FINANCIAL MANAGEMENT

FINANCIAL MANAGEMENT

 

BY

RITTIK CHANDRA

 

Published by:

RITTIK CHANDRA

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CHAPTER 1: FINANCIAL MANAGEMENT OF BUSINESS EXPANSION, COMBINATION AND ACQUISITION

STRUCTURE

1.0 Objectives

1.1 Introduction

1.2 Mergers and acquisitions

1.2.1 Types of Mergers

1.2.2 Advantages of merger and acquisition

1.3 Legal procedure of merger and acquisition

1.4 Financial evaluation of a merger/acquisition

1.5 Financing techniques in merger/Acquisition

1.5.1 Financial problems after merger and acquisition

1.5.2 Capital structure after merger and consolidation

1.6 Regulations of mergers and takeovers in India

1.7 SEBI Guidelines for Takeovers

1.8 Summary

1.9 Keywords

1.10 Self assessment questions

 

1.0 OBJECTIVES

After going through this lesson, the learners will be able to

Know the meaning and advantages of merger and acquisition.

Understand the financial evaluation of a merger and acquisition.

Elaborate the financing techniques of merger and acquisition.

Understand regulations and SEBI guidelines regarding merger and acquisition.

 

1.1 INTRODUCTION

Wealth maximisation is the main objective of financial management and growth is essential for increasing the wealth of equity shareholders. The growth can be achieved through expanding its existing markets or entering in new markets. A company can expand/diversify its business internally or externally which can also be known as internal growth and external growth. Internal growth requires that the company increase its operating facilities i.e. marketing, human resources, manufacturing, research, IT etc. which requires huge amount of funds. Besides a huge amount of funds, internal growth also require time. Thus, lack of financial resources or time needed constrains a company’s space of growth. The company can avoid these two problems by acquiring production facilities as well as other resources from outside through mergers and acquisitions.

 

1.2 MERGERS AND ACQUISITIONS

Mergers and acquisitions are the most popular means of corporate restructuring or business combinations in comparison to amalgamation, takeovers, spin-offs, leverage buy-outs, buy-back of shares, capital reorganisation, sale of business units and assets etc. Corporate restructuring refers to the changes in ownership, business mix, assets mix and alliances with a motive to increase the value of shareholders. To achieve the objective of wealth maximisation, a company should continuously evaluate its portfolio of business, capital mix, ownership and assets arrangements to find out opportunities for increasing the wealth of shareholders. There is a great deal of confusion and disagreement regarding the precise meaning of terms relating to the business combinations, i.e. mergers, acquisition, take-over, amalgamation and consolidation. Although the economic considerations in terms of motives and effect of business combinations are similar but the legal procedures involved are different. The mergers/amalgamations of corporates constitute a subject-matter of the Companies Act and the acquisition/takeover fall under the purview of the Security and Exchange Board of India (SEBI) and the stock exchange listing agreements.

A merger/amalgamation refers to a combination of two or more companies into one company. One or more companies may merge with an existing company or they may merge to form a new company. Laws in India use the term amalgamation for merger for example, Section 2 (IA) of the Income Tax Act, 1961 defines amalgamation as the merger of one or more companies (called amalgamating company or companies) with another company (called amalgamated company) or the merger of two or more companies to form a new company in such a way that all assets and liabilities of the amalgamating company or companies become assets and liabilities of the amalgamated company and shareholders holding not less than nine-tenths in value of the shares in the amalgamating company or companies become shareholders of the amalgamated company. After this, the term merger and acquisition will be used interchangeably. Merger or amalgamation may take two forms: merger through absorption, merger through consolidation. Absorption is a combination of two or more companies into an existing company. All companies except one lose their identity in a merger through absorption. For example, absorption of Tata Fertilisers Ltd. (TFL) by Tata Chemical Limited (TCL). Consolidation is a combination of two or more companies into a new company. In this form of merger, all companies are legally dissolved and new company is created for example Hindustan Computers Ltd., Hindustan Instruments Limited, Indian Software Company Limited and Indian Reprographics Ltd. Lost their existence and create a new entity HCL Limited.

 

1.2.1 Types of Mergers

Mergers may be classified into the following three types- (i) horizontal, (ii) vertical and (iii) conglomerate.

Horizontal Merger

Horizontal merger takes place when two or more corporate firms dealing in similar lines of activities combine together. For example, merger of two publishers or two luggage manufacturing companies. Elimination or reduction in competition, putting an end to price cutting, economies of scale in production, research and development, marketing and management are the often cited motives underlying such mergers.

Vertical Merger

Vertical merger is a combination of two or more firms involved in different stages of production or distribution. For example, joining of a spinning company and weaving company. Vertical merger may be forward or backward merger. When a company combines with the supplier of material, it is called backward merger and when it combines with the customer, it is known as forward merger. The main advantages of such mergers are lower buying cost of materials, lower distribution costs, assured supplies and market, increasing or creating barriers to entry for competitors etc.

Conglomerate merger

Conglomerate merger is a combination in which a firm in one industry combines with a firm from an unrelated industry. A typical example is merging of different businesses like manufacturing of cement products, fertilisers products, electronic products, insurance investment and advertising agencies. Voltas Ltd. is an example of a conglomerate company. Diversification of risk constitutes the rationale for such mergers.

 

1.2.2 Advantages of merger and acquisition

The major advantages of merger/acquisitions are mentioned below:

Economies of Scale: The operating cost advantage in terms of economies of scale is considered to be the primary objective of mergers. These economies arise because of more intensive utilisation of production capacities, distribution networks, engineering services, research and development facilities, data processing system etc. Economies of scale are the most prominent in the case of horizontal mergers. In vertical merger, the principal sources of benefits are improved coordination of activities, lower inventory levels.

Synergy: It results from complementary activities. For examples, one firm may have financial resources while the other has profitable investment opportunities. In the same manner, one firm may have a strong research and development facilities. The merged concern in all these cases will be more effective than the individual firms combined value of merged firms is likely to be greater than the sum of the individual entities.

Strategic benefits: If a company has decided to enter or expand in a particular industry through acquisition of a firm engaged in that industry, rather than dependence on internal expansion, may offer several strategic advantages: (i) it can prevent a competitor from establishing a similar position in that industry; (ii) it offers a special timing advantages, (iii) it may entail less risk and even less cost.

Tax benefits: Under certain conditions, tax benefits may turn out to be the underlying motive for a merger. Suppose when a firm with accumulated losses and unabsorbed depreciation mergers with a profitmaking firm, tax benefits are utilised better. Because its accumulated losses/unabsorbed depreciation can be set off against the profits of the profit-making firm.

Utilisation of surplus funds: A firm in a mature industry may generate a lot of cash but may not have opportunities for profitable investment. In such a situation, a merger with another firm involving cash compensation often represent a more effective utilisation of surplus funds.

Diversification: Diversification is yet another major advantage especially in conglomerate merger. The merger between two unrelated firms would tend to reduce business risk, which, in turn reduces the cost of capital (K0) of the firm’s earnings which enhances the market value of the firm.

 

1.3 LEGAL PROCEDURE OF MERGER AND ACQUISITION

The following is the summary of legal procedures for merger or acquisition as per Companies Act, 1956:

Permission for merger: Two or more 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 company.

Information to the stock exchange: The acquiring and the acquired companies should inform the stock exchanges where they are listed about the merger/acquisition.

Approval of board of directors: The boards of the directors 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 boards of directors of the individual companies should be made to the High Court. The High Court would convene 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 approving the amalgamation scheme. At least, 75 per cent of shareholders and creditors in separate meeting, voting in person or by proxy, must accord their approval to the scheme.

Sanction by the High Court: After the approval of shareholders and creditors, on the petitions of the companies, the High Court will pass order sanctioning the amalgamation scheme after it is satisfied that the scheme is fair and reasonable. If it deems so, it can modify the scheme. The date of the court’s hearing will be published in two newspapers, and also, the Regional Director of the Company Law Board will be intimated.

Filing of the Court order: After the Court order, its certified true copies will be filed with the Registrar of 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/or pay cash for the shares and debentures of the acquired company. These securities will be listed on the stock exchange.

 

1.4 FINANCIAL EVALUATION OF A MERGER/ACQUISITION

A merger proposal be evaluated and investigated from the point of view of number of perspectives. The engineering analysis will help in estimating the extent of operating economies of scale, while the marketing analysis may be undertaken to estimate the desirability of the resulting distribution network. However, the most important of all is the financial analysis or financial evaluation of a target candidate. An acquiring firm should pursue a merger only if it creates some real economic values which may arise from any source such as better and ensured supply of raw materials, better access to capital market, better and intensive distribution network, greater market share, tax benefits, etc.

The shareholders of the target firm will ordinarily demand a price for their shares that reflects the firm’s value. For prospective buyer, this price may be high enough to negate the advantage of merger. This is particularly true if several acquiring firms are seeking merger partner, and thus, bidding up the prices of available target candidates. The point here is that the acquiring firm must pay for what it gets. The financial evaluation of a target candidate, therefore, includes the determination of the total consideration as well as the form of payment, i.e., in cash or securities of the acquiring firm. An important dimension of financial evaluation is the determination of Purchase Price.

Determining the purchase price: The process of financial evaluation begins with determining the value of the target firm, which the acquiring firm should pay. The total purchase price or the price per share of the target firm may be calculated by taking into account a host of factors. Such as assets, earnings, etc.

The market price of a share of the target can be a good approximation to find out the value of the firm. Theoretically speaking, the market price of share reflects not only the current earnings of the firm, but also the investor’s expectations about future growth of the firm. However, the market price of the share cannot be relied in many cases or may not be available at all. For example, the target firm may be an unlisted firm or not being traded at the stock exchange at all and as a result the market price of the share of the target firm is not available. Even in case of listed and oftenly traded company, a complete reliance on the market price of a share is not desirable because (i) the market price of the share may be affected by insiders trading, and (ii) sometimes, the market price does not fully reflect the firm’s financial and profitability position, as complete and correct information about the firm is to available to the investors.

Therefore, the value of the firm should be assessed on the basis of the facts and figures collected from various sources including the published financial statements of the target firm. The following approaches may be undertaken to assess the value of the target firm:

1 Valuation based on assets: In a merger situation, the acquiring firm ‘purchases’ the target firm and, therefore, it should be ready to pay the worth of the latter. The worth of the target firm, no doubt, depends upon the tangible and intangible assets of the firm. The value of a firm may be defined as:

Value = Value of all assets – External liabilities

In order to find out the asset value per share, the preference share capital, if any, is deducted from the net assets and the balance is divided by the number of equity shares. It may be noted that the values of all tangible and intangible assets are incorporated here. The value of goodwill may be calculated if not given in the balance sheet, and included. However, the fictious assets are not included in the above valuation. The assets of a firm may be valued on the basis of book values or realisable values as follows:

2. Valuation based on earnings: The target firm may be valued on the basis of its earnings capacity. With reference to the capital funds invested in the target firm, the firms value will have a positive correlations with the profits of the firm. Here, the profits of the firm can either be past profits or future expected profits. However, the future expected profits may be preferred for obvious reasons. The acquiring firm shows interest in taking over the target firm for the synergistic efforts or the growth of the new firm. The estimate of future profits (based on past experience) carry synergistic element in it. Thus, the future expected earnings of the target firm give a better valuation. These expected profit figures are, however, accounting figures and suffer from various limitations and, therefore, should be converted into future cash flows by adjusting non-cash items.

In the earnings based valuation, the PAT (Profit After Taxes) is multiplied by the Price-Earnings Ratio to find out the value.

Market price per share = EPS × PE ratio

The earnings based valuation can also be made in terms of earnings yield as follows:

Earnings yield = (EPS/MPS) ×100

 

The earnings yield gives an idea of earnings as a percentage of market value of a share. It may be noted that for this valuation, the historical earnings or expected future earnings may be considered.

Earnings valuation may also be found by capitalising the total earnings of the firm as follows:

Value = (Earnings/ Capitalisation rate) ×100

 

 

3. Dividend-based valuation: In the cost of capital calculation, the cost of equity capital, ke, is defined (under constant growth model) as:

D0 = Dividend in current year D1 = Dividend in the first year g = Growth rate of dividend

P0 = Initial price

This can be used to find out the P0 as follows:

 

 

4. Capital Asset Pricing Model (CAPM)-based share valuation:

The CAPM is used to find out the expected rate of return, Rs, as follows:

Rs = IRF + (RM - IRF)β

Where,

Rs = Expected rate of return, IRF = Risk free rate of return, RM = Rate of Return on market

Impressum

Verlag: BookRix GmbH & Co. KG

Texte: RITTIK CHANDRA
Bildmaterialien: RITTIK CHANDRA
Lektorat: RITTIK CHANDRA
Tag der Veröffentlichung: 07.07.2013
ISBN: 978-3-7309-3566-8

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