Capital Budgeting Decisions

Chapter - 32 : 

Chapter - 32 Corporate Restructuring, Mergers and Acquisitions

Chapter Objectives : 

2 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Chapter Objectives Discuss the form of mergers and acquisitions. Highlight the real motives of mergers and acquisitions. Illustrate the methodology for evaluating mergers and acquisitions. Focus on the considerations that are important in the mergers and acquisitions negotiations. Understand the implications and evaluation of the leveraged buyouts.

Introduction : 

3 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Introduction Corporate restructuring includes mergers and acquisitions (M&As), amalgamation, takeovers, spin-offs, leveraged buy-outs, buyback of shares, capital reorganisation etc. M&As are the most popular means of corporate restructuring or business combinations.

Types of Business Combination : 

4 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Types of Business Combination Merger or Amalgamation Merger or amalgamation may take two forms: Absorption  is a combination of two or more companies into an existing company. Consolidation is a combination of two or more companies into a new company. In merger, there is complete amalgamation of the assets and liabilities as well as shareholders’ interests and businesses of the merging companies. There is yet another mode of merger. Here one company may purchase another company without giving proportionate ownership to the shareholders’ of the acquired company or without continuing the business of the acquired company.

Types of Business Combination : 

5 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Types of Business Combination Forms of Merger: Horizontal merger   Vertical merger   Conglomerate merger   Acquisition may be defined as an act of acquiring effective control over assets or management of a company by another company without any combination of businesses or companies. A substantial acquisition occurs when an acquiring firm acquires substantial quantity of shares or voting rights of the target company.

Types of Business Combination : 

6 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Types of Business Combination Takeover – The term takeover is understood to connote hostility. When an acquisition is a ‘forced’ or ‘unwilling’ acquisition, it is called a takeover. A holding company is a company that holds more than half of the nominal value of the equity capital of another company, called a subsidiary company, or controls the composition of its Board of Directors. Both holding and subsidiary companies retain their separate legal entities and maintain their separate books of accounts.

M&A in India : 

7 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. M&A in India

Motives of Mergers and Acquisitions : 

8 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Motives of Mergers and Acquisitions Mergers and Acquisition are intended to: Limit competition. Utilise under-utilised market power. Overcome the problem of slow growth and profitability in one’s own industry. Achieve diversification. Gain economies of scale and increase income with proportionately less investment. Establish a transnational bridgehead without excessive start-up costs to gain access to a foreign market.

Motives and Benefits of Mergers and Acquisitions : 

9 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Motives and Benefits of Mergers and Acquisitions Utilise under-utilised resources–human and physical and managerial skills. Displace existing management. Circumvent government regulations. Reap speculative gains attendant upon new security issue or change in P/E ratio. Create an image of aggressiveness and strategic opportunism, empire building and to amass vast economic powers of the company.

Benefits of Mergers and Acquisitions : 

10 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Benefits of Mergers and Acquisitions The most common advantages of M&A are: Accelerated Growth Enhanced Profitability Economies of scale  Operating economies   Synergy Diversification of Risk

Benefits of Mergers and Acquisitions : 

11 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Benefits of Mergers and Acquisitions Reduction in Tax Liability Financial Benefits Financing constraint  Surplus cash  Debt capacity  Financing cost  Increased Market Power

Analysis of Mergers and Acquisitions : 

12 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Analysis of Mergers and Acquisitions There are three important steps involved in the analysis of mergers or acquisitions: Planning Search and screening Financial evaluation

Value Creation Through Mergers and Acquisitions : 

13 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Value Creation Through Mergers and Acquisitions Merger will create an economic advantage (EA) when the combined present value of the merged firms is greater than the sum of their individual present values as separate entities.

Valuation under Mergers and Acquisitions: DCF Approach : 

14 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Valuation under Mergers and Acquisitions: DCF Approach In order to apply DCF technique, the following information is required: Estimating Free Cash Flows Revenues and expenses Capex and depreciation: Working capital changes Estimating the Cost of Capital Terminal Value

Financing a Merger : 

15 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Financing a Merger Cash Offer: A cash offer is a straightforward means of financing a merger. It does not cause any dilution in the earnings per share and the ownership of the existing shareholders of the acquiring company. Share Exchange: A share exchange offer will result into the sharing of ownership of the acquiring company between its existing shareholders and new shareholders (that is, shareholders of the acquired company). The earnings and benefits would also be shared between these two groups of shareholders. The precise extent of net benefits that accrue to each group depends on the exchange ratio in terms of the market prices of the shares of the acquiring and the acquired companies. The bootstrapping phenomenon.

Merger Negotiations: Significance of P/E Ratio and EPS Analysis : 

16 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Merger Negotiations: Significance of P/E Ratio and EPS Analysis The mergers and acquisitions decisions are also evaluated in terms of EPS, P/E ratio, book value etc. Share Exchange Ratio The share exchange ratio (SER) would be as follows: The exchange ratio in terms of the market value of shares will keep the position of the shareholders in value terms unchanged after the merger since their proportionate wealth would remain at the pre-merger level.

Merger Negotiations: Significance of P/E Ratio and EPS Analysis : 

17 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Merger Negotiations: Significance of P/E Ratio and EPS Analysis Post-merger weighted P/E ratio: (Pre-merger P/E ratio of the acquiring firm)  (Acquiring firm’s pre-merger earnings  Post-merger combined earnings) + (Pre-merger P/E ratio of the acquired firm)  (Acquired firm’s pre-merger earnings  Post-merger combined earnings)

Merger Negotiations: Significance of P/E Ratio and EPS Analysis : 

18 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Merger Negotiations: Significance of P/E Ratio and EPS Analysis Earnings Growth The formula for weighted growth in EPS can be expressed as follows: Weighted Growth in EPS = Acquiring firm’s growth × (Acquiring firm’s pre-merger PAT/combined firm’s PAT) + Acquired firm’s growth × (Acquired firm’s pre-merger PAT/combined firm’s PAT).

Factors Influencing the Earnings Growth : 

19 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Factors Influencing the Earnings Growth The important factors influencing the earnings growth of the acquiring firm in future are: The price–earnings ratios of the acquiring and the acquired companies. The ratio of share exchanged by the acquiring company for one share of the acquired company. The pre-merger earnings growth rates of acquiring and the acquired companies. The level of profit after tax of the merging companies. The weighted average of the earnings growth rates of the merging companies.

Leveraged Buy-outs : 

20 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Leveraged Buy-outs A leveraged buy-out (LBO) is an acquisition of a company in which the acquisition is substantially financed through debt. When the managers buy their company from its owners employing debt, the leveraged buy-out is called management buy-out (MBO). The following firms are generally the targets for LBOs: High growth, high market share firms High profit potential firms High liquidity and high debt capacity firms Low operating risk firms The evaluation of LBO transactions involves the same analysis as for mergers and acquisitions. The DCF approach is used to value an LBO.

Tender Offer and Hostile Takeover : 

21 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Tender Offer and Hostile Takeover A tender offer is a formal offer to purchase a given number of a company’s shares at a specific price. Tender offer can be used in two situations. First, the acquiring company may directly approach the target company for its takeover. If the target company does not agree, then the acquiring company may directly approach the shareholders by means of a tender offer. Second, the tender offer may be used without any negotiations, and it may be tantamount to a hostile takeover.

Defensive Tactics : 

22 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Defensive Tactics Divestiture  Crown jewels  Poison pill  Greenmail White knight  Golden parachutes

Regulation of Mergers and Takeovers in India : 

23 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Regulation of Mergers and Takeovers in India In India, mergers and acquisitions are regulated through: The provision of the Companies Act, 1956, The Monopolies and Restrictive Trade Practice (MRTP) Act, 1969, The Foreign Exchange Regulation Act (FERA), 1973, The Income Tax Act, 1961, and The Securities and Controls (Regulations) Act, 1956. The Securities and Exchange Board of India (SEBI) has issued guidelines to regulate mergers, acquisitions and takeovers.

Regulation of Mergers and Takeovers in India : 

24 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Regulation of Mergers and Takeovers in India Legal Measures against Takeovers Refusal to Register the Transfer of Shares: a legal requirement relating to the transfer of shares have not be complied with; or the transfer is in contravention of the law; or the transfer is prohibited by a court order; or the transfer is not in the interests of the company and the public. Protection of Minority Shareholders’ Interests SEBI Guidelines for Takeovers: Disclosure of share acquisition/holding Public announcement and open offer Offer price Disclosure Offer document

Legal Procedures : 

25 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Legal Procedures Permission for merger Information to the stock exchange Approval of board of directors Application in the High Court Shareholders’ and creditors’ meetings Sanction by the High Court Filing of the Court order Transfer of assets and liabilities Payment by cash or securities

Accounting for Mergers and Acquisitions : 

26 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Accounting for Mergers and Acquisitions Pooling of Interests Method In the pooling of interests method of accounting, the balance sheet items and the profit and loss items of the merged firms are combined without recording the effects of merger. This implies that asset, liabilities and other items of the acquiring and the acquired firms are simply added at the book values without making any adjustments. Purchase Method Under the purchase method, the assets and liabilities of the acquiring firm after the acquisition of the target firm may be stated at their exiting carrying amounts or at the amounts adjusted for the purchase price paid to the target company.