The Synergy Behind a Merger and Acquisition Finance Essay

This is the basic equation of synergy which exists behind a merger or an acquisition. The main principle behind buying or acquiring a company is to create a shareholder value very much above that of the sum of the two companies. The total value of firms after M&A is greater than their simple arithmetical sum and the reasoning behind M&A is that when two companies join hands or somehow come together are more valuable than two separately existing companies. Mergers and acquisitions (M&A) refers to the aspect of Corporate finance Corporate management Corporate strategies M&A deals with the buying, selling, combining or acquiring of different companies that can financially aid or help a company to grow in a given industry and grow quickly without creating another business entity. It comes into play whenever a company considers to expand its business and gain market leadership at the cost of their current scenario. All the Strong companies buy other smaller companies to create a more cost-efficient and competitive company. The companies come together hoping to gain a larger market share as well as to achieve greater efficiency. It is due to these potential benefits that the target companies of the acquisition, will agree to be purchased when they know they can't survive alone in the market and shall eventually die in the future run. M&A have become a huge driving force in the economic and the financial environment around the world. They generally create huge public interest and presents the most dramatic picture of Corporate Finance. M&A play a major part in the world of corporate finance. So M&A can be regarded as a long term investment for the company which takes over the the other company. It rarely looks at the short term monetary benefits and weighs gaining leadership as a priority. The companies which participate in M&A do so just because of their mutual benefits. M&A helps firms to implement their strategic decisions of diversification for the maximisation of company's growth by expanding and enhancing their operations. It refers to the external expansion of a firm through combining with another company and gain competitive advantage in terms of Expansion of the customer base, Cutting out the competition Entry into a new market or a product segment.

HISTORY OF M&A

Period

Name

Facet

1889 - 1904 Ist Wave Horizontal mergers 1916 - 1929 IInd Wave Vertical mergers 1965 - 1989 IIIrd Wave Diversified and Conglomerate mergers 1992 - 1998 IVth Wave Hostile takeovers; Congeneric mergers; Corporate Raiding 2000 - Vth Wave Cross-border mergers

MERGERA

It is a combination of two or more businesses so as to form one and it occurs when two or more companies combine to form a new company. The term 'Amalgamation' is also used for a merger as all the assets, liabilities as well as the shareholders interest of the merging companies are agglomerated into the acquiring company. A majority vote of shareholders is required to approve a merger undertaking. Merger suggests a balance of strength and willingness between the two to join forces refers to the consolidation of companies. Merger is a financial tool that is used for enhancing long-term profitability by expanding their operations.A Merger may be of two forms: Merger through absorption - involves two or more companies which combine into an existing company and transfers all its assets, liabilities and shares to the acquiring company. Generally a smaller firm is absorbed by a larger firm for mutual benefits. Here the weaker firm loses its identity and becomes a part of the powerful firm, which assumes all the rights of the merging organisation. As a result the acquired company ceases to exist. e.g. Absorption of Tata Fertilizers Ltd (TFL) by Tata Chemicals Ltd (TCL), where TCL completely took over TFL. Merger through consolidation - involves two or more companies which combine to form a new company. In this, all the companies are legally dissolved and a new entity is created. The assets and liabilities of the acquired company are transferred to the new company in exchange for shares or cash. E.g. In 1986, Hindustan Computers Ltd, Indian software Company Ltd, Hindustan Instruments Ltd and Indian Reprographics Ltd merged to form HCL Ltd. A fundamental characteristic of a merger (either through absorption or consolidation) is that the acquiring company (existing or new) takes over the ownership as well as the control of other companies and combines their operations with its own operations.

VARIETIES OF MERGERS

Horizontal Merger -refers to the merger of two companies which are direct competitors of one another. They serve the same market and sell the same product. This usually happens in the case of two competing companies merging who has the same product lines and markets. occurring between companies producing similar goods or offering similar services. occurs frequently as a result of larger companies attempting to create more efficient economies of scale. This type of merger can either have a very large effect or little to no effect on the market. When two very small companies horizontally merge, the results are less noticeable. e.g. If a small local drug store were to horizontally merge with another local drugstore, the effect of this merger on the drugstore market would be minimal. In a large horizontal merger, however, the resulting rippling effects can be felt throughout the whole economy and greatly affect the market sector. Large horizontal mergers are often seen as anticompetitive agreements, considering that If one company holding twenty percent of the market share combines with another company also holding similar market share, their combined share holding will then increase .This large horizontal merger gives the new company an unfair market advantage over its competitors. This promotes anti-competitive environment where the end customer suffers and has to succumb to the prices of the market leader and also the firm limits its production and gaining competitive advantage. e.g. The amalgamation of Daimler-Benz and Chrysler. The formation of Brook Bond Lipton India Ltd. through the merger of Lipton India and Brook Bond The merger of Bank of Mathura with ICICI (IndustrialA CreditA and Investment Corporation of India) Bank The merger of BSES (Bombay Suburban Electric Supply) Ltd. with Orissa Power Supply Company The merger of ACC (erstwhile Associated Cement Companies Ltd.) with Damodar Cement say, if merging of Pizza Hut and Dominos McDonalds and Burger King Vertical Merger- a merger between a consumer and a company or a supplier and a company. Here two firms involved in the same business but on different levels join hands where the two companies involved in producing different goods and services for a specific finished product, integrate and one firm acquires another firm in the same industry but at a different stage in the production cycle. This merger allows the firm to gain more control of another level of the manufacturing or selling process within that single industry. It involves integrating its supply chain into its operations. The acquiring firm, through a vertical merger, may lower its cost of production and distribution and make more productive and efficient use of its resources. e.g. a baseball bat company merging with a wood production company. an ice cream cone supplier merges with an ice cream maker. Reliance Industries Lmtd. (RIL) merging with Reliance Petroleum Lmtd (RPL) Time Warner Incorporated, a major cable operation, and the Turner Corporation, which produces CNN, TBS, and other programming. Market-extension merger -A When two companies that sell the same products but in different markets merge. It basically expands the market base of the product. e.g. can be Bharti and Warid, extended its market in Bangladesh. Product-extension merger - The merging of two companies selling different but somewhat related products in the same market. They usually serve a common market and enables the new company to go in for a pooling in of their products so as to serve a common market, which was earlier fragmented among them. e.g. The acquisition of Mobilink Telecom Inc. by Broadcom. Broadcom deals in the manufacturing Bluetooth personal area network hardware systems and chips for IEEE 802.11b wireless LAN whereas Mobilink Telecom Inc. deals in the manufacturing of product designs meant for handsets that are equipped with the Global System for Mobile Communications technology. Conglomeration - Two companies which have no common business areas merge together and refers to the merger of companies, which do not either sell any related products or cater to any related markets. There are two types of conglomerate mergers: pure mixed. While the Pure conglomerate mergers involve companies with nothing in common between them, the mixed conglomerate mergers involve companies that are looking for product extensions or market extensions. Conglomerate mergers helps the companies to diversify and as a result, the merging companies can also bring down the levels of their exposure to risks.

e.g.

Reliance capital bought adlabs

Phillip Morris, a tobacco company which acquired General Foods in 1985.

TRIANGULAR MERGER

-refers to the acquisition of a local company through a share swap with a local subsidiary that is wholly owned by a foreign buyer. Here the acquiring corporation could acquire control of the target firm without being a constituent corporation. The acquiring firm forms a new subsidiary into which the target firm is merged. The stockholders of the acquiring firm do not have the right to vote on the merger since they are not a constituent corporation. The stockholders of the target corporation will have the same rights as in a normal two-party merger. TRIANGULAR MERGER

ACQUISITION

-the act of acquiring effective control over assets or management of a company by other company without any combination of businesses or companies. Acquisition -it usually refers to a purchase of a smaller or a weaker firm by a larger and a powerful one. Objectives of Acquisitions: To complement or substitute for Research and Development To enter speedily into the emerging competitive markets To supplement the existing product and business with latest technology To acquire and retain the talented people and staff Acquisition may take two forms: Friendly Takeover or Acquisition: When management of the two firms mutually and willingly agrees for the takeover, it is called acquisition or friendly takeover. e.g. UK-based Vodafone AirTouch and the German Mannesmann AG, agreed to a "friendly takeover" in February 2000. Vodafone declared that it would fully respect the corporate culture of Mannesmann, including the employees' co-determination rights. 2. Takeover (Hostile): When an acquisition is 'forced or unwilling' it is called a takeover. As per MRTP Act, takeover means "acquisition of not less than 25 percent of the voting power in a company." Hewlett-Packard's takeover of Compaq. The deal was valued at $25 billion, Oracle buying PeopleSoft that happened in 2004. Microsoft planning to purchase Yahoo in a hostile environment Although, they are often considered to have the same meaning, the terms 'merger' and 'acquisitions' are slightly different from each other.

Mergers

Acquisitions

It occurs when two or more companies combine to form a new company. It occurs when a company takes over another company Significant restructuring occurs in the company Corporate leadership doesn't change much Very few deals of this type takes place Most of the deals that occur are of this type only Both the companies' stocks are surrendered and new company stock is issued in its place. The acquired company's stocks are transferred and its assets are merged into the acquiring company's assets. Both of CEOs agree that joining together is in the best interest of both of their companies. The target company also does not want to be purchased. occurs between equals occurs only when one large takes over a smaller one ensures profitability without any negative connotation carries a negative impression on everyone Although, in reality an acquisition takes place, the firms declare it as a merger to avoid any negative impression. Whether a purchase is considered as a merger or an acquisition actually depends on the purchase whether it is friendly or hostile and how it has been announced. So the real difference lies in how the purchase is communicated to all and received by the target company's board of directors, shareholders and employees.

Some Motives of Mergers and Acquisitions

Economy of scale: refers to the fact that the combined company can reduce its fixed costs by removing redundant departments or operations, lowering the costs of the company and thus increasing their profit margins. Economy of scope: refers to the efficiencies associated with demand changes, like increasing/decreasing the scope of the marketing and distribution of a wide array of products. A company uses a specific set of skills to widen its activities. e.g. Proctor and Gamble can enjoy economies of scope if it acquires a consumer product company. Increased revenue or market share: It assumes that the buyer will be absorbing and amalgamating a major competitor and thus increase its market power (by capturing increased market share). Geographical or other diversification: It is designed to smoothen the earnings results of a company, which over the long term smoothens the stock price of a company, giving the investors extra confidence in investing in the company. Taxation: A profitable company can buy a loss maker to use the target's loss as their advantage by reducing their tax liability. Synergy: For example, managerial economies such as the increased opportunity of managerial specialization. Another example is of purchasing economies due to increased order size and associated bulk-buying discounts. Resource transfer: the resources are unevenly distributed all across the firms and the interaction of target and acquiring firm resources can create value through either overcoming information uneveness or by combining scarce resources. Vertical integration: Vertical integration occurs when an upstream and downstream firm merge and the reason is to internalise an externality problem. e.g. company engaged in oil exploration and production (ONGC) with company engaged in refining and its marketing (HPCL) to improve coordination and control.

DUBIOUS REASONS FOR MERGER

Diversification

Achieve risk reduction Depends on the correlation

Lower financing cost

Larger size and greater earnings stability Reduce the cost of borrowing More feasible than internal investment

MERGERS AND ACQUISITIONS: VALUATION

Investors in a company whose A aim is to take over another one must determine whether the purchase will be beneficial to them; they must find out how much the company being acquired is actually worth and is it an advantageous acquisition or not. Naturally, both the sides of anA M&A deal will have varied ideas about the worth of a target company: its seller will tend to valueA the company as high of a price as possible, whereas the buyer will try to get the lowest price that he can. There are some legitimate ways to value companies. The most common is to look at the comparable companies in an industry, but deal makers employ a variety of other methods and tools when assessing a target company. Comparative RatiosA - the basic comparative metrics on which acquiring companiesA may base their offers: Price-EarningsA RatioA (P/E Ratio)A - With this, an acquiring companyA makes an offerA which isA a multiple of the earnings of the target company. Enterprise-Value-to-SalesA RatioA (EV/Sales)A - With this, the acquiring company can make an offer as a multiple of the revenues, also, being aware of theA price-to-sales(P/S) ratioA of other companies in the industry as well. Discounted Cash FlowA (DCF) -A evaluation tool in M&A, Discounted cash flow analysis determines a company's current value according to its estimated future cash flows. The forecasted free cash flows (net incomeA + depreciation/amortization - capital expenditures - change in working capital) are discounted to present value using company's weighted average costs of capitalA (WACC). Replacement CostA - When the acquisitions are based on the cost of replacing the target company. Suppose the value of a company is the sum of all its equipment and staffing costs resources and the acquiring company can order the target to sell at that price, or it will create a competitor for the same cost price. Obviously, it would take very long to assemble effective management, acquire properties and get the correct equipments. So this method of establishing a price certainly wouldn't make much sense in a service industry where the key assets - people and the ideas - are hard to value, retain and develop. Synergy- The idea that the value and performance of two companies combined will be greater than the sum of the separate individual parts. The Buyers will need to pay a premium if they hope to even acquire the company, inspite of what pre-merger evaluation advises them. For the sellers, it is that premium which represents their company's future prospects. As for the buyers, this premium represents part of the post-merger synergy they expect can be achieved. For example, if Company A has an excellent product but lousy distribution whereas Company B has a great distribution system but poor products, the companies could create synergy with a merger. When NPV is positive then the acquisition appears viable and profitable for the company and enhances its growth prospects. If company A wants to buy company B, then NPV of purchase must be >0.

NPV = Gain - Cost > 0

Gain = PVAB - (PVA + PVB) = Value of Synergy

i.e. PV of combined company AB >than PV of each separate entities.

COMPENSATION IN MERGERS AND ACQUISITIONS

Firm A acquires firm B Determine benefit of the merger Benefit = PVAB - (PVA + PVB) Acquiring company to compensate acquired company by: Compensation in Cash Compensation in Stock

COMPENSATION IN CASH

Firm A acquires firm B and compensates in cash COMPENSATION IN CASH = CASH - PVB NPV to A = Benefit - Cost = [(PVAB - (PVA + PVB)] - [Cash - PVB] = PVAB - PVA - Cash NPV to B = (Cash - PVB)

Compensation in Stock

Sometimes, instead of paying cash, we can compensate acquired company in terms of stocks. Firm 'A' plans to acquire firm B. True cost will be:

COST = AŽA± PVAB - PVB

PVAB = PVA + PVB + benefit

COST = AŽA±PVAB - PVB

NPV to A = Benefit - cost Usually, it is observed that if compensation is paid in cash, cost of acquisition is independent of the gains of acquisition. On the other hand, if the compensation is paid in stock, cost of acquisition is dependent on the gains of acquisition.

FACTORS: CASH V/S STOCK COMPENSATION

Whether to pay for an acquisition in cash or in stock is an important decision. It depends on these factors: Overvaluation: if acquiring firm's stock is overvalued relative to acquired company's stock, paying in stock can be less costly than paying in cash. Taxes: considering shareholders of the acquired firm, cash compensation is a taxable transaction while stock compensation is not. Sharing of Risks and Rewards: if cash compensation is paid, then shareholders of acquired firm neither bear risks nor enjoy rewards of merger. On the other hand, if stock compensation is paid, shareholders of the company partake in the risks as well as rewards of the merger. Discipline: usually seen that acquisitions financed by cash tend to succeed more compared to acquisitions financed by stock because perhaps cash buyers are more disciplined, circumspect and rigorous in their evaluation.

Biggest Recent Mergers and Acquisitions deals in India

Tata Steel acquired 100% stake in Corus Group in 2007 with an all cash deal amounting to $12.2 billion. Vodafone purchased administering interest of 67% owned by Hutch-Essar for a worth of $11.1 billion in 2007. The acquisition of Japanese pharmaceutical company Daiichi Sankyo by Indian major Ranbaxy for $4.5 billion.A The Oil and Natural Gas Corp purchased Imperial Energy Plc in 2009 and The deal amounted to $2.8 billion. In 2008 NTT DoCoMo, the Japan based telecom firm acquired 26% stake in Tata Teleservices for USD 2.7 billion.A

CONCLUSION

Mergers and Acquisitions form an important facet of Corporate Finance and Strategy. It is involved in Investment Banking too. Many companies believe that the best way toA gain competitive advantageA is toA expand ownership boundaries through M&A. M&A is basically depicted by the equation 1+1=3, which means that a combined company is far more valuable than separately existing business entities. Investors can be confident that a merger will always deliver enhanced market power.A A merger involves the mutual decision of two companies to combine and becomeA one entity; itA can be seen as a decision made byA two "equals" whereas a takeover or acquisition, is characterized by the purchase of a smaller company by a much larger one. AA mergerA takes place when two or more companies decide to combine into one entity or business or when one company buys another, while anA acquisitionA always involves purchase of one by another company. Mergers generate synergies whichA allows for enhanced cost efficiency of a new entity made from two smaller entities - synergy is the basic principle behind mergers and acquisitions. Most gains are pushed towards the selling shareholders and an M&A deal can be completed by a cash transaction, stockA transaction or a combination of both. The acquiring companies use several methods to evaluate their targets. Some are based on the comparative ratios - like theA P/SA  and P/EA  ratios -A replacement costA orA discounted cash flowA analysis.

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