MF 0011 – Mergers and Acquisitions.

Question 1 – Elaborate on the basic steps in organising a merger and explain on the five stage model of mergers and acquisitions.

Answer 1Basic steps in organizing a merger:

Pre-acquisition Review – Management reviews the company’s growth plans, alternatives and pros and cons of each alternative.Following questions are answered in this step: Is our company undervalued? Would a merger/acquisition improve valuations? Why further growth is not possible? Would an acquisition help? Are we a desirable target for acquiring companies? Are we interested in being acquired?

Search and Screen Targets – It involves searching for possible takeover candidates who meet the strategic compatibility of the acquirer. Compatibility and fit should be assessed by the acquiring company across all the necessary criteria.

Valuation of the target company – It’s imperative to confirm that the target company is an accurate fit to the acquirer. A due diligence of all the aspects of the target company is conducted.The direction/content of the due diligence depends on company’s expectation from the merger/acquisition.The merged entity = value of acquiring company + acquired company + synergies – cost of acquisition.

Negotiation – A negotiation plan is developed basis various key aspects. Both the companies prepare an agreement/memorandum of understanding to effect the merger.

Post-merger Integration – Upon successful conclusion of negotiations, the two companies announce an agreement to merge. It’s the responsibility of both the companies to merge

1. Pre-acquisition review.

2. Search and screen targets.

3. Valuation of the target company.

4. Negotiation.

5. Post-merger integration.

their distinctions to ensure harmony in stakeholders working. Synergies are realized only when the post-merger integration is successful.

The Five-Stage Model:

1. Corporate strategy evolution – Corporate strategy is concerned with the ways of optimizing the firm’s current business portfolio and with how this portfolio can be changed to serve the interests of the corporation’s stakeholders. Merger and acquisition can serve both the corporate and the business objectives.

2. Organizing for acquisitions – Understanding the decision process of acquisition is important as it has an effect on its quality/value creation and success of the post-merger integration. This complex decision is taken by the managers after evaluating the proposal economically, strategically and financially.

3. Deal structuring and negotiation – The process explained in previous two stages results in target selection. The deal making/structuring takes place at this stage. The deal structuring and negotiation process is complex and involves several interconnected aspects.

4. Post-acquisition integration – At his stage, the objective is to enable the managed organization deliver the strategic and value expectations that propelled the merger in the first place. It’s therefore the major factor that determines the success of the acquisition.

5. Post-acquisition audit and organizational learning – For acquisition-making to become a firm’s core competence, possessing and developing learning capabilities is a must. It should be a part of the competitive strategy.

1.Corporate strategy evolution.

2.Organizing for acquisition.

3.Deal structuring and negotiations.

4.Post-acquisition integration.

5.Post-acquisition audit and organisational learning.

Question 2 – Synergy is the additional value that’s generated by the combination of two or more than two firms creating opportunities. Explain the role of industry life cycle and pre-requisites for creation of synergy.

Answer 2Role of Industry Life Cycle:Figure below depicts the different stages of industry life cycle.

Fragmentation Stage – In this stage, a new industry develops a business. Plans for introducing new products/services are made. Problems of innovation and invention are overcome at this stage.

Shake-out – At this stage, competitors begin realizing business opportunities. There’s a rapid rise in the value of the industry as well. To gain benefits of the growing opportunities, many firms enter this stage through mergers/acquisitions.

Maturity – The dominant business model’s efficiency gives companies a competitive advantage over competition. Due to the presence of many competitors and products/services substitutes, the competition is aggressive. Cooperation, competition and price take a complex form. To gain competitive advantage, some firms may shift some of their productions overseas.

Decline – At this stage, there is a possibility of destruction between businesses resulting in the failure of those with heavy bureaucracies. In addition, the market demand may be fully met or suppliers may have a shortage. In this stage many companies leave the market, many try to take the advantage by acquiring companies which are performing low and many other companies also try to merge with other companies.

Fragmentation Shake-out

Maturity Decline

Prerequisites for the creation of synergy:There are certain requirements which must be met for synergy to be created; those are termed as the building blocks for creation of synergy. The chances for creating synergy are substantially higher when all the following four prerequisites exist.

Strategic compatibility – There are various ways the capabilities of the organisations’ strategic capabilities can be matched. When combined firms/organizations are both strong/weak in the same business activities, the newly created firm displays the same capabilities, although the magnitude of the strength/weakness is greater and no synergy results.

Organisational compatibility – Organisational compatibility from operational point of view suggests that the integration processes that are developed and used to combine the operations can be expected to bring about desired results effectively.

Managerial actions – It’s related to the actions/initiatives that managers take for their firms to realize the benefits. Creation of synergy requires active involvement/participation of the management. Managers must recognize the importance/magnitude of integration issues and the need to involve human resources in implementing a combination.

Value creation – The focus here is on deriving benefits from synergy in excess of the costs to be incurred. The costs associated with ‘financing of the transaction’ and ‘premium paid for purchase’ have to be controlled.

Question 3 – Corporate restructuring is broad based business initiative that results in major change of size, ownership, control and/or management.

Answer 3Characteristics of Corporate Restructuring:The key characteristics of corporate restructuring are: Selling or closing of unprofitable divisions from its core business, thereby achieving staff

reduction and a stronger balance sheet. Revamping of corporate management. Sale of underutilised assets such as patents/brands. Outsourcing of operations like payroll and technical support to a more efficient third

party. Moving of operations like manufacturing to lower-cost locations. Reorganisation of major functions like sales, marketing and distribution. Renegotiation of labour contracts at reduced costs. Refinancing of corporate debt to reduce interest payments. A major public relations campaign to change the position of the company in the market.

Types of Corporate Restructuring:Following figure briefly depicts the two broad categories of Corporate Restructuring

Financial RestructuringThe process of turning unfavourable environment for a company can be turned into a favourable environment by reorganizing its financial assets and liabilities, is called Financial Restructuring. It’s often linked to the corporate restructuring as restructuring the general performance of a company is likely to affect its financial state. Every business has to go through a restructuring at some point in its cycle. Sometimes it’s used while resources are allocated for a new marketing campaign or the launch of a new product.Need for financial restructuring: To eliminate wastes arising from the operations of a firm. To reduce costs and stabilize/increase profits.

Organisational RestructuringIn this, the focus is on management and internal corporate governance structures. It’s practised by many companies to keep their management in synch with the changing business conditions.Need for organisational restructuring: To incorporate new skills and capabilities to meet current/expected operational

requirements. To clearly/effectively communicate the accountability for results. To help a company manage an over or understaffed departments and in turn reduce the

problems caused by significant staffing increase/decrease and retain well performing personnel.

To make the organisational communication consistent, continuous and efficient.

Question 4 – Leveraged Buyouts (LBO) is financing technique of purchasing a private company with the help of borrowed or debt capital.

Answer 4Modes of LBOs:

Corporate Restructuring

Financial Restructuring

Organisational

Restructuring

Senior Debt – It’s the topmost of all the other debts and equity capital in the business. Specific assets of the company generally secure the debt, which implies that the lender can take over the assets in case of breach in obligations; therefore the cost of debt is lower. Mostly, the debt repayment is done over 7 years approximately through equal annual instalments.

Subordinated Debt – In this debt, at the end of the term, repayment is done in the form of one ‘bullet’ payment. Lending costs are comparatively higher in this debt as it offers less security to the lender.

Mezzanine Finance – It’s considered a type of intermediate financing between debt and equity. It’s usually high risk subordinated debt. The lenders can opt for an enhanced return which is made available to them by the grant of an ‘equity kicker’ that can be crystalized upon an exit.

Loan Stock – It can be regarded as a form of equity financing once it’s convertible into equity capital.

Preference Share – It’s a part of company’s share capital. It gives fixed dividend and priority repayment at the time of company winding up.

Ordinary Share – It’s the riskiest. However, if the company is successful, majority of the upside would be enjoyed by the ordinary shareholders.

Governance aspects of LOBs:

Modes of LBO

Financing

Senior Debt

Subordinated Debt

Mezzanine Finance

Loan Stock

Preference Shares

Ordinary Shares

Reduction in cost – An LBO privatises a public corporation. In case of public corporation, the management is different from owners thus it may take decisions without owners’ approval.

Efficiency – A private firm is quite quick in decision-making which is needed in a fast-changing environment. A public corporation is inevitably bound by overlong approval systems and documentary support for every decision.

The tax benefit of leveraging – The concept of stepping up of assets for depreciation as an ingredient of LBO calls for additional tax advantages.

Information – Management/investors in LBO deal have more information on the value of the firm than the ordinary shareholders. Because of this, a buyout proposal give indication to the market that the post buyout scenario would result in more income than expected or that the firm is less risky than perceived. It adds value to the LBO and due to this; the buyout investors don’t mind paying large premiums on such deals.

Question 5 – Joint Ventures (JV) have become an important strategic option for many businesses. Give a meaning of JV with example. Explain the characteristics of Joint Ventures. Also explain the Rationale for Joint Ventures and alternatives to JV’s as expansion strategy options with example.

Answer 5Meaning of Joint Venture (JV):The term ‘JV’ describes the commercial arrangement between/among two or more economically independent entities. In practice, it’s determined by a number of factors like nature/size of enterprise, anticipated length of the venture, etc.Example: NPCIL-IOCL. Date of establishment – 6th April 2011. Joint venture Holders – Nuclear Power Corporation of India Limited, Indian Oil. Areas of operation – Operation and development of nuclear power plant, developing

nuclear energy, generating electricity.This is a joint venture between two renowned companies of India namely Indian oil Corporation of India and Nuclear power Corporation. They have an objective of portraying nuclear power as a safe energy for people and environment.

Characteristics of JV: Active investments. Involved parties provide skills, money, etc. It’s a business project rather than a long-term bond between/among firms. It’s a combined extension of the firms’ commercial activities. The relationship of the participants is almost consistently regulated by a written

agreement called a JV Agreement (JVA).

Rationale of JVs: To share costs/other expenses and reduce the financial burden. To have better credit/more assets to access bigger resources. To access/share technological resources, ideas, new markets, etc. To attain economies of scale. To gain distribution channels or raw material supply-chains. To diversify risk. To outspread activities with smaller investments than if done independently. To take benefit of favourable tax treatment/political incentives.

Alternatives to JVs as Expansion Strategy options:Partnerships are special purpose vehicles set-up by two or more independent entities for a specific purpose.

Licensing arrangements, here, an entity with income-producing asset, licenses the asset to another entity to generate income.

A strategic alliance is when two or more entities join together for a set period of time. The entities are not in direct competition but deal in product/services that are directed towards the same target market.

Examples:Walmart Stores and Bharti Enterprises signed a Memorandum of Understanding to explore business opportunities in the Indian retail industry. This JV marked the entry of Walmart into the Indian retailing industry.

Question 6 – Amalgamation is the nature of merger is an amalgamation/consolidation which satisfies/meets the following conditions. Explain the two methods of amalgamation.Explain the treatment of Goodwill arising on Amalgamation and treatment of reserves of amalgamation.

Answer 6Methods of Amalgamation:Following are the two methods as per AS 14:

Pooling of interest Method:Steps involved:1. The assets, liabilities and reserves are recorded by the transferee company at the

current value.2. The net profit/net loss of the transferor company is aggregated with that of the

transferee company or transferred to the General Reserve, if any.3. The difference between purchase consideration and share capital should be adjusted in

the reserves.

Purchase method:Steps involved:1. Assets and liabilities should be merged at the present holding sums/amounts or there

must be a consideration on the individual identifiable assets and liabilities based on their fair values at the date of amalgamation.

2. The reserves of the transferor company (other than statutory reserves) should not be incorporated in the financial statements of the transferee company;

3. The legislative reserves should be integrated in the financial accounts of the transferee company and should be maintained for a specified period.

4. Any consideration in excess over the net assets value should be recognized/recorded in the financial accounts of the transferee company as goodwill. In case of it being lower, it should be treated as capital reserve/fund.

5. The goodwill arising on amalgamation should be written off over a period of five years.

Treatment of Goodwill arising on Amalgamation:In amalgamation, goodwill represents a payment made in anticipation of future income and is treated as an asset to be amortized to income on a systematic basis over its useful life, generally not exceeding five years.

Treatment of reserves of Amalgamation: In case of ‘amalgamation in the nature of merger’, the reserves recorded in the accounts

of the transferee company the same way they are recorded in the transferor company. In case of ‘amalgamation in the nature of purchase’, the identity of the reserves/funds is

not conserved. The consideration amount is deducted from the net asset value of the transferor company. Negative result is debited to goodwill and positive result is credited to capital reserve.