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Corporate Finance

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Corporate Finance ­FIN 622
VU
Lesson 33
MERGERS & ACQUISITIONS
In this hand out we shall take up following topics:
Synergies
Types of mergers
Why mergers fail?
Merger process
Acquisition consideration
Synergies and Types of Synergies: (Continued from Lecture 32)
It results from complementary activities .for instance, one firm may have substantial amount of financial
resources while the other has profitable investment opportunities.
Synergy is the energy or force created by the working together of various parts or processes. Synergy in
business is the benefit derived from combining two or more elements (or businesses) so that the
performance of the combination is higher than that of the sum of the individual elements (or businesses).
The enhanced result of two or more people, groups or organizations working together is called synergy. In
other words, one and one equal three! It comes from the Greek "synergia," which means joint work and
cooperative action. The word is used quite often to mean that combining forces produces a better product.
However, in the field of software development, synergy is not the result. In many cases, the more people
assigned to a programming job, the more the quality suffers.
The idea that the value and performance of two companies combined will be greater than the sum of the
separate individual parts.
Types of Synergies:
1-Operational synergies ­ Discussed in Lecture 32
2- Financial synergies
Financial synergies:
If the future cash flow stream of two companies is not positively correlated then combining the two will
reduce the variability of cash flow or will bring stability in cash flow thus may increase the value by having
cheaper financing available. Lenders and creditors like to have stable cash flow that signals the ability of
company to settle its short term and long term obligations.
Diversification normally reduces the risk. If the earnings of two combined entities remain unchanged then
there are still chances of increased firm value. In this case, the reduction in the risk level will add value to
the firm.
From shareholders' stand point if there are no operating economies in a merger, then it will not add value to
the shareholders' wealth.
This should be noted that managers often consider the total risk as this effect the job security and
diversification argument can make sense from a managerial stand point if not a shareholders'.
If the future cash flow of merged entities is not perfectly positively correlated then by merging the two cash
flow variations can be reduced.
Other synergies:
Surplus Human Resources: companies with skilled managers and staff can best utilize these resources only if
they have problems to solve. The acquisition of inefficient companies is sometimes the only way of using
skilled human resources
Surplus cash flow: companies with large amounts of surplus cash may see the acquisition of other
companies as the only possible application for these funds.
Market power: horizontal mergers may enable the company to seek a degree of monopoly power which
could increase its profitability.
Organic growth: growth using mergers and acquisition is speedier than the organic growth.
Types of Mergers
From the perspective of business structures, there is a whole host of different mergers. Here are a few
types, distinguished by the relationship between the two companies that are merging:
·  Horizontal merger - Two companies that are in direct competition and share the same product lines
and markets.
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·
Vertical merger - A customer and company or a supplier and company. Think of a cone supplier
merging with an ice cream maker.
·
Market-extension merger - Two companies that sell the same products in different markets.
·
Product-extension merger - Two companies selling different but related products in the same
market.
·
Conglomeration - Two companies that have no common business areas.
There are two types of mergers that are distinguished by how the merger is financed. Each has
certain implications for the companies involved and for investors:
o  Purchase Mergers - As the name suggests, this kind of merger occurs when one company
purchases another. The purchase is made with cash or through the issue of some kind of
debt instrument; the sale is taxable.
Acquiring companies often prefer this type of merger because it can provide them with a
tax benefit. Acquired assets can be written-up to the actual purchase price, and the
difference between the book value and the purchase price of the assets can depreciate
annually, reducing taxes payable by the acquiring company. We will discuss this further in
part four of this tutorial.
Consolidation Mergers - With this merger, a brand new company is formed and both companies are bought
and combined under the new entity. The tax terms are the same as those of a purchase merger.
Profitable growth constitutes one of the prime objectives of most of the business firms. It can be achieved
internally either through the process of introducing /developing new products or by expanding / enlarging
the capacity of existing products the firm is engaged. Alternatively the growth process can be facilitated
externally by the acquisitions of existing business firms. This acquisition is technically referred to as
mergers, acquisitions, amalgamations, takeovers, absorption, consolidation etc.
Mergers are a tool used by companies for the purpose of expanding their operations and increasing their
profit.
Usually mergers occur in a consensual setting where executives from the target company help those from
the purchaser in a due diligence process to ensure that the deal is beneficial to both parties. Acquisitions can
also happen through a hostile takeover by purchasing the majority of outstanding shares of a company in
the open market against the wishes of the target's board. In most of the countries, business laws vary from
state to state whereby some companies have limited protection against hostile takeovers. One form of
protection against a hostile takeover is the shareholder rights plan, otherwise known as the "poison pill".
Why mergers fail?
Lack of planning or overoptimistic planning
Planning is a crucial exercise that will help determine the success or failure of a merging organization.
However, many merging organizations do not have adequate or complete integration and implementation
plans in place. Only one out of five companies that have acquired another has developed a clear and
satisfactory implementation plan.
Putting the forecast results on paper is much simpler than actually achieving them. During the planning
phase the synergies may be over-estimated because of the subjective judgment issues in estimations.
A major downside of the planning process is that it can take the focus away from daily business activities. It
can also fail to address serious HR issues and activities that can have a strong impact on the organization.
Another flaw in many M&A plans is that they often include expectations that are unrealistic and that will
stretch the merging organizations beyond their capabilities.
Human integration
As discussed above, the early stages of mergers and acquisitions (i.e.
Planning and negotiation) are often carried out in secret and do not usually involve human resources in the
discussions.
This lack of involvement by human resources can have a detrimental impact on the merger, since it means
that many issues that are directly linked to the success or failure of the merger will have been overlooked.
If legal and financial experts are driving the strategic work behind the integration, then a number of
important considerations critical for the financial success of the merger, such as the productivity of the new
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employees, may be overlooked unless human resources and corporate communications staff members
provide their input.
Corporate culture
Even if two companies seem to have all the right ingredients in place for a successful merger, cultural
differences can break the deal. It is not enough for two companies to appear to fit well on paper; at the end
of the day, if the people are not able to work together, the merger will not succeed. Poor communications
and inability to manage cultural differences are the two main causes of failed mergers. Cultural differences
that cannot be resolved affect communications, decision-making, productivity and employee turnover at all
levels of the organization.
All the best laid plans ­ exhaustive analyses of strategies, marketing tactics, legal issues, etc. ­ can fall apart
if the people cannot work together. If the two workforces fail to unite behind the strategic goals underlying
the consolidation, even the best financial deals and most rigorous legal contracts fail to guarantee success.
An example which demonstrates the importance of cultural differences is the Daimler Chrysler merger. The
post-merger phase highlighted the difficulty of trying to integrate two very divergent cultures. Even though
in the beginning, Daimler-Benz and Chrysler both expressed their commitment to working together and
sharing work practices and product development methods, this commitment did not materialize, a
phenomenon exemplified by the Daimler management's unwillingness to use Chrysler parts in Mercedes
cars.
Lack of communications:
Employee communications is considered as being one of the most important issues which needs to be
addressed during a merger or acquisition process. Poor communication between people at all levels of the
organization, and between the two organizations that are merging, is one of the principal reasons why
mergers fail.
Middle management and lower level employees in particular are kept in the dark when it comes to merger
issues. Most of companies customize merger information for middle management and lower levels of
employees. Therefore, it is not surprising that many managers find themselves learning more about their
corporation from reading the daily business section of the newspaper than from their own superiors.
Not only is lack of communication a serious issue for merging organizations, the deliberate withholding of
information from employees on the part of the senior executives who are dealing with the merger, is also a
major problem, and contributes to confusion, uncertainty and a loss of trust and loyalty on the part of
employees. In some cases, companies even feel the need to lie to their employees by making reassuring
statements about the continuity of their roles and pay packages, and by falsely stating that there will be no
redundancies.
Lack of information, no clear direction and confusing messages, all boil down to uncertainty, which is
destructive.
Talent Departure:
An increase in the turnover rate of productive employees is one of the greatest prices of corporate mergers.
Mergers and acquisitions often lead to the loss of the merging companies' greatest assets: talented
employees and key decision-makers. According to the American Management Association, one out of four
top performers leaves the company within 3 months of the announcement of an event involving major
change in the organization and 47% of senior managers in the acquired company leave within the first year.
A Wall Street Journal article estimated that 50-75% of managers in companies that have merged plan to
leave within three years. Yet the decision to merge or acquire is often based on the desire to gain a talented
workforce, and new knowledge and expertise. This obvious contradiction is not dealt with satisfactorily by
company leaders who are not taking sufficient steps to resolve this problem. They need to realize that when
employees leave the company following a merger or acquisition, they are taking with them the knowledge
and expertise that was part of the reason the merger occurred in the first place.
Employees are the most important assets companies have. Yet they are totally forgotten about when a deal
is being done. The boards and senior management just don't get it.
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Frequently, employees do not leave of their own free will following an M&A transaction, as companies
reduce their headcounts and downsize in a bid to reduce costs. At the same time, however, companies in
today's economy seem to be rated more and more on their innovative capabilities and unique expertise,
which reinforces the notion that employees are a company's greatest assets.
Not only do merging companies suffer a drop in productivity as a result of losing talented employees, but
lower morale and a sense of insecurity on the part of the employees who remain in the newly-merged
organization can also lead to productivity problems.
Remaining employees end up distrusting their employer and often become reluctant to safeguard the
interests of the new company. They also become de-motivated to work to their best abilities.
The resulting loss of creative power can cripple a corporation that is competing within a rapidly changing
industry.
Loss of Customers:
With the loss of employees also comes the loss of customers during mergers and acquisitions. Some of the
most talented employees, responsible for bringing in valuable business to their organizations, are often the
ones who leave, resulting in the loss of key customers.
All companies need to remember: it's the people who produce profits, represent the company, establish
rapport with the customers, and, ultimately, are the ones that will make the combined company succeed.
Even if merging companies succeed in retaining the employees that bring in the business, customers may
still decide to take their business to other companies if they fear that their level of service is going to
deteriorate in the newly merged organization. Lack of communication on the part of management is
therefore the culprit not only when it comes to the employees of the merging organizations, but also when
it comes to their customers.
Merger and Acquisition Process:
Determining the Target (Company)
Once the management has decided to expand through mergers and acquisitions, it must determine the
prospective target company in the sector it is interested in.
First step in this regard would be to evaluate the feasibility from commercial and financial viewpoint. M &
A transactions are carried out as going concern and purchase of assets basis, we will highlight the areas that
need special focus by the management:
Organizational information: that includes management, skill and expertise, other employees, payroll
structure and appointment terms, unionization, benefit plans.
Sales & Marketing: historic sales trend and analysis, products ­ strengths, market share, sales net work,
market reputation.
Technology: Technical expertise required to run the targeted company, future assessment, research &
development required.
Financial & Accounting information: historical accounts, profitability analysis, assets and liabilities true
position, accounting policies, equity analysis.
Cash & Bank: details of bank accounts, collaterals against loans, details of agreements like leases, forward
rates, etc.
Tax: tax computations like for depreciation, deferred tax, any pending case with tax department,
outstanding liabilities for income and sales tax, rather for other taxes as well.
Formulation of Scheme:
Once the prospecting phase is over, the companies seek the help of legal and financial consultants to
finalize the details of proposed scheme of merger.
Memorandum of Association:
The object clause of amalgamated company should be examined to see if it permits continuation of the
business amalgamating (transfer) company by it, if it does not, then suitable amendments / alteration must
be made in the manner prescribed in the companies act.
Intimation to Stock Exchange and Notification:
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As soon as the offer of merger is made, the stock exchanges where these companies are listed should be
notified and the fact of the offer should be announced in the newspapers. To ensure proper disclosure, the
announced is made in the form approved by the regional stock exchange.
Directors Approval of the Proposed Scheme
The proposed scheme of merger should be submitted to the Board of Director of each company for their
approval.
Shareholders Approval:
The scheme, once approved by the Board of Directors, should be placed before shareholders at a general
meeting for their approval. It is not a legal necessity, but the company in practice gets the scheme approved
by its shareholders before they file an application for the sanction of the court.
Transfer of Assets and Liabilities, issuance of Shares, etc.
Finally, the companies can implement the scheme by transferring assets and liabilities by issuing of shares
and given any other consideration to the members of the amalgamating company, as per the scheme of
merger.
Cultural due diligence
When merging with another firm, most companies focus more on the deal than on the subsequent
integration of the companies. This may explain, at least in part, why most of them fail.
Despite popular beliefs to the contrary, the single greatest barrier to business success is the one
erected by culture.
How important is culture in an organization? In recent years it has been acknowledged as being as
significant a factor in international business as the bottom line. While the mergers and acquisitions boom
has slowed somewhat in 2002, the percentage of acquisitions across borders has continued to increase,
expected to reach 50 percent of all M&A activity by 2003.
According to the International Labor Organization, 70 percent of mergers and acquisitions worldwide fail
to meet their strategic objectives within two years. International consultants KPMG revealed in a recent
study "the overwhelming cause for failure of M & As is the people and the cultural differences." Meaning
that in the majority of instances, these business ventures run aground due to organizational culture conflicts.
Since knowledge is power, the obvious approach is for the acquiring party to perform a cultural due
diligence before making the final decision, to determine if there is cultural synergy between the partners.
This is often rejected by the company being investigated, however, since it requires allowing the (as yet
uncommitted) outside faction full access to HR policy and company personnel.
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Table of Contents:
  1. INTRODUCTION TO SUBJECT
  2. COMPARISON OF FINANCIAL STATEMENTS
  3. TIME VALUE OF MONEY
  4. Discounted Cash Flow, Effective Annual Interest Bond Valuation - introduction
  5. Features of Bond, Coupon Interest, Face value, Coupon rate, Duration or maturity date
  6. TERM STRUCTURE OF INTEREST RATES
  7. COMMON STOCK VALUATION
  8. Capital Budgeting Definition and Process
  9. METHODS OF PROJECT EVALUATIONS, Net present value, Weighted Average Cost of Capital
  10. METHODS OF PROJECT EVALUATIONS 2
  11. METHODS OF PROJECT EVALUATIONS 3
  12. ADVANCE EVALUATION METHODS: Sensitivity analysis, Profitability analysis, Break even accounting, Break even - economic
  13. Economic Break Even, Operating Leverage, Capital Rationing, Hard & Soft Rationing, Single & Multi Period Rationing
  14. Single period, Multi-period capital rationing, Linear programming
  15. Risk and Uncertainty, Measuring risk, Variability of return–Historical Return, Variance of return, Standard Deviation
  16. Portfolio and Diversification, Portfolio and Variance, Risk–Systematic & Unsystematic, Beta – Measure of systematic risk, Aggressive & defensive stocks
  17. Security Market Line, Capital Asset Pricing Model – CAPM Calculating Over, Under valued stocks
  18. Cost of Capital & Capital Structure, Components of Capital, Cost of Equity, Estimating g or growth rate, Dividend growth model, Cost of Debt, Bonds, Cost of Preferred Stocks
  19. Venture Capital, Cost of Debt & Bond, Weighted average cost of debt, Tax and cost of debt, Cost of Loans & Leases, Overall cost of capital – WACC, WACC & Capital Budgeting
  20. When to use WACC, Pure Play, Capital Structure and Financial Leverage
  21. Home made leverage, Modigliani & Miller Model, How WACC remains constant, Business & Financial Risk, M & M model with taxes
  22. Problems associated with high gearing, Bankruptcy costs, Optimal capital structure, Dividend policy
  23. Dividend and value of firm, Dividend relevance, Residual dividend policy, Financial planning process and control
  24. Budgeting process, Purpose, functions of budgets, Cash budgets–Preparation & interpretation
  25. Cash flow statement Direct method Indirect method, Working capital management, Cash and operating cycle
  26. Working capital management, Risk, Profitability and Liquidity - Working capital policies, Conservative, Aggressive, Moderate
  27. Classification of working capital, Current Assets Financing – Hedging approach, Short term Vs long term financing
  28. Overtrading – Indications & remedies, Cash management, Motives for Cash holding, Cash flow problems and remedies, Investing surplus cash
  29. Miller-Orr Model of cash management, Inventory management, Inventory costs, Economic order quantity, Reorder level, Discounts and EOQ
  30. Inventory cost – Stock out cost, Economic Order Point, Just in time (JIT), Debtors Management, Credit Control Policy
  31. Cash discounts, Cost of discount, Shortening average collection period, Credit instrument, Analyzing credit policy, Revenue effect, Cost effect, Cost of debt o Probability of default
  32. Effects of discounts–Not effecting volume, Extension of credit, Factoring, Management of creditors, Mergers & Acquisitions
  33. Synergies, Types of mergers, Why mergers fail, Merger process, Acquisition consideration
  34. Acquisition Consideration, Valuation of shares
  35. Assets Based Share Valuations, Hybrid Valuation methods, Procedure for public, private takeover
  36. Corporate Restructuring, Divestment, Purpose of divestment, Buyouts, Types of buyouts, Financial distress
  37. Sources of financial distress, Effects of financial distress, Reorganization
  38. Currency Risks, Transaction exposure, Translation exposure, Economic exposure
  39. Future payment situation – hedging, Currency futures – features, CF – future payment in FCY
  40. CF–future receipt in FCY, Forward contract vs. currency futures, Interest rate risk, Hedging against interest rate, Forward rate agreements, Decision rule
  41. Interest rate future, Prices in futures, Hedging–short term interest rate (STIR), Scenario–Borrowing in ST and risk of rising interest, Scenario–deposit and risk of lowering interest rates on deposits, Options and Swaps, Features of opti
  42. FOREIGN EXCHANGE MARKET’S OPTIONS
  43. Calculating financial benefit–Interest rate Option, Interest rate caps and floor, Swaps, Interest rate swaps, Currency swaps
  44. Exchange rate determination, Purchasing power parity theory, PPP model, International fisher effect, Exchange rate system, Fixed, Floating
  45. FOREIGN INVESTMENT: Motives, International operations, Export, Branch, Subsidiary, Joint venture, Licensing agreements, Political risk