept of corporate restructuring

· Discuss the characteristics of corporate restructuring

· Discuss about the forms of corporate restructuring

3.2 Background

One of the most high profile features of the business and investment worlds is corporate restructuring. In the case of mergers and acquisitions, the potential acquiring firm has to deal with the management and shareholders of the other firm. Corporate restructuring is carried out internally in the firm with the consent of its various stakeholders. Corporate restructuring has gained considerable importance due to the following reasons:

· Intense competition

· Globalization

· Technological Change

· Initiation of Structural reforms in industry due to LPG (shedding non core activities)

· Foreign investment

It involves significant re-orientation, re-organization or realignment of assets and liabilities of the organization through conscious management action to improve future cash flow stream.

3.3 Meaning

Corporate restructuring is an episodic exercise, not related to investments in new plant and machinery which involve a significant change in one or more of the following:

· Pattern of ownership and control

· Composition of liability

· Asset mix of the firm

It is a comprehensive process by which a company can consolidate its business operations and strengthen its position for achieving the desired objectives:

· Staying

· Synergetic

· Competitive

· Successful

Restructuring is the act of partially dismantling and reorganizing a company for the purpose of making it more efficient and therefore more profitable. It generally involves selling of portions of the company and making severe staff reductions. Restructuring is often done as part of a bankruptcy or of a takeover by another firm, particularly a leveraged buyout by a private equity firm.

The rationale behind corporate restructuring is to conduct business operations in more efficient, effective and competitive manner in order to increase organization’s market value of share, brand power and synergies.

3.4 Characteristics

The selling of portions of the company, such as a division that is no longer profitable or which has distracted management from its core business, can greatly improve the company’s balance sheet. Staff reductions are often accomplished partly through the selling or closing of unprofitable portions of the company and partly by consolidating or outsourcing parts of the company that perform redundant functions left over from old acquisitions that were never fully integrated into the parent organization.

Other characteristics of restructuring can include:

· Changes in corporate management (usually with golden parachutes)

· Retention of corporate management

· Sale of underutilized assets

· Outsourcing of operations such as payroll and technical support to a more efficient third party

· Moving operations such as manufacturing to lower-cost locations

· Reorganization of functions such as sales, marketing, and distribution

· Renegotiation of labour contracts to reduce overhead

· Refinancing of corporate debt to reduce interest payments

· Forfeiture of all or part of the ownership share by pre structuring stock holders


The important rationale behind every corporate restructuring is:

· To flatten organization so that it could encourage culture of initiatives and innovations

· To increase focus on core areas of work and to get closer to the customer

· To reduce cost/ reduce level of hierarchy / reduce communication delay

· To reshape the organization for the new era

· To develop organization on the guidelines of consultant / stake holder

I. Self Assessment Questions

1. Why has corporate restructuring gained considerable importance in these days?

_________________________________________________________

_________________________________________________________

_________________________________________________________

2. Corporate restructuring involves a significant change in:

_________________________________________________________

_________________________________________________________

_________________________________________________________

3. What are the rationales behind corporate restructuring?

_________________________________________________________

_________________________________________________________

3.6 Different Methods of Restructuring

The various forms of corporate restructuring are described in this sub section of this unit.

Sell-Offs

A sell-off is the outright sale of a company subsidiary. Normally, sell-offs are done because the subsidiary doesn’t fit into the parent company’s core strategy. The market may be undervaluing the combined businesses due to a lack of synergy between the parent and subsidiary. As a result, management and the board decide that the subsidiary is better off under different ownership.

It is usual practice of corporate to sell-off which is to divest unprofitable or less profitable business so as to avoid further drain on its resources. On the other hand, some companies may also resort to sell non-core business, though profitable, in order to ease their liquidity problems.

Besides getting rid of an unwanted subsidiary, sell-offs also raise cash, which can be used to pay off debt. In the late 1980s and early 1990s, corporate raiders would use debt to finance acquisitions. Then, after making a purchase they would sell-off its subsidiaries to raise cash to service the debt. The raiders’ method certainly makes sense if the sum of the parts is greater than the whole. When it isn’t, deals are unsuccessful.

3.6.2 Spin off

The creation of an independent company is through the sale or distribution of new shares of an existing business/division of a parent company. It is a kind of de-merger when an existing parent company transforms into two or more separately re-organized different entity. The parent company distributes all the shares it owns in a controlled subsidiary to its own shareholder on a pro-rata basis. In this process, the parent company gains effect to making two of the one company. It may be in the form of subsidiary or a separate company. There is no money transaction in spin off. The transaction is treated as stock dividend and tax free exchange. Both companies exist and carry on business. It does not alter ownership proportion in any company. The newly created entity becomes an independent company taking its own decision and developing its own policies and strategies, which need not necessarily, be the same as those of the parent company. Spin-off is necessary for a company having brand equity or multi-product company enters into collaboration with a foreign company. Businesses wishing to ’streamline’ their operations often sell less productive or unrelated subsidiary businesses as spin-offs. The spun-off companies are expected to be worth more as independent entities than as parts of a larger business.

Businesses wishing to ’streamline’ their operations often sell less productive or unrelated subsidiary businesses as spin-offs. The spun-off companies are expected to be worth more as independent entities than as parts of a larger business.

3.6.3 Divestitures

Divestiture is a transaction through which a firm sells a portion of its assets or a division to another company. It involves selling some of the assets or division for cash or securities to a third party which is an outsider. These assets may be in the form of plant, division or product line, subsidiary and so on. The divestiture process is a form of contraction for the selling company and means of expansion for the purchasing company. For a business, divestiture is the removal of assets from the books. Businesses divest by the selling of ownership stakes, the closure of subsidiaries, the bankruptcy of divisions, and so on.

The buyers benefit due to low acquisition cost of a completely established product line which is easy to combine in his existing business and increase his profit and market share. The seller can concentrate after divestiture more on profitable segment and consolidate its business activities. The motive for divestiture is to generate cash for the expansion of other product lines, to get rid of poorly performing operation, to streamline the corporate firm or to restructure the company’s business consistent with its strategic goals. Divestiture enables the selling firm to have more lean and focused operation. This in turn, helps the selling company to increase its efficiency and profitability and also helps to create more value for its shareholders.

1. Reasons for divestitures

The general opinion is that divestiture is the outcome of incapability of the parent company to manage dissimilar assets or assets creating negative synergy. Some of the reasons for divestitures are mentioned here below:

· Corporate attempt to adjust changing economic and political environment of the country

· Strategy to enable others to exploit opportunity effectively to optimize return

· To correct the previous investment decision where the company moved into the operational field having no expertise or experience to run on profitable basis

· To help finance the acquisition

· To realize the capital gain from the assets acquired at the time when they were under performing

· To make financial and managerial resources available for developing other more profitable opportunities

· Selling not required or unconnected parts in the business due to:

- Poor fit of Division

- Reverse Synergy

- Poor Performance

- Capital Market Factor

- Cash flow factors

- Abandoning the core business

2. Financial Evaluation of Divestiture

The divestiture decision can be considered similar to reverse capital budgeting decision. In this case, the selling firm receives cash by divesting an asset, say division of the firm, and these cash flows received are then compared with the present value of the cash flows after tax sacrificed on account of parting of a division or asset. The steps involved in assessing whether the divestiture is profitable for the selling firm or not are as follows:

i) Computation of decrease in cash flow after tax (for year 1,2,…n) due to sale of division

ii) Multiply by appropriate cost of capital factor relevant to division

iii) Computation of decrease in present value of the selling firm ( i x ii)

iv) Computation of present value of obligations related to the liabilities of the division (assuming liabilities are also transferred with the sale of a division)

v) Present value lost due to sale of division (iii – iv)

The decision criteria regarding acceptance and rejection of divestiture decision is as follows:

· Present value lost due to sale of division is less than the sale proceeds obtained from it : Accept, that is, sell the division

· Present value lost due to sale of division is more than the sale proceeds obtained from it : Reject, that is, keep the division

II. Self Assessment Questions

1. Why corporate go for Sell-off?

__________________________________________________________________________________________________________________

2. Differentiate between Sell-off and Spin-off:

___________________________________________________________________________________________________________________________________________________________________________

3. What are the steps involved in assessing whether the divestiture is profitable?

__________________________________________________________________________________________________________________

3.6.4 Equity Carved Out

It resembles to Initial Public Offering (IPO) of some portion of the common stock of a wholly owned subsidiary by the parent company. A parent firm makes a subsidiary public through an initial public offering (IPO) of shares, amounting to a partial sell-off. A new publicly-listed company is created, but the parent keeps a controlling stake in the newly traded subsidiary. Equity carved out is also a means of reducing their exposure to a riskier line of business. In the process of equity carved out, some of the shares of subsidiary are offered for sale to general public for increasing cash flow without loss of control. A carve out occurs when a parent company sells a minority (usually 20% or less) stake in a subsidiary for an IPO or rights offering. In this form of restructuring, an established brick-and-mortar company hooks up with the venture investors and a new management team to launch a spin off. In most cases, the parent company will spin off the remaining interests to existing shareholders at a later date when the stock price is much higher.

More and more companies are using equity carve-outs to boost shareholder value.

A carve-out is a strategic avenue a parent firm may take when one of its subsidiaries is growing faster and carrying higher valuations than other businesses owned by the parent. A carve-out generates cash because shares in the subsidiary are sold to the public, but the issue also unlocks the value of the subsidiary unit and enhances the parent’s shareholder value. The new legal entity of a carve-out has a separate board, but in most carve-outs, the parent retains some control. In these cases, some portion of the parent firm’s board of directors may be shared. Since the parent has a controlling stake, meaning both firms have common shareholders, the connection between the two will likely be strong.

That said, sometimes companies carve-out a subsidiary not because it’s doing well, but because it is a burden. Such an intention won’t lead to a successful result, especially if a carved-out subsidiary is too loaded with debt or had trouble even when it was a part of the parent and is lacking an established track record for growing revenues and profits. Carve-outs can also create unexpected friction between the parent and subsidiary. Problems can arise as managers of the carved-out company should be accountable to their public shareholders as well as the owners of the parent company. This can create divided loyalties.

3.6.5 Leveraged buy outs (LBO)

It is a strategy involving the acquisition of another company using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition. It is nothing but takeover of a company using the acquired firm’s assets and cash flow to obtain financing. In LBO, the assets of the company being acquired are used as collateral for the loans in addition to the assets of the acquiring company. A LBO occurs when a financial sponsor gains control of a majority of a

target company’s equity through the use of borrowed money or debt. The purpose of leveraged buyouts is to allow companies to make large acquisitions without having to commit a lot of capital.

Leveraged buyouts are risky for the buyers if the purchase is highly leveraged. An LBO can be protected from volatile interest rates by an Interest Rate Swap, locking in a fixed interest rate, or an interest rate Cap which prevents the borrowing cost from rising above a certain level. LBOs also have been financed with high-yield debt or Junk Bonds and have also been done with the interest rate capped at a fixed level and interest costs above the cap added to the principal. For commercial banks, LBOs are attractive because these financings have large up-front fees. They also fill the gap in corporate lending created, when large corporations begin using commercial paper and corporate bonds in place of bank loans.

In an LBO, there is usually a ratio of 90% debt to 10% equity. Because of this high debt-equity ratio, the bonds usually are not investment grade and are referred to as junk bonds. In 1980 several prominent buyouts led to the eventual bankruptcy of the acquired companies. This was mainly due to the fact that the leverage ratio was nearly 100% and the interest payments were so large that the company’s operating cash flows were unable to meet the obligation. In the US, specialized LBO firms provide finance for acquisition against target company’s assets or cash flows.

1. Rationale The two important purposes of debt financing for leveraged buyouts are:

a) The use of debt increases (leverages) the financial return to the business concerns. As the debt in an LBO has a relatively fixed albeit high cost of capital, any returns in excess of this cost of capital flows through to the equity.

b) The tax shield of the acquisition debt increases the value of the firm. This enables the company to pay a higher price than would otherwise be possible. Because income flowing through to equity is taxed, while interest payments to debt are not, the capitalized value of cash flowing to debt is greater than the same cash stream flowing to equity

It can be considered ironic that a company’s success (in the form of assets on the balance sheet) can be used against it as collateral by a hostile company that acquires it. For this reason, some regard LBOs as an especially ruthless, predatory tactic. LBOs focus more on growth and complicated financial engineering to achieve their returns.

2. Stages of LBO operation:

The following are the procedures involved in LBO operations:

· Arrangement of Finance

· Taking Private – The organizing sponsor buys all the outstanding shares of the company and takes it private or purchases all the assets of the company.

· Restructuring – Consolidation and reorganization of the target company’s operations.

- To increase profit/ cash flow reducing operating cost

- Consolidation and reorganization of existing production

- Changing production mix / price

- Trimming Employment

- Implementation of better terms from various suppliers

· Reverse LBO: Investor group may take the company to public again through public equity offering.

3. Candidates for LBO Exercise

The candidates for implementation of LBO strategy are the possible target firms threatened by takeover proposals from outside. The typical targets include any of the following:

· If the company does not have share holdings more than 51%

· If the company is over leveraging with the debt components nearing to maturity

· If company has diversified into unrelated areas and thus facing problems

· If the company is earning low operating profits due to poor management and there is a possibility of turnaround

· If the company is having an asset structure which is grossly underutilized

· If the company’s present management is facing managerial incompetence

Candidate for LBO include:

4. Value Generation through LBO

LBO must generate some values for business / owners / shareholders etc. The following are the assumptions of source of value generation through LBO:

· Current price of the target company understates the original value of the firm so some values are created by taking the firm private

· The values so created are transferred to the share holders and buy out groups from other parties involved in such an operation

· Consumer non-durable goods and manufacture sector

5. Criticisms

The LBO form of restructuring is criticized on the following grounds:

· Heavy Deployment of Debt

· Employees of Target company are warned of losing their jobs

· Long-term growth of restructured firm is disrupted due to new management

· Degree of bankruptcy is more

3.6.6 Management buy outs (MBO)

MBO is the form of corporate divestment by way of ‘going private’ through management’s purchase of all outstanding shares. It is a special case of acquisition which occurs when the managers of a company buy or acquire a large part of the company. In this form of acquisition, company’s existing managers acquire a large part or all of the company. It occurs when the managers and executives of a company purchase controlling interest in a company from existing shareholders. In many cases the company will already be a private company, but if it is public then the management will take it private

In most cases, the management will buy out all the outstanding shareholders and then take the company private because it feels it has the expertise to grow the business better if it controls the ownership. Quite often, management will team up with a venture capitalist to acquire the business, because it is a complicated process that requires significant capital.

1. Purpose of MBO

The purpose of such a buyout from the managers’ point of view may be:

· To save their jobs, either if the business has been scheduled for closure or if an outside purchaser would bring in its own management team.

· To maximize the financial benefits they receive from the success they bring to the company by taking the profits for themselves.

· To ward-off aggressive buyers

The goal of an MBO may be to strengthen the managers’ interest in the success of the company. In most cases, the management will then take the company private. MBOs have assumed an important role in corporate restructurings besides mergers and acquisitions. Key considerations in an MBO are fairness to shareholders, price, the future business plan, and legal and tax issues.

2. Benefits

MBO generates value to a corporate in the following ways:

· It provides an excellent opportunity for management of undervalued companies to realize the intrinsic value of the company

· Lower Agency Cost: Cost associated with conflict of interest between owner and managers

· Source of tax savings: Since interest payments are tax deductible, pushing up gearing rations to fund a management buyout can provide large tax covers

3. Ideal MBO Candidates

The companies having the following situation are the ideal candidate for MBO:

· Stable predictable earnings

· Undervalued by market

· Minimal sales fluctuations

· Low capital Requirement Expenditures

· Unutilized debt capacity

· Large amount of cash and cash equivalents

· Substantial Asset Base for use as collateral

3.6.7 Master Limited Partnerships

MLPs emerged during the late 1970s and early 1980s as a means of asset securitization financing initially among real-estate-based businesses. Typically, several smaller partnerships were rolled into an MLP, with partners receiving MLP units in exchange for their partnership interests. The format soon gained favor among upstream oil and gas exploration and development companies and MLPs were eventually adopted by a wide range of industries both in the U.S. and in Canada, where the format is known as the Royalty Trust. Today’s MLPs are predominantly active in the energy, lumber, and real estate industries in the developed countries.

MLPs are a type of limited partnership in which the shares are publicly traded. The limited partnership interests are divided into units which are traded as shares of common stock. Shares of ownership are referred to as units. MLPs generally operate in the natural resource, financial services, and real estate industries. Unlike a corporation, a master limited partnership is considered to be the aggregate of its partners rather than a separate entity.

There are two types of partners in this type of partnership. They are called as general partners and limited partners. The general partner is the party responsible for managing the business and bears unlimited liability. The general partner is typically the sponsor corporation or one of its operating subsidiaries. General partner receives compensation that is linked to the performance of the venture and is responsible for the operations of the company and, in most cases, is liable for partnership debt. The limited partner is the person or group (retail investors) that provides the capital to the MLP and receives periodic income distributions from the MLP’s cash flow. The limited partners have no day-to-day management role in the partnership.

It has the advantage of limited liability for the limited partners. The transferability provides for continuity of life. MLP is not treated as an entity; it is treated as partnership for which income is allocated pro-rata to the partners. The advantage of MLPs is the combination of the tax benefits of a limited partnership with the liquidity of a publicly traded company.

MLPs allow for pass-through income, meaning that they are not subject to corporate income taxes. The partnership does not pay taxes from the profit – the money is only taxed when unit holders receive distributions. The owners of an MLP are personally responsible for paying taxes on their individual portions of the MLP’s income, gains, losses, and deductions. This eliminates the "double taxation" generally applied to corporations (whereby the corporation pays taxes on its income and the corporation’s shareholders also pay taxes on the corporation’s dividends). That is, MLP is taxed as partnership avoids double taxation and the business achieves a lower effective tax rate. The lower cost of capital resulting from the reduced effective tax rate provides the partnership with a competitive advantage when vying against corporations during competitive asset sales or bidding wars and can ultimately provide a higher return to unit holders.

Different Types of MLPs

· Roll Up MLP:

- Formed by the combination of two or more partnerships into one publicly traded partnership

· Liquidation MLP:

- Formed by a complete liquidation of a corporation into an MLP

· Acquisition MLPs:

- Formed by an offering of MLP interest to the public with the proceeds used to purchase assets

· Roll Out MLPs:

- Formed by a corporations contribution of operating assets in exchange for general and limited partnership interest in MLP, followed by a public offering of limited partnership interest by the corporations of the MLP or both

· Start Up MLP:

- Formed by partnership that is initially privately held but later offers its interests to the public in order to finance internal growth

3.6.8 Employee stock ownership plans (ESOP)

The employee stock ownership plan (ESOP) concept was developed in the 1950s. An ESOP is a type of defined contribution benefit plan that buys and holds company stock. ESOP is a qualified, defined contribution, employee benefit plan designed to invest primarily in the stock of the sponsoring employer. Contributions are made by the sponsoring employer. ESOP is a trust established by a corporate which acts as a tax-qualified, defined-contribution retirement plan by making the corporation’s employees partial owners. ESOPs are "qualified" in the sense that the ESOP’s sponsoring company, the selling shareholder and participants receive various tax benefits. ESOPs are often used in closely held companies to buy part or all of the shares of existing owners, but they also are used in public companies. An employee stock ownership plan (ESOP) is a retirement plan in which the company contributes its stock to the plan for the benefit of the company’s employees. With an ESOP, you never buy or hold the stock directly.

ESOPs are often used as a corporate finance strategy and are also used to align the interests of a company’s employees with those of the company’s shareholders. Employee stock ownership plans can be used to keep plan participants focused on company performance and share price appreciation. By giving plan participants, an interest in seeing that the company’s stock performs well, these plans are believed to encourage participants to do what’s best for shareholders, since the participants themselves are shareholders.

ESOPs are most commonly used to provide a market for the shares of departing owners of successful, closely held companies, to motivate and reward employees, or to take advantage of incentives to borrow money for acquiring new assets in pretax rupees. In almost every case, ESOPs are a contribution to the employee, not an employee purchase.

1. ESOP Rules

In an ESOP, a company sets up a trust fund, into which it contributes new shares of its own stock or cash to buy existing shares. Alternatively, the ESOP can borrow money to buy new or existing shares, with the company making cash contributions to the plan to enable it to repay the loan. Regardless of how the plan acquires stock, company contributions to the trust are tax-deductible, within certain limits.

Shares in the trust are allocated to individual employee accounts. Allocations are made either on the basis of relative pay or some more equal formula. As employees accumulate seniority with the company, they acquire an increasing right to the shares in their account, a process known as vesting. Employees must be 100% vested within three to six years, depending on whether vesting is all at once or gradual

When employees leave the company, they receive their stock, which the company must buy back from them at its fair market value. Private companies must have an annual outside valuation to determine the price of their shares. In private companies, employees must be able to vote their

allocated shares on major issues, such as closing or relocating, but the company can choose whether to pass through voting rights (such as for the board of directors) on other issues. In public companies, employees must be able to vote on all issues.

2. Uses of ESOPs

1. To buy the shares of a departing owner:

· Owners of privately held companies can use an ESOP to create a ready market for their shares. The company can make tax-deductible cash contributions to the ESOP to buy out an owner’s shares, or it can have the ESOP borrow money to buy the shares

2. To borrow money at a lower after-tax cost:

· The ESOP borrows cash, which it uses to buy company shares or shares of existing owners. The company then makes tax-deductible contributions to the ESOP to repay the loan, meaning both principal and interest are deductible

3. To create an additional employee benefit:

· A company can simply issue new or treasury shares to an ESOP, deducting their value from taxable income. Or a company can contribute cash, buying shares from existing public or private owners. Rather than matching employee savings with cash, the company will match them with stock from an ESOP, often at a higher matching level

3. Types of ESOPs

ESOPs have been identified as following types:

1. Leveraged ESOPs

· Funds are borrowed to purchase securities of the employer firm.

2. Leveragable ESOPs

· The plan is authorized, but not required to borrow funds.

3. Non-leveraged ESOPs

· Non-leveraged ESOPs are essentially stock bonus which are required to invest primarily in the securities of the employer firm to enable employees to strengthen their ownership hold

In simple words, an ESOP can help a business firm in following ways:

· Turn all or part of your business assets into cash

· Sell your business and defer taxes or gains (special tax rules apply when investing the sale proceeds)

· Bring about broad-based employee ownership of your business

· Provide tax-deferred retirement benefits for your employees

· Useful to fight hostile takeover

ESOPs have been frequently used in a wide variety of capital restructuring activities and buyouts of large private companies as well. ESOPs have been used toward takeover defenses to hostile tender offers and were employed in divestitures, to same failing corporate and as method of railing new capital.

III. Self Assessment Questions

1. Name the few companies who have recently gone for Equity carved out

__________________________________________________________________________________________________________________

2. Who are the candidates for implementation of LBO strategy?

__________________________________________________________________________________________________________________

3. What are the purposes behind MBO?

__________________________________________________________________________________________________________________

4. State the different types of MLPs

__________________________________________________________________________________________________________________

5. List the various uses of ESOPs

__________________________________________________________________________________________________________________

3.6.9 Joint Venture (JV)

Joint Ventures are partnership in which two or more firms carry out a specific project or corporate in a selected area of business. A joint venture is an entity formed between two or more parties to undertake economic activity together. The parties agree to create a new entity by both

contributing equity, and they then share in the revenues, expenses, and control of the enterprise. The venture can be for one specific project only, or a continuing business relationship such as the Sony Ericsson joint venture. This is in contrast to a strategic alliance, which involves no equity stake by the participants, and is a much less rigid arrangement. Joint Venture may be temporary or long-term.

1. Why Joint Ventures?

As there are good business and accounting reasons to create a joint venture with a company that has complementary capabilities and resources, such as distribution channels, technology, or finance, joint ventures are becoming an increasingly common way for companies to form strategic alliances. In a joint venture, two or more "parent" companies agree to share capital, technology, human resources, risks and rewards in a formation of a new entity under shared control. Broadly, the important reasons for forming a joint venture can be presented as below:

=> Internal Reasons:

· Build on company’s strengths

· Spreading cost and risk

· Improving access to financial resources

· Economies of scale and advantages of size

· Access to new technologies and customers

· Access to innovative managerial practices

=> Competitive Goals

· Influencing structural evolution of the industry

· Pre-empting competition

· Defensive response to blurring industry boundaries

· Creation of stronger competitive units

· Speed to market

· Improved agility

=> Strategic Goals

· Synergies

· Transfer of Technology/skills

· Diversification

2. When do Joint Ventures form?

A joint venture is often seen as a very viable business alternative in this sector, as the companies can complement their skill sets while it offers the foreign company a geographic presence. Broadly, when corporate go for joint ventures can be listed as under:

· When an activity is uneconomical for an organization to do alone

· When the risk of the business has to be shared

· To pool distinctive competence of two or more organizations

· To overcome hurdles such as: import quotas, tariff, nationalistic political interest etc

3. Characteristics of Joint Ventures

The important characteristics of joint venture business are as follows:

· Every Joint Venture has a scheduled life cycle which will end sooner or later

· Every Joint Venture has to be dissolved when it has out lived its life cycle

· Changes in the Environment force joint ventures to be redesigned regularly

· Joint Ventures between Indian company and other nations also follow life cycle

· Other nations seek to absorb their partners’ competence

4. Benefits of Joint Venture

In recent days, business firms go for corporate restructuring in the form of joint venture, as it provides certain tangible benefits to both the companies in the following ways:

· Combining complementary R&D or technologies

· Efficient commercialization of technology or business concept

· Developing or acquiring marketing or distribution expertise

· Sharing of scientist or professionals with unique skills

· Financial support or sharing of economic risk

· Acceleration of revenue growth

· Ability to increase profit margins

· Expansion of new domestic market

· New product development

3.7 Summary

Companies undertake corporate restructuring to enhance the shareholders value. A company that has been restructured effectively will generally be leaner, more efficient, better organized, and better focused on its core business. Corporate restructuring can take the forms of ownership restructuring, business restructuring and asset restructuring. Divestiture, Spin-off and Equity Carve-out are basically a ‘Down Sizing’ of parent firm. LBO results in change in ownership whereas sale of asset amounts to asset restructuring. Business restructuring may take place in the form of Divestiture, sale-off, spin-off. Corporations often employ several restructuring methods discussed in this unit in tandem or sequentially.


1. What is corporate restructuring? What are the major forms in which it can be carried out?

2. Compare and contrast the different corporate restructuring methods.

3. What are the implications of a corporate spin-off?

4. What is Divestiture? What is the rationale for it?

5. What are the implications of an equity carved out?

6. What do you mean by Leveraged Buy-out? Explain the steps involved in LBO operation.

7. What is MBO? What is the rationale for it? What are its advantages?

8. Explain MLP.

9. How ESOPs help in corporate restructuring?

10. Why business firms go for joint ventures?


SAQs

I 1. Refer to Section 3.1

2. Refer to Section 3.2


II 1. Refer to Section 3.5.1

2. Refer to Section 3.5.2

3. Refer to Section 3.5.3.2

III 1. Biocon, TCS, PTC





TQs

1. Refer to Section 3.3 and 3.6










Copyright © 2009 SMU

Powered by Sikkim Manipal University

.

MF0002-Unit-02-Mergers & Acquisition – A strategic perspective Unit 2 Mergers & Acquisition – A strategic perspective

Structure

2.1 Introduction

Objectives

2.2 Merger Process

Formulation of the Vision

Pre-Merger planning

Post-Merger Planning

2.3 Basic steps in Strategic planning in Merger


2.4 The Five-stage Model

Corporate strategy development

Organizing for acquisitions

Deal structuring and negotiation

Post-acquisition integration

Post acquisition audit and organizational learning

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

Cash Offer

Equity Share Financing

Debt and Preference Shares Financing

Hybrids


2.6 Mergers as a capital Budgeting decision

2.7 Summary



2.1 Introduction

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

Objectives

After studying this unit, you should be able to

· Understand the process involved in mergers

· Discuss the technique of evaluation of merger proposals

· Describe the methods of financing merger

2.2 Merger Process

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

2.2.1 Formulation of the Vision

The acquiring company must formulate the future vision of merger move in advance. The following vision should be identified while planning for mergers and acquisitions.

· Growth – The vision for an organization defines its purpose, where it is heading, and what it intends to do once it gets there. The vision includes a well-defined set of core values and beliefs that define a company’s culture and purpose.

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

2.2.2 Pre-Merger planning

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

2.2.3 Post-Merger Process

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

2.3 Basic steps in Strategic planning in Merger

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

1. Assessment of changes in the organization environment

2. Evaluation of company capacities and limitations

3. Assessment of expectations of stakeholders

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

5. Formulation of the missions, goals and polices

6. Development of sensitivity to critical external environmental changes

7. Formulation of internal organizational performance measurements

8. Formulation of long range strategy programs

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

10. Organization, funding and other methods to implement all of the proceeding elements

11. Information flow and feedback system for continued repetition of all essential elements and for adjustment and changes at each stage

12. Review and evaluation of all the processes

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


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

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

_________________________________________________________

_________________________________________________________

3. State the critical activities in strategic planning processes.

_________________________________________________________

_________________________________________________________

_________________________________________________________

2.3 The Five-Stage (5-S) model

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

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

1. Corporate strategy development

2. Organizing for acquisitions

3. Deal structuring and negotiation

4. Post-acquisition integration

5. Post acquisition audit and organizational learning

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

2.4.1 Stage 1: Corporate strategy development

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

2.4.2 Organizing for acquisitions

One of the major reasons for the observed failure of many acquisitions may be that firms lack the organizational resources and capabilities for making acquisitions. It is also likely that the acquisition decision-making processes within firms are far from the models of economic rationality that one may assume. Thus, a pre-condition for a successful acquisition is that the firm organises itself for effective acquisition making. An understanding of the acquisition decision process is important, since it has a bearing on the quality of the acquisition decision and its value creation logic. At this stage the firm lays down the criteria for potential targets of acquisitions consistent with the strategic objectives and value creation logic of the firm’s corporate strategy and business model.

2.4.3 Stage 3: Deal structuring and negotiation

This stage consists of:

· Valuing target companies

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

· Obtaining and evaluating about the target from the target as well as from other sources

· Performing due diligence

· Determining the range of negotiation parameters

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

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

2.4.4 Post-acquisition integration

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

2.4.5 Post acquisition audit and organizational learning

The importance of organization to the success of future acquisitions needs much greater recognition, given the high failure rate of acquisitions. Post-merger audit by internal auditors can be acquisition specific as well as being part of an annual audit. Internal auditor has a significant role in ensuring organizational learning and its dissemination.

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

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

2.5.1 Cash Offer

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

a) Agreeableness of acquiree

b) Ability of the acquirer to raise additional funds needed

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

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

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

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

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

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

2.5.2 Equity Share Financing

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

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

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

Where one company is notably larger than the other, people may nevertheless be wary of calling the deal a merger, as the shareholders of the larger company will still dominate the merged company.

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

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

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

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

2.5.3 Debt and Preference Shares Financing

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

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

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

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

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

2.5.4 Hybrids

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


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

_________________________________________________________

_________________________________________________________

2. The various means of financing mergers are:

_________________________________________________________

_________________________________________________________

3. The main considerations for selecting cash payment are:

_________________________________________________________

_________________________________________________________

2.6 Merger as a Capital Budgeting Decision

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

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

· the payment made to discharge the external liabilities,

· estimated value of the obligations assumed,

· Liquidation expenses to be met by the acquiring firm and so on less cash proceeds expected to be realized by the acquiring firm from the sale of certain assets of the target firm.

If the net present value is positive, accept the merger proposal otherwise reject the proposal.

Steps used to evaluate merger decision

· Determination of projected incremental free cash flows

· Determination of terminal value

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

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

–TV = FCF (t+1) / Ko

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

–TV= FCF (t+1) (1 +g) / (Ko – g)

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

–TV = FCF (t+1) (1-g) /(Ko + g)

· Determination of appropriate discount rate

· Determination of present value of free cash flows

· Determination of cost of acquisition

· Determination of net present value of the merger proposal

Example

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

Additional information:

http://resources.smude.edu.in/slm/wp-content/uploads/2009/08/clip-image00218.jpg

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

Land and buildings: Rs. 500 lakh

Plant and Machinery Rs. 500 lakh

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

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

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

Year 1 2 3 4 5Expected Benefits (Cash Flows) Rs.

200 300 260 200 100

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

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

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

Solution:

1. Calculation of cost of acquisition

(Rs. lakhs)

Fixed Assets:

Land & Buildings

Plant & Machinery

Goodwill

500

500

50

1050

Current Assets:

Inventories

Debtors

Bank

70

35

15

120

Total 1170

1. Mode of Payments:

Rs. 1170 lakh is payable as follows:

Cash payment to pay 13% Debentures and current liabilities 130

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

1. Calculation of present value of expected benefits:

1. Present Value of expected benefit after the forecast period

TV5 = FCF 5 (1 +g)/(K –g)

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

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

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

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

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

Total Present Value of Expected Benefits Rs. 1257.83

Less: Cost of Acquisition Rs. 1170.00

Net Present Value Rs. 87.83

Suggestion: As the NPV is positive, acquisition of ABC Ltd. is financial viable to XYZ Ltd.

2.7 Summary

Merger and acquisition is a strategic business decision. It should go in a planned manner and in sequential process. Behind every merger and acquisition the future vision of the decision should


be clear. Hence, the mergers and acquisition process needs to be viewed as a multi-stage process. The five-stage model conceptualizes the merger and acquisition process. The financial framework of merger covers determining the firm’s value and financing techniques and analysis of merger as a capital budgeting decision. Cash offers, equity share financing, debt financing and hybrid source are the various methods of financing in mergers and acquisitions. Merger as a capital budgeting decision involves the valuation of the target firm in terms of its potential to generate incremental future free cash flows to the acquiring firm. Merger should be undertaken when the acquiring company’s gain exceeds the cost.


1. Explain the three phases of merger process.

2. What are the basic steps in strategic planning in merger

3. Explain the five stages of merger and acquisition process under 5-S model

4. How are mergers financed?

5. Why is the capital budgeting technique of evaluating a merger proposition more appropriate?

2.9 Answers to SAQs & TQs

Answers to SAQs I

1. Yes



Answers to SAQs II




Answers to Terminal Questions








.

MF0002-Unit-03-Corporate Restructuring Unit 3 Corporate Restructuring

Structure

3.1 Introduction

Objectives

3.2 Background

3.3 Meaning

3.4 Characteristics



3.6 Different methods of restructuring

Sell-off

Spin off

Divestitures


Equity Carved out

Leveraged buy outs (LBO)

Management buy outs

Master limited partnerships

Employee stock ownership plans (ESOP)


Joint Ventures

3.7 Summary



3.1 Introduction

This unit introduces the basic concept and characteristic of corporate restructuring. It will help you to understand how corporate restructuring is carried out internally in the firm for making it more profitable and viable. You will also be able to understand about the various forms of corporate restructuring in this unit.

Objectives


· Define the concept of corporate restructuring

· Discuss the characteristics of corporate restructuring

· Discuss about the forms of corporate restructuring

3.2 Background

One of the most high profile features of the business and investment worlds is corporate restructuring. In the case of mergers and acquisitions, the potential acquiring firm has to deal with the management and shareholders of the other firm. Corporate restructuring is carried out internally in the firm with the consent of its various stakeholders. Corporate restructuring has gained considerable importance due to the following reasons:

· Intense competition

· Globalization

· Technological Change

· Initiation of Structural reforms in industry due to LPG (shedding non core activities)

· Foreign investment

It involves significant re-orientation, re-organization or realignment of assets and liabilities of the organization through conscious management action to improve future cash flow stream.

3.3 Meaning

Corporate restructuring is an episodic exercise, not related to investments in new plant and machinery which involve a significant change in one or more of the following:

· Pattern of ownership and control

· Composition of liability

· Asset mix of the firm

It is a comprehensive process by which a company can consolidate its business operations and strengthen its position for achieving the desired objectives:

· Staying

· Synergetic

· Competitive

· Successful

Restructuring is the act of partially dismantling and reorganizing a company for the purpose of making it more efficient and therefore more profitable. It generally involves selling of portions of the company and making severe staff reductions. Restructuring is often done as part of a bankruptcy or of a takeover by another firm, particularly a leveraged buyout by a private equity firm.

The rationale behind corporate restructuring is to conduct business operations in more efficient, effective and competitive manner in order to increase organization’s market value of share, brand power and synergies.

3.4 Characteristics

The selling of portions of the company, such as a division that is no longer profitable or which has distracted management from its core business, can greatly improve the company’s balance sheet. Staff reductions are often accomplished partly through the selling or closing of unprofitable portions of the company and partly by consolidating or outsourcing parts of the company that perform redundant functions left over from old acquisitions that were never fully integrated into the parent organization.

Other characteristics of restructuring can include:

· Changes in corporate management (usually with golden parachutes)

· Retention of corporate management

· Sale of underutilized assets

· Outsourcing of operations such as payroll and technical support to a more efficient third party

· Moving operations such as manufacturing to lower-cost locations

· Reorganization of functions such as sales, marketing, and distribution

· Renegotiation of labour contracts to reduce overhead

· Refinancing of corporate debt to reduce interest payments

· Forfeiture of all or part of the ownership share by pre structuring stock holders


The important rationale behind every corporate restructuring is:

· To flatten organization so that it could encourage culture of initiatives and innovations

· To increase focus on core areas of work and to get closer to the customer

· To reduce cost/ reduce level of hierarchy / reduce communication delay

· To reshape the organization for the new era

· To develop organization on the guidelines of consultant / stake holder


1. Why has corporate restructuring gained considerable importance in these days?

_________________________________________________________

_________________________________________________________

_________________________________________________________

2. Corporate restructuring involves a significant change in:

_________________________________________________________

_________________________________________________________

_________________________________________________________

3. What are the rationales behind corporate restructuring?

_________________________________________________________

_________________________________________________________

3.6 Different Methods of Restructuring

The various forms of corporate restructuring are described in this sub section of this unit.

Sell-Offs

A sell-off is the outright sale of a company subsidiary. Normally, sell-offs are done because the subsidiary doesn’t fit into the parent company’s core strategy. The market may be undervaluing the combined businesses due to a lack of synergy between the parent and subsidiary. As a result, management and the board decide that the subsidiary is better off under different ownership.

It is usual practice of corporate to sell-off which is to divest unprofitable or less profitable business so as to avoid further drain on its resources. On the other hand, some companies may also resort to sell non-core business, though profitable, in order to ease their liquidity problems.

Besides getting rid of an unwanted subsidiary, sell-offs also raise cash, which can be used to pay off debt. In the late 1980s and early 1990s, corporate raiders would use debt to finance acquisitions. Then, after making a purchase they would sell-off its subsidiaries to raise cash to service the debt. The raiders’ method certainly makes sense if the sum of the parts is greater than the whole. When it isn’t, deals are unsuccessful.

3.6.2 Spin off

The creation of an independent company is through the sale or distribution of new shares of an existing business/division of a parent company. It is a kind of de-merger when an existing parent company transforms into two or more separately re-organized different entity. The parent company distributes all the shares it owns in a controlled subsidiary to its own shareholder on a pro-rata basis. In this process, the parent company gains effect to making two of the one company. It may be in the form of subsidiary or a separate company. There is no money transaction in spin off. The transaction is treated as stock dividend and tax free exchange. Both companies exist and carry on business. It does not alter ownership proportion in any company. The newly created entity becomes an independent company taking its own decision and developing its own policies and strategies, which need not necessarily, be the same as those of the parent company. Spin-off is necessary for a company having brand equity or multi-product

company enters into collaboration with a foreign company. Businesses wishing to ’streamline’ their operations often sell less productive or unrelated subsidiary businesses as spin-offs. The spun-off companies are expected to be worth more as independent entities than as parts of a larger business.

Businesses wishing to ’streamline’ their operations often sell less productive or unrelated subsidiary businesses as spin-offs. The spun-off companies are expected to be worth more as independent entities than as parts of a larger business.

3.6.3 Divestitures

Divestiture is a transaction through which a firm sells a portion of its assets or a division to another company. It involves selling some of the assets or division for cash or securities to a third party which is an outsider. These assets may be in the form of plant, division or product line, subsidiary and so on. The divestiture process is a form of contraction for the selling company and means of expansion for the purchasing company. For a business, divestiture is the removal of assets from the books. Businesses divest by the selling of ownership stakes, the closure of subsidiaries, the bankruptcy of divisions, and so on.

The buyers benefit due to low acquisition cost of a completely established product line which is easy to combine in his existing business and increase his profit and market share. The seller can concentrate after divestiture more on profitable segment and consolidate its business activities. The motive for divestiture is to generate cash for the expansion of other product lines, to get rid of poorly performing operation, to streamline the corporate firm or to restructure the company’s business consistent with its strategic goals. Divestiture enables the selling firm to have more lean and focused operation. This in turn, helps the selling company to increase its efficiency and profitability and also helps to create more value for its shareholders.

1. Reasons for divestitures

The general opinion is that divestiture is the outcome of incapability of the parent company to manage dissimilar assets or assets creating negative synergy. Some of the reasons for divestitures are mentioned here below:

· Corporate attempt to adjust changing economic and political environment of the country

· Strategy to enable others to exploit opportunity effectively to optimize return

· To correct the previous investment decision where the company moved into the operational field having no expertise or experience to run on profitable basis

· To help finance the acquisition

· To realize the capital gain from the assets acquired at the time when they were under performing

· To make financial and managerial resources available for developing other more profitable opportunities

· Selling not required or unconnected parts in the business due to:

- Poor fit of Division

- Reverse Synergy

- Poor Performance

- Capital Market Factor

- Cash flow factors

- Abandoning the core business

2. Financial Evaluation of Divestiture

The divestiture decision can be considered similar to reverse capital budgeting decision. In this case, the selling firm receives cash by divesting an asset, say division of the firm, and these cash flows received are then compared with the present value of the cash flows after tax sacrificed on account of parting of a division or asset. The steps involved in assessing whether the divestiture is profitable for the selling firm or not are as follows:

i) Computation of decrease in cash flow after tax (for year 1,2,…n) due to sale of division

ii) Multiply by appropriate cost of capital factor relevant to division

iii) Computation of decrease in present value of the selling firm ( i x ii)

iv) Computation of present value of obligations related to the liabilities of the division (assuming liabilities are also transferred with the sale of a division)

v) Present value lost due to sale of division (iii – iv)

The decision criteria regarding acceptance and rejection of divestiture decision is as follows:

· Present value lost due to sale of division is less than the sale proceeds obtained from it : Accept, that is, sell the division

· Present value lost due to sale of division is more than the sale proceeds obtained from it : Reject, that is, keep the division


1. Why corporate go for Sell-off?

__________________________________________________________________________________________________________________

2. Differentiate between Sell-off and Spin-off:

___________________________________________________________________________________________________________________________________________________________________________

3. What are the steps involved in assessing whether the divestiture is profitable?

__________________________________________________________________________________________________________________

3.6.4 Equity Carved Out

It resembles to Initial Public Offering (IPO) of some portion of the common stock of a wholly owned subsidiary by the parent company. A parent firm makes a subsidiary public through an initial public offering (IPO) of shares, amounting to a partial sell-off. A new publicly-listed company is created, but the parent keeps a controlling stake in the newly traded subsidiary. Equity carved out is also a means of reducing their exposure to a riskier line of business. In the process of equity carved out, some of the shares of subsidiary are offered for sale to general public for increasing cash flow without loss of control. A carve out occurs when a parent company sells a minority (usually 20% or less) stake in a subsidiary for an IPO or rights offering. In this form of restructuring, an established brick-and-mortar company hooks up with the venture investors and a new management team to launch a spin off. In most cases, the parent company will spin off the remaining interests to existing shareholders at a later date when the stock price is much higher.

More and more companies are using equity carve-outs to boost shareholder value.

A carve-out is a strategic avenue a parent firm may take when one of its subsidiaries is growing faster and carrying higher valuations than other businesses owned by the parent. A carve-out generates cash because shares in the subsidiary are sold to the public, but the issue also unlocks the value of the subsidiary unit and enhances the parent’s shareholder value. The new legal entity of a carve-out has a separate board, but in most carve-outs, the parent retains some control. In these cases, some portion of the parent firm’s board of directors may be shared. Since the parent has a controlling stake, meaning both firms have common shareholders, the connection between the two will likely be strong.

That said, sometimes companies carve-out a subsidiary not because it’s doing well, but because it is a burden. Such an intention won’t lead to a successful result, especially if a carved-out subsidiary is too loaded with debt or had trouble even when it was a part of the parent and is lacking an established track record for growing revenues and profits.

Carve-outs can also create unexpected friction between the parent and subsidiary. Problems can arise as managers of the carved-out company should be accountable to their public shareholders as well as the owners of the parent company. This can create divided loyalties.

3.6.5 Leveraged buy outs (LBO)

It is a strategy involving the acquisition of another company using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition. It is nothing but takeover of a company using the acquired firm’s assets and cash flow to obtain financing. In LBO, the assets of the company being acquired are used as collateral for the loans in addition to the assets of the acquiring company. A LBO occurs when a financial sponsor gains control of a majority of a target company’s equity through the use of borrowed money or debt. The purpose of leveraged buyouts is to allow companies to make large acquisitions without having to commit a lot of capital.

Leveraged buyouts are risky for the buyers if the purchase is highly leveraged. An LBO can be protected from volatile interest rates by an Interest Rate Swap, locking in a fixed interest rate, or an interest rate Cap which prevents the borrowing cost from rising above a certain level. LBOs also have been financed with high-yield debt or Junk Bonds and have also been done with the interest rate capped at a fixed level and interest costs above the cap added to the principal. For commercial banks, LBOs are attractive because these financings have large up-front fees. They also fill the gap in corporate lending created, when large corporations begin using commercial paper and corporate bonds in place of bank loans.

In an LBO, there is usually a ratio of 90% debt to 10% equity. Because of this high debt-equity ratio, the bonds usually are not investment grade and are referred to as junk bonds. In 1980 several prominent buyouts led to the eventual bankruptcy of the acquired companies. This was mainly due to the fact that the leverage ratio was nearly 100% and the interest payments were so large that the company’s operating cash flows were unable to meet the obligation. In the US, specialized LBO firms provide finance for acquisition against target company’s assets or cash flows.

1. Rationale The two important purposes of debt financing for leveraged buyouts are:

a) The use of debt increases (leverages) the financial return to the business concerns. As the debt in an LBO has a relatively fixed albeit high cost of capital, any returns in excess of this cost of capital flows through to the equity.

b) The tax shield of the acquisition debt increases the value of the firm. This enables the company to pay a higher price than would otherwise be possible. Because income flowing through to equity is taxed, while interest payments to debt are not, the capitalized value of cash flowing to debt is greater than the same cash stream flowing to equity

It can be considered ironic that a company’s success (in the form of assets on the balance sheet) can be used against it as collateral by a hostile company that acquires it. For this reason, some

regard LBOs as an especially ruthless, predatory tactic. LBOs focus more on growth and complicated financial engineering to achieve their returns.

2. Stages of LBO operation:

The following are the procedures involved in LBO operations:

· Arrangement of Finance

· Taking Private – The organizing sponsor buys all the outstanding shares of the company and takes it private or purchases all the assets of the company.

· Restructuring – Consolidation and reorganization of the target company’s operations.

- To increase profit/ cash flow reducing operating cost

- Consolidation and reorganization of existing production

- Changing production mix / price

- Trimming Employment

- Implementation of better terms from various suppliers

· Reverse LBO: Investor group may take the company to public again through public equity offering.

3. Candidates for LBO Exercise

The candidates for implementation of LBO strategy are the possible target firms threatened by takeover proposals from outside. The typical targets include any of the following:

· If the company does not have share holdings more than 51%

· If the company is over leveraging with the debt components nearing to maturity

· If company has diversified into unrelated areas and thus facing problems

· If the company is earning low operating profits due to poor management and there is a possibility of turnaround

· If the company is having an asset structure which is grossly underutilized

· If the company’s present management is facing managerial incompetence

Candidate for LBO include:

4. Value Generation through LBO

LBO must generate some values for business / owners / shareholders etc. The following are the assumptions of source of value generation through LBO:

· Current price of the target company understates the original value of the firm so some values are created by taking the firm private

· The values so created are transferred to the share holders and buy out groups from other parties involved in such an operation

· Consumer non-durable goods and manufacture sector

5. Criticisms

The LBO form of restructuring is criticized on the following grounds:

· Heavy Deployment of Debt

· Employees of Target company are warned of losing their jobs

· Long-term growth of restructured firm is disrupted due to new management

· Degree of bankruptcy is more

3.6.6 Management buy outs (MBO)

MBO is the form of corporate divestment by way of ‘going private’ through management’s purchase of all outstanding shares. It is a special case of acquisition which occurs when the managers of a company buy or acquire a large part of the company. In this form of acquisition, company’s existing managers acquire a large part or all of the company. It occurs when the managers and executives of a company purchase controlling interest in a company from existing shareholders. In many cases the company will already be a private company, but if it is public then the management will take it private

In most cases, the management will buy out all the outstanding shareholders and then take the company private because it feels it has the expertise to grow the business better if it controls the ownership. Quite often, management will team up with a venture capitalist to acquire the business, because it is a complicated process that requires significant capital.

1. Purpose of MBO

The purpose of such a buyout from the managers’ point of view may be:

· To save their jobs, either if the business has been scheduled for closure or if an outside purchaser would bring in its own management team.

· To maximize the financial benefits they receive from the success they bring to the company by taking the profits for themselves.

· To ward-off aggressive buyers

The goal of an MBO may be to strengthen the managers’ interest in the success of the company. In most cases, the management will then take the company private. MBOs have assumed an important role in corporate restructurings besides mergers and acquisitions. Key considerations in an MBO are fairness to shareholders, price, the future business plan, and legal and tax issues.

2. Benefits

MBO generates value to a corporate in the following ways:

· It provides an excellent opportunity for management of undervalued companies to realize the intrinsic value of the company

· Lower Agency Cost: Cost associated with conflict of interest between owner and managers

· Source of tax savings: Since interest payments are tax deductible, pushing up gearing rations to fund a management buyout can provide large tax covers

3. Ideal MBO Candidates

The companies having the following situation are the ideal candidate for MBO:

· Stable predictable earnings

· Undervalued by market

· Minimal sales fluctuations

· Low capital Requirement Expenditures

· Unutilized debt capacity

· Large amount of cash and cash equivalents

· Substantial Asset Base for use as collateral

3.6.7 Master Limited Partnerships

MLPs emerged during the late 1970s and early 1980s as a means of asset securitization financing initially among real-estate-based businesses. Typically, several smaller partnerships were rolled into an MLP, with partners receiving MLP units in exchange for their partnership interests. The format soon gained favor among upstream oil and gas exploration and development companies

and MLPs were eventually adopted by a wide range of industries both in the U.S. and in Canada, where the format is known as the Royalty Trust. Today’s MLPs are predominantly active in the energy, lumber, and real estate industries in the developed countries.

MLPs are a type of limited partnership in which the shares are publicly traded. The limited partnership interests are divided into units which are traded as shares of common stock. Shares of ownership are referred to as units. MLPs generally operate in the natural resource, financial services, and real estate industries. Unlike a corporation, a master limited partnership is considered to be the aggregate of its partners rather than a separate entity.

There are two types of partners in this type of partnership. They are called as general partners and limited partners. The general partner is the party responsible for managing the business and bears unlimited liability. The general partner is typically the sponsor corporation or one of its operating subsidiaries. General partner receives compensation that is linked to the performance of the venture and is responsible for the operations of the company and, in most cases, is liable for partnership debt. The limited partner is the person or group (retail investors) that provides the capital to the MLP and receives periodic income distributions from the MLP’s cash flow. The limited partners have no day-to-day management role in the partnership.

It has the advantage of limited liability for the limited partners. The transferability provides for continuity of life. MLP is not treated as an entity; it is treated as partnership for which income is allocated pro-rata to the partners. The advantage of MLPs is the combination of the tax benefits of a limited partnership with the liquidity of a publicly traded company.

MLPs allow for pass-through income, meaning that they are not subject to corporate income taxes. The partnership does not pay taxes from the profit – the money is only taxed when unit holders receive distributions. The owners of an MLP are personally responsible for paying taxes on their individual portions of the MLP’s income, gains, losses, and deductions. This eliminates the "double taxation" generally applied to corporations (whereby the corporation pays taxes on its income and the corporation’s shareholders also pay taxes on the corporation’s dividends). That is, MLP is taxed as partnership avoids double taxation and the business achieves a lower effective tax rate. The lower cost of capital resulting from the reduced effective tax rate provides the partnership with a competitive advantage when vying against corporations during competitive asset sales or bidding wars and can ultimately provide a higher return to unit holders.

Different Types of MLPs

· Roll Up MLP:

- Formed by the combination of two or more partnerships into one publicly traded partnership

· Liquidation MLP:

- Formed by a complete liquidation of a corporation into an MLP

· Acquisition MLPs:

- Formed by an offering of MLP interest to the public with the proceeds used to purchase assets

· Roll Out MLPs:

- Formed by a corporations contribution of operating assets in exchange for general and limited partnership interest in MLP, followed by a public offering of limited partnership interest by the corporations of the MLP or both

· Start Up MLP:

- Formed by partnership that is initially privately held but later offers its interests to the public in order to finance internal growth

3.6.8 Employee stock ownership plans (ESOP)

The employee stock ownership plan (ESOP) concept was developed in the 1950s. An ESOP is a type of defined contribution benefit plan that buys and holds company stock. ESOP is a qualified, defined contribution, employee benefit plan designed to invest primarily in the stock of the sponsoring employer. Contributions are made by the sponsoring employer. ESOP is a trust established by a corporate which acts as a tax-qualified, defined-contribution retirement plan by making the corporation’s employees partial owners. ESOPs are "qualified" in the sense that the ESOP’s sponsoring company, the selling shareholder and participants receive various tax benefits. ESOPs are often used in closely held companies to buy part or all of the shares of existing owners, but they also are used in public companies. An employee stock ownership plan (ESOP) is a retirement plan in which the company contributes its stock to the plan for the benefit of the company’s employees. With an ESOP, you never buy or hold the stock directly.

ESOPs are often used as a corporate finance strategy and are also used to align the interests of a company’s employees with those of the company’s shareholders. Employee stock ownership plans can be used to keep plan participants focused on company performance and share price appreciation. By giving plan participants, an interest in seeing that the company’s stock performs well, these plans are believed to encourage participants to do what’s best for shareholders, since the participants themselves are shareholders.

ESOPs are most commonly used to provide a market for the shares of departing owners of successful, closely held companies, to motivate and reward employees, or to take advantage of incentives to borrow money for acquiring new assets in pretax rupees. In almost every case, ESOPs are a contribution to the employee, not an employee purchase.

1. ESOP Rules

In an ESOP, a company sets up a trust fund, into which it contributes new shares of its own stock or cash to buy existing shares. Alternatively, the ESOP can borrow money to buy new or existing shares, with the company making cash contributions to the plan to enable it to repay the loan. Regardless of how the plan acquires stock, company contributions to the trust are tax-deductible, within certain limits.

Shares in the trust are allocated to individual employee accounts. Allocations are made either on the basis of relative pay or some more equal formula. As employees accumulate seniority with the company, they acquire an increasing right to the shares in their account, a process known as vesting. Employees must be 100% vested within three to six years, depending on whether vesting is all at once or gradual

When employees leave the company, they receive their stock, which the company must buy back from them at its fair market value. Private companies must have an annual outside valuation to determine the price of their shares. In private companies, employees must be able to vote their allocated shares on major issues, such as closing or relocating, but the company can choose whether to pass through voting rights (such as for the board of directors) on other issues. In public companies, employees must be able to vote on all issues.

2. Uses of ESOPs

1. To buy the shares of a departing owner:

· Owners of privately held companies can use an ESOP to create a ready market for their shares. The company can make tax-deductible cash contributions to the ESOP to buy out an owner’s shares, or it can have the ESOP borrow money to buy the shares

2. To borrow money at a lower after-tax cost:

· The ESOP borrows cash, which it uses to buy company shares or shares of existing owners. The company then makes tax-deductible contributions to the ESOP to repay the loan, meaning both principal and interest are deductible

3. To create an additional employee benefit:

· A company can simply issue new or treasury shares to an ESOP, deducting their value from taxable income. Or a company can contribute cash, buying shares from existing public or private owners. Rather than matching employee savings with cash, the company will match them with stock from an ESOP, often at a higher matching level

3. Types of ESOPs

ESOPs have been identified as following types:

1. Leveraged ESOPs

· Funds are borrowed to purchase securities of the employer firm.

2. Leveragable ESOPs

· The plan is authorized, but not required to borrow funds.

3. Non-leveraged ESOPs

· Non-leveraged ESOPs are essentially stock bonus which are required to invest primarily in the securities of the employer firm to enable employees to strengthen their ownership hold

In simple words, an ESOP can help a business firm in following ways:

· Turn all or part of your business assets into cash

· Sell your business and defer taxes or gains (special tax rules apply when investing the sale proceeds)

· Bring about broad-based employee ownership of your business

· Provide tax-deferred retirement benefits for your employees

· Useful to fight hostile takeover

ESOPs have been frequently used in a wide variety of capital restructuring activities and buyouts of large private companies as well. ESOPs have been used toward takeover defenses to hostile tender offers and were employed in divestitures, to same failing corporate and as method of railing new capital.


1. Name the few companies who have recently gone for Equity carved out

__________________________________________________________________________________________________________________

2. Who are the candidates for implementation of LBO strategy?

__________________________________________________________________________________________________________________

3. What are the purposes behind MBO?

__________________________________________________________________________________________________________________

4. State the different types of MLPs

__________________________________________________________________________________________________________________

5. List the various uses of ESOPs

__________________________________________________________________________________________________________________

3.6.9 Joint Venture (JV)

Joint Ventures are partnership in which two or more firms carry out a specific project or corporate in a selected area of business. A joint venture is an entity formed between two or more parties to undertake economic activity together. The parties agree to create a new entity by both contributing equity, and they then share in the revenues, expenses, and control of the enterprise. The venture can be for one specific project only, or a continuing business relationship such as the Sony Ericsson joint venture. This is in contrast to a strategic alliance, which involves no equity stake by the participants, and is a much less rigid arrangement. Joint Venture may be temporary or long-term.

1. Why Joint Ventures?

As there are good business and accounting reasons to create a joint venture with a company that has complementary capabilities and resources, such as distribution channels, technology, or finance, joint ventures are becoming an increasingly common way for companies to form strategic alliances. In a joint venture, two or more "parent" companies agree to share capital, technology, human resources, risks and rewards in a formation of a new entity under shared control. Broadly, the important reasons for forming a joint venture can be presented as below:

=> Internal Reasons:

· Build on company’s strengths

· Spreading cost and risk

· Improving access to financial resources

· Economies of scale and advantages of size

· Access to new technologies and customers

· Access to innovative managerial practices

=> Competitive Goals

· Influencing structural evolution of the industry

· Pre-empting competition

· Defensive response to blurring industry boundaries

· Creation of stronger competitive units

· Speed to market

· Improved agility

=> Strategic Goals

· Synergies

· Transfer of Technology/skills

· Diversification

2. When do Joint Ventures form?

A joint venture is often seen as a very viable business alternative in this sector, as the companies can complement their skill sets while it offers the foreign company a geographic presence. Broadly, when corporate go for joint ventures can be listed as under:

· When an activity is uneconomical for an organization to do alone

· When the risk of the business has to be shared

· To pool distinctive competence of two or more organizations

· To overcome hurdles such as: import quotas, tariff, nationalistic political interest etc

3. Characteristics of Joint Ventures

The important characteristics of joint venture business are as follows:

· Every Joint Venture has a scheduled life cycle which will end sooner or later

· Every Joint Venture has to be dissolved when it has out lived its life cycle

· Changes in the Environment force joint ventures to be redesigned regularly

· Joint Ventures between Indian company and other nations also follow life cycle

· Other nations seek to absorb their partners’ competence

4. Benefits of Joint Venture

In recent days, business firms go for corporate restructuring in the form of joint venture, as it provides certain tangible benefits to both the companies in the following ways:

· Combining complementary R&D or technologies

· Efficient commercialization of technology or business concept

· Developing or acquiring marketing or distribution expertise

· Sharing of scientist or professionals with unique skills

· Financial support or sharing of economic risk

· Acceleration of revenue growth

· Ability to increase profit margins

· Expansion of new domestic market

· New product development

3.7 Summary

Companies undertake corporate restructuring to enhance the shareholders value. A company that has been restructured effectively will generally be leaner, more efficient, better organized, and better focused on its core business. Corporate restructuring can take the forms of ownership restructuring, business restructuring and asset restructuring. Divestiture, Spin-off and Equity Carve-out are basically a ‘Down Sizing’ of parent firm. LBO results in change in ownership whereas sale of asset amounts to asset restructuring. Business restructuring may take place in the form of Divestiture, sale-off, spin-off. Corporations often employ several restructuring methods discussed in this unit in tandem or sequentially.


1. What is corporate restructuring? What are the major forms in which it can be carried out?

2. Compare and contrast the different corporate restructuring methods.

3. What are the implications of a corporate spin-off?

4. What is Divestiture? What is the rationale for it?

5. What are the implications of an equity carved out?

6. What do you mean by Leveraged Buy-out? Explain the steps involved in LBO operation.

7. What is MBO? What is the rationale for it? What are its advantages?

8. Explain MLP.

9. How ESOPs help in corporate restructuring?

10. Why business firms go for joint ventures?


SAQs

I 1. Refer to Section 3.1



II 1. Refer to Section 3.5.1



III 1. Biocon, TCS, PTC





TQs













.

MF0002-Unit-04-Valuation Unit 4 Valuation

Structure

4.1 Introduction

Objectives

4.2 Meaning and Valuation Approaches

4.3 Basis of valuation


4.4 Valuation Methods

Relative Valuation

Discounted cash flow valuation

Market Multiple Analysis


Earning Analysis


Valuing Operating and Financial Synergy

Valuing corporate control

Valuing LBO

http://resources.smude.edu.in/slm/?p=57650

4.5 Summary


4.7 Answers to SAQs and TQs

4.1 Introduction

This unit presents a comprehensive approach to corporate valuation. It provides a unique combination of practical valuation techniques with the most current thinking to provide an up-to-date synthesis of valuation theory, as it applies to mergers, buyouts and restructuring. The unit will provide the understanding and the answers to the problems encountered in valuation practice, including detailed treatments of free cash flow valuation; financial and valuation of leveraged buyouts.

Objectives


· Define the concept of Valuation of corporate merger and acquisition

· Discuss the valuation in relation to merger and acquisition activity

· Discuss the valuation of operation and financial synergy

· Discuss the valuation of LBO

4.2 Meaning and Valuation Approaches

Once a firm has an acquisition motive, there are two key questions that need to be answered.

· The first relates to how to best identify a potential target firm for an acquisition

· The second is the more concrete question how to value a target firm

Valuation is the process of estimating the market value of a financial asset or liability. Valuations can be done on assets or on liabilities. Valuations are required in many contexts including merger and acquisition transactions. Valuation is the starting point of any merger, buyout or restructuring decision.

Before any mergers & acquisitions take place, a valuation of the intended firm must be conducted in order to determine the true financial worth of the company in question. Valuation is the device to assess the worth of the enterprise. Valuation of both companies is necessary for fixing the consideration amount to be paid in the form of exchange of shares.

Such valuation helps in determining the value of shares of the acquired company as well as the acquiring company to safeguard the interest of the share holders of both the companies. Valuation is necessary for the decision making by shareholders to sell their interest in the company in the form of shares.

To enable shareholders of both the companies, to take decision in favour of amalgamation, valuation of shares is needed. The valuation should give answer to the following basic questions:

· What is the maximum price that should be paid to the shareholder of the merged company?

· How is the price justified with reference to the value of assets, earnings, cash flows, balance sheet implications of the amalgamation?

· What should be the strength of the surviving company reflected in market price or enhanced earning, capacity with reference to the acquired strategies to justify the consideration of the merged company?

The above questions find answers in valuation and fixation of exchange ratios. There are two final points worth making here, before we move on to valuation. The first is that firms often choose a target firm and a motive for the acquisition simultaneously, rather than sequentially. That does not change any of the analysis in these sections. The other point is that firms often have more than one motive in an acquisition, say, control and synergy. If this is the case, the search for a target firm should be guided by the dominant motive.

4.3 Basis of Valuation

Valuation of business is done using one or more of these types of models:

1. Relative value models determine the value based on the market prices of similar business.

2. Absolute value models determine the value by estimating the expected future earnings from owning the business discounted to their present value

An accurate valuation of companies largely depends on the reliability of the company’s financial information. Inaccurate financial information can lead to over and undervaluation. In an acquisition, due diligence is commonly performed by the buyer to validate the representations made by the seller.

The financial analysis required to be made in the case of merger or takeover is comprised of valuation of the assets and stocks of the target company in which the acquirer contemplates to invest large amount of capital. The financial evaluation of a merger is needed to determine the earnings and cash flows, areas of risk, the maximum price payable to the target company and the best way to finance the merger. In M & A, the acquiring firm must pay a fair consideration to the target firm. But, sometimes, the actual consideration may be more than or less than the fair consideration. A merger is said to be at a premium when the offer price is higher than the target

firm’s pre-merger market value. It may have to pay premium as an incentive to the target firm’s shareholders to induce them to sell their shares.

The value of the firm depends not only upon its earnings but also upon the operating and financial characteristics of the acquiring firm. It is therefore, not possible to place a single value for the acquired firm. Instead, a range of values is determined, which would be economically justifiable to the prospective acquirer. To determine an acceptable price for a firm, a number of factors, qualitative (managerial talent, strong sales staff, excellent production department etc) as well as quantitative (value of an asset, earnings of the firm etc) are relevant. Therefore, the focus of determining the firm’s value is on several quantitative variables. There are several bases of valuation as listed below:

· Asset Value

The business is taken as going concern and realizable value of assets is considered which include both tangible and intangible assets. The value of goodwill is added to the value of the tangible assets which gives value of the company as a going concern. Goodwill represents the company’s excess earning power capitalized on the basis of certain number of year’s purchases.

· Capitalized earnings

This is the predetermined rate of return expected by an investor. In other words, this is simple rate of return on capital employed. Under this method, the expected profit will be divided by the expected rate of return to calculate the value of the acquisition.

· Market Value of listed stocks

Market value is the value quoted for the stocks of listed company at stock exchanges. The market price reflects investor’s anticipation of future earnings, dividend payout ratio, confidence in management of company, operational efficiency etc. The temporary factors causing volatility are eliminated by averaging the quotations over a period of time to arrive at a fair market value. The acquirer pays only market value in hostile takeover. The market value approach is one of the most widely used in determining value, especially of large listed firms. The market value provides a close approximation of the true value of a firm.

· Earnings Per Share

The value of a prospective acquisition is considered to be a function of the impact of the merger on the earnings per share. The analysis could focus on whether the acquisition will have a positive impact on the EPS after the merger or if it will have the effect of diluting the EPS. The future EPS will affect the firm’s share prices, which is the function of price-earning (P/E) ratio and EPS.

· Investment value

Investment value is the cost incurred (original investment plus the interest accrued thereon) to establish an enterprise. This determines the sale price of the target company which the acquirer may be asked to pay for the negotiated merger.

· Book Value

Book value represents the total worth of the assets after depreciation but with revaluation. Book value is the audited written down money worth of the total net tangible assets owned by a company. The total net assets are composed of gross working capital plus fixed assets minus outside liabilities. The book value, as the basis of determining a firm’s value, suffers from a serious limitation as it is based on the historical costs of the assets of the firm. Historical costs do not bear a relationship either to the value of the firm or to its ability to generate earnings. However, it is relevant to the determination of a firm’s value for the following reasons:

i) It can be used as a starting point to be compared and complemented by other analyses.

ii) The ability to generate earnings requires large investments in fixed assets and working capital and study of these factors is particularly appropriate and necessary in mergers

· Cost basis valuation

Cost of the assets less depreciation becomes the basis under this method. This method ignores intangible assets like goodwill. It does not give weight to changes in price level.

· Reproduction Cost

Reproduction cost method is based on assessing the current cost of duplicating the properties or constructing similar enterprise in design and material. It does not take into account the intangible assets for valuation purpose.

· Substitution cost

Substitution cost is the estimate of the cost of construction of the undertaking or enterprise in the same utility and capacity.

Out of the above nine methods of valuation, the important methods are: assets based valuation, earning based valuation and market price valuation. These methods are frequently used in the corporate mergers and acquisition.


1. Why valuation is necessary in mergers and acquisitions?

__________________________________________________________________________________________________________________

2. What are the basic questions taken into consideration in valuation?

__________________________________________________________________________________________________________________

3. What are the two basic models in valuation of business?

__________________________________________________________________________________________________________________

4. List the various basis of valuation.

__________________________________________________________________________________________________________________

5. How do you value using EPS and Book Value as basis in valuation?

__________________________________________________________________________________________________________________

4.4 Valuation Methods

The financial consideration generally is the form of exchange of shares. This requires that relative value of each firm’s share and based on this value a particular exchange ratio is determined. The determination of the exchange ratio is therefore, based on the value of the shares of the company involved in the merger.

The valuation of an acquisition is not fundamentally different from the valuation of any firm, although the existence of control and synergy premiums introduces some complexity into the valuation process. Given the inter-relationship between synergy and control, the safest way to value a target firm is in steps, starting with a relative and discounted cash flow valuation (status quo valuation of the firm), and following up with a value for control and a value for synergy.

4.4.1 Relative Valuation

If the motive for acquisitions is under valuation, the target firm must be under valued. How such a firm will be identified depends upon the valuation approach and model used.

· With relative valuation, an under valued stock is one that trades at a multiple (of earnings, book value or sales) well below that of the rest of the industry, after controlling for significant differences on fundamentals. For instance, a bank with a price to book value ratio of 1.2 would be an undervalued bank, if other banks have similar fundamentals (return on equity, growth, and risk) but trade at much higher price to book value ratios.

· In discounted cash flow valuation approaches, an under valued stock is one that trades at a price well below the estimated discounted cash flow value.

4.4.2 Discounted Cash Flow (DCF) Methods

It may be started with the valuation of the target firm by estimating the firm value with existing investing, financing and dividend policies. This valuation provides a base from which the control and synergy premiums can be estimated. The value of the firm is a function of its cash flows from existing assets, the expected growth in these cash flows during a high growth period, the length of the high growth period, and the firm’s cost of capital.

In a merger or acquisition, the acquiring firm is buying the business of the target company rather than a specific asset. Thus, merger is special type of capital budgeting decision. The acquiring firm incurs a cost (in buying the business of the target firm) in the expectation of a stream of benefits (in the form of cash flows) in the future. The merger will be advantageous to the acquiring company, if the present value of the target merger is greater than the cost of acquisition. In order to apply DCF techniques, the following information is required.

· Estimation of cash flows

· Timing of cash flows

· Discount rate

The appropriate discount rate depends on the risk of the cash flows.

Discounted cash flow is a method for determining the current value of a company using future cash flows adjusted for time value. The future cash flow set is made up of cash flows within the determined forecast period and a continuing value that represents a steady state cash flow stream after the forecast period, known as the Terminal Value. In conducting a valuation of a firm, cash flow is usually the main consideration. There is a five-step process for evaluating a company’s cash flow:

i) Analyze operating activities

ii) Analyze the investments necessary to buy new property or business

iii) Analyze the capital requirements of the firm

iv) Project the annual operating flows and terminal value of the firm

v) Calculate the Net Present Value of those cash flows to calculate the firm’s value

In nutshell, the following steps are involved in the financial evaluation of a merger:

· Identify growth and profitability assumptions and scenarios

· Project cash flows magnitudes and their timing

· Estimate the cost of capital

· Compute NPV for each scenario

· Decide if the acquisition is attractive on the basis of NPV

· Decide if the acquisition should be financed through cash or exchange of shares

· Evaluate the impact of the merger on EPS and P/E Ratio

1. Estimating Free Cash Flows

The steps in the estimation of the cash flow are as follows:

· The first step in the estimation of cash flow is the projection of sales.

· The second step is to estimate expenses.

· The third step is to estimate the additional capital expenditure and depreciation.

· Final step is to estimate changes in net working capital due to change in sales.

The above mentioned steps can be presented in the form of below mentioned model.

Net Sales

Less: Cost of goods sold

Selling & Admn. Exp

Depreciation

Total Exp

PBT

Tax @ %

PAT

(+) Depreciation

Funds from operation

(-) Increase in NWC

Cash from operation

(-) Capital Expenditure

Free Cash Flow

+ Salvage Value

(at the end of the year)

P.V. Factor

Present Value

The above steps can be presented in a mathematical equation as below to calculate cash flows:

NCF = EBIT

Where,

· NCF means net cash flows;

· EBIT means earnings before interest and tax;

· T means Tax Rate;

· DEP means depreciation;

· Delta NWC means changes in working capital; and

· Delta CAPEX means changes in capital expenditure.

Here it should be noted that the discount rate should be average cost of capital.

2. Terminal Value

Terminal value is the value of cash flows after the horizon period. It is difficult to estimate the terminal value of the firm as the firm is normally acquired as going concern. The terminal value is the present value of free cash flow after the forecast period. Its value can be determined under three different situations as below:

· When terminal value is likely to be constant till infinity:

TV = FCFt-1 / Ko

· When terminal value is likely to grow at a constant rate

http://resources.smude.edu.in/slm/wp-content/uploads/2009/08/clip-image0028.gif

TV = FCFt-1 (1+g)/(Ko-g)

· When terminal value is likely to decline at a constant rate

TV = FCFt-1(1-g)/(Ko+g)

Where, FCFt-1 refers to the expected cash flow in first year after the horizon period, Ko refers average cost of capital.

Example

ABC Company Limited targeted to acquire XYZ Company Ltd. The Projected Post Merger Cash Flow Statements for the XYZ Company Ltd is given below:

(Rs. in millions)

Year 1 Year 2 Year 3 Year 4 Year 5

Net Sales Rs. 105 Rs. 126 Rs. 151 Rs. 174 Rs. 191Cost of goods sold 80 94 111 127 136Selling and administration Expenses 10 12 13 15 16Depreciation 8 8 9 9 10EBIT 7 12 18 23 29Interest* 3 4 5 6 7EBT 4 8 13 17 22Taxes (40%) $ 1.6 3.2 5.2 6.8 8.8Net Income 2.4 4.8 7.8 10.2 13.2Add Depreciation 8 8 9 9 10Free Cash Flows 10.4 12.8 16.8 19.2 23.2Less retention needed for growth # 4 4 7 9 12

Add Terminal Value @

126.3Net Cash Flows** 6.4 8.8 9.8 10.2 137.5

* Interest payments are estimated based on XYZ Co’s existing debt, plus additional debt required to finance growth

$ The taxes are the full corporate taxes attributable to XYZ’s operation

# Some of the cash flows generated by the XYZ after the merger must be retained to finance asset replacements and growth, while some will be transferred to ABC to pay dividends on its stock or for redeployment within the company. These retentions are net of any additional debt used to help finance growth.

@ XYZ’s available cash flows are expected to grow at a constant 6% rate after Year 5.

The value of all post- Year 5 cash flows as on December 31, Year 5 is estimated by use of the constant growth model to be Rs. 126.3 million:

TV(Year 5) = FCF(Year 6)/(k-g)

= {Rs.23.2 – Rs.12.0)(1.06)}/(0.154 -0.06)

= Rs. 126.3 million

The Rs. 126.3 million is the present value at the end of Year 5 of the stream of cash flows for Year 6 and thereafter. Here, it estimated 15.4 per cent as cost of capital.

** These are the net cash flows projected to be available to ABC by virtue of the acquisition. The cash flows could be used for dividend payments to ABC share holders, finance asset expansion in ABC’s other divisions and subsidiaries and so on.

The current value of XYZ to ABC’s shareholders is the present value of the cash flows expected from XYZ discounted at 15.4% :

Value (Year 0) = (Rs.6.4)/(1.154)1 + (Rs. 8.8) / (1.154)2 + (Rs.9.8)/ (1.154)3 +

(Rs. 10.2) / (1.154)4 + (Rs.137.5)/(1.154)5 = Rs. 91.5 million

Thus, the value of Target Company to ABC shareholders is Rs. 91.5 million.

It should be noted that in a merger analysis, the value of the target consists of the target’s pre merger value plus any value created by operating or financial synergies. In this example, it is assumed that target company’s capital structure and tax rate constant. Therefore, the only synergies were operating synergies, and these effects were incorporated into the forecasted cash flows. If there had been financial synergies, the analysis would have to be modified to reflect this added value.

4.4.3 Market Multiple Analysis

The another method of valuing a target company is market multiple analysis, which applies a market-determined multiple to net income, earnings per share, sales, and book value or number of subscribers (in case of cable TV or cellular telephone systems). While DCF method applies valuation concept in a precise manner, focusing on expected cash flows, market multiple analysis is more judgmental.


This method uses sample ratios from comparable peer groups for determining the current value of a company. The specific ratio to be used depends on the objective of the valuation. The valuation could be designed to estimate the value of the operation of the business or the value of the equity of the business.

To explain the concept, note that XYZ company’s projected net income is Rs. 2.4 million in Year 1 and it rises to Rs. 13.2 million in Year 5, for an average of Rs.7.7 million over five year projected period. The average P/E ratio for publicly traded companies similar to XYZ is 12. To estimate XYZ’s value using the market P/E multiple approach, simply multiply its Rs. 7.7 million average net income by market multiple of 12 to obtain the value (Rs.7.7 x 12) Rs. 92.4 million. This is the equity or the ownership value of the firm. It can be noted here that we used the average net income over the coming five years to value XYZ. The market P/E multiple of 12 is based on the current year’s income of comparable companies, but XYZ’s current income does not reflect synergistic effects or managerial changes that will be made. By averaging future net income, we are attempting to capture the value added by ABC to XYZ’s operations.

EBITDA is another commonly used measure in the market multiple approach. When calculating the value of the operation, the most commonly used ratio is the EBITDA multiple, which is the ratio of EBITDA (Earnings before Interest Taxes Depreciation and Amortization) to the Enterprise Value (Equity Value plus Debt Value). This multiple is based on total value, since EBITDA measures the entire firm’s performance. Multiplying the Target Company’s EBITDA by the market multiple gives an estimate of the targets’ total value. To find the target’s estimated stock price per share, subtract debt from total and then divide by the number of equity shares.


1. What are the basic pieces of information required for DCF technique?

__________________________________________________________________________________________________________________

2. List the five-step process for evaluating a company’s cash flow.

___________________________________________________________________________________________________________________________________________________________________________

3. What is terminal value?

__________________________________________________________________________________________________________________

4.4.4 Earnings Analysis

When valuing the equity of a company, the most widely used multiple is the Price Earnings Ratio (P/E Ratio) of stocks in a similar industry, which is the ratio of Stock price to Earnings per Share of any public company. Earning per share (EPS) is the earning attributable to share holders which are reflected in the market price of the shares. Using the sum of multiple P/E Ratio’s improves reliability but it can still be necessary to correct the P/E Ratio for current market conditions. A reciprocal of this ratio (EPS/P) depicts yield. Share price (P) can be determined as P = EPS x P/E Ratio. While planning for takeover, P/E ratio plays significant role in decision making for the acquirer in the following ways:

· Target Company’s P/E ratio is exit ratio and higher the ratio means the acquirer has to pay more. In such cases, merger will lead to dilution in EPS and adversely affect share prices. If the exit ratio of Target Company is less than the acquirer, then shareholders of both companies benefit.

· A company can increase its EPS by acquiring another company with a P/E ratio lower than its own, if business is acquired by exchange of shares.

Example

ABC Company Ltd takes over XYZ Company Ltd. The merger is not expected to yield in economies of scale and operating synergy. The relevant data for two companies are as follows:

ABC Ltd XYZ Ltd

No. of Shares 10,000 5,000Total Earnings 1,00,000 50,000EPS 10 10P/E Ratio 2 1.5

ABC Ltd acquires XYZ at share-for –share exchange. The exchange ratio has been calculated as under:

Assume that XYZ Ltd is going to exchange its share with ABC Ltd at its market price. The exchange ratio will be: 15/20 = 0.75. That is for every one share of XYZ Ltd., 0.75 share of ABC Ltd will be issued. In total 3750 (0.75×5000) shares of ABC Ltd will need to be issued in order to acquire XYZ Ltd. Hence, the total number of shares in combined company will be 13,750 (10000 + 3750).

Impact of merger on ABC Ltd shareholders:

EPS on merger = (100000 + 50000) / 13750 = Rs. 10.91

Net gain in EPS = Rs. 10.91 – Rs. 10.00 = Re. 0.91

Market Price of share (after merger) = EPS x P/E Ratio = Rs. 10.91 x 2 = 21.82

Net gain in Market Price = Rs. 21.82 – Rs. 20.00 = Rs. 1.82

Impact of Merger on XYZ Ltd shareholders:

New EPS = 0.75 x 10.91 = Rs. 8.18

EPS dilution (Net Loss) = Rs. 10.00 – Rs. 8.182 = Rs. 1.82

ABC Ltd shareholders have gained in the combined company from the merger because the P/E ratio of target company (XYZ) is less than that of the acquirer.


Analyze the impact of merger on ABC Ltd and XYZ Ltd if Target Company demands a price of Rs. 22 per share instead of Rs. 15 per share.

1. Exchange Ratio

_________________________________________________________

2. Total No. of shares in combined company

_________________________________________________________

3. EPS after merger

_________________________________________________________

4. EPS dilution for XYZ Ltd

_________________________________________________________

5. Market Price of share of ABC Ltd (after merger)

_________________________________________________________

It is very important to note that valuation is more an art than a science because it requires judgment:

1) There are very different situations and purposes in which you value an asset. In turn this requires different methods or a different interpretation of the same method each time.

2) All valuation models and methods have their limitations (e.g., mathematical, complexity, simplicity, comparability) and could be widely criticized. As a general rule the valuation models are most useful when you use the same valuation method as the "partner" you are interacting with. Mostly the method used is industry or purpose specific;

3) The quality of some of the input data may vary widely

4) In all valuation models there are a great number of assumptions that need to be made and things might not turn out the way you expect. Your best way out of that is to be able to explain and stand for each assumption you make;

4.4.5 Valuing Operating and Financial Synergy

The third reason to explain the significant premiums paid in most acquisitions is synergy. Synergy is the potential additional value from combining two firms. It is probably the most widely used and misused rationale for mergers and acquisitions.

1. Sources of Operating Synergy

Operating synergies are those synergies that allow firms to increase their operating income, increase growth or both. It can be categorized operating synergies into four types:

a) Economies of scale that may arise from the merger, allowing the combined firm to become more cost-efficient and profitable.

b) Greater pricing power from reduced competition and higher market share, which should result in higher margins and operating income.

c) Combination of different functional strengths, as would be the case when a firm with strong marketing skills acquires a firm with a good product line.

d) Higher growth in new or existing markets, arising from the combination of the two firms. This would be the case, when a multinational consumer products firm acquires an emerging market firm, with an established distribution network and brand name recognition, and uses these strengths to increase sales of its products.

Operating synergies can affect margins and growth, and through these the value of the firms involved in the merger or acquisition.

2. Sources of Financial Synergy

Synergy can also be created from purely financial factors. With financial synergies, the payoff can take the form of either higher cash flows or a lower cost of capital. Included are the following:

1. A combination of a firm with excess cash, or cash slack, (and limited project opportunities) and a firm with high-return projects (and limited cash) can yield a payoff in terms of higher value for the combined firm. The increase in value comes from the projects that were taken with the excess cash that otherwise would not have been taken. This synergy is likely to show up most often when large firms acquire smaller firms, or when publicly traded firms acquire private businesses.

2. Debt capacity can increase, because when two firms combine, their earnings and cash flows may become more stable and predictable. This, in turn, allows them to borrow more than they could have as individual entities, which creates a tax benefit for the combined firm. This tax benefit can either be shown as higher cash flows, or take the form of a lower cost of capital for the combined firm.

3. Tax benefits can arise either from the acquisition taking advantage of tax laws or from the use of net operating losses to shelter income. Thus, a profitable firm that acquires a money-losing firm may be able to use the net operating losses of the latter to reduce its tax burden. Alternatively, a firm that is able to increase its depreciation charges after an acquisition will save in taxes, and increase its value.

Clearly, there is potential for synergy in many mergers. The more important issues are whether that synergy can be valued and, if so, how to value it.

3. Valuing Operating Synergy

There is a potential for operating synergy, in one form or the other, in many takeovers. Synergy can be valued by answering two fundamental questions:

1. What form is the synergy expected to take?

· Will it reduce costs as a percentage of sales and increase profit margins (e.g., when there are economies of scale)?

· Will it increase future growth (e.g., when there is increased market power) or the length of the growth 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 expected growth rates (market power, higher growth potential)

- a longer growth period (from increased competitive advantages)

- a lower cost of capital (higher debt capacity)

2. When will the synergy start affecting cash flows?

· Synergies can show up instantaneously, but they are more likely to show up over the time. Since the value of synergy is the present value of the cash flows created by it, the longer it takes for it to show up, the lesser its value.

Once we answer these questions, we can estimate the value of synergy using an extension of discounted cash flow techniques.

· First, we value the firms involved in the merger 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, we build in the effects of synergy into expected growth rates and cash flows, and we value the combined firm with synergy.

· The difference between the value of the combined firm with synergy and the value of the combined firm without synergy provides a value for synergy.

4.4.6 Value Creation through Synergy

Synergy is a stated motive in many mergers and acquisitions. If synergy is perceived to exist in a takeover, the value of the combined firm should be greater than the sum of the values of the bidding and target firms, operating independently.

V(PQ) > V(P) + V(Q)

Where,

· V(PQ) = Value of a firm created by combining P and Q (Synergy)

· V(P) = Value of firm P, operating independently

· V(Q) = Value of firm Q, operating independently

Merger will create an economic advantage (EA) through synergy when the combined present value of the merger firms is greater than the sum of their individual present values as separate entities. If firm P and firm Q merge, and they are separately worth VP and VQ respectively, and worth VPQ in combination then the economic advantage will occur if:

The economic advantage is equal to:

EA =

Merger and acquisition involves costs. The Cost of merging to P in the above example is:

Cash Paid – VQ




The net economic advantage of merger (NEA) is positive if the economic advantage exceeds the cost of merging. Thus,

Net Economic Advantage = Economic Advantage – Cost of Merging

NEA =

represent the benefit results from operating efficiency and synergy when two firms merge. If the acquiring firm pays cash equal to the value of the acquired firm, then the entire advantage of merger will accrue to the shareholders of acquired firm. In practice, the acquiring and the acquired firm may share the economic advantage between themselves.

4.4.7 Valuing Corporate Control

If the motive for the merger is control, the target firm will be a poorly managed firm in an industry where there is potential for excess returns. In addition, its stock holdings will be widely dispersed (making it easier to carry out the hostile acquisition) and the current market price will be based on the presumption that incumbent management will continue to run the firm. Many hostile takeovers are justified on the basis of the existence of a market for corporate control. Investors and firms are willing to pay large premiums over the market price to control the management of firms, especially those that they perceive to be poorly run.

The value of wresting control of a firm from incumbent management is inversely proportional to the perceived quality of that management and its capacity to maximize firm value. In general, the value of control will be much greater for a poorly managed firm that operates at below optimum capacity than for a well managed firm. The value of controlling a firm comes from changes made to existing management policy that can increase the firm value. Assets can be acquired or liquidated, the financing mix can be changed and the dividend policy re-evaluated, and the firm can be restructured to maximize 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 current management

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

4.4.8 Valuing Leveraged Buyouts

Leveraged buyouts are financed disproportionately with debt. This high leverage is justified in several ways as pointed below:



· First, if the target firm initially has too little debt relative to its optimal debt ratio, the increase in debt can be explained partially by the increase in value moving to the optimal ratio provides. The debt level in most leveraged buyouts exceeds the optimal debt ratio, however, which means that some of the debt will have to be paid off quickly in order for the firm to reduce its cost of capital and its default risk.

· A second explanation is provided by Michael Jensen, who proposes that managers cannot be trusted to invest free cash flows wisely for their stockholders; they need the discipline of debt payments to maximize cash flows on projects and firm value.

· A third rationale is that the high debt ratio is temporary and will disappear once the firm liquidates assets and pays off a significant portion of the debt.

The extremely high leverage associated with leveraged buyouts creates two problems in valuation.

· First, it significantly increases the risk of the cash flows to equity investors in the firm by increasing the fixed payments to debt holders in the firm. Thus, the cost of equity has to be adjusted to reflect the higher financial risk the firm will face after the leveraged buyout.

· Second, the expected decrease in this debt over time, as the firm liquidates assets and pays off debt, implies that the cost of equity will also decrease over time.

Since the cost of debt and debt ratio will change over time as well, the cost of capital will also change in each period. In valuing a leveraged buyout, then, we begin with the estimates of free cash flow to the firm, just as we did in traditional valuation. The DCF approach is used to value an LBO. However, instead of discounting these cash flows back at a fixed cost of capital, we discount them back at a cost of capital that will vary from year to year. Once we value the firm, we then can compare the value to the total amount paid for the firm. As LBO transactions are heavily financed by debt, the risk of lender is very high. Therefore, in most deals they require a stake in the ownership of the acquired firm.

4.5 Summary

Merger should be undertaken when the acquiring company’s gain exceeds the cost. The cost is the premium that the acquiring company pays for the target company over its value as a separate entity. Merger benefits may result from economies of scale, increased efficiency, tax shield or shared resources. Discounted cash flow technique can be used to determine the value of the target company to the acquiring company. This unit described different techniques for the valuation of target companies on the basis of various parameters.


1. Explain how terminal value can be determined under three different situations

2. Explain the market multiple model of valuation

3. What are the sources of Operating Synergy?

4. What are the sources of Financial Synergy?

5. Explain the process of valuing LBO.


SAQs I






SAQs II



3. Refer to Section 4.4.2-2

SAQs III

1. 1.1

2. 15500

3. Rs. 9.67

4. Re. 0.33

5. Rs. 19.34

TQs








.

MF0002-Unit-05-Process of Merger Integration Unit 5 Process of Merger Integration

Structure

5.1 Introduction

Objectives

5.2 Integration planning


5.3 Factors in post-merger integration

5.4 Implementation of integration process

5.5 Post-merger integration model

5.6 Strategic interdependence and autonomy

5.7 Political and cultural aspects of integration


5.8 Cultural profiling and assessment of cultural compatibility

5.9 Human resources management issues

5.10 Problems in integration

5.11 Five rules for integration process

5.12 Managerial Challenges


5.13 Summary


5.15 Answer to SAQs and TQs

5.1 Introduction

This unit explains the process involved in merger integration. To start with you need to know the various aspects which need to be integrated in the post-merger entity. You will also be able to understand about major problems and challenges involved in the mergers and acquisition in this unit.

Objectives


· Discuss the alternative acquisition integration approaches

· Describe the political, cultural and change management perspectives on integration

· Discuss the problems that may arise in the integration process

· Discuss about the Managerial challenges of Mergers and acquisition

The most difficult part of merger or acquisition is the integration of the acquired company into the acquiring company. The difficulty of integration also depends on the degree of control desired by the acquirer. The post-merger and acquisition integration of the firm is a crucial task to be accomplished for effective performance. The post-merger integration process starts after the successful deal of merger. Extent of integration is defined by the need to maintain the separateness of the acquired business. The value creation in merger depends upon this integration. The rationalist view of acquisitions is as below:


The acquirer may simply desire financial consolidation leaving the entire management to the existing managers. On the other hand, if the intention is total integration of manufacturing, marketing, finance, personnel etc., integration become quite complex. There is a need to determine the manner in which the acquired company will be integrated into the acquiring firm’s culture. The process of post-merger integration involves:

· Evaluation of organizational cultural fit

· Development of integration approach

· Matching strategy, organization and culture between acquirer and acquired

· Results

Integration of two organizations is not a matter of just changing the organization structure and establishing a new hierarchy of authority. There are various stages in the process of integration. In involves integration of various functional areas at the functional level in order to synergize. Some of the functional areas of importance are: Accounting, R&D, Procurement, Management Team, Marketing & Sales and Brands. Another important aspect of integration is the cultural integration of acquiring and acquired firms- policies, procedures and styles. The human side of the M&A is another aspect of integration. This involves the emotional integration of personnel of the organization.

5.2 Integration Planning

The success of an integration process depends upon the role of acquisition and the nature of managers involved in the transaction and implementation. The process of integration itself has to be planned so that the acquired or merged company integrates smoothly. Therefore, merger and acquisition requires a detailed planning for integration as given below:

· Integration plan

Once the merger or acquisition took place, the acquiring company should prepare a detailed strategic plan for integration based on its own and the target company’s strength and weakness.

· Communication

The plan of integration should be communicated to all employees and also their involvement in making integration smooth and easy and remove any ambiguity or fear in the minds of the staff.

· Authority and responsibility

In order to avoid any confusion and indecisiveness, the acquiring company should take all employees into confidence and decide the authority and responsibility relationships.

· Cultural integration

Management should focus on the cultural integration of the employees. A proper understanding of culture of two organizations, clear communication and training can help to bridge the cultural gaps.

· Skill and competencies up-gradation

The acquired company can conduct a survey of employees to make an assessment of the gaps in the skills and competencies. If there is difference in the skills and competencies of employees of merging company, management should prepare a plan for skill and competencies up-gradation through training.

· Structural Adjustments

The acquired company may design the new organization structure and redefine the roles, authorities and responsibilities of the employees.

· Control System

It is to ensure that it is in control of all resources and activities of the merged entity. It must put proper financial control in place so that resources are optimally utilized and wastage is avoided.


1. List the rationalists’ view of merger

__________________________________________________________________________________________________________________

2. What are the processes involved in post-merger integration?

___________________________________________________________________________________________________________________________________________________________________________

3. List the detailed planning for post-merger integration

__________________________________________________________________________________________________________________

5.3 Factors in post-merger integration

There are many factors which require attention of the management and tend to widen its role in post-merger integration. A list of such factors is give below in brief:

· Legal obligation

Fulfillment of legal obligation becomes essential in post-merger integration. Such obligations depend upon the size of the company, debt structure and controlling regulations, distribution channels, and dealer net-work, suppliers’ relations etc. In all or some of these cases legal documentation would be involved. The rights and the interests of the stake holders should be protected with the new or changed management of the acquiring company. Regulatory bodies like RBI, Stock Exchanges, SEBI etc would also ensure adherence to their respective guidelines and regulations. It should be ensured at the time of integration that the company out its legal obligations in all related and requisite areas.

· Consolidation of operations

Acquiring company has to consolidate the operations, blending the acquired company’s operations with its own operation. The consolidation of operation covers not only the production process, adoption of new technology and engineering requirements in the production process, but also the entire technical aspects covering technical know-how, project engineering, plant layout, schedule of implementation, product designs, plant and equipments, manpower requirements, work schedule, pollution control measure etc. in the process leading to the final product.

· Installation of top management

Merger and acquisition affect the top management structure. A cohesive team is required at board level as well as senior executive level. Installation of management in the process of integration involves combination of issues related to:

· Selection or transfer of managers

· Changes in organizational structure

· Development of consistent corporate culture, including a frame of reference to guide strategic decisions making

· Commitment and motivation of personnel

· Establishment of new leadership

The integration would involve induction of the directors of the acquired company on the Board of acquiring company, or induction of persons outside who have expertise in directing and policy planning. At top level also, changes are required, particularly depending upon terms and conditions of the merger to adjust in suitable positions the top executive of the acquired company to create congenial environment within the organization. The mechanism of corporate control encompassing delegation of power and power of control, accounting responsibility, MIS and communication channels are the important factors to be taken into consideration in the process of integration.

· Rationalizing financial resources

It is important to revamp the financial resources of the company to ensure availability of financial resources and liquidity. Sometimes on happening of certain uncontrollable events, the financing plans have got to be verified, reviewed and changed.

· Integration of financial structure

This is an important aspect which concerns most of stake holders of the company. Generally, financial structure is reorganized as per the scheme of arrangement, merger or amalgamation approved by the shareholders and creditors. But in the case of takeover or acquisition of an undertaking made by one company of the other through acquiring financial stake by way of acquisition of shares, the integration of financial structure would be a post-merger event which might compel the company to change its capital base, revalue its assets and reallocate reserves.

· Toning up production and marketing management

With regard to the size of the company and its operational scale, its production line is to be adjusted during post-merger period. Decisions are taken on the basis of feasibility studies done by the experts. For tuning up of production, it is also necessary that resources be properly allocated for planned programme for utilization of scarce and limited resources available to a firm so as to direct the production process to result into optimal production and operational efficiency. Revamping of marketing strategy is also essential in post-merger integration. This is done on the basis of market surveys and recommendations of the marketing experts. Pricing policy also deserve attention for gaining competitive strength in the different market segments.

· Corporate planning and control

Corporate planning to a large extent is guided by the corporate policy. Corporate policy prescribes guidelines that govern the decision making process and regulates the implementation of the decisions. Control as an activity of management involves comparison of performance with predetermined standards. In each area of corporate activities whether it is personnel, material, financial – management, planning is associated with control.

5.4 Implementation of integration process

There are many ways to implement integration. You must send senior-level leaders out to talk with employees; encourage cross-organizational reflections at the end of partnering experiments (to capture and pass on lessons learned); and establish “one company” measurement processes to minimize the natural tendency to compare one group’s results to the others’. To carry off this approach, however, the integration must be:

· Driven by a crystal-clear vision of the new organization, including its intended mission (core purpose), strategy, and essential values

· Owned and executed by and with key stakeholders

· Fluidly coordinated and flexibly self-adjusting

· Continually providing communication laterally, as well as vertically, across the system and in sync with the needs of ongoing day-to-day operations

· Open, interactive, and responsive to feedback

· Cognizant of human needs for inclusion, order, self-control, and choice

In addition, the merging companies need to form a dedicated merger project organization, which should be networked together to create an integrated learning system. Specifically, the Merger Executive Committee is the driving force behind the transition to the new entity. Members of this group must make a commitment to work together to ensure the success of the new system. From the beginning, the way the team members are selected and the way they act, individually and collectively, will be the two strongest messages the new organization receives about what is to be expected and valued.

5.5 Post-merger integration model

This stage of the acquisition process is a major determinant of the success of the acquisition in creating value. There are four broad sources of added value as given below:

· Operating resources sharing

- The capabilities and benefits under this source are: sales force, manufacturing facilities, trade marks, brand names, distribution channels, office space etc.

· Functional skills

- The specific capabilities and benefits transferable under this are: design, product development, production, techniques, material handling, quality control, packaging, marketing, promotion, training and organizational routines

· General management

- The capabilities and benefits are: strategic direction, leadership, vision, resource allocation, financial planning and control, human resource management, relations with suppliers, management style to motivate staff

· Size benefits

- Market power, purchasing power, access to financial resources, risk diversification, cost of capital reduction are the important capabilities and benefits under this heading.

Out of the above four sources of added value, the first three require operational capability transfer between the acquiring and the acquired firms. The fourth is size related and derives from the increased size of the combined entity relative to the pre-combination firms. These capabilities and benefits lead to one or more of the three broad sources of value: cost savings, revenue

enhancement and real options. The extent of integration depends upon the degree of strategic interdependence between the two firms as a precondition for capability transfer and value creation.

5.6 Strategic interdependence and autonomy

Haspeslagh and Jemison model the trade-off between the need for strategic interdependence and the need for autonomy for the acquired firm as shown here below:

At the two extremes is complete preservation and complete absorption. Most acquisitions require a mixture of interdependence and autonomy. This leads to four types of post-acquisition integration:

· Absorption

- Under this, integration implies a full consolidation of the operations, organization and culture of both firms over time

- Operational resourced need to be pooled to eliminate duplication

- Acquisition aimed at reducing production capacity in a declining industry dictates an absorption approach.

· Preservation

- In a preservation acquisition, there is a great need for autonomy.

- Acquired firm’s capabilities must be nurtured by the acquirer with judicious and limited intervention, such as financial control while allowing the acquired firm to develop and exploit its capabilities to the full

- The acquirer uses the acquisition as a learning opportunity that may be central to a strategy such as platform building

· Symbiosis

- Two firms initially co-exist but gradually become interdependent.

- Need simultaneous protection and permeability of the boundary between two firms


- No sharing of operational resources takes place, but there may be a gradual transfer of functional skills.

· Holding Company

- Intervention by the parent is passive and more in the nature of a financial portfolio motivated by risk reduction, reduction in capital costs

- Parent seeks no interaction among the portfolio companies

- Line between preservation and holding company types may not be quite distinct in some acquisitions

Acquired company managers select an appropriate integration approach that will lead to exploitation of the capabilities of the two firms for securing sustainable competitive advantage. If the capabilities to be transferred are not properly identified owing to deficiencies of the pre-acquisition decision making, the value creation may not result from the integration process.

5.7 Political and cultural aspects of integration

The value chains of the acquirer and the acquired, need to be integrated in order to achieve the value creation objectives of the acquirer. This integration process has three dimensions: the technical, political and cultural. The technical integration is similar to the capability transfer discussed above. The integration of social interaction and political relationships represents the informal processes and systems which influence people’s ability and motivation to perform. At the time of integration, the acquirer should have regard to these political relationships, if acquired employees are not to feel unfairly treated.

An important aspect of integration is the cultural integration of the acquiring and acquired firms. The culture of an organization is embodied in its collective value systems, beliefs, norms, ideologies myths and rituals. They can motivate people and can become valuable sources of efficiency and effectiveness. The following are the illustrative organizational diverse cultures which may have to be integrated during post-merger period:

· Strong top leadership versus Team approach

· Management by formal paper work versus management by wandering around

· Individual decision versus group consensus decision

· Rapid evaluation based on performance versus Long term relationship based on loyalty

· Rapid feedback for changes versus formal bureaucratic rules and procedures

· Narrow career path versus movement through many areas

· Risk taking encouraged versus ‘one mistake you are out’

· Risky activities versus low risk activities

· Narrow responsibility arrangement versus ‘Everyone in this company is salesman (or cost controller, or product quality improver etc.)’

· Learn from customer versus ‘We know what is best for the customer’

The above illustrative culture may provide basis for the classification of organizational culture. There are four different types of organizational culture as mentioned below:

· Power

- The main characteristics are: essentially autocratic and suppressive of challenge; emphasis on individual rather than group decision making

· Role

- The important features are: bureaucratic and hierarchical; emphasis on formal rules and procedures; values fast, efficient and standardized culture service

· Task/achievement

- The main characteristics are: emphasis on team commitment; task determines organization of work; flexibility and worker autonomy; needs creative environment

· Person/support

- The important features are: emphasis on equality; seeks to nurture personal development of individual members

Poor cultural fit or incompatibility is likely to result in considerable fragmentation, uncertainty and cultural ambiguity, which may be experienced as stressful by organizational members. Such stressful experience may lead to their loss of morale, loss of commitment, confusion and hopelessness and may have a dysfunctional impact on organizational performance. Mergers between certain types can be disastrous. Differences in culture may lead to polarization, negative evaluation of counterparts, anxiety and ethnocentrism between top management teams of the acquired and acquiring firms. In assessing the advisability of an acquisition, the acquirer must consider cultural risk in addition to strategic issues. The differences between the national and the organizational culture influence the cross-border acquisition integration. Thus, merging firms must consciously and proactively seek to transform the cultures of their organizations.


1. What are the four broad sources of value creation?

______________________________________________________________________________________________________________

2. What are the four types of post-merger integration?

______________________________________________________________________________________________________________

3. What are the four different types of organizational culture?

______________________________________________________________________________________________________________

5.8 Cultural profiling and assessment of cultural compatibility

The steps for cultural profiling and assessment of cultural compatibility are as follows:

· The first step towards cultural integration and aligning culture to strategy is the profiling of the cultures of the merging firms.

· The next step is the evaluation of the compatibility of the cultures and identifying the areas of potential conflict.

· Thirdly, a cultural awareness programme through education, workshops and working together needs to be set up.

· Finally, a new culture has to be evolved.

5.9 Human resources management issues

In the course of integration the merging firms have to confront the following issues:

· Board-level changes

Board-level positions may have to be revamped to align directorial expertise with the emerging needs of the post-merger business. The new board should change leaders so that they can carry out the change process dictated by the merger. Board-level changes could also be inspirational for the rest of the organization. This is particularly so where the merging partners had experienced performance problems which triggered the merger.

· Choosing the right people for the right position

In all integration types, there will be rival claims for senior executive positions such as the chairman, CEO, CFO, COO, heads of divisions, heads of functions such as R & D, etc., if both merging firms had these positions prior to the merger. The choice of the right person for the right

job is important. Such choices are based on tribal affiliations of the acquirer. Accent on merit is as important as the integrity of the process of managerial appointments.

· Management and workforce redundancy

In merger with its emphasis on efficiency savings through consolidation of duplicate functions or production sites, head count reduction is perhaps inevitable. However, head count reduction should be driven not by legal minimalism but by transparently genuine concern for the welfare of the people being made redundant. Companies often arrange for counselling, training and outplacement programme to alleviate the distress to the employees.

· Aligning performance evaluation and reward system

The balance between basic compensation (salary) and performance-related compensation (bonuses, stock options) may differ between two firms, and altering the balance to introduce more pay-to-performance sensitivity may engender resentment and resistance. However, changing the performance evaluation and reward system may be a necessary element in evolving a new culture because of their power to motivate staff and influence their behaviour.

· Key people retention

The uncertainty during a merger often leads senior managers to end it by leaving. Key people retention may be achieved through devices such as ‘golden hand cuffs’ (i.e., special bonuses or stock options or generous earn-outs etc). Often these people probably already wealthy may be empted to stay not with offers of more wealth but with positions of power and prestige that reflect their merit.

5.10 Problems in integration

The post-merger integration problems may arise from three possible sources:

· Determinism

Determinism is a characteristic of managers who believe that the acquisition blue print can be implemented without change and without regard for ground realities. They tend to forget that the blueprint was based on incomplete information. They do not consider that the implementation process is one where mutual learning between the acquirer and the acquired takes place and the process is especially adaptive in the light of this learning. Determinism leads to a rigid and unrealistic programme of integration and builds up hostility from managers. Such hostility leads to a non-co-operative attitude among managers and vitiating the atmosphere for a healthy transfer.

· Value Destruction

At personal level, the acquisition is value destroying for managers, if integration experience is contrary to their expectations. Value destruction may take the form of reduced remuneration in

the post acquisition firm or loss of power or of symbols of corporate status. For instance, the target firm managers may be given positions which fail to acknowledge their seniority in the pre acquisition target or their expertise. Where there is perceived value destruction of this kind, again smooth integration is not possible.

· Leadership Vacuum

The management of the interface requires tough and enlightened leadership from the top managers of the acquirer. Where the integration task is delegated to the operational managers of the two firms without visible involvement or commitment of the top management, the integration process can degenerate into mutual frictions. The top management must be intervened to avoid frictions that arise between groups of managers in the integration process.

· Information system (IS) integration

IS integration is a critical, but often neglected part of the overall integration programme. IS compatibility between acquirer and the acquired companies must be seriously considered even at the pre-deal stage. This is particularly important in mergers that seek to leverage each company’s information on customers, markets or processes with that of the other company as in banking and insurance merger, or in the merger of two banks. The compatibility of IS must be considered as thoroughly as any strategic, operational, organizational or political issue. IS integration in merger depends on a mix of both technical and organizational factors. Organizational compatibility must be considered alongside IS synergies.

5.11 Five rules for integration process

Peter Drucker provides the following five rules for the integration process:

· Ensure that the acquired firm has ‘common core unit’ with the parent. They should have overlapping characteristics like shared technology or markets to exploit synergies.

· The acquirer should think through what potential skill contribution it can make to the acquiree

· The acquirer must respect the products, markets and customers of the acquired firm.

· The acquirer should provide appropriately skilled top management for the acquiree within a year

· The acquirer should make several cross-company promotions within a year.

5.12 Managerial Challenges

· Clearly, an urgent need to rationalize, streamline, and eliminate duplication will drive the first weeks and months of post-merger integration. However, rationalization increases only the potential of the new company to yield greater value to its shareholders. It is one thing to design a new architecture and relationships on paper, quite another to bring them to life. No matter how

visionary the leader or competent the financier, each quickly learns that synergy cannot be generated solely from above – or realized simply by reducing headcount. Synergy requires the engagement and commitment of the whole organization. And therein lies the challenge.

· Most mergers are seen as times of chaos, fear, uncertainty, distraction, limitation, and dehumanization. The process is painful, and the results costly. When knowledge capital is lost through turnover of key individuals during a merger, when pride in the company and pride in one’s work are eroded through ill treatment at the hands of merger managers, when innovations are abandoned in favour of outdated practices just because one group is considered the “home team” and the new one deemed expendable, the webs that make the organization work break down and fall apart. When people stop caring, they lose interest in making business processes better. If they are not asked for their opinions, they have no means or motivation to tell the new system designers the hidden secrets of success and supportability.

· When selection processes do not seem fair and open, good people do not step forward – they walk away to take on new challenges elsewhere. These are not the conditions under which synergistic growth is likely. Fortunately, it doesn’t have to be this way. Managed in a holistic way, a merger can become an opportunity for people to learn, grow, and have a voice. Shared visioning activities and cross-company merger project teams can provide opportunities to meet new people and gain new perspectives and skills. Work-redesign processes give functional team members the chance to innovate, to show what they are capable of.

· Changes in organizational design or expansions in job scope offer many the challenge of taking on a new job, function, or level of responsibility – even, perhaps, moving closer to fulfilling some of their own, long-held aspirations for their work and their lives.

· Another challenge is that merger managers must juggle strategy, organization, staffing, systems, and culture, on top of keeping the day-to-day business performing. They feel pressure most urgently to demonstrate the wisdom and value of the investment decision by recovering the costs of the merger and boosting short-term and intermediate-term share price performance. So they focus on restructuring to realize the benefits of creating economies of scale, streamlining operations, capitalizing on product and market synergies, and spinning off non-core businesses.

· Most post-merger implementation plans seem to assume that if the merger’s financial priorities are thoroughly addressed, the human foundation will take care of itself. The synergy created by a successful merger is a dynamic energy. It arises from ongoing encounters between people and groups with different world views, knowledge, and experience, and it transforms the whole into something greater than the sum of its parts. But it never happens automatically. To harness the valuable differences between two merging companies and convert them into opportunities for innovation, performance excellence, and market leadership, the merging companies need to take a very careful look at the entire merger process.


1. What are the five human resources management issues confronted in merger integration?

__________________________________________________________________________________________________________________

2. What are the three possible sources of problems in integration?

__________________________________________________________________________________________________________________

5.13 Summary

To sum up, post-merger integration is a wider term which encompasses the reorganization of each and every aspect of the company’s functional area to achieve the objectives planned and aimed at merger and acquisition. Depending on the type of acquisition made, its strategic rationale and value creation logic, the companies involved in the merger have to be integrated in varying degrees. It involves integration of systems, processes, procedures, strategy, reporting systems etc. Integrating organizations may require people to change their mindset, cultures and behaviours. Cultural issues have to be addressed during integration process. Integration implies a full consolidation of the operations, organization and culture of both firms over time.


1. What are the factors to be considered in post-merger integration?

2. What is capability transfer? What are the different capabilities that may be transferred or shared in a merger?

3. What is strategic autonomy? Why is it important to acquisitions integration process?

4. What is the importance of organizational, political and cultural issues to integration?

5. What are the human resources management issues confronted in merger integration process?

6. What are the problems of post-merger integration? How can integration be achieved?

5.15 Answer to SAQs and TQs

SAQs




II 1. Refer to Section 5.5



III 1. Refer to Section 5.10


TQs









.

MF0002-Unit-06-Accounting for Amalgamation Unit 6 Accounting for Amalgamation

Structure

6.1 Introduction

Objectives

6.2 Definitions

6.3 Types of Amalgamation

6.4 Methods of Accounting for Amalgamations

Pooling Interest Method

The Purchase Method

Different features of pooling and purchase methods

6.5 Consideration


6.6 Treatment of Reserves on Amalgamation

6.7 Treatment of Goodwill arising on Amalgamation

6.8 Balance of Profit and Loss Account

6.9 Treatment of Reserves specified in a Scheme of Amalgamation

6.10 Amalgamation after the Balance Sheet Date

6.11 Accounting treatment of share premium, goodwill and other profits

6.12 Accounting problems in assets transfer

6.13 Accounting practices of merger and amalgamation

Books of accounts of vendor company

Books of accounts of Purchasing company


6.14 Summary



6.1 Introduction

This unit explains the accounting process involved in merger and acquisition. It explains two important methods of accounting for amalgamations. You will understand the various methods of calculation of purchase consideration and also basis of calculation of exchange ratio. This unit also focuses on basic accounting aspects and treatment relating to amalgamation of companies and various accounting procedures of amalgamation under Indian Companies Act 1956 as well.

Objectives


· Discuss the accounting procedure for amalgamations

· Describe the treatment of any resultant goodwill or reserves

· Discuss the methods of accounting for amalgamation

· Discuss about the procedure laid down under Indian Companies Act of 1956

Accounting for mergers or takeovers shall depend on the nature of transaction. Takeovers and mergers both are to be treated differently in books of accounts. Because in merger the main issues which deserve attention are: continuity of the business of the target company by the acquirer company; equity voting to be held by the shareholder of merger company; whereas in takeovers, the acquirer company treats the acquired company as an investment.

Accounting Standard (AS) 14 issued by the Council of the Institute of Chartered Accountants of India deals with ‘Accounting for Amalgamations’. This standard will come into effect in respect of accounting periods commencing on or after 1.4.1995 and will be mandatory in nature. The Guidance Note on Accounting Treatment of Reserves in Amalgamations issued by the Institute in 1983 will stand withdrawn from the aforesaid date. This statement deals with accounting for amalgamations and the treatment of any resultant goodwill or reserves. This statement is directed principally to companies although some of its requirements also apply to financial statements of other enterprises. This statement does not deal with cases of acquisitions which arise when there is a purchase by one company (referred to as the acquiring company) of the whole or part of the shares, or the whole or part of the assets, of another company (referred to as the acquired company) in consideration for payment in cash or by issue of shares or other securities in the acquiring company or partly in one form and partly in the other. The distinguishing feature of an acquisition is that the acquired company is not dissolved and its separate entity continues to exist.

6.2 Definitions

The following terms are used in this statement with the meanings specified:

a) Amalgamation means an amalgamation pursuant to the provisions of the Companies Act, 1956 or any other statute which may be applicable to companies.

b) Transferor Company means the company which is amalgamated into another company.

c) Transferee Company means the company into which a transferor company is amalgamated.

d) Reserve means the portion of earnings, receipts or other surplus of an enterprise (whether capital or revenue) appropriated by the management for a general or a specific purpose other than a provision for depreciation or diminution in the value of assets or for a known liability.

e) Amalgamation in the nature of merger is an amalgamation which satisfies all the following conditions.

i) All the assets and liabilities of the transferor company become, after amalgamation, the assets and liabilities of the transferee company.

ii) Shareholders holding not less than 90% of the face value of the equity shares of the transferor company (other than the equity shares already held therein, immediately before the amalgamation, by the transferee company or its subsidiaries or their nominees) become equity shareholders of the transferee company by virtue of the amalgamation.

iii) The consideration for the amalgamation receivable by those equity shareholders of the transferor company who agree to become equity shareholders of the transferee company is discharged by the transferee company wholly by the issue of equity shares in the transferee company, except that cash may be paid in respect of any fractional shares.

iv) The business of the transferor company is intended to be carried on, after the amalgamation, by the transferee company.

v) No adjustment is intended to be made to the book values of the assets and liabilities of the transferor company when they are incorporated in the financial statements of the transferee company except to ensure uniformity of accounting policies.

f) Amalgamation in the nature of purchase is an amalgamation which does not satisfy any one or more of the conditions specified in sub-paragraph (e) above.

g) Consideration for the amalgamation means the aggregate of the shares and other securities issued and the payment made in the form of cash or other assets by the transferee company to the shareholders of the transferor company.

h) Fair value is the amount for which an asset could be exchanged between a knowledgeable willing buyer and a knowledgeable willing seller in an arm’s length transaction.

i) Pooling of interests is a method of accounting for amalgamations, the object of which is to account for the amalgamation as if the separate businesses of the amalgamating companies were intended to be continued by the transferee company. Accordingly, only minimal changes are made in aggregating the individual financial statements of the amalgamating companies.

6.3 Types of Amalgamation

Generally speaking, amalgamations fall into two broad categories.

· In the first category are those amalgamations where there is a genuine pooling not merely of the assets and liabilities of the amalgamating companies but also of the shareholders’ interests and of the businesses of these companies. Such amalgamations are those which are in the nature of ‘merger’ and the accounting treatment of such amalgamations should ensure that the resultant figures of assets, liabilities, capital and reserves more or less represent the sum of the relevant figures of the amalgamating companies.

· In the second category are those amalgamations which are in effect a mode by which one company acquires another company and, as a consequence, the shareholders of the company which is acquired normally do not continue to have a proportionate share in the equity of the combined company, or the business of the company which is acquired is not intended to be continued. Such amalgamations are amalgamations in the nature of ‘purchase’.

An amalgamation is classified as an ‘amalgamation in the nature of merger’ when all the conditions listed in paragraph 3(e) are satisfied. There are, however, differing views regarding the nature of any further conditions that may apply. Some believe that, in addition to an exchange of equity shares, it is necessary that the shareholders of the transferor company obtain a substantial share in the transferee company even to the extent that it should not be possible to identify any one party as dominant therein. This belief is based in part on the view that the exchange of control of one company for an insignificant share in a larger company does not amount to a mutual sharing of risks and benefits.

Others believe that the substance of an amalgamation in the nature of merger is evidenced by meeting certain criteria regarding the relationship of the parties, such as the former independence of the amalgamating companies, the manner of their amalgamation, the absence of planned transactions that would undermine the effect of the amalgamation, and the continuing participation by the management of the transferor company in the management of the transferee company after the amalgamation.

6.4 Methods of Accounting for Amalgamations

There are two main methods of accounting for amalgamations:

a) the pooling of interests method

b) the purchase method

The use of the pooling of interests method is confined to circumstances which meet the criteria referred to in paragraph 3(e) for an amalgamation in the nature of merger.

The objective of the purchase method is to account for the amalgamation by applying the same principles as are applied in the normal purchase of assets. This method is used in accounting for amalgamations in the nature of purchase.

6.4.1 Pooling Interest Method

Under the pooling of interests method, the assets, liabilities and reserves of the transferor company are recorded by the transferee company at their existing carrying amounts.

If, at the time of the amalgamation, the transferor and the transferee companies have conflicting accounting policies, a uniform set of accounting policies is adopted following the amalgamation. The effects on the financial statements of any changes in accounting policies are reported in accordance with Accounting Standard (AS) 5, ‘Prior Period and Extraordinary Items and Changes in Accounting Policies’.

6.4.2 The Purchase Method

Under the purchase method, the transferee company accounts for the amalgamation either by incorporating the assets and liabilities at their existing carrying amounts or by allocating the consideration to individual identifiable assets and liabilities of the transferor company on the basis of their fair values at the date of amalgamation. The identifiable assets and liabilities may include assets and liabilities not recorded in the financial statements of the transferor company.

Where assets and liabilities are restated on the basis of their fair values, the determination of fair values may be influenced by the intentions of the transferee company. For example, the transferee company may have a specialized use for an asset, which is not available to other potential buyers. The transferee company may intend to effect changes in the activities of the transferor company which necessitates the creation of specific provisions for the expected costs, e.g. planned employee termination and plant relocation costs.

6.4.3 Different features of pooling and purchase methods

A comparison of the two methods can be summarized as under:

Point of Difference Pooling Method Purchase MethodApplicability Amalgamation as merger Amalgamation as purchase

of assetsTreatment of financial data

Total incorporation of figures. Aggregation of financial data relating to assets, liabilities, reserves and P & L account of transferor into transferee company

Partial incorporation of figures: only net assets are incorporated in books of transferee company. Reserves and P & L A/c are not incorporated

Goodwill and Capital Reserves

No goodwill or capital reserve. The difference bet-ween purchases considera-tion and value of assets is adjusted in general reserves

Goodwill or capital reserves are given adjustment

Amalgamation adjustment A/c

No such account is necessary It is necessary as explained above

6.5 Consideration

The consideration for the amalgamation may consist of securities, cash or other assets. In determining the value of the consideration, an assessment is made of the fair value of its elements. A variety of techniques are applied in arriving at fair value. For example, when the consideration includes securities, the value fixed by the statutory authorities may be taken to be the fair value. In case of other assets, the fair value may be determined by reference to the market value of the assets given up. Where the market value of the assets given up cannot be reliably assessed, such assets may be valued at their respective net book values.

Many amalgamations recognize that adjustments may have to be made to the consideration in the light of one or more future events. When the additional payment is probable and can reasonably be estimated at the date of amalgamation, it is included in the calculation of the consideration. In all other cases, the adjustment is recognized as soon as the amount is determinable [see Accounting Standard (AS) 4, Contingencies and Events Occurring after the Balance Sheet Date].

The amount of purchase consideration is determined by the following methods:

· Lump-sum Method

When the acquiring company agrees to pay a lump-sum amount to the target company, it is called lump-sum payment of purchase consideration.

· Payment Method

Under this method, all payments made by the acquiring company to the acquired company are added.

Cash xxx

Shares xxx

Debentures xxx

Liquidation Expenses xxx

Purchase consideration XXX

In this case, the value of assets and liabilities taken over by the purchasing company need not be taken into account. Only payments are to be added to arrive at the amount of purchase consideration.

· Net Asset Method

The purchase consideration under this method is determined as follows:

Assets taken over at agreed values xxx

Less: Liabilities taken over at agreed values xxx

Purchase Consideration xxx

Add: Liquidation expenses agreed to be paid by acquiring company xxx

Total Purchase Consideration XXX

The above amount of purchase consideration is discharged by the purchasing company as follows:

Cash xxx

Shares xxx

Debentures xxx

Purchase consideration XXX

· Value of shares methods

Under this method, the purchase consideration is calculated with reference to the value of shares (Net Asset or Market or capitalization or fair value) of two companies involved.


1. Under the purchase of interests method, the assets, liabilities and reserves of the transferor company are recorded by the transferee company at their existing carrying amounts – Right or Wrong

2. ……………… is the amount which is paid by the purchasing company for the purchase of the business of the vendor company

3. Under net payment method, purchase consideration is calculated by adding the various payments made by the purchasing company – Right or Wrong

6.6 Treatment of Reserves on Amalgamation

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’, the identity of the reserves, other than the statutory reserves, is not preserved. 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. If the result of the computation is positive, the difference is credited to Capital Reserve.

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.

6.7 Treatment of Goodwill arising on 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 amortized to income on a systematic basis over its useful life. Due to the nature of goodwill, it is frequently difficult to estimate its useful life with reasonable certainty. Such estimation is, therefore, made on a prudent basis. Accordingly, it is considered appropriate to amortize goodwill over a period not exceeding five years unless a somewhat longer period can be justified.

Factors which may be considered in estimating the useful life of goodwill arising on amalgamation include:

· the foreseeable life of the business or industry;

· the effects of product obsolescence, changes in demand and other economic factors;

· the service life expectancies of key individuals or groups of employees;

· expected actions by competitors or potential competitors; and

· legal, regulatory or contractual provisions affecting the useful life.

6.8 Balance of Profit and Loss Account

In the case of an ‘amalgamation in the nature of merger’, the balance of the Profit and Loss Account appearing in the financial statements of the transferor company is aggregated with the corresponding balance appearing in the financial statements of the transferee company. Alternatively, it is transferred to the General Reserve, if any.

In the case of an ‘amalgamation in the nature of purchase’, the balance of the Profit and Loss Account appearing in the financial statements of the transferor company, whether debit or credit, loses its identity.

6.9 Treatment of Reserves specified in a Scheme of Amalgamation

The scheme of amalgamation sanctioned under the provisions of the Companies Act, 1956 or any other statute may prescribe the treatment to be given to the reserves of the transferor company after its amalgamation. Where the treatment is so prescribed, the same is followed.

6.10 Amalgamation after the Balance Sheet Date

When an amalgamation is effected after the balance sheet date but before the issuance of the financial statements of either party to the amalgamation, disclosure is made in accordance with AS 4, ‘Contingencies and Events Occurring After the Balance Sheet Date’, but the amalgamation is not incorporated in the financial statements. In certain circumstances, the amalgamation may also provide additional information affecting the financial statements themselves, for instance, by allowing the going concern assumption to be maintained.

6.11 Accounting treatment of share premium, goodwill and other profits

· Share Premium account

Share premium is difference between the sale price of the share and its par value. Section 78 of the Companies Act, 1956 empowers a company to issue shares at a premium. A sum equal to the aggregate amount or value of the premium on those shares shall be transferred to an account to be called ‘the share premium account’. Share premium account cannot be distributed to shareholders except by the way of bonus issue, writing of preliminary expenses other expenses incurred or discount allowed on any issue of shares or debentures or to provide premium payable on the redemption of redeemable preference shares or debentures. The board of the acquiring company shall fix up price of shares issued in three possible manners: at nominal value of shares,

at price equal to market price, at price equal to book price or the current valuation reflecting the value of the consideration. In merger, the shares acquired by the company’s shareholders are issued at nominal value whereas in takeovers it is the market value at which such shares are issued by the acquiring company.

· Goodwill

Goodwill represents the difference between the value of the assets of the acquired company at the date of acquisition by acquiring company and the cost in investments for acquired company. It is an intangible asset and is available for a takeover of going concern.

· Other Profits

The retained earnings and capital reserves of acquired company in the year before acquisition may be passed on to the acquiring company on merger which requires treatment in accounts of the acquiring company as pre-acquisition profit. The question arises whether these profits could be taken as current income of the acquiring company or be treated as capital profit. These accounting problems solicit appropriate solutions in the light of the existing accounting practices and the tax laws. Similarly, the problems of accounting remain to be settled in respect of: profit in the year of acquisition of the company being acquired, profit of the company on consolidation after merger and post acquisition accounts etc.

6.12 Accounting problems in assets transfer

Various assets are taken over in merger against total consideration paid for their acquisition. To give accounting treatment to different assets acquired, the main difficulty arises regarding depreciation for each individual asset. Therefore, a decision has to be taken to treat different assets at book value, market value or replacement value with care of legal aspects involved therein.

6.13 Accounting practices of merger and amalgamation

Once the purchase consideration has been arrived at and all the legal procedure and formalities are over, then the accounting process begins. The target company (vendor) is taken as vendor whose books of accounts are to be closed as the business goes into liquidation. The acquirer (purchases) assumes the status as purchaser in whose books of account the acquisition is recorded as purchase transaction. The following are the accounting practices of mergers and amalgamations:

6.13.1 Books of accounts of vendor company

The following are the journal entries passed in the books:

· Transfer of assets

All assets which the acquiring company is taking over at book value are transferred to Realization Account

Realization A/c Dr.

To All Assets taken over (individually at book value)

· Transfer of liabilities

All liabilities take which the acquiring company is taking over are transferred to Realization Account.

All Liabilities A/c (individually at book value) Dr.

To Realization A/c

· Purchase consideration value proposed

The purchase consideration to be received by the transfer company should be transferred to Realization Account

Purchasing Company A/c Dr.

To Realization A/c

· Receipt of the purchase consideration money

Bank A/c Dr.

Equity Share in Purchasing Company Dr.

Debenture in Purchasing Company A/c Dr.

To Purchasing Company

· Assets or Liabilities not taken over

Sometimes, the transferee does not take over some of the assets or liabilities. Such assets are to be sold outsider

Cash or Bank Account Dr.

To Asset Account

Liabilities are to be redeemed

Liabilities account Dr.

To Bank or Cash Account

Profit or Loss if any on sale of asset or redemption of liabilities should be transferred to Realization.

· Liquidation Expenses

i) When the Vender Company is to bear:

Realization A/c Dr.

To Cash/Bank A/c

ii) When it is to be borne by the purchasing Company and included in the Purchase Consideration

Realization A/c Dr.

To Cash / Bank A/c

iii) When expenses are paid by purchasing company in addition to Purchase Consideration

Purchasing Company A/c Dr.

To Cash / Bank A/c

Cash / Bank A/c Dr.

To Purchasing Company A/c

iv) If they are incurred directly by the purchasing company and not handed over to the liquidator of the vender company, no entry is required.

· Payment to Debenture and Preference Shareholders

Debenture / Pref. Share Capital A/c Dr.

To Debenture / Pref. Share – Holders A/c

In case any excess amount (premium) to be paid

Realization A/c Dr.

Debenture / Pref. Share – Holders A/c

If they agree to accept less amount (Discount), the above entry has to be reversed

· Payment to equity shareholders of transferor company

i) Profit or Loss in Realization A/c has to be transferred to Equity Shareholders A/c. If there is profit the entry would be:

Realization A/c Dr.

Equity Share Holders A/c

The above entry would be revered in case there is loss

ii) For transfer of Equity Share Capital and accumulated Profits:

Equity Share Capital A/c Dr.

P & L A/c Dr.

General Reserve A/c Dr.

Capital Reserve A/c Dr.

Any other Accumulated Profit Dr.

To Equity Share Holders A/c

iii) For transfer of P & L A/c Debit Balance and Fictitious Asset

Equity Shareholders A/c Dr.

To P & L A/c

To Preliminary Expenses A/c

iv) For paying off Equity Shareholders

Equity Shareholders A/c

To Cash A/c

To Shares in Purchasing Company

6.13.2 Books of accounts of Purchasing company

The following are the journal entries passed in the books:

· Purchase Consideration Agreed upon

Business Purchase A/c Dr.

To Liquidator of Vender Company

· For Assets and liabilities taken over

Assets A/c Dr. (individually with agreed value)

To Liabilities A/c (individually with agreed value)

To Business Purchase A/c

i) In case of purchase consideration is less than net assets (assets less liabilities) taken over, the difference should be treated as capital profit and to be credited as Capital Reserve in the above entry

ii) In case purchase consideration is more than net assets, the difference should be treated as capital loss and to be debited to Goodwill A/c in the above entry

· For payment of Purchase Consideration

Liquidator of Vendor Company A/c Dr.

To Cash/Bank A/c

To Share Capital A/c

To Share Premium A/c (if any)

To Debenture A/c

· For payment of Liquidation Expenses of Vendor Company

i) If it is included in the Purchase consideration, no entry is required

ii) If it is not included in the Purchase consideration, and paid separately,

Goodwill A/c Or Capital Reserve A/c Dr.

To Cash / Bank A/c

· For set-off inter company Owings

i) Debtors and Bill Receivables of Purchasing Company may represent Creditors or Bill Payable of Vendor company. For set-off mutual debts:

Sundry Creditors or Bills Payable A/c Dr.

To Sundry Debtors or Bill Receivables A/c

ii) The stock of Vendor Company may consist of goods sold by purchasing company at a profit. Similarly stock of purchasing company may consist of goods sold by Vendor Company at profit. For eliminating unrealized profit on such stocks:

Goodwill or Capital Reserve A/c Dr.

To Stock A/c

No entries are required for the above two cases in the books of vendor company as all the accounts are closed therein.

· Inter Company Holdings

There may be three situations with reference to inter company holdings:

i) Shares held by the purchasing company in the vender company:

In this case, the purchasing consideration is calculated ignoring the fact that some shares are held by the purchasing company and then has to be adjusted for the shares held by the purchasing company. Suppose A Ltd acquires the business of B Ltd on a valuation of Rs. 500000 and if A Ltd is holding 30% equity shares in B Ltd, the purchase consideration should be treated as only Rs. 350000 as 30% of Rs. 500000 or Rs. 150000 already belongs to A Ltd. But while recording the entries at the time of acquisition the amount representing cost of shares should be credited with the cost of such shares and then only goodwill or capital reserve should be ascertained.

ii) Shares held by the vender company in the purchasing company:

In this case when the assets of the vendor company are acquired by the purchasing company, the later company cannot purchase its own shares. The shares which are already held by the vendor company will be deducted from the shares to be given by the purchasing company to the vendor company. Vendor Company is required to revalue the shares in purchasing company. If there is any gain or loss, that should be transferred to realization account. Shares in purchasing company are not to be transferred to the realization account like other assets

iii) Shares held by both companies in each other

As the shares are held by both companies in each other, it becomes necessary to determine the value of share of both companies. The value of shares of one company is dependent on the value of the shares of the other company. The purchase consideration is to be calculated by way of

simultaneous equations, if it is on the basis of net assets or intrinsic value. If purchase consideration is on the basis of payment method, it will not pose any problem.


1. All the assets and liabilities taken over by the purchasing company should be transferred to Realization account in the books of Vendor’s book at its Current Market Value – Right or Wrong

2. Cost of liquidation of the vendor company agreed to be paid by the purchasing company is debited to ………………… in the books of latter company.

3. Accumulated losses in the vendor company should be transferred to……………

4. Accident Compensation Fund is a liability and should be closed by transferring it to Realization Account – Right or Wrong

Example I

A Ltd has decided to merge with B Ltd. The Balance Sheet in the summarized for each of the above companies is given below:

A Ltd

Liabilities include – Equity share capital Rs. 10,00,000; Reserve and Surplus Rs. 3,00,000; Sundry Creditors 2,00,000; Assets include Sundry fixed assets Rs. 8,00,000; 10%Debenture of B Ltd acquired at discount @ 5% Rs. 95,000; stock Rs. 4,00,000; Sundry Debtors Rs. 80,000; Cash at Bank Rs. 10,000; Bills Receivable Rs. 15,000. Total: 14,00,000

B Ltd

Liabilities include – Equity Share capital Rs. 25,00,000; Reserve and Surplus Rs. 7,00,000; Debentures: 8,00,000; Bills Payable Rs. 25,000; Sundry Creditors: 3,75,000 (Total: Rs. 44,00,000). Assets include: Sundry Fixed Assets: Rs. 28,00,000; Stock Rs. 11,00,000; Sundry Debtors: 1,00,000; Cash at Bank Rs. 20,000; Bills recoverable Rs. 80,000.

B Ltd. acquires the total business of A Ltd. for Rs. 13,00,000 by issue of Equity shares at par. In A Ltd’s Balance Sheet Rs. 20,000 due from B Ltd to A Ltd is included in Sundry Debtors and Rs. 50,000 due from B is included in Bills recoverable as B Ltd’s acceptances in favour of A Ltd.

You are required to prepare the Realization account, Equity Share holders Account in the books of A Ltd and Business Purchase A/c and A Ltd’s Liquidator A/c and summarized balance sheet of the amalgamated company after making adjustment of inter-company Owings.

Books of A Ltd

Realization Account

Dr. Amount Cr. AmountTo Fixed Assets 8,00,000 By Creditors 1,00,000To 10% Debentures in B Ltd 95,000 By B Ltd 14,00,000To Sundry Debtors 80,000 To Stocks 4,00,000 To Cash at Bank 10,000 To Bills receivable 15,000 To Equity Shareholders

(transfer of profit)

1,00,000

Total 15,00,000 Total 15,00,000

Equity Shareholders Account

Dr. Amount Cr. AmountTo Equity Shares in B Ltd

14,00,000 By Equity share capital a/c 10,00,000

By Reserves and Surplus 3,00,000 By Realization A/c (profit) 1,00,000Total 14,00,000 Total 14,00,000

Books of B Ltd

Business Purchase Account

Dr. Amount Cr. AmountTo A Ltd’s Liquidator A/c

14,00,000 By Fixed Assets 8,00,000

To Sundry Creditors 1,00,000 By Investments in Debentures

95,000

By Stocks 4,00,000 By Sundry Debtors 80,000 By Cash at Bank 10,000 By Bills Receivables 15,000 By Goodwill 1,00,000Total 15,00,000 Total 15,00,000

A Ltd’s Liquidator Account

Dr. Amount Cr. AmountTo Equity Share Capital 14,00,000 By Business Purchase 14,00,000

A/c A/cTotal 14,00,000 Total 14,00,000

Adjustment of Inter-Company Owings

1. Bills Payable A/c Dr. 25,000

To Bills Receivables A/c 25,000

(Cancellation of bills earlier accepted in favour of A Ltd now received as part of A Ltd.’s business)

2. Sundry Creditors A/c Dr. 50,000

To Sundry Debtors A/c 50,000

(B Ltd’s acceptance in favour of A Ltd eliminated)

3. 10% Debenture A/c Dr. 1,00,000

To Investment in Debenture A/c 95,000

To Goodwill 5,000

(Debenture held as investment to A Ltd cancelled. Goodwill a/c reduced by excess amount paid over cost)

Balance Sheet of B Ltd (after amalgamation)

Liabilities Amount Assets AmountEquity Share Capita 39,00,000 Goodwill 1,00,000

Less 5,000

Reserves and Surplus 7,00,000 Fixed Assets 28,00,000

Plus 8,00,000

36,00,000

Debenture 8,00,000

Less: 1,00,000

7,00,000 Stocks 15,00,000

Sundry Creditors

3,75,000

Less 50,000

3,25,000 Sundry Debtors

4,00,000

Less 50,000

3,50,000

Bills Receivables 80,000 55,000

Less 25,000 Cash at Bank 25,000Total 56,25,000 Total 56,25,000

Example II

The following are the Balance Sheet of ST Ltd and SM Ltd as at 31st December 2006.

Liabilities ST Ltd SM Ltd Assets ST Ltd SM LtdShare Capital (Face Value Rs. 10 each)

150000 120000 Fixed Assets:

Cost Less Dep.

140000 75000

Reserves 95000 10000 Current Assets: 10% Debentures - 20000 Trade Debtors 30000 50000Current Liabilities:

Trade Creditors

47000 32000 Balance at Bank

80000 10000

Total 292000 182000 Total 292000 182000

ST Ltd agreed to absorb SM Ltd as on 31st December 2006 on the following terms:

1. ST Ltd agreed to repay 10% debenture of SM Ltd

2. ST Ltd to revalue its Fixed Assets at Rs. 195000 to be incorporated in the books

3. Share of both companies to be valued on net assets basis after considering Rs. 50000 towards value of goodwill of SM Ltd

4. The cost of absorption of Rs. 3000 are met by ST Ltd

You are required to:

a) Calculate the ratio of exchange

b) Give journal entries in the books of Strong Ltd

Solution:

Calculation of Exchange Ratio

Assets & Liabilities ST Ltd SM LtdA. Fixed Assets (Cost less 195000 75000

Depreciation)

Goodwill

Stock

Trade Debtors

Bank Balance

-

42000

30000

80000

50000

47000

50000

10000Total Assets 347000 232000Less:

B. 10% Debentures

Trade Creditors

-

47000

20000

32000

Total Liabilities 47000 52000Net Assets (A-B) 300000 180000No. of Shares 15000 12000Intrinsic Value of Shares: 300000/15000

= Rs. 20

180000/12000

= Rs. 15

ST Ltd will issue shares to shareholders of SM Ltd.,

180000/20 = 9000 shares issued to shareholders of 12000 shares.

Ratio of exchange = 9 : 12

9000 shares at Rs. 20 each = Rs. 180000

That is 9000 shares at Rs. 10 premium on each share

Journal entries in the books of ST Ltd

1. Business Purchase A/c Dr. Rs. 180000

To Liquidators of SM Ltd Rs. 180000

2. Fixed Asset A/c Dr Rs. 75000

Goodwill A/c Dr. Rs. 50000

Stock A/c Dr. Rs. 47000

Trade Debtor A/c Dr. Rs. 50000

Bank A/ Dr. Rs. 10000

To 10% Debentures A/c Rs. 20000

To Trade Creditors A/c Rs. 32000

To Business Purchase A/c Rs. 180000

3. Liquidator of SM Ltd A/c Dr. Rs.180000

To Share Capital A/c (9000×10) Rs. 90000

To Share Premium A/c (9000×10) Rs. 90000

4. Goodwill A/c Dr. Rs. 3000

To Bank Rs. 3000

Example III

ABC Ltd and XYZ Ltd carrying on similar business decided to amalgamate and for this purpose a new company being formed to take over assets and liabilities of both companies. For this, it is agreed that fully paid shares of Rs. 100 each shall be issued by the new company to the value of net assets of each of the old companies:

Balance Sheet of ABC Ltd as at 31st December 2006

Liabilities Rs. Assets Rs.Share Capital of Rs. 50 each 50000 Goodwill 5000General Reserve 20000 Land & Buldg 17000P & L A/c 3000 Plant & Machinery 24000Sundry Creditors 4000 Stock 24000Bills Payable 4000 Debtors 12000 Furniture & Fittings 5000 Cash at Bank 8000Total 81000 Total 81000

Balance Sheet of XYZ Ltd as at 31st December 2006

Liabilities Rs. Assets Rs.800 Eq. Shares of Rs. 50 each

40000 Goodwill 2000

Bank Overdraft 8000 Land & Bldg 10000Sundry Creditors 8000 Plant & Machinery 16000

Stock 7500 Furniture & Fittings 7500 Debtors 7000 Cash 300

Profit & Loss A/c 5700Total 56000 Total 56000

The following is the accepted scheme of valuation of the business of the two companies:

ABC Ltd

a. To provide reserve for bad debts at the rate of 5% on debtors

b. To write off Rs. 400 from stock; and

c. To write off 33.33% from plant and machinery

XYZ Ltd

a) To eliminate its goodwill and profit and loss account balance

b) To write off bad debts to amount of Rs. 1000 and to provide reserve of 5% on the balance of debtors

c) To write off Rs. 1400 from the value of stock

d) To write down plant and machinery @ 10%

You are required to compute purchase consideration and balance sheet of amalgamated company (AX Ltd)

Solution:

ABC Ltd XYX Ltd TotalGoodwill 5000 - 5000Land & Buldg 17000 10000 27000Plant & Machinery 16000 14400 30400Furniture & Fittings 5000 7500 12500Stock 9600 6100 15700Debtors 12000 6000 18000Cash 8000 300 8300Total Assets (A) 72600 44300 116900Less: RBD Sundry Creditors

Bills Payable Total Liabilities (B) 8600 16300 24900Purchase Consideration (A-B) 64000 28000 92000

ABC Ltd receives 640 shares of Rs. 100 each = 64000

XYZ Ltd receives 280 shares of Rs. 100 each = 28000

Total 920 shares of Rs. 100 each = 92000

Balance Sheet of AX Ltd as at 31st December 2006

Liabilities Rs. Assets Rs.Share Capital:

920 Eq.Shares of Rs. 100 each

92000 Fixed Assets:

Current Liabilities:

Sundry Creditors

Bills Payable

Bank Overdraft

12000

4000

8000

Goodwill

Land & Buildings

Furniture & Fittings

Plant & Machinery

5000

27000

12500

30400 Current Assets:

Stock

Debts: 18000

Less: RBD 5% 900

Cash & Bank Balance

15700

17100

8300

Total 116000 Total 116000

6.14 Summary

Accounting rules may influence not only the presentation of post-combination performance, but also the financial structure of the deal resulting in the combination. In this unit, we have discussed the accounting rules for reporting mergers and acquisitions. Essentially these rules are concerned with: the valuation of the consideration paid by the acquirer, the valuation of the assets and the estimation of goodwill and the treatment of goodwill. Goodwill is often a large cost in many acquisitions and reflects the target company’s competitive advantage and future growth opportunities. Choice of accounting method for a particular business combination depends upon the choice of payment method which has an impact on post acquisition performance measure.


1. Differentiate between the pooling and purchase methods of accounting for amalgamation.

2. What entries should be passed in the books of a company that goes into liquidation for the purpose of amalgamation or absorption?

3. When the purchase price exceeds the net value of the business how is the difference dealt with?

4. Explain accounting treatment with regard to inter-company holdings under different situations.

5. ABC company Ltd is agreed to acquire the business of XYZ Ltd as on 31st December 2006. The summarized Balance Sheet of XYZ Ltd on that date was under:

Liabilities Rs. Assets Rs.Share Capital in fully paid shares of Rs. 10 each

300000 Goodwill 50000

General Reserve 85000 Land & Bldgs & Machinery

320000

Profit & Loss A/c 55000 Stock in trade 840006 % Debenture 50000 Debtors 18000Creditor 10000 Cash and Bank Balance 28000Total 500000 Total 500000

The consideration payable by ABC Ltd was agreed upon as follows:

i) Cash payment equivalent to Rs. 2.50 for every share of Rs. 10 in XYZ Ltd

ii) Issue of 45000 (Rs. 10) shares full paid in ABC Ltd having an agreed value of Rs. 15 per share

iii) Issue of such an amount of fully paid 5% debentures of ABC Ltd at 96% as is sufficient to discharge the 6% Debentures of XYZ Ltd at a premium of 20%

iv) The director to ABC Ltd valued land, building and machinery at Rs. 600000; the stock in trade at Rs 71000 and the debtors at their book value subject to an allowance of 5% to cover doubtful debts. The cost of liquidation of XYZ Ltd ws Rs. 2500.

ABC Ltd also issued to public 5000 shares of Rs. 10 each at Rs. 15 per share. The shares were fully subscribed and paid for.

You are required to prepare ledger accounts in the books of XYZ Ltd and prepare opening Balance Sheet of ABC Ltd after acquisition.


SAQs

I 1. Wrong

2. Purchase Consideration

3. Right

SAQs II

1. Wrong

2. Goodwill or Capital Reserve

3. Equity Share Holders A/c

4. Wrong

TQs





5. As below

In the books of XYZ Ltd

1. Computation of Purchase Consideration

Cash (30000 x Rs. 2.50) Rs. 75000

Shares (45000x Rs. 15) Rs. 675000

5% Debentures ( 50000+20% premium) Rs. 60000

(625 Debtures x100x(96/100)

Total Rs. 810000

2. Realization A/cTo Sundry Assets 500000 By Creditors 10000

To Debentureholders ( 20% of 50000) 10000By ABC Ltd (P.C.) 810000

To Cash (Cost of Liquidation) 2500To Equity Shareholders A/c (Profit) 307500Total 820000 Total 820000

3. Share Holders A/c

To Shares of ABC Ltd 675000By Share Capital A/c 300000

To Cash A/c 72500 By General Reserve 85000By P & L A/c 55000By Realization A/c 307500


4. ABC LtdTo Reailzation A/c 810000 By Cash 75000

By Shares in ABC Ltd 6750005% Debentures 60000


5. Debenture Holders A/cTo 5% Debentures in A BC Ltd 60000 By Debenture A/c 50000

Realization 10000Total 60000 Total 60000

6. Cash A/c To ABC Ltd 75000 By Realization A/c 2500

By Shareholders A/c 72500


In the books of ABC Ltd

1. Computation of Goodwill / Capital Reserve

Land, Bldg, Machinery 600000Stock-in-trade 71000Debtors 18000Cash at Bank 28000Less: Creditors 10000 Provision for RBD 900 10900Net 706100

Purchase Consideration 810000Goodwill 103000

2. Calculation of discount on issue of Debenture

625×100 = 62500 x (4/100) = Rs. 2500

3. Balance Sheet of ABC Ltd. as on 31-12-2006Equity Shares (5000 shares of Rs. 10 each) 500000 Goodwill 103900

Reserves & SurplusLand & Bldg & Machinery 600000

Share Premium( 50000×5) 250000 Stock in trade 710005% Debentures (625×100) 62500 Debtors 18000Creditors 10000 Less RBD 900 17100

Cash at Bank

(28000+75000-75000) 28000Discount on issue of Dbentures 2500




.

MF0002-Unit-07-Takeover Defenses Unit 7 Takeover Defenses

Structure

7.1 Introduction

Objectives

7.2 Types of takeover

7.3 Techniques of Raid


7.4 Defences against Takeover Bid

Advance preventive measures for Defences

Defence in face of Takeover Bid (Strategies)

Financial Defensive Measures


7.5 Anti Takeover amendments

7.6 Legal measures against Takeovers

7.7 Guidelines for Takeovers


7.8 Summary



7.1 Introduction

This unit would discuss defense against the acquisition by taking over the shares listed on any stock exchanges. It explains the concept and various forms of takeover device prevailing in the corporate world and the technique of corporate raid as well. You will also understand about the various defensive mechanisms that can be adopted to face the takeover raid, which in turn focuses on corporate strategies to avoid takeover raid and the legal measures against takeovers in India.

Objectives


· Discuss the various forms of takeover

· Describe the strategies to avoid takeover bid

· Discuss the defensive mechanisms to face takeover raid

· Discuss about the legal measures relating to corporate takeover

Takeover implies acquisition of controlling interest in a company by another company by taking over of the shares listed on any stock exchange. It does not lead to the dissolution of the company whose shares are being or have been acquired. It simply means a change of controlling

interest in a company through the acquisition of its shares by another group. The acquisition transactions in such shares are subject to the conditions of listing agreement. When a profit earning company takes over a financially sick company to bail it out, it is known as ‘bail out takeover’. Such takeovers are in pursuance of a scheme of rehabilitation approved by public financial institutions. Corporate takeovers in India are governed by the listing agreement with stock exchanges and the SEBI Substantial Acquisition of Shares and Takeover (SEBI Code) Code. The raid, bids and defences are the outcome of takeover. Corporates can stall such takeover through strategic defensive steps.

Mergers and takeovers are motivated and negotiated under the dominance of hostility and friendliness pressure and influences and are accordingly classified as friendly mergers and hostile mergers. The raids, bids and defences are the outcome of human moods. Corporate wars and offensive postures can be avoided and can be stalled through defensive steps.

7.2 Types of Takeover

There are two types of takeover bids as discussed below:

· Friendly Takeover

- Mergers and takeovers could be through negotiations with the consent of target company’s executives or Board of Directors. Such mergers are called friendly mergers. These mergers are negotiated mergers and if the parties do not reach an agreement during negotiations, the proposal stands terminated.

· Hostile takeover

- An acquirer company may not offer the target company the proposal to acquire its undertaking, but silently and unilaterally may pursue efforts to gain controlling interest in it against the wishes of the management. Such acts of acquirer are known as “raid” or “Take over raids”. These “raids” when organized in a systematic way are called “Takeover bids”. Both the raids and bids, lead to merger or takeover. A takeover is hostile when it is in the form of “raid”. The forces of competition and product provide strength and weakness to the rivals in the industry, trade or commerce.

7.3 Techniques of Raid

The acquirer can follow any of the following techniques to acquire control of another company:

· Takeover bid

A takeover bid gives impression of the intention reflected in the action of acquiring shares of a company to gain control of its affairs. A bid has been distinguished as below:

- Mandatory Bid

SEBI Takeover Regulations, 1997 contain provisions for making public announcement in the following cases viz:

i) For acquisitions of 15% or more of the share or voting rights.

ii) For acquiring additional shares or voting rights to the extent of 10% or more shares or voting rights in any period of 12 months, if such person already holds not less than 15% but not more than 75% of the shares or voting rights in a company.

iii) For acquiring shares or voting rights along with persons acting in concert, to exercise more than 75% of voting rights in a company.

The following are the conditions for Mandatory Bids:

i) Consideration offered should be in cash if in other securities in the same be undertaken for cash offer

ii) Offer price must be highest price which offer paid in past twelve months for the same class of shares.

- Partial Bids

Partial bid is understood when a bid made for acquiring part of the shares of a class of capital where the offeror intends to obtain effective control of the offeree through voting powers. Such bids are made for equity shares carrying voting rights. Partial bid is also understood when the offeror bids all the issued non-voting shares in a company. Regulation 12 of SEBI Takeover Regulations, 1997, it is necessary to make public announcement in accordance with the Regulations.

- Competitive Bid

This can be made by any person within 21 days of public announcement of the offer made by the acquirer. Such bid shall be made through public announcement in pursuance of provisions of regulation 25 of the SEBI take over regulation 1997. Such competitive bid shall be for the equal number of shares or more for which first offer was made.

· Tender Offer

In the earlier cases, negotiations were confined to the managements and boards of directors of the companies involved. However, the acquiring company can make a tender offer directly to the shareholders of the company it wishes to acquire.

A ‘tender offer’ is an offer to buy current shareholders’ stock at a specified price, often with the objective of gaining control of the company. The offer is often made by another company, usually for more than the present market price as an incentive to tender. Use of the tender offer

allows the acquiring company to bypass the management of the company it wishes to acquire and therefore serves as a treat in any negotiations with that management.

The tender offer can also be used when there are no negotiations, but when one company simply wants to acquire another. It is not possible to surprise another company with its acquisition, however, because the SEBI requires rather extensive disclosure. The primary selling tool is the premium that is offered over the existing market price of the stock. The tender offer itself is usually communicated through financial newspapers. Direct mailings are made to the shareholders of the company being bid for, if the bidder is able to obtain a list of shareholders.

Tender offer can be used in two situations:

· The acquiring co. may directly approach the target company for its takeover. If target company does not agree, then the acquiring co. may directly approach the shareholders by means of a tender offer.

· The tender offer may be used without any negotiations – like hostile takeover.

· The shareholders are generally approached through announcement in the financial press or through direct communication individually.

· They may or may not react to a tender offer.

· The reaction exclusively depends upon difference between the market price and offered price.

The tender offer may or may not be acceptable to the management of the target company. The management may use techniques to discourage its shareholders from accepting tender offer by announcing higher dividends, issue of bonus or rights shares etc., and make it difficult for the acquirer to acquire controlling shares.

The target company may also launch a counter publicity programme by informing that the tender offer is not in the interest of the shareholders. As per latest SEBI guidelines, public announcement is necessary as mandatory bid for tender offer to acquire the shares or control in the target company.


1. Distinguish between friendly takeover and hostile takeover

_________________________________________________________

_________________________________________________________

_________________________________________________________

2. List the various techniques of raid

_________________________________________________________

_________________________________________________________

3. Define Tender Offer

_________________________________________________________

_________________________________________________________

4. Under what situations, can tender offer be used?

_________________________________________________________

_________________________________________________________

7.4 Defenses against Takeover Bid

The following Defensive method measures can be adopted to face takeover bids:

7.4.1 Advance preventive measures for Defenses

The target company should take precautions when it feels that takeover bid is imminent through market reports or available information. Some of the advance measures are discussed below:

· Joint Holdings or Joint Voting Agreement

- Two or more major shareholders may enter into agreement for block voting or block sale of shares – rather than separate voting or sale of shares. This agreement is entered into, in collaboration with or without cooperation of target company’s directors who wish to exercise effective control of the company.

· Inter locking Share Holdings or Cross Share Holdings

- Two or more group companies acquire share of each in large quantity or one company may distribute share to the shareholders of its group company to avoid threats of takeover bids. If the interlocking of share holdings is accompanied by joint voting agreement, then the joint system of advance defense could be termed as “Pyramiding”, the safest device of defense.

· Issue of Block Shares to Friends and Associates

- The director’s issue block shares to their friends and associates to continue maintaining their controlling interest and as a safeguard to the threats of dislodging their control position. This may also be done by issue of right shares.

· Defensive Merger

- The directors of a threatened company may acquire another company for shares as a defensive measure to forestall two unwelcome takeover bids. For this purpose they put long block shares of their own company in the hands of shareholders of friendly to make their own company least attractive for takeover bid.

· Share with non-voting rights like preference shares

- Non-voting shares are a convenient method of providing for any desired adjustment of control on a merger of two companies.

· Convertible Securities

- It is necessary that the company’s capital structure should contain loan capital by way of debentures to make the company less attractive to corporate raiders.

· Dissemination to shareholders of favourable financial information.

- The dissemination of information about the company’s favourable features of operations and profitability go a long way in bringing the market price of share nearer to its true assets’ value. This type of behaviour on the part of the directors of the company elicit confidence of shareholders in their management and control which will in many ways help preventing any takeover bid to be in or to succeed.

· Making the possession of two company’s asset less attractive.

- This is possibly done by putting the assets outside the control of the shareholders by entering into various types of financial arrangements like sale and lease back, mortgage of assets to FIs for long term loans etc.

· Long Term services Assessments

- Directors having specialized skills in any specific technical field may enter into contract with the company with the specific approval of shareholders or the Companies Act 1956. The prospective bidder would not be attracted due to:

– Fear of non-co-operation by such director

– High compensation for terminating the agreement.

In view of these circumstances, the takeover game becomes unattractive to the bidders.

· Other preventive measures

1. Maintaining a fraction of share capital uncalled, which can be called up during any emergency like takeover bid or liquidation threat. Such strategy is known as “Rainy day call”

2. Companies may form group or cartel to fight against any future bid of takeover by way of pooling funds to use it to counter the takeover bids.

7.4.2 Defense in face of takeover bid (Strategies)

A company is supposed to take defensive steps when it comes to know that some corporate raider has been making efforts for takeover. For defense against takeover bid, two types of strategies could be as below:

· Commercial Strategies

1. Dissemination of favourable information among shareholders.

2. Step up dividend and update share price record (i.e. pushing up share price)

3. To revalue the fixed assets periodically and incorporate them in the balance sheet

4. Reorganization of Capital structure

5. Research based arguments should be prepared to show and convince the shareholders that the offer is incapable of managing the business.

6. Trace out the various discouraging commercial features of the functioning of the acquiring company (e.g. Pending cases in labour/consumer/tax tribunal)

· Tactical / Defense Strategies

1. The directors of the company may persuade their friends and relatives to purchase the shares of the offeree company

2. The board may make attempt to win over the shareholders through raising their emotional attachment, loyalty and patriotism etc.

3. Recourse to legal actions

In order to defuse situation of hostile takeover attempts, companies have been given power to refuse to register the transfer of shares under relevant sections of Companies Act 1956. If this is done, a company must inform the transferee and the transferor within 60 days. It is the responsibility of the directors to accept a takeover bid.

A refusal to register is permitted if:

- A legal requirement relating to the transfer of shares is not complied with

- The transfer is in contravention of the law

- The transfer is prohibited by a court order

- The transfer is not in the interest of the company and public.

4. Operation “White Knights”

- The white knight defense involves choosing another company with which the target prefers to be combined. A target company is said to use a “white knight” when its management offers to be acquired by a friendly company to escape from a hostile takeover. An alternative company might be preferred by the target because it sees greater compatibility, or the new bidder might promise not to break up the target or engage in massive employees’ dismissal. The possible motive for the management of the target company to do so is not to lose the management of the company. White knight offers a higher bid to the target company than the present predator to avert the takeover bid by hostile suitor. With the higher bid offered by the “white knight” the predator might not remain interested in acquisition and hence the target company is protected from losing to corporate raid.

5. White Square

- The white square is a modified form of a white knight. The difference being that the white square does not acquire control of the target. In a white square transaction, the target sells a block of its stock to a third party it considers to be friendly. The white square sometimes is required to vote its shares with the target management. These transactions often are accompanied by a stand-still agreement that limits the amount of additional target stock the white square can purchase for a specified period of time and restricts the sale of its target stock, usually giving the right of first refusal to the target. In return, the white square often receives a seat on the target board, generous dividends, and/or a discount on the target shares. Preferred stock enables the board to tailor the characteristics of that stock to fit the transaction and so usually is used in white square transaction.

6. Disposing of “Crown Jewel”

- When a target company uses the tactics of divestiture, it is said to sell the “Crown Jewel”. The precious assets in the company are called “crown jewel” to depict the greed of the acquirer under the takeover bid. These precious assets attract the rider to bid for the company’s control. The company as a defense strategy, in its own interest, sells these valuable assets at its own initiative leaving the rest of the company intact. Instead of selling these valuable assets, the company may also lease them or mortgage them to creditors so that the attraction of free assets to the predator is over. As per SEBI takeover regulation, the above defense can be used only before the predator makes public announcement of its intention to take over the target company

7. ‘Pac-Man’ strategy:

- It is making counter bid for the bidder. The Pac-Man defense is essence involves the target counter offering for the bidder. Under this strategy the target company attempts to takeover the hostile raider. This happens when the target company is quite larger than predator. This severe

defense is rarely used and in fact usually is designed not to be used. If the Pac Man defense is used, it is extremely costly and could have devastating financial effects for both firms involved. There is a risk that under state law, should both firms buy substantial stakes in each other, each would be ruled as subsidiaries of the other and be unable to vote its shares against the corporate parent. The severity of the defense may lead the bidder to disbelieve that the target actually will employ the defense.

8. “Golden Parachutes”

- Golden parachutes are separation provisions of an employment contract that compensate managers for the loss of their jobs under a change-of- control clause. The provision usually calls for a lump-sum payment or payment over a specified period at full or partial rates of normal compensation. When a company offers hefty compensations to its managers if they get ousted due to takeover, the company is said to offer golden parachutes. This reduces their resistance to takeover. This envisages a termination packages for senior executives and used as a protection to the directors of the company against the takeover bid.

9. “Shark Repellent” character

- The companies change and amend their bylaws and regulations to be less attractive for the corporate raider company. Such features in the bylaws are called “Shark Repellent” character. Companies adopt this tactic as precautionary measure against prospective bids. Eg: Share holder’s approvals for approving combination proposal are fixed at minimum by 80-95% of the shareholders meeting.

10. Swallowing “Poison Pills” strategy

- Poison pills represent the creation of securities carrying special rights exercisable by a triggering event. The triggering event could be the accumulation of a specified percentage of target shares or the announcement of a tender offer. The special rights take many forms but they all make it costlier to acquire control of the target firm. As a tactical strategy, the target company might issue convertible securities, which are converted into equity to deter the efforts of the offer, or because such conversion dilutes the bidders shares and discourages acquisition. Another example, Target Company might rise borrowing distorting normal Debt to Equity ratio. Poison pills can be adopted by the board of directors without shareholder approval. Although not required, directors often will submit poison pill adoptions to shareholders for ratification.

11. Green Mail

- It refers to an incentive offered by the management of the target company to the potential bidder for not pursuing the takeover. The management of the target company may offer the acquirer for its shares a price higher than the market price. A large block of shares is held by an unfriendly company which forces the target company to repurchase the stock at a substantial premium to prevent the takeover. The purpose of the premium buyback presumably is to end a hostile takeover threat by the large block holder or green mailer. This is an expensive defense mechanism. The large block investors involved in greenmail help bring about management

changes either changes in corporate personnel, or changes in corporate policy, or have superior skills at evaluation potential takeover targets.

12. Poison Put

- A covenant allowing the bondholder to demand repayment in the event of a hostile takeover. This poison put feature seeks to protect against risk of takeover-related deterioration of target bonds, at the same time placing a potentially large cash demand on the new owner, thus raising the cost of an acquisition. Merger and acquisition activity in general has had negative impacts on bondholders’ wealth. This was particularly true when leverage increases where substantial.

13. “Grey Knight”

- A friendly party of the target company who seeks to takeover the predator. The target company may adopt a combination of various strategies for successfully averting the acquisition bid.

All the above strategies are experience based and have been successfully used in developed nations and some of them have been tested by Indian companies also.

7.4.3 Financial Defensive Measures

The firm could become a takeover target of another firm seeking to benefit from an association with highly efficient firm in terms of:

· High sales growth

· High profit margin

· Low stock price

· Highly liquid balance sheet

A combination of these factors can simultaneously make a firm an attractive investment opportunity and facilitate its financing. A firm fitting the afore-mentioned description would do well to take at least some of the following steps as defensive measure against takeover:

· Increase debt with borrowed funds used to repurchase equity

· Increase dividends on remaining shares

· Structure loan covenants to force acceleration of repayment in the event of takeover

· Liquidate the securities portfolio and draw down excess cash

· Invest continuing cash flows from operations in profitable projects

· Use some of the excess liquidity to acquire other firms

· Divest subsidiaries

· Realize the true value of undervalued assets by selling them of or restructuring.

Self Assessment Questions II

1. List the advance preventive measures for takeover Defenses

___________________________________________________________________________________________________________________________________________________________________________

2. List the few commercial strategies for defense against takeover bid

___________________________________________________________________________________________________________________________________________________________________________

3. List the few tactical strategies for defense against takeover bid

___________________________________________________________________________________________________________________________________________________________________________

4. What is disposing of crown jewel?

__________________________________________________________________________________________________________________

5. What is pac-man strategy?

__________________________________________________________________________________________________________________

6. What is shark repellent?

__________________________________________________________________________________________________________________

7. What is poison pills strategy?

__________________________________________________________________________________________________________________

7.5 Anti takeover amendments

Anti takeover amendments generally impose new conditions on the transfer of managerial control of the firm through a merger or tender offer or by replacement of the board of directors. There are four major types of anti takeover amendments as below:

· Supermajority Amendments

It requires shareholders’ approval by at least two-thirds vote and sometimes as much as 90 percent of the voting power of outstanding capital stock for all transactions involving change of control. In most existing cases, however, the supermajority provisions have a board-out clause that provides the board with the power to determine when and if the super majority provision will be in effect. Pure supermajority provisions would seriously limit management’s flexibility in takeover negotiations.

· Fair-price Amendments

Fair price amendments are supermajority provisions with a board-out clause and additional clause waiving the supermajority requirement if a fair price is paid for all the purchased shares. The fair price is defined as the highest price paid by the bidder during a specified period. Fair price amendments defend against two-tier tender offers that are not approved by the target’s board. A uniform offer for all shares to be purchased in a tender offer and in a subsequent cleanup merger or tender offer will avoid the supermajority requirement. The fair price amendment is the restrictive in the class of supermajority amendments.

· Classified Board

This anti takeover amendment provides for staggered or classified boards of directors to delay effective transfer of control in a takeover. The rationale here is to ensure continuity of policy and experience. For instance, a nine member board might be divided into three classes, with only three members standing for election to a three year term, each year. Thus, a new majority shareholder would have to wait at least two annual meetings to gain control of the board of directors. Under this type, a greater shareholder vote is required to elect a single director.

· Authorization of Preferred stock

The board of directors is authorized to create a new class of securities (like preferred stock) with special voting rights. This may be issued to friendly parties in a control contest. This device is a defense against hostile takeover bids.

· Other anti takeover actions

Other amendments that management may propose as a takeover defense include:

- Abolition of cumulative voting where it is not required by state law

- Reincorporation in a state with more accommodating anti takeover laws

- Provisions with respect to the scheduling of shareholders’ meetings and introduction of agenda items, including nomination of candidates to the board of directors.

7.6 Legal measures against Takeovers

Company Act 1956 restricts individual or a company or a group of individual from acquiring shares, together with the shares held earlier, in a public company to 25% of the total paid up capital. Also the central government needs to be intimated whenever such holding exceeds 10% of the subscribed capital. The approval of the central government is necessary if such investment exceeds 10% of the subscribed capital of another company. These precautionary measures are against the takeover bids of public limited company.

7.7 Guidelines for Takeovers

SEBI has provided guidelines for takeovers. The salient features of the guidelines are:

· Notification of Takeover

- If an individual or a company acquires 5% or more of the voting capital of a company, the target company and the stock exchange shall be notified

· Limit to Share Acquisition

- An individual or a company can continue acquiring the shares of another company without making any offer to the other shareholders, until the individuals or the company acquire 10% of the voting capital.

· Public Offer

- If holding company of the acquiring company exceeds 10%, a public offer to purchase a minimum of 20% of the shares shall be made to the remaining share holders through a public announcement.

· Offer price

- The offer price shall not be less than the average of the weekly high or low of the closing prices during the last six months preceding the date of announcement.

· Disclosure

- The offer should disclose the detailed terms of the offer, identity of the offerer, details of the offerer’s existing holdings in the offerer company etc.,

· Offer Documents

- The offer document should contain the offer’s financial information, its intention to continue the offer company’s business and to make major change and L.T commercial justification for the offer.


1. What is anti takeover amendments?

____________________________________________________________________________________________________________

2. List the four major types of amendments

____________________________________________________________________________________________________________

3. List the important guidelines as per SEBI for takeover

____________________________________________________________________________________________________________

7.8 Summary

In this unit, we have discussed the important elements of takeover bid strategies. Depending upon whether the bid is friendly or hostile, these strategies differ. When faced with a potential or actual hostile takeover bid, target company managers may resist the bid both for their own reasons and in order to negotiate better terms for shareholders. They can set up takeover defenses in anticipation of a hostile bid or adopt defensive tactics once the bid has been made. The pre-bid defenses are of a strategic nature. Takeover defenses and anti takeover measures have become part of management’s long term strategic planning for the firm. Different legal and regulatory jurisdictions may not allow certain strategies. Bid strategies must anticipate defense strategies and prepare for different target defenses.


1. Explain the various types of corporate takeover.

2. What are the different techniques of raid?

3. Explain various defensive methods against takeover bid.

4. What are the two types of strategies for defense against takeover bid?

5. What are the three types of anti takeover amendments and how do they work to defend a target from an unwelcome takeover?

6. What are the features of the guidelines as provided by the SEBI for takeover?


SAQs I





SAQ II




4. Refer to Section 7.4.2 (point 6)




SAQ III




TQs









.

MF0002-Unit-08-Legal and Regulatory framework of Unit 8 Legal and Regulatory framework of

Merger & Acquisition

Structure

8.1 Introduction

8.2 Companies Act, 1956

8.3 Legal Measures against Takeover


8.4 Buy Back of own shares

8.5 Legal Procedures

8.6 Securities and Exchange Board of India Act, 1992

8.7 SEBI (Substantial Acquisition of Shares and Takeovers) Regulations 1997

8.8 Income Tax Act 1961

8.9 Foreign Exchange Management Act (FEMA) 1999

8.10 Listing Agreements


8.11 Summary



8.14 Summary



8.1 Introduction

This unit highlights the salient features and the impact of the various legislations which have a bearing on the M & A activities. The important clauses which are relevant to mergers and acquisition activities have been explained in this unit. This unit also focuses on how the takeovers and mergers are controlled under the provisions of various Acts. The nature of recommendations of the Companies Act 1956 will be discussed in this unit. Besides, the securities regulations, particularly SEBI and its takeover codes will also be discussed in this unit. You will also understand the legal procedure to be adopted in M & A activities.

Objectives

After studying this unit, you should be able to

· Discuss the various provisions under Companies Act 1956

· Describe the major sections of Income Tax Act 1961 affecting M & A activities

· Discuss the guidelines of SEBI takeover code

· Discuss about the other legal issues related to M & A

Laws have been enacted in most of the countries to control and regulate the business combinations with a view to protect minority shareholders and discourage monopolistic corporate behaviour. Despite the free economy, the protection of the interest of the common investors has always been given top priority in most of the countries. In India, mergers and acquisitions are regulated through the provision of Companies Act 1956, the MRTP Act 1969, the FEM Act 1999, Income Tax Act 1961, the Securities and Control (Regulations) Act 1956, the SEBI Act 1992, and SEBI (Substantial Acquisition of Shares and Takeovers Regulations, 1997. The relevant provisions of the few important statutes mentioned above regulating the takeover and mergers of corporate enterprises are discussed in this unit.

8.2 Companies Act, 1956

Whenever two or more companies agree to merge with each other, they have to prepare a scheme of amalgamation. The acquiring company should prepare the scheme in consultation with its merchant banker or financial institution. It should be ensured that the scheme is just and equitable to the shareholders and employees of each of the amalgamating companies and to the public. The scheme of merger / amalgamation is governed by the provisions of Section 391-394 and Section 111 of Companies Act 1956.

The legal process requires approval to the schemes as detailed below:

· Section 391

In terms of Section 391, shareholders of both the amalgamating and the amalgamated companies should hold their respective meetings under the directions of the respective high courts and consider the scheme of amalgamation. A separate meeting of both preference and equity shareholders should be convened for this purpose. Further, in terms of Section 81(A), the shareholders of the amalgamated company are required to pass a special resolution for the issue of shares to the shareholders of the amalgamating company, in amalgamation. Approvals are required from the creditors, banks and financial institutions to the scheme of amalgamation, in terms of their respective agreements or arrangements with each of the amalgamating and the amalgamated companies as also under section 391. Under this section, a company can compromise or make an arrangement with its creditors or members. Approval of the respective high court scheme is required to confirm the amalgamation. The court has the power to sanction or reject any such scheme of compromise or arrangement.

· Section 392

The court has the power to give such direction in regard to any matter or make such modification in the compromise or arrangement as it may consider necessary for the proper working of the scheme. The court can modify the scheme at the instance of any shareholder. However, the court has no power to modify the scheme pronounced but not sanctioned by the high court before the date of the government notification of the company as a relief undertaking.

· Section 393

This provides supportive provisions for compliance such as providing a statement stating the terms of compromise or arrangement and explaining its effect along with the notice calling the meeting. In case the notice is advertised, then it should specify the venue and the manner in which members attending the meeting can obtain copies of the statement of compromise or arrangement. The refusal to supply particulars is punishable with fine.

· Section 394

This section facilitates reconstruction and amalgamation. Under this section, the court should give notice of every application made to it under section 391-394 to the central government or regional directors of company law board and take into consideration the representations, if any made to it by the government before passing any order. However, the court is not bound to go by

the opinion of the government or regional director as to the matters of public interest; rather it can form its independent opinion over the matter. The court may make provisions for the transfer of the whole or any part of the undertaking, property or liability of any transferor company to the transferee company.

· Section 395

This section contains provisions for the compulsory acquisition by the transferee company of shares of the dissenting minority. The shares may be acquired on the same terms as those offered for the shares of the approving shareholders. However, this requires approval of not less than 90 percent of the value of the shares whose transfer is involved. This does not include the shares already held by the transferee company or its nominee or subsidiary.

· Section 396

This section outlines the power of the central government to provide for an amalgamation in national interest. Provisions in sections 395, 396 and 396A are supplementary in the matters of amalgamation.

· Section 111

The board of directors of a corporate enterprise can refuse to register the transfer of shares in certain circumstances under apprehension of takeover bids or corporate raids. The company can refuse to transfer the shares acquired by the acquirer. The company law board has the power to decide on the matter. Refusal transfer can be made if such transfer is against the interests of the company or against public interest.

Some of the provisions of the working draft of Companies Bill 1997 are as follows:

· The bill has deleted the provisions of Section 108 – A to 108 – I of the Companies Act 1956 under which prior permission of the central government is required for the acquisition and transfer of shares. This is being done in view of the repeal of the MRTP Act and the enactment of the Depositories Act, new takeover code and changes in the Securities Contract (Regulation) Act, 1956.

· The provisions regulating buy back of shares are contained in section 77A, 77AA and 77B of the Companies Act 1956. These were inserted by the companies (Amendment) Act, 1999. These include passing of a special resolution, filing a declaration of solvency and complying with certain norms such as a ban on issuing any new shares for 12 months, maintenance of a debt-equity ratio of less than 2:1 and such other restrictions relating to voting rights, dividend rights, bonus issues and rights issue eligibility. This buy back can be for preventing a takeover or for treasury operations.

· Clause 272 provides that in the event of any person, group or corporate body acquiring 95 per cent of the shares of a public listed company and the company getting de-listed, the residual

shareholders should sell their shares to the 95 percent owner at a price determined in accordance with government rules.

· Clause 73 provides for the employee stock options to employees, officers and working directors, provided the option together with existing capital shall not amount to an increase of more than 5 per cent of the existing capital.

8.2 Legal Measures against Takeover

The companies Act restricts an individual or a company or a group of individuals from acquiring shares, together with the share held earlier in a public company to 25 percent of the total paid-up capital. Also the central government needs to be intimated whether such holding exceeds 10 percent of the subscribed capital. The Companies Act also provides for the approval of shareholders and the central government when a company by itself or in association of an individual or individuals purchases shares of another company in excess of its specified limits. The approval of the Central Government is necessary if such investment exceeds 10 percent of the subscribed capital of another company. These are the precautionary measures against the takeover of public limited companies.

Self Assessment Questions I

1. Which of the statutes regulate the takeover and mergers of corporate enterprises in India?

___________________________________________________________________________________________________________________________________________________________________________

2. Which of the sections of Companies Act 1956 governs the scheme of merger and amalgamation?

__________________________________________________________________________________________________________________

3. “The Companies Act restricts an individual or a company or a group of individual from acquiring shares, together with the share held earlier in a public company to 30 percent of the total paid-up capital”. Yes or No

4. Approval of shareholders and the central government when a company by itself or in association of an individual or individuals purchases shares of another company in excess of 10 percent of the subscribed capital of another company.

Right or Wrong

8.4 Buy Back of own shares

The buyback scheme will enable companies to reduce their outstanding share capital and improve their earnings per share. Company management can avoid a takeover attempt by buying back at high cost shares bought by their predator. Buy back helps companies to ward off hostile takeover bids. A company is also prohibited from funding any operations for buy back of its own shares. The buyback routes are:

· From existing shareholders on proportionate basis

· Open market operations

· Specified purchase through negotiated or other arrangements

· Repurchase of share issued through employees share option

· From odd lots

Buy back provides the advantage of moving in and out of equity and debt in response to changing return on capital. Promoters of Indian companies can now consolidate their positions through buy-backs. The companies will have to inform the investors that they want to go in for a buy back, the quantum of shares that they propose to buy and the period within which the buy back process is to be completed. In addition, the board of directors have to inform whether the shares bought will be extinguished or resold.

8.5 Legal Procedures

The summary of legal procedures for mergers or acquisition laid down in the Companies Act, 1956 is given here below:

· Permission for merger

Companies can amalgamate only when amalgamation is permitted under their memorandum of association. Also the acquiring company should have the permission in its object clause to carry on the business of the acquired. Otherwise it is necessary to seek the permission of the shareholders, board of directors and the Company Law Board before affecting the merger.

· Information to the stock exchange

The acquiring and the acquired companies should inform the stock exchanges where they have listed about the merger

· Approval of board of directors (BODs)

The BODs of the individual companies should approve the draft proposal for amalgamation and authorize the managements of companies to further pursue the proposal.

· Application in the High Court

An application for approving the draft amalgamation proposal duly approved by the BODs of the individual companies should be made to the High Court. The High Court convenes a meeting of the shareholders and creditors to approve the amalgamation proposal. The notice of meeting should be sent to them at least 21 days in advance.

· Shareholders’ and creditors’ meetings

The individual companies should hold separate meetings of their shareholders and creditors for approval of scheme of merger. At least 75 percent of shareholders and creditors must accord their approval to the scheme.

· Sanction by the High Court

After the above approvals, the High Court will pass order sanctioning the amalgamation scheme, only if scheme is fair and reasonable. If necessary, court can modify the scheme.

· Filling the Court order

After the Court order, its certified true copies will be filed with the Registrar of the companies.

· Transfer of Assets and Liabilities

The assets and liabilities of the acquired company will be transferred to the acquiring company in accordance with the approved scheme with effect from the specified date.

· Payment by cash or securities

As per the proposal, the acquiring company will exchange shares and debentures and pay cash for the shares and debentures of the acquired company. The securities will be listed on the stock exchange.

8.6 Securities and Exchange Board of India Act, 1992

The salient features of the Regulations relating to takeover under SEBI Act are given below:

SEBI has two provisions to protect the investors’ interest. One is the escrow account deposit and the other that in case of non-payment, the company will not be allowed to operate in the capital market. The escrow account requires the bidder to have an upfront deposit of 10 percent of the value of the bid. In case of default, the entire amount in the escrow account is forfeited. Indian regulations limit the cumulative investments of foreign institutional investors in any Indian company to 24 per cent and to five percent for individual FIIs. SEBI protects the rights of minority shareholders in the event of a hostile acquisition in various ways.

· Raiders must reveal their ultimate intentions when buying into a public company

· Predators cannot use shells or fronts to corner stakes

· Clandestine deals between principal shareholders and bidders are prohibited

· A hostile raider with a 10 percent stake cannot purchase more shares without making a public tender offer.

· Foreign investor cannot sell more than one percent stake in an Indian company without a public notice

· Directors cannot refuse to register shares without shareholders’ approval.

Section 15H of SEBI Act prescribes penalty for non-disclosure of acquisition of shares and takeovers. According to this section, if any person, who is required under this Act or any rules or regulations made there under, fails to:

i) disclose the aggregate of his share holding in the body corporate before he acquires any shares of that body corporate; or

ii) Make a public announcement to acquire shares at a minimum price – he shall be liable to a penalty not exceeding five lakh rupees.

8.7 SEBI (Substantial Acquisition of Shares and Takeovers) Regulations 1997

The following are the salient features of some of the important guidelines for takeover.

· Disclosure of share acquisition or holding

i) Any person who acquires 5 percent or 10 percent or 14 percent share or voting rights of the target company, should disclose of his holdings at every stage to the target company and the Stock Exchanges within two days of acquisition or receipt of intimation of allotment of shares.

ii) Any person who holds more than 15 percent but less than 75 percent shares or voting rights of target company, and who purchases or sells shares aggregating to 2 per cent or more shall within two days disclose such purchase or sale along with the aggregate of his shareholding to the target company and the stock exchanges.

iii) Any person who holds more than 15 percent shares or voting rights of target company and promoter and person having control over the target company, shall within 21 days from the financial year ending March 31 as well as the record date fixed for the purpose of dividend declaration disclose every year the aggregate shareholding to the target company.

· Public Announcement and open offer

i) An acquirer, who intends to acquire share which along with his existing shareholding would entitle him to exercise 15 percent or more voting rights, can acquire such additional shares only after making public announcement to acquire at least additional 20 percent of the voting capital of Target Company from the shareholders through an open offer.

ii) An acquirer who holds 15 per cent or more but less than75 percent of shares or voting rights of target company, can acquire such additional share as would entitle him to exercise more than 5 percent of the voting rights in any financial year ending March 31, only after making a public announcement to acquire at least additional 20 percent shares of target company from the shareholders through an open offer.

iii)An acquirer, who holds 75 percent shares or voting rights of a target company, can acquire further shares or voting rights only after making a public announcement to acquire at least additional 20 percent shares of target company from the shareholders through an open offer.

· Offer Price

The acquirer is required to ensure that all the relevant parameters are taken into consideration while determining the offer price and that justification for the same is disclosed in the letter of offer. The relevant parameters are:

- Negotiated price under the agreement which triggered the open offer

- Price paid by the acquirer for acquisition, if any including by way of allotment in a public or rights or preferential issue during the twenty six week period prior to the date of public announcement, whichever higher

- The average of the weekly high and low of the closing prices of the shares of the target company as quoted on the stock exchange where the shares of the company are most frequently traded during the twenty six weeks or the average of the daily high and low prices of the shares as quoted on the stock exchange where the shares of the company are most frequently traded during the two weeks preceding the date of the public announcement, whichever is higher

In case the shares of Target Company are not frequently traded, and then parameters based on the fundamentals of the company such as return on net worth of the company, book value per share, EPS etc. are required to be considered and disclosed.

· Disclosure

The offer should disclose the detailed terms of the offer, identity of the offerer, details of the offerer’s existing holdings in the offeree company etc. and the information should be made available to all the shareholders at the same time and in the same manner.

· Offer Document

The offer document should contain the offer’s financial information, its intention to continue the offeree company’s business and to make major changes and long-term commercial justification for the offer.

You may down load the updated information and materials regarding the above subject at the following official website of SEBI.

http://www.sebi.gov.in/acts/SubstantialAcquationTakeover.html

8.8 Income Tax Act 1961

Income tax Act, 1961 is most important legislation for takeovers, acquisitions, mergers, amalgamations and de-mergers or divisions. The various sections are applicable to different situations and in different circumstances to prevent tax-avoidance as well as create incentives for the healthy growth of the business enterprises. One of the motives for mergers is the tax savings under Income Tax Act, Section 72A. It is attractive for amalgamation of a sick company with a healthy and profitable one to take advantage of the carry forward losses. The conditions are:

· The amalgamating company is not financially viable by reasons of its liabilities, losses and other relevant factors immediately before such amalgamation.

· Amalgamation is in public interest.

· Any other conditions of the central government to ensure that the benefit under this section is restricted to amalgamations which enable rehabilitation or revival of the business of the amalgamation company.

The following are the major tax benefits available to the amalgamated company:

a) The Income Tax Act, 1961, stipulates two prerequisites for any amalgamation – through which the amalgamated company seeks to avail the benefits of set-off/carry forward of losses and unabsorbed depreciation of the amalgamating company against its future profits under section 72-A, namely:

i) all property and liabilities of the amalgamated company/companies immediately before amalgamation, should vest with /become the liabilities of the amalgamated company,

ii) the shareholders, other than the amalgamated company/its subsidiary, holding at least 90 percent value of shares/ voting power in the amalgamating company should become shareholders of the amalgamated company by virtue of amalgamation.

b) Deduction of following expenditure or expenses would be made in the books of amalgamated company in the same manner as would have been allowed to the amalgamating company:

· Expenditure on scientific research

· Expenditure on acquisition of patent rights or copy right

· Expenditure on know-how

· Preliminary expenses

· Expenditure on prospecting of certain minerals

· Bad debts etc.

The Income tax Act for all types of business merger and acquisition has become fully tax natural. The unwritten-off amount with respect to all the above items is treated in the hands of the amalgamated company in the same manner as would have been treated by the amalgamating company. Thus, the amalgamated company is not put to any disadvantage as far as the income tax concessions and incentives are concerned.

c) The tax concessions to the amalgamating company are summarized below:

· According to Section 47 (vi) where there is a transfer of any capital asset by an amalgamating company to any Indian amalgamated company, such transfer will not be considered as transfer for the purpose of capital gain.

· According to Section 45(b) of the Gift Tax Act, where there is a transfer of any asset by an Indian amalgamating company, gift tax will not be attracted

· According to Section 47 (vii), where a shareholder of an Indian amalgamating company transfer his shares, such transaction will be disregarded for capital gain purposes, provided the transfer of shares is made in consideration of the allotment of any share to him or shares in the amalgamated company.

8.9 Foreign Exchange Management Act (FEMA) 1999

Provisions of FEMA are applicable where the scheme of amalgamation or merger or takeover envisage issue of shares/cash option to Non-Resident Indians, the affected Companies are required to obtain prior permission of the RBI under FEMA. RBI is empowered to give general or special permission to any dealing in foreign exchange. RBI has made Foreign Exchange Management (Transfer or Issue of Security by a person resident outside India) Regulations, 2000 under section 47 of FEMA to prohibit, restrict or regulate, transfer or issue security by a person outside India. Regulation 7 of the above Regulation states as under:

Issue and acquisition of shares after merger or de-merger or amalgamation of Indian companies – where scheme of merger or amalgamation of two or more Indian companies or a reconstruction by way of de-merger or otherwise of an Indian company has been approved by a court in India, the transferee company or, as the case may be, the new company may issue shares to the shareholders of the transferor company resident outside India, subject to the certain conditions specified therein.

8.10 Listing Agreements

The takeover of companies listed on the stock exchanges is regulated by Clause 40-A and 40-B of the listing agreements. While Clause 40-A deals with conditions for continued listing, Clause 40-B contains the requirements to be met when a takeover offer is made.

The company agrees that the following would also be the conditions for continued listing:

i) When a person acquires or agrees to acquire 5 percent or more of the voting rights of any securities, the acquirer and the company should comply with the relevant provisions of SEBI takeover code.

ii) When any person acquires or agrees to acquire any securities exceeding 15 percent of the voting rights in a company or if any person who holds securities carrying, in aggregate, less than 15 percent of the voting rights and seek to acquire securities exceeding 15 percent of voting rights of the company, he should comply with the relevant provisions of the SEBI takeover Code.

The company also agrees that it is a condition for continuous listing that whenever the takeover offer is made or there is any change in the control of the management of the company, person who secures the control and the company whose shares have been acquired would comply with the relevant provisions of the SEBI takeover code.


1. “Buy back helps companies to ward off ………. ……………takeover bids”.

2. List sequentially the legal procedures for mergers or acquisition laid down in the Companies Act, 1956.

__________________________________________________________________________________________________________________

3. How does escrow account deposit protect the investors’ interest?

4. List some of the important guidelines for takeover as per SEBI (Substantial Acquisition of Shares and Takeovers) Regulations 1997.

5. One of the motives for mergers is the tax evading under Income Tax Act, Section 72A.

6. Takeover of companies listed on the stock exchanges is regulated by Clause ……….and ………… of the listing agreements.

8.11 Summary

Mergers and acquisition may degenerate into the exploitation of shareholders, particularly minority shareholders. They may also encourage the monopoly and monopolistic corporate behaviour. Therefore, the mergers and acquisition activities are regulated under various laws in India which provides a legal framework under which M & A activities can be undertaken. The objectives of laws as well as the stock exchange requirements are to make merger deals transparent and protect the interest of the shareholders, particularly the small shareholders. Most of the legal systems have been under review and are being reformulated in accordance with the emerging corporate scenario in India. There are several panels who have suggested the modifications in various laws with regard to Mergers and Acquisition. Some of these are

incorporated in Companies Bill, 1997. The major provision is about the buy-back possibilities for the incumbent management. In addition to SEBI takeover codes, companies have to plan the tax element in their activities. There are also other legislations that influence the merger and acquisitions activities. The important highlights of the relevant sections in these acts are which have bearing on the mergers and acquisition activities are discussed in detail in this unit. It should be noted here that the mergers and amalgamations are governed by the Companies Act, the courts and law, the takeovers and acquisitions are regulated by the SEBI.


i) Discuss in brief the legislation applicable to mergers and takeovers in India. What are the objectives of such legislation?

ii) What is the legal process requires approval to the schemes of mergers and amalgamations as per Companies Act 1956?

iii) What are the legal measures against corporate takeover?

iv) Briefly explain the legal procedures for mergers or acquisition as per Companies Act 1956.

v) What are the salient features of the Regulations relating to takeover under SEBI Act?

vi) What are the salient features of some of the important guidelines for takeover as per SEBI (Substantial Acquisition of Shares and Takeovers) Regulations 1997?

vii) What are the major tax benefits available to the amalgamated company?


SAQs I



3. No

4. Right

SAQs II

a) Hostile takeover

b) Refer to Section 8.5

c) Refer to Section 8.6

d) Refer to Section 8.7

e) Tax Saving

f) Clause 40-A and 40-B

TQs










.

MF0002-Unit-09-Leverage Buyout and Management buy out Unit 9 Leverage Buyout and Management buy out

Structure

9.1 Introduction

9.2 Definition

9.3 Modes of purchase

9.4 Investors

9.5 Governance aspects of LBO

9.6 LBOs And corporate Governance

9.7 Stages of LBO operation

9.8 Candidates for LBO exercise

9.9 Financing Aspects of LBO

9.10 Indian scenario

9.11 Management Buyout

9.12 Summary

9.1 Introduction

This unit highlights the salient features of the mergers and acquisition for the purchase of a company and the modalities involved in acquisition process and the impact of the various arrangements which have a bearing on the M & A activities. The important funding methodologies which are relevant to mergers and acquisition activities have been discussed to enable the students to acquaint with the concepts.

In the Industry’s infancy in the 1960s, the acquisitions were called ‘bootstrap’ transactions, and characterised by Victor Posner’s hostile takeover of Sharon Steel Corp. in 1969. The industry was conceived by persons like Jerome Kohlberg while working on Wall Street in the 1960s and 1970s and pioneered by the firm he helped found with Henry Kravis, Kohlberg Kravis Roberts & Co.(KKR).

O. Wayne Rollins, Rollins Inc. (ROL), is credited by Harvard Business School as completing what is believed to be the first leveraged buyout in the business history through the acquisition of Orkin Exterminating Company in 1964. However, the first LBO may have been the purchase by McLean Industries, Inc. Of Waterman Steamship Corporation in May 1956. Under the terms of that transaction, McLean borrowed $42 million and raised another $7 million through issue of preferred stock.

9.2 Definition.

A leveraged buyout is essentially a strategy involving the acquisition of another company using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition. In general an LBO is defined as the acquisition , financed largely by borrowing of all the stock or assets of a hitherto public company by a small group of investors. Debt financing represents usually 50 % o or more of the purchase price. The tangible assets of the firm to be acquired are used as collateral for the loans to be obtained for financing the acquisition. The cash requirements for debt servicing force management, to shed unneeded assets, improve operating efficiency and forego wasteful capital expenditure.

Subordinated debt is either unrated or low rated debt referred to as junk bond financing. It is used to raise the balance of purchase price. Subordinated debt, referred to as “mezzanine money”, is provided most frequently by pension funds, insurance companies, venture capital partnerships, venture-capital subsidiaries of commercial banks, and foundations and endowments.

A Management Buyout (MBO) occurs when a company’s managers acquire a large part of the company. It is a special case of such an acquisition. The goal of such a buyout may be to strengthen the managers’ interest in the success of the company. In most cases, the management will take the company private. MBOs have assumed an important role in the corporate restructurings besides Mergers and acquisitions. The key considerations are the fairness to shareholders, the price, the future business plan, legal and tax issues.

9.3 Modes of Purchase

Leveraged Buyout is undertaken either in stock purchase format or asset purchase format. In the former, the target shareholders simply sell their stock and all interest in the target company to the buying group and then the two firms may be merged. And in asset purchase format, the target company sells its assets to the buying group. After the buyout the acquired company is run as a privately held company for a few years after which resale of the firm is anticipated. This buying group may be sponsored by specialists in the field or investment bankers that arrange such deals and usually includes representation by incumbent management.

Self Assessment Questions I

1. Leveraged Buyout is a purchase of a _______ company with _________funds.

2. Subordinated debt mostly referred to as ———– is provided most frequently by ——– funds.

3. A ___________occurs when company managers acquire a large part of the company.

4. Leveraged Buyout is undertaken either by ______purchase format or __________purchase format.

9.4 Investors

Buyers of the firm targeted to become an LBO consist of the managers of the firm that is being acquired. The buying group often forms a shell corporation to act as the legal entity making the acquisition. An MBO or LBO is a defensive measure against takeover. In the United States the decade 1950s and 1960s witnessed leveraged transactions of privately held small to medium companies and the LBO activity tapered off during late sixties. Renewed interest in LBOs emerged in late 80s when conglomerates that had amassed large portfolios of business during 1960s and 70s began to divest many of their holdings. These transactions were often financed by leveraged buyouts.

Investors in LBOs are referred to as financial buyers who hold their investments for a minimum period of 5 to 7 years. LBOs are a healthy way to create value where control of companies is

advocated to promote competency and efficiency. They can improve operating performance by restoring strong constructive relationships among the owners, managers, and other corporate stock holders. Private equity partnerships make most of the investment in LBOs. Private equity partnerships eliminate the separation of ownership and control. Incentives to achieve high exit values for the partnership investment are provided to the general partners. At the same time limited partners are protected by the partnership’s limited life and prohibition of reinvestment with in the partnership. The limited partners, who put almost all the money are mostly institutional investors and are first in line when partnership investments are sold. The general partners who organize and manage the fund get a carried interest in fund’s profits.

9.5 Governance aspects of LBO

LBOs offer a useful format for effective governance of corporations. They are not merely deals but represent an alternative model for corporate ownership and control just as public ownership, venture capital ownership and franchise arrangements. Temporary ownership by LBO firm can provide an important bridge to better long term management and performance.

LBO model of ownership is quite adaptable to a wide business enterprise. One unique aspect of LBO approach to ownership and governance is exemplified by direct lines of communication between owners and top management, managerial autonomy and a willingness by owners to step in and direct operations to solve chronic problems. Trust is built over time in a variety of ways including the alignment of interests through equity ownership and incentive compensation.

9.6 LBO and Corporate Governance

The Cadbury committee in Great Britain while attempting to set forth principles of best practice in British corporate governance studied LBOs, venture capital firms and relational investing (Warren Buffet) as possible models for best practice. Primarily since LBOs are viewed as financial transactions, its effects on governance are often overlooked. Finance and Governance are closely related.

Debt and equity are not merely different types of financial claims but constitute alternative approaches to monitoring corporate performance and directing management, governance. Debt and Equity are opposite ends of continuum of potential governance regimes. Debt is rigid but leads to a simple and low cost regime. Equity is flexible and adoptive but is complex and costly.

The ideal form of governance depends on nature of assets to be managed, the transaction stream those assets support and the growth opportunities. LBO is one form of governance which is suitable to a large section of business. LBOs represent a young and still evolving organizational form in a market determined economy.

9.7 Stages for LBO Operation

First stage of LBO consists of raising the cash required for the buyout and devising a management incentive system. About 10% of the cash is put up by investor group and 50% to 60

percent is raised by borrowing against company’s assets in secured bank acquisition loans. LBO represent debt bonding activity.

In the second stage of operation the organizing sponsor group may adopt stock purchase format or asset purchase format. In stock purchase format all outstanding shares of the company are purchased and a new company is formed. A new private company purchases all the shares of the company.

In the third stage of operation the management strives to increase profits and cash flows by reducing operating costs and altering market strategies. LBO Bond managers to meet newly set targets. The investor group in the fourth stage may take the company public again if the company is strong and the goals of the group are achieved. The reverse LBOs are undertaken mostly by successful LBO companies through public equity offering known as secondary initial public offering. The purpose of reconversion to public ownership is to create liquidity for existing share holders.


1. An LBO or an MBO is a ——— measure against take over.

2. Investors in LBOs are referred to as ——– buyers who hold their investments for ——– years.

3. Private equity partnerships eliminate the separation of ——– and —–.

4. Temporary ownership by an LBO firm can provide an important bridge to better long term ———— and ———–.

9.8 Candidate for LBO exercise

LBO targets are found in manufacturing firms in basic, non-regulated industries with low financing requirement. High tech firms are less appropriate since they do not have adequate track record, carry higher business risk and have fewer leverage able assets. Leveraged buyouts are likely to occur in firms or industries where managers are vulnerable to expropriation and assets are conducive to allow greater borrowing to finance buyouts. These conditions are likely to exist in mature firms with limited growth opportunities. Track record of capable management enhances success of LBO. The purchase price in LBOs should be slightly above book value.

Vulnerability to opportunistic behaviour among stake holders may give rise to hold up or moral hazard. Hold up or expropriation of quasi rents is likely in the case of specialised investment. Debtor-creditor relations give rise to moral hazard especially when the firm’s assets are plastic allowing for a wide range of discretionary decisions. Quasi rent can be appropriated by share holders, labour and other stake holders. Protection is available to managers by holding incentive compensation contract more tightly related to performance.

9.9 Financing Aspects of LBO

The Reserve Bank of India has to come out with guidelines for financing Leveraged Buyouts. Financing Indian M&As needs a new orientation. It is high the Regulator realises that absence of bank lending for corporate take over is seriously hampering the growth of Indian M&A activity.. The numerous financing constraints that continue to dog the Indian M&A scene should become a matter of great concern for the central banker. The basic issue is that RBI continues to have archaic rules which do not allow banks to finance corporate acquisitions. The warped rationale behind these rules: banks should stay away from financing speculative activities. But, mergers and acquisition are not speculative activities. Says Mr Sunil Gulati, Managing Director of Bank of America and head of its Investment banking group: ’Acquisition of a strategic controlling stake in a company’s an economic activity. It creates value.’ That is why acquisition needs to be financed like any other economic activity.

What is needed now is a plan of action to enable public sector banks finance corporate acquisitions. Since these banks are guided by RBIs lending norms, it is essential that the central banker takes the initiative and frames clear and focussed guidelines for M&A financing by banks. There are RBI guidelines setting out sectoral funding limits to protect a bank’s portfolio. Similar guidelines can be provided by the RBI in the area of M&A financing. Such M&A guidelines should make takeover funding easier and transparent. As of now RBI is expected to tell the banks to put in place transparent leveraged buyout rules approved by their boards.

9.10 Indian Scenario

Leveraged buyout financing is likely to emerge in India against the backdrop of the government’s divestment programme. The RBI neither prohibits nor endorses M&A financing. Banks have lent money to some corporate which have picked up public sector undertakings through divestment route. But this is more in the nature of balance sheet financing, not leveraged buyout financing. Indian banks have traditionally been doing either balance sheet financing or asset based financing. Loan decisions are mainly taken on the basis of the cash flow of corporate.

In a leveraged buyout, a significant amount of the funding of the takeover of the controlling interest in a company comes from borrowed funds, usually 70% or more of the total purchase price. As per international buyout practices, a target company’s assets serve as security for the loans taken by the acquiring firm. The latter repays the loans out of the cash flow of the acquired company through its profits or by selling its assets. Globally, many leveraged buyouts have been financed through junk bonds. This is not the practice in India.

In the absence of clear rules governing M&A financing, banks have gone for asset financing. Deutsche Bank, for instance, part financed the Tata’s acquisition of a 25% government holding in Videsh Sanchar Nigam Limited. The foreign bank undertook the buyout deal by placing debt instruments with mutual funds and foreign institutional investors. The Tatas raised the required funds by leveraging their own balance sheet. Generally three factors are considered essential for a successful buyout. An acquiring company must have the ability to borrow significant sums against its assets. It should also be able to retain or attract a strong management team and have the potential to enhance the value of each investment. The ability of a company to support a leveraged buyout depends on whether it can service the principal and interest payment obligations.

Public sector banks have avoided this kind of financing with a few exceptions. On the other hand Foreign banks, which have the expertise and experience, have taken the lead in financing LBO. The Government has ruled that multinational companies will have to bring in funds from abroad rather than raise money from local banks for acquisitions.

Bank of America financed Gujrat Ambuja for acquiring DLF cement and also funded Grasim for acquiring the brands of Coats Viyella. But, such M&A financing deals are few and far between. The only financial institution which is taking some interest in financing M&A deals is the ICICI. The French cement major Lafarge partly financed its takeover of Tisco’s cement division through loans from ICICI and HDFC. Meanwhile Lafarge is planning to Part-finance its acquisition of Raymond’s cement division through domestic loans. After all, money is fungible. So, banks and FIs should provide financial assistance to companies for various purposes. And Leveraged Buyout is certainly one economic purpose which needs funding.

Self assessment Questions

1. LBO represents ——- bonding activity.

2. In Stock purchase format all ——– ——- of the company are purchased and a _____ _______is formed.

3. In the third stage of operation the management strives to increase ________and cash flows by reducing ______and altering ________strategies.

4. The purchase price in LBOs should be slightly above —— value.

5. Hold up or expropriation of ________is likely in the case of specialised investment.

6. In a Leveraged Buy Out , a significant amount of the takeover of the __________interest comes from _______funds,

7. Leveraged BUYOUT financing is likely to emerge in India against the backdrop of the government’s ———— programme.

9.11 Management buyout and buy-ins

In a management buyout (MBO), the parent sells a division or subsidiary to the incumbent management, or a private company is bought by incumbent management. In a Management Buy-in (MBI), a new management team replaces the incumbent management. Where a public listed company is bought by its management, it is referred to as ‘going private’, since the company ceases to be listed. It is pertinent to note that MBOs, MBIs have been significant in UK acquisitions in the last few years, accounting for about 11 percent of the acquisitions.

MBAs arise from a number of different sources. The vast majority of them are divestments by UK and foreign parents of subsidiaries. Private, family owned companies are also often sold to managers. Companies in receivership, or parts of those companies, are also bought by managers

as MBOs. Receivership as a source of MBOs is obviously related to the state of the economy, and becomes more prominent in recession. Divestments in a recession tend to be defensive and driven by rationalisation and cost cutting, whereas in boom time they are triggered more by strategic restructuring.

9.11.1 Managerial motivations for an MBO

What drives managers to become owners of the businesses they have run under the direction and control of a parent? A survey of MBO managers by WRIGHT et al, (1991) revealed a number of reasons, of which the most important was the desire to run one’s own business. In order of importance, managerial motivations in MBOs were as follows:

Opportunity to control own business. Long- term faith in company. Better financial rewards. Opportunity to develop own talents. Absence of head office constraints. Fear of redundancy. Fear of new owner after anticipated acquisition.

Financial and investment constraints imposed by the head office in a group may result in under exploitation of the full potential of a business, and may lead to frustration among the divisional managers.

9.11.2 Structure of an MBO

Since managers do not have the financial resources to buy out their companies on their own, the financial structure of an MBO depends on the capital supplied by specialist capital providers and banks. Management provides a small part of the equity. Institutions which specialise in MBO financing, such as venture capital firms, provide additional equity. Further funding is provided by debt, which falls into two types: senior debt and mezzanine debt.

In some MBOs, equity has also been raised from the employees by the formation of an employee share ownership plan (ESOP). Contribution from the company towards the purchase of its shares by an ESOP is corporation tax free. Moreover, the plan can borrow money to buy shares, and the contribution from the company can then be used to pay interest and repay the borrowing. Thus an ESOP is a tax-efficient method of raising funds to finance equity.

Senior debt has priority in payment of interest and repayment of principal. It is a secure debt and if it is a term loan, has a pre-arranged repayment schedule. The interest rate is normally a floating rate at a margin of 2-3 percent over LIBOR( London Inter Bank Offer Rate). Some part of the Senior debt may be short term. Mezzanine debt, as the name suggests, is junior or subordinated to senior debt in terms of interest payment and capital repayment. It is not secured and is, therefore, more risky. Both debt components rank above equity.

The mezzanine layer is often in the form of preference shares or convertible loan stock or convertible preference shares. In the United Kingdom, some firms specialise in providing mezzanine or intermediate finance. The interest rate is generally 4-5 percent above LIBOR. Interest rate margins for both senior and mezzanine debt depend on the general level of interest rates, the demand for debt and the competition among banks.

Institutional equity providers earn their reward from the return realised at the time of exit of the MBO. Exit is the process of realisation of the investments made in an MBO. Equity investors may expect an internal rate of return (IRR) of 25-30%. Once again this return depends on the riskiness of the MBO, demand for funds and competition among institutional equity providers, and the lead time to exit. The following case provides an example of such a structure:

Financing the DRG Litho Supplies MBO, 1991

DRG Litho Supplies Ltd. was bought out by the management team from DRG plc after it was taken over in a contested bid by Pembridge Investments in 1989. The total financing needed was:

Price payable to vendor £20.70m

Working capital 1.65m

Fees 1.00m

———–

23.35m

This was provided by:

Management equity £0.50m

Institutions: share capital 7.35

Mezzanine: 4.00

Senior debt: Term loan 7.00

Overdraft and short term 4.50

———–

23.35m

SOURCE: Ernst & Young 1991 MBO guide

In larger deals, the number of institutional equity and debt providers increases substantially as a mechanism for spreading risk. To the senior lenders, the mezzanine and equity provide a cushion. In the above case, senior debt of £11.5 million is backed by £11.85 million of equity and mezzanine. However, the larger the mezzanine, greater the cash outflow, the smaller will be the retained earnings owing to interest payment and the smaller the resulting net worth. Senior lenders are therefore wary of too much mezzanine, although it ranks behind the Senior debt.

Mezzanine lenders often demand an ‘equity kicker’ or ‘sweetener’ to compensate them for the high risk they run. An equity kicker is an equity warrant, and it enables the mezzanine holder to partake of the upside potential of an MBO by exercising the warrants, and to receive shares in the company. Where there is a financing gap after tapping all the above sources, sometimes vendor agrees to fill the gap. Vendor financing can take the form of unsecured loan notes or preference shares or convertibles. Vendor financing also demonstrates goodwill towards the management. Where the MBO maintains some trading links with the erstwhile parent, such as a supplier, Vendor financing smoothens such links.

9.11.3 THE RATCHET

MBOS have in the past been structured to include an incentive for the management to achieve or exceed agreed levels of performance after the buyout. Such an incentive is known as Ratchet. There are three types of ratchets related to targets based on:

Profit Level Time of Exit Debt repayment.

The first two ratchets increase the amount or proportion of equity made available to the management when the targets are met. The last ratchet allows the interest margin on senior debt to be reduced if the MBO generates a sufficiently high level of cash flows. Reverse ratchet penalise management for failure to achieve targets. Ratchet, though conceptually attractive as an incentive mechanism, may encounter several problems in practice.

First, profit level ratchets require an agreed set of rules for measuring profits. Managements and the capital providers may disagree on the interpretation of these rules.

Second, may be forced to adopt expedient policies which maximise short-term profits but endanger the long-term prospects of the company, such as cutting down on R&D.

Third, the timing of exit is determined at the time of investment and may force an inappropriate exit.

IV Self Assessment Questions

1. In a management Buy-in , a —– ———— team replaces the ——— management.

2. Divestments in a recession tend to be defensive and driven by ———-and ———– whereas in boom time they are triggered by strategic ———–.

3. In the structure of an MBO, funding is provided by debt which falls into two types: ——— debt ————- debt.

4. Senior debt has priority in payment of ——— and repayment of ——-.

5. The mezzanine layer is often in the form of ———– ———- or ——–stock.

6. Mezzanine lenders often demand an —— ——— or ———–.

7. An incentive for the management to achieve or exceed agreed level of performance after the buyout is known as ———.

9.12 Summary

One particular of acquisition which characterised the 1980s mergers and acquisitions scene is the leveraged buyout (LBO). As the name suggests, an LBO is an acquisition which is heavily financed by debt; either bank debt or securitised debt (i.e. bonds). Such a description, of course, fits many of the structure of MBOs discussed above. Thus an MBO is a particular type of LBO.

In other types, an investing firm such as Kohlberg, Kravis and Roberts (KKR) collects a pool of equity, acts as a sponsor to a buyout , arranges the necessary debt finance and makes the takeover bid. The 1980s also witnessed the use of Junk Bonds in financing LBOs. Junk bonds are corporate bonds which have not been accorded the investment grade rating by S & P or Moody’s rating services. They are deemed risky enough for certain trust institutions to be prevented from investing in them. Hence the name Junk Bond (JB) A more respectable name for such type of bond is high-yield bonds.

9.13. Terminal Questions.

1. Explain the concept of LBO and state how it is undertaken.

2. How is Leveraged Buyout an alternative model for Corporate Governance?

3. Explain the different stages of LBO operation.

4. Discuss the methodology of financing LBOs in general and with particular reference to India.

5. Explain the managerial motivations of an MBO.

6. What is ‘ratchet’? Explain three types of ratchet.


SAQ I

1. Private, borrowed

2. Mezzanine money, Pension

3. Management buy out

4. Stock, Asset

SAQ II

1. Defensive

2. Financial, 5 to 7

3. Ownership, control

4. Management, Performance

SAQs III

1. Debt

2. Outstanding shares, new company

3. Profits, operating costs, market

4. Book

5. Quasirents

6. Controlling, borrowed

7. Divestment

SAQs IV

1. New Management, Incumbent

2. Rationalization, cost cutting, restructuring

3. Senior, Mezzanine

4. Interest, principal

5. Preference shares, convertible

6. Equity Kicker, sweetner

7. Ratchet.

TQs

1. 9.2,3

2. 9.5,6

3. 9.7

4. 9.9,10

5. 9.11.2

6. 9.11.3



.

MF0002-Unit-10-Demergers Unit-10-Demergers

10.1 Introduction

Objectives

10.2 Background

10.3 Meaning

10.4 Characteristics

10.5 Structure of Demergers

10.6 Tax Implications for Demerger

10.7 Summary



10.1 Introduction

This Unit introduces the fundamental concept and characteristic of Demergers. Also enable the student to understand how Demergers is carried out internally in the firm for making it more profitable and viable. In addition, student should be able to understand and appreciate the tax implication of demergers.

Objectives


· Define the concept of Demerger.

· Discuss the characteristics and rationale of demerger.

· Discuss about the Tax implications for demerger.

The structure and characteristics of Demerger, one of the many forms of corporate divestment, are examined and illustrated.

10.2 Background

In the 1980s many companies pursued different methods of restructuring their business mainly aimed at enhancing share holders’ value. These include spin-offs or demergers and equity carve-outs. Innovative methods of financing acquisition of even large firms, such as Leveraged Buy-outs discussed in the previous unit, were introduced into the M&A scene. Together, these developments widened the scope and variety of transaction in the M&A market for corporate control.

10.3 Meaning

‘Demerger’, in relation to the companies, means transfer (pursuant to a scheme of arrangement under section 391 to 394 of the Companies Act 1956) by a demerged company in the following manner:

1. All the property of the undertaking, being transferred by the demerged company, becomes the property of the resulting company.

2. All the liabilities relating to the firm being transferred by the demerged company, become the liabilities of the resulting company.

3. The properties and liabilities of the firm being transferred by the demerged company are transferred at values appearing in its book of account immediately before the demerger. For this purpose any change in the value of assets consequent to their valuation shall be ignored.

10.4. Characteristics

In a corporate spin-off, a company floats a subsidiary which may be a small part of the parent company. The creation of an independent company is through the sale or distribution of new shares of an existing business division of a parent company. It is a kind of demerger when the existing parent company transforms to two or more separately re-organised different entity. The newly floated company now has an independent existence and is separately valued in the stock market.

Shares in the spun-off company are distributed to the shareholders of the parent company, and they own shares in two companies rather than just one. This increases the flexibility of the shareholder’s portfolio decisions, since they now have the freedom to alter the proportion of their investment invested in each company. Previously, their investment was indivisible because they could invest in the subsidiary only by investing in the parent.

A demerger is a variant of a spin-off, but the demerged company tends to be larger than a spin-off. .From the parent’s point of view, the spin-off may be preferable to a sell-off, since in the latter case the parent has to decide what to do with the sale proceeds when it does not have any investment opportunities to finance, Further, it appears that the stock market puts a higher value on two companies than on the parent prior to demerger because of the greater information about the separation companies after the flotation.

In the United Kingdom Demergers have been a few so far and in some cases demergers were in response to a hostile takeover. To illustrate, the conglomerate BAT (activities – tobacco, retailing, paper, financial services) was the target of a hostile takeover bid by the Hoylake consortium for £13 billion in 1989. Hoylake wanted to create value by unbundling BAT. However, BAT after a sustained defense campaign, thwarted the takeover bid and took the decision of demerging on its own. Ultimately BAT in a corporate spin-off, a subsidiary by name Argos for retail services and Wiggins Teape Appleton for pulp, paper were floated.

In the same manner, Recal’s demerger of Vodafone (Racal Telecom) and Chubb was triggered by Williams Holdings Hostile bid. In the case of ICI, even though a decision was being contemplated for demerger, Hanson’s acquisition of 2.8% stake in ICI in 1991, treated by ICI as a hostile bid, added to the urgency and a new subsidiary Zeneca was floated. As per Sir Christopher Hogg, chairman of Courtaulds, the demergers release a great deal of energy among the managers of the separate companies Viz. Courtaulds and courtaulds Textiles. Prior to demerger Courtaulds was capitalized at £1025 million in March 1990. Later, on the first day of trading in the shares of two demerged companies, Courtaulds and Courtaulds Textiles were valued at £1241 million and £248 million respectively, a substantial increase in the combined value of £464 million.

Table showing Corporate Demergers in the United Kingdom

Year Parent(activities) Spun-off(activities)1984 Bowater International

(packaging, tissues, building products, paper, services)

Bowater North America(Newsprint, paper and pulp)

1990 Courtaulds (chemicals, clothing and spinning)

Courtaulds Textiles(clothing,fabricks, and fabrics spinning)

1990 BAT(tobacco,retailing, paper, financial services)

Argos( retailer)

1990 BAT(same as above) Wiggins Teape Appleton (pulp and paper)

1991 Racal electronics (communications,cellular telephones, security systems)

Racal Telecom (cellular telephones)

1992 Racal Electronics(as above)

Chubb Group (security systems)

1993 ICI (explosives, industrial chemicals, materials, pharmaceuticals, agrochemicals and speciality chemicals)

Zeneca (pharmaceuticals, agrochemicals andspecialities)

Source: Mergers and Acquisition by Dr P S Sudarshanam.

Self Assessment questions I

1. Demerger, in relation to the companies, means transfer by a demerged company of its —– or ——- undertakings to the ———– company.

2. Demerger is a variant of ——– but demerged company tends to be ———- than spin-off.

1. It appears that the stock market puts a ——– value on two companies than on the parent before ———— because of greater information about the separation companies after ————.

4. Prior to demerger, Courtaulds was capitalized at £——— million.

10.5. Structure of Demergers

In case of demergers, shares of the newly floated company should be distributed to the share holders of the parent company. The ratio of shares held by a share holder in the demerged companies will reflect the ratio of assets or value of the two companies. In case of demerger of

Courtaulds share holders received 1 courtaulds Textiles share for every 4 shares held in courtaulds (parent company).

However incase of ICI demerger, for every one share held in parent company (ICI), they received one share of Zeneca. The allocation of assets and liabilities is often a complex process, and will certainly affect the stock market valuation of the demerged companies. For example, if a high percentage of parent company debt is loaded on the demerged company, then the market may perceive the demerged company as a more risky company and owing to this, the subsidiary may be undervalued.

The newly created entity becomes an independent company taking its own decision and developing its own policies and strategies , which need not be necessarily be the same as those of parent company. Spin-off is necessary for a company having brand equity or multi product company entering to a collaboration with a foreign company. Businesses wishing to streamline their operations often sell less productive or unrelated subsidiary business as spin-offs. The spun off companies are expected to be worth more as independent companies than as part of larger business.

Businesses wishing to ‘streamline’ their operations often sell less productive or unrelated subsidiary businesses as spin-offs. The Spun-off companies are expected to be worth more as independent entities than as parts of a larger business.

10.6. Tax Implications for Demergers

Finance Act, 2000 under section 2 deals with issues relating to taxes in respect demerged undertaking. The amendments made by the finance Act, 1999 basically dealt with demergers and sale of business. Sub clauses (vib), (vic)and (vid) were added to section 47 of the Income Tax Act exempting specified transfers from the levy of capital gains tax. Similarly, amendments were made to section 43 (6) of dealing with computation of ‘written down value’ in the hands of the transferor company and transferee company in case of ‘demerger’. Section 2(19AA) was introduced to define ’demerger’. Section 72 A dealing with carry forward of loss of the amalgamated company was substituted with effect from April 1, 2000.

The substituted section not only deals with loss of the amalgamated company but also deals with loss pertaining to the demerged /hived off undertaking in the hands of the transferee company. The substituted section not only deals with the loss pertaining to un-absorbed loss of a firm in case it is succeeded to a company.

Carry forward and set off of loss and depreciation- when permitted in the hands of amalgamated company and demerged company(sec. 72A)

Generally, depreciation and business loss can be carried forward by a person who has incurred loss. Section 72A provides an exception to this rule. Section 72a is applicable in the following cases from the assessment year 2000-01:

a. Amalgamation of companies

b. Demerger

c. Conversion of proprietary concern/firm into company.

Demerger: In the case of demerger, the accumulated loss and un-absorbed depreciation of the demerged company will be allowed to be carried forward and set off in the hands of the resulting company. The Central Government may, for this purpose, by notification in the official Gazette, specify such conditions as it considers necessary to ensure that the demerger is for genuine purposes.

The manner of computation of loss/depreciation allowance which will be carried forward by the resulting company is shown below:

If the loss/depreciation is directly relatable to the undertakings transferred to the resulting company then such loss/depreciation shall be allowed to be carried forward in the hands of the resulting company. However, such loss or unabsorbed depreciation is not directly relatable to the firm transferred to the resulting company, it will be apportioned between the demerged company and the resulting company in the same proportion in which the assets of the firm have been retained by the demerged company and transferred to the resulting company, and it will be allowed to be carried forward and set off in the hands of the demerged company or the resulting company as the case may be.

Demerger is a tool to release and realize share holder value. Transfer of assets should be at values considered proper by the management and approved by share holders. One should note that it may not be possible to transfer all assets to the demerged company. An example could be – brands. It may be more viable to permit the use of brand rather transferring the brand. Further some creditors would like to remain with Transferor Company. Again share holders could receive bonds, debentures and cash from the transferee company, instead of only shares.

The function of law should be to protect the interest of revenue as it has been done in case of depreciation. It can provide that in cash is received it will go to reduce the cost of shares of the transferor company. The money received on maturity in respect of bonds or debentures will reduce the cost of shares of transferor company. The law could be amended to provide that the cost of shares of the transferee company shall be ‘nil’ as in the case of bonus shares.

CASE STUDY: DEMERGER RAISES TAX PROBLEMS FOR COURTAULDS

The initial reaction of the Inland Revenue to the demerger proposal was one

of suspicion. The main difficulty was with the company’s £60 million of

unrecovered Advance corporation Tax(ACT). In case of COURTAULDS 75% of its’ chemical business turnover was from overseas, whereas Textile business were mostly United kingdom based. Owing to this, for textiles to be assigned most of the unrecovered ACT would reduce the future tax liability of both companies. In this context COURTAULDS proposed splitting the ACT in the proportion of £40 million going to textiles and £20 million to chemicals. However,

Inland Revenue (UK Tax Recovery Department) did not accept the division.(source Financial times, 12.11.1990).

Self Assessment questions II

1. The ratio of shares held by a share holder in the demerged companies will reflect the ratio of ——– or ——— of the two companies.

2. In case of demerger of Courtaulds, share holders received —– Courtaulds textiles share for every ——– shares held in Courtaulds, parent company.

3. If a high percentage of parent company ——– loaded on the ———- company, then the market may perceive the demerged company and owing to this, the subsidiary may be ————–..

4. Finance Act 2000, under section —– deals with issues relating to taxes in respect ————– undertakings.

5. In the case of demerger, the ————— —- and ———- ——— of the demerged company will be allowed to be carried forward and set off in the hands of the resulting company.

10.7. Summary

Demergers means an existing company transforms into two or more separately re-organized different entities. .The newly floated company now has an independent existence and is separately valued in the stock market.

Further it appears that the stock market puts a higher value on two companies than on the parent prior to demerger because of greater information about the separation companies after the floatation.

The ratio of shares held by a shareholder in the demerged companies will reflect the ratio of assets or value of the two companies. A high percentage of parent company debt is loaded to the demerged company , then the market may perceive the demerged company as a more risky company and owing to this, the subsidiary may be undervalued.

Finance Act 2000 under section2 deals with issues relating to taxes in respect of demerged undertaking. In case of demergers the accumulated loss and unabsorbed depreciation of the demerged company will be allowed to be carried forward and set off in the hands of the resulting company.

10.8. Terminal Questions.

1. Explain the ‘background’ and ‘meaning’ of demergers.2. Explain the characteristics of demergers.3. Discuss the tax implications of demergers.

4. Comment on the structure of demergers.

10.9. Answers to SAQs and TQs.

Self Assessment questions I

1. One, more, Resulting

2. Spin off, larger

3. Higher, demerger, floatation.

4. £1025

Self Assessment questions II

1. Assets, value

2. One, four

3. Debt, demerged, undervalued.

4. Two, demerged

5. Accumulated loss, unabsorbed depreciation.

Terminal Questions

1. 10.2,3

2. 10.4

3. 10.6

4. 10.5

Reference:

1. J. Fred Weston, Mark L Mitchell, J Harold Mulherin, Takeover, Restructuring and Corporate Governance, 4th Edition, Pearson Education, Delhi.

2. Sudi Sudarsanam, Creating Value from Mergers and Acquisition: The Challenges, Pearson Education, Delhi.

3. S. Shiva Ramu, Corporate Growth through Mergers and Acquisitions, Response Books, New Delhi.

4. J.C. Verma, Corporate Mergers, Amalgamations & Takeovers, Bharath Publishing House, New Delhi.

5. Aswath Damodaran, “Corporate Finance- Theory and Practice”, John Wiley & Sons Inc New York.

6. M.Y.Khan & P.K. Jain, Financial Management,4th edition, Chapter 33, Tata McGraw Hill Publishing Company ltd, New Delhi.

7. I.M. Pandey, Financial Management, 9th Edition, Chapter 32, Vikas Publishing House Pvt Ltd, New Delhi.



.