TYPES OF COMBINATION There is a great deal of confusion and disagreement regarding the precise meaning of terms relating to the business combination, viz. merger, acquisition, takeover, amalgamation and consolidation. Here these terms are defined keeping in mind the relevant legal framework in India. Merger or Amalgamation A merger is said to occur when two or more companies combine 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(l A) of the Income Tax Act, 1961 defines amalgamation as the merger of one or more companies with another company or the merger of two or more companies (called amalgamating company or companies) to form anew company (called amalgamated 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 share- holders holding not less than ninetenths in value of the shares in the amalgamating company or companies become shareholders of the amalgamated company. Merger or amalgamation may take two forms: .Merger through absorption .Merger through consolidation Absorption 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.. Consolidation A consolidation is a combination of two or more companies into a new company. In this form of merger, all companies are legally dissolved and anew entity is created. In a consolidation, the acquired company transfers its assets, liabilities and shares to the acquiring company for cash or exchange of shares. In a narrow sense, the terms amalgamation and consolidation are some- times used interchangeably. An example of consolidation is the merger or amalgamation of Hindustan Computers Ltd., Hindustan Instruments Ltd., Indian Software Company Ltd., and Indian Reprographics Ltd. in 1986 to an entirely new company called HCL Ltd.

Acquisition A fundamental characteristic of merger (either through absorption or consolidation) is that the acquiring company (existing or new) takes over the ownership of other companies and combine, their operations with its own operations. An acquisition may be defined as an act of acquiring effective control by one company over assets or management of another company without any combination of companies. Thus, in an acquisition two or more companies may remain independent, separate legal entity, but there may be change in control of companies. Takeover A takeover may also be defined as obtaining of control over management of a company by another. An acquisition or take-over does not necessarily entail full, legal control. A company can have effective control over another company by holding minority ownership. Takeover vs. acquisition Sometimes, a distinction between takeover and acquisition is made. The term takeover is understood to connote hostility. When an acquisition is a 'forced' or 'unwilling' acquisition, it is called a takeover. In an unwilling acquisition, the management of "target" company would oppose a move of being taken over. When managements of acquiring and target companies mutually and willingly agree for the takeover, it is called acquisition or friendly takeover. An example of acquisition is the acquisition of controlling interest (45 per cent shares) of Universal Luggage Manufacturing Company Ltd. by Blow Plast Ltd. Similarly, Mahindra and Mahindra Ltd., a leading manufacturer of jeeps and tractors acquired a 26 per cent equity stake in Allwyn Nissan Ltd. In recent years, a number of hostile takeovers could be witnessed in India. Examples include takeover of Shaw Wallace, Dunlop, Mather and Platt and Hindustan Dorr Oliver by Chhabrias, Ashok Leyland by Hindujas and ICIM, Harrison Malayalam and Spencers by Goenkas. Holding company A company can obtain the status of a holding company by acquiring shares of other companies. A holding company is a company which 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. Forms of Merger

There are three major types of mergers: Horizontal merger This is a combination of two or more firms in similar type of production, distribution or area of business. Examples would be combining of two book publishers or two luggage manufacturing companies to gain dominant market share. Vertical merger This is a combination of two or more firms involved in different stages or production or distribution. For example, joining of a TV manufacturing (assembling) company and a TV marketing company or the joining of a spinning company and a weaving company. Vertical merger may take the form of 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. Conglomerate merger This is a combination of firms engaged in unrelated lines of business activity. A typical example is merging of different businesses like manufacturing of cement products, fertilizers products, electronic products, insurance investment and advertising agencies. L&T is an example of conglomerate companies. MOTIVES AND BENEFITS OF MERGERS: It is believed that mergers and acquisitions are strategic decisions leading to the maximisation of a company's growth by enhancing its production and marketing operations. They have become popular in the recent times because of the enhanced competition, breaking of trade barriers, free flow of capital across countries and globalisation of business as a number of economies are being deregulated and integrated with other economies. A number of, reasons are attributed for the occurrence of mergers and acquisitions. For example, it is suggested that mergers and acquisition are intended to:y y y y y y

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 Utilise under-utilised resources-human and physical and managerial skills

y

y y y y

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.

Are there any real benefits of merger? A number of benefits of mergers are claimed. All of them are not real benefits. Based on the empirical evidence and the experiences of certain companies, the most common motives and advantages of mergers and acquisitions are explained below:y

Maintaining or accelerating a company's growth, particularly when the internal growth is constrained due to paucity of resources;

y

Enhancing profitability, through cost reduction resulting from economies of scale, operating efficiency and synergy;

y

Diversifying the risk of the company, particularly when it acquires those businesses whose income streams are not correlated;

y

Reducing tax liability because of the provision of setting-off accumulated losses and unabsorbed, depreciation of one company against the profits of another;

y

Limiting the severity of competition by increasing the company's market power.

ANALYSIS OF MERGERS AND ACQUISITIONS There are three important steps involved in the analysis of mergers and acquisitions:y y y

Planning Search and screening Financial evaluation.

Planning The acquiring firm should review its objective of acquisition in the context of its strengths and weaknesses, and corporate goals. This "will help in indicating the product-market strategies that are appropriate for the company. It will also force the firm to identify business units that should be dropped and those that should be added. The planning of acquisition will require the analysis of industry-specific and the firm-specific information. The acquiring firm will need industry data on market growth, nature of competition, ease of entry, capital and labour intensity, degree of regulation etc. About the target firm the information needed will include the quality of management, market share, size, capital structure, profitability, production and marketing capabilities etc. Search and Screening Search focuses on how and where to look for suitable candidates for acquisition. Screening process shortlists a few candidates from many available. Detailed information about each of these candidates is obtained. Merger objectives may include attaining faster growth, improving profitability, improving managerial effectiveness, gaining market power and leadership, achieving cost reduction etc. These objectives can be achieved in various ways rather than through mergers alone. The alternatives to merger include joint ventures, strategic alliances, elimination of inefficient operations, cost reduction and productivity improvement, hiring capable managers etc. If merger is considered as the best alternative, the acquiring firm must satisfy itself that it is the best available option in terms of its own screening criteria and economically most attractive. Financial Evaluation Financial evaluation of a merger is needed to determine the earnings and cash flows, areas of risk, the maximum price payable to the target company and the best way to finance the

merger. The acquiring firm must pay a fair consideration to the target firm for acquiring its business. In a competitive market situation with capital market efficiency, the current market value is the correct and fair value of the share of the target firm. The target firm will not accept any offer below the current market value of its share. The target firm may, in fact, expect the offer price to be more than the current market value of its share since it may expect that merger benefits will accrue to the acquiring firm. A merger is said to be at a premium when the offer price is higher than the target firm's pre-merger market value. The acquiring firm may pay the premium if it thinks that it can increase the target firm's after merger by improving its operations and due to synergy .It may have to pay premium as an incentive to the target firm's shareholders to induce them to sell their shares so that the acquiring firm is enabled to obtain the control of the target firm.

Value Created by Merger A merger will make economic sense to the acquiring firm if its shareholders benefit. 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. For example, if firm P and firm Q merge, and they are separately worth Vp and Vq respectively, and worth Vpq in combination, then the economic advantage will occur if: Vpq > (Vp+ Vq)

and it w-mequal to: EA = Vpq - (Vp + Vq) Suppose that firm P acquires firm Q. After merger P will gain the present value of Q, i.e., Vq but it will also have to pay a price (say in cash) to Q. Thus, the cost of merging to P is: Cash paid -Vq. For P. the net economic advantage of merger (NEA) is positive if the economic advantage exceeds the cost of merging. Thus Net economic advantage = economic advantage- cost of merging NEA = [Vpq - (Vp + Vq) -(cash paid -Vq) The economic advantage. i.e. [Vpq -(Vp + Vq), represents the benefits resulting from operating efficiencies and synergy when two firms merge. If the acquiring firm pays cash equal to the value of the acquired firm. i.e. cash paid -Vq = 0, then the entire advantage of merger will accrue to the shareholders of the acquiring firm. In practice, the acquiring and the acquired firm may share the economic advantage between themselves.

ILLUSTRATION 1: Firm P has a total market value of Rs 18 crore ( 12 1akh shares of Rs 150 market t value per share).Firm Q has a total market value of Rs 3 crore (5 lakh of Rs 60 market value per share). Firm P is considering the acquisition of Firm Q. The value of P after merger (that is, the combined value of the merged firms) is expected to be Rs 25 crore due to the operating efficiencies. Firm P is required to pay Rs 4.5 crore to acquire Firm Q. The net economic advantage to Firm P if it acquires Firm Q is the difference between economic advantage and the cost of merger to P: NEA = [25- (18 + 3)] - (4.5- 3) = (4 -1.5) = Rs 2.5 crore. The economic advantage of Rs 4 crore is divided between the acquiring firm Rs 2.5 crore and the, target firm, Rs 1.5 crore.

The acquiring firm can issue pares to the target firm instead of paying cash. The effect will be the same if the shares are exchanged in the ratio of cash-to-be-paid to combined value of the merged firms. In Illustration 1. Firm P may issue 4.5/25 = 0.18 or 18 per cent shares to Q's shareholders in the combined firm. Then the total number of shares (X) in the combined firm will be as follows: X=12+0.18X X-0.18 X= 12 X= 12/0.82 = 14.63 1akh shares and the new share price will be: 25/0.1463= Rs 170.9. Firm Q will get 2.63lakh shares of Rs 170.9 each. Thus, the cost of acquisition to Firm P remains the same: (2.63 lakh x Rs 170.9) -Rs 3 crore = Rs 1.5 crore. In practice, the number of shares to be exchanged may be based on the current market value of the acquiring firm. Thus in Illustration 1, Firm Q may require 300,000 shares (i.e.. Rs 4.5 crore/Rs 150) of the acquiring Firm P. Now Firm P after merger will have 15 lakh shares of total value of Rs 25 crore. The new share price will be: Rs 25/0.15 = Rs 166.67. The worth of shares given to the shareholders of Firm Q will be Rs 5 crore (i.e., Rs 1.66.67 x 3 lakh). The cost of merger to Firm P is Rs 2 crore (i.e., the value of share exchanged. Rs/5 crore less the value of the acquired firm. Rs 3 crore). Thus, the effective cost of merger maybe more when the merger is financed by issuing shares rather than paying cash.

DCF EVALUATION OF MERGERS In a merger or acquisition, the acquiring firm is buying the business of the target firm, rather than a specific asset. Thus, merger is a special type of capital budgeting decision. What is the value of the target firm to the acquiring firm after merger? This value should include the effect of operating efficiencies and synergy. The acquiring firm should appraise merger as a capital budgeting decision, following the discounted cash flow (DCF) approach. The acquiring firm incurs a cost (in buying the business of the target firm) in the expectation of a stream of benefits (in the form of cash flows) in the future. The merger will be advantageous to the acquiring company if the present value of the target merger is greater than the cost of acquisition. Mergers and acquisitions involve complex set of managerial problems than the purchase of an asset. Nevertheless, DCF approach is an important tool in analyzing mergers and acquisitions. In order to apply DCF techniques following information is required:y y y

Estimation of cash flows Timing of cash flows Discount rate.

Consider the case of S Engineering and XL Equipment Company in Illustration 2 for an approach for the financial evaluation of a merger. ILLUSTRATION 2 S Engineering Company was established in 1953 to manufacture industrial equipments for cement, fertiliser and textile industries. The company's management is concerned about the instability of its earnings due to the cyclical nature of its business. During the past five years, S's sales have grown at about 11 per cent per annum, and profit after tax at 9 percent. The fluctuating profits of the company have caused its P/E ratio to be much lower than the industry average ranging between 45-50 (See Tables 1 and 2 for S's summarised financial performance). Currently, S's share is selling for Rs 57.8 in the market. S's top management has chalked out a plan of acquisition to reduce its earnings instability. The company laid down three criteria for acquisition. First, the target company should broadly belong to the related business. Second, it should be a well-known company in its field, but should be smaller than S in size. Third, it should have a wide range of products in growth markets with a high degree of stability. Applying these criteria, S has identified XL Equipment Company as a possible target company for acquisition. XL is known for its

quality of products and strong distribution. Due to poor management, the company's performance in the past few years has not been good. Its sales have grown at 4 per cent per year during the 1994-98 period against the industry growth rate of 8 per cent per year. The company's earnings have been low and the average market price of company's shares in recent times has been lower than its book value (see Tables 3 and 4 for XL's summarised financial performance). The current price of XL's share is Rs 24.9. The management of S thinks that if they could acquire XL it could turnaround the company. They could increase XL's growth rate to 8 per cent within two-three years and reduce cost of goods sold to 66 per cent of sales and selling and administrative expenses to 15 per cent. S anticipates that to support the growth in XL's sales, capital expenditure (CAPEX) equal to 5 per cent of sales may be needed each year. At what price should S acquire XL ? Table 1: S ENGINEERING COMPANY Summarised Profit and Loss Statement and Per Share Data (Rs lakh ) 1994 1995 1996 1997 1998 Profit and Loss Items Net Sales 5470 6154 7256 7523 8205 Cost of Goods Sold 3900 4500 5457 5479 5975 Depreciation 110 155 139 125 143 Selling and Admin Expenses 670 788 983 1003 1020 Total Expenses 4680 5443 6579 6607 7138 PBIT 790 711 677 916 1067 Interest 130 151 173 191 284 PBT 660 560 504 725 783 Tax 350 290 250 368 380 PAT 310 270 254 357 403 Per Share Data EPS(Rs) 1.97 1.71 1.61 2.27 2.56 DPS 1.25 1.30 1.30 1.50 1.80 Book Value 25.28 26.00 26.41 26.72 27.49 Market Value(Rs.) High 54.34 61.25 57.50 71.25 75.05 Low 30.68 31.25 33.03 35.00 38.00 Average 42.51 46.25 45.27 53.13 56.53 P/E Ratio High 27.58 35.82 35.71 31.39 29.32 Low 15.57 18.27 20.52 15.41 14.84

Average

21.58 27.05 28.12 23.41 22.08

Table 2 : S Engineering Company Summarised Balance Sheet as on 31 st March 1998 (Rs. lakh) Sources of funds Shareholders funds Paid up capital (15749785 shares of Rs. 10 each ) Reserves and Surplus Borrowed Funds -Secured -Unsecured Capital employed Uses of funds Gross block Less: depreciation Net block Investment Current assets Less: current liabilities Net current assets Net assets

1575 2755 4330 1203 967 2170 6500 6231 1626 4605 29 4634 3726 1860 1866 6500

Table 3: XL EQUIPMENT COMPANY Summarised Profit and Loss Statement and Per Share Data (Rs lakh ) 1994 1995 1996 1997 1998 Profit and Loss Items Net Sales 1442 1477 1580 1642 1695 Cost of Goods Sold 995 1042 1125 1165 1195 Depreciation 37 40 45 45 40 Selling and Admin Expenses 260 275 280 292 302 Total Expenses 1292 1357 1450 1502 1537 PBIT 150 120 130 140 158 Interest 19 15 23 25 30 PBT 131 105 107 115 128 Tax 45 34 35 40 45 PAT 86 71 72 75 83 Per Share Data EPS(Rs) 3.44 2.84 2.88 3.00 3.32

DPS Book Value Market Value(Rs.) High Low Average P/E Ratio High Low Average

1.80 1.60 1.60 1.60 1.80 23.76 25.00 26.28 27.68 29.20 30.84 44.04 42.25 35.48 28.16 22.12 25.80 24.38 16.28 13.14 26.48 34.92 33.32 25.88 20.65 8.97 6.43 7.70 15.51 14.67 11.83 8.48 9.08 8.47 5.43 3.96 12.30 11.57 8.27 6.22

Table 4 : XL Equipment Company Summarised Balance Sheet as on 31 st March 1998 (Rs. lakh) Sources of funds Shareholders funds Paid up capital (25 lakh shares of Rs. 10 each ) Reserves and Surplus Borrowed Funds -Secured -Unsecured Capital employed Uses of funds Gross block Less: depreciation Net block Investment Current assets Less: current liabilities Net current assets Net assets

250 480 730 144 96 240 970 657 285 372 23 753 178 575 970

We can use the DCF approach to determine the value of XL company to S Ltd.

Estimating Free Cash Flows

The first step in the estimation of cash flows is the projection of sales. XL in the past has grown at an average annual rate of 4 per cent. After acquisition, sales are expected to grow at 8 per cent per year. We assume that S would need a few years to achieve this growth rate. Thus sales may be assumed to grow at 5 per cent in 1999, 6 per cent in 2000,7 per cent in 2001 and thereafter, at 8 per cent per annum. The second step is to estimate expenses. Due to operating efficiency and consolidation of operations, costs are expected to decline. XL's cost of goods sold has averaged around 70-71 per cent of sales and is now anticipated to be brought down to 66 per cent of sales. We may assume that S would take about two-three years to reduce the cost of goods sold. Selling and administrative expenses can also be estimated in the similar way. Depreciation can be estimated keeping in mind the anticipated capital expenditure in each year ( viz. 5 per cent of sales) and average annual depreciation rate ( viz. about 11 per cent for XL during the past five years). We have assumed a diminishing balance method for depreciation. Thus, depreciation for 1999 and 2000 would be as follows: DEP 99 = 0.11 (372 + CAPEX98) = 0.11 (372 + 0.05 x 1780) = 0.11 (372 + 89) = 0.11 (461) = 50 DEP 2000 = 0.11 (461 -50 + 0.05 x 1887) =0.11 (411 +94) = 55 CAPEX and depreciation for other years can be similarly calculated as shown in Table 5. In the calculation of the cash flows, we should also account for increase in net working capital (NWC) due to expansion of sales. XL's net working capital to sales ratio in 1998 is 34 per cent. If working capital is assumed to be managed as in the past, we can assume NWC to sales ratio to remain as 34 per cent. Note that since we shall be calculating the value of XL (representing the value of both shareholders and lenders), using the weighed cost of capital as the discount rate, interest charges would not be subtracted in calculating free flows. XL has been paying an average tax of 34 per cent. This might be due to tax incentives available to the company. The company may have to pay tax at l current marginal tax rate of 35 per cent. Table 5 provides the estimation of net cash flows. Estimating the Cost of Capital Since we are determining XL's value, the discount rate should be XL's average cost of capital. In the year 1998, the outstanding debt of the company is Rs 240 lakh and interest paid is Rs 30lakh. Thus, the interest rate works out to 12.5 per cent. A higher marginal rate of interest,

say, 15 per cent may be assumed for the future. On the after-tax basis, the cost of debt would be: 0.15 (1- 0.35) = 0.975 or 9.75 per cent. We can calculate the company's cost of equity using the dividend-growth model. XL's average /share price in 1998 is Rs 20.65, and it paid a dividend of Rs 1.80. Thus, its dividend yield is: 1.8/20.65 = 0.087 or 8.7 per cent. The company has been paying about 55 per cent of its earnings as dividend and retaining 45 %. The average return on equity has been 12 %. Thus the companys growth rate is: 0.45 x 0.12 = 0.054 or 5.4%. XLs cost of equity is: 0.0878 + 0.054 =0.14 or 14%. Given its capital structure in 1998, its WACC is appr. 13% as shown in table 6.

Table 6: XL Company estimation of cash flows (Rs. lakh) Year Net sales Cost goods sold Selling and 302 admin. Expenses Depreciation 40 Total expenses PBT Tax @35% PAT Add: depreciation Funds from 143 operations Less: increase NWC Cash from 138 167 208 237 257 277 299 324 350 378 in 30 36 45 55 59 64 69 75 81 87 168 203 253 292 316 341 369 398 430 465 158 55 103 40 181 63 118 51 227 79 148 56 296 104 192 61 348 122 226 66 376 132 244 72 405 142 264 78 438 153 284 84 472 165 307 91 510 178 331 99 550 193 358 107 51 56 61 66 72 78 84 91 99 107 302 302 302 327 353 381 412 445 480 519 1998 99 2000 2001 2002 2003 2004 2005 2006 2007 2008

1695 1780 1887 2019 2180 2354 2543 2746 2966 3203 3460 of 1195 1246 1302 1360 1439 1554 1678 1813 1958 2114 2283

1537 1599 1660 1723 1832 1979 2137 2309 2494 2693 2909

operations

Less: CAPEX Free flow Add: salvage value(end of time horizon) NCF to S PVF@ 13% Present value NWC@ 34% of net sales 575 cash

89

94

101

109

118

127

137

148

160

173

49

72

107

128

139

150

162

175

189

205

2231

49 0.88 1300 43

72 0.78 56

107 0.69 73

128 0.61 78

139 0.54 75

150 0.48 72

162 0.43 69

175 0.38 66

189 0.33 62

2435 0.29 706

605

641

686

741

801

865

934

1008 1089 1176

Table 6: XLs WACC: Amount Weight Cost Equity 730 Debt 240 970 0.753 0.247 1.000 Weighted cost

0.1400 0.1054 0.0975 0.0241 0.1295

Terminal Value It would include the salvage value and the net WC released. To estimate the salvage value of the firm, we can capitalize the net cash flows at the end of the tenth year: Salvage value = 205/0.13 = Rs. 1577 Net cash flows after tenth year could be assumed to grow at a constant rate (say, 3.5 per cent in this case). Then, the salvage value can be calculated using a method similar to the dividend-growth model as follows: SVn = NCFn(l +g)/ (k-g) ; 205(1.035)/ (0.13-0.035) =Rs2231 This value is used in our calculations in Table 5.

Value of XL's Shares We can discount the net cash flows in Table 5 to calculate XL's value. It is Rs 1,300 lakh. Since XL has Rs 240 lakh outstanding debt in the year 1998, the value of its shares is: (Rs. Lakh) XLs Value Less: debt 1300 240

Value of XLs shares 1060 Value per share 1060/25= 42.40

The maximum price per share which S may be prepared to pay for XL's share is Rs 42.40, The current market price of the share is Rs 24.90. Thus, S may have to pay a premium of about 70 per cent over the current market price. (If the high market price Rs 28.16 is considered, premium should not exceed 51 per cent). How should S finance acquisition of XL ? Should it exchange shares or pay in cash? Financing a Merger: Cash or Exchange of Shares A merger can be financed by cash or exchange of shares or a combination of cash, shares and debt. The means of financing may change the debt-equity mix of the combined or the acquiring firm after the merger. When a large merger takes place, the desired capital structure is difficult to be maintained, and it makes the calculation of the cost of capital a formidable task. Thus, the choice of the means of financing a merger may be influenced by its impact on the acquiring firm's capital structure. The other important factors are the financial condition and liquidity position of the acquiring firm, the capital market conditions, the availability of long-term debt etc. Cash offer: A cash offer is a straight forward 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. It is also unlikely to cause wide fluctuations in the share prices of the merging companies. The shareholders of the target company get cash for selling their shares to the acquiring company. This may involve tax liability for them.

Share exchange: A share exchange offer will result into the sharing of ownership of the

acquiring company between its existing shareholders and new shareholders (existing 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. In an exchange of shares, the receiving shareholders would not pay any ordinary income tax immediately. They would pay capital gains tax when they sell their shares after holding them for the required period. Let us assume that S decided to consider a price of Rs 42.4 per share to acquire XL. Should S pay cash or exchange shares to acquire XL? S would need, say, Rs 1, 060 lakh in cash. It can borrow funds as well as use its tradable (temporary) investment and surplus cash for acquiring XL. It has a current debt equity ratio of 0.5: 1. After merger, its (the combined firm) debt would be Rs 2,410 lakh (Rs 2, 170 lakh of S and Rs 240 lakh of XL). The debt capacity of the combined firm would depend on its target debt ratio. Assuming that it is 1: 1, then it can have a total debt of Rs 4,330 lakh (i.e. equal to the combined firms equity, which is, pre-merger equity of S). Thus, unutilised debt capacity is Rs 1, 920 lakh, i.e. Rs 4,330 lakh minus the combined debt of S and XL, Rs 2,410 lakh. Further, both companies have marketable investments of Rs 52 lakh, which may also be available for acquisition. Since S has excess debt capacity, it can borrow Rs 1, 060 lakh to acquire XL. Even up to a target debt ratio of 0.80: 1, S would be able to acquire XL for cash. S could also acquire XL through the exchange of shares. If the company feels that its shares are either under-valued or over-valued in the market, it can follow a similar procedure as in the case of XL to calculate the value of its shares. For simplicity, let us assume that S's share price is fairly valued in the market. Its current price per share in 1998 is Rs 57.8. At this price, the company must exchange 18.3 lakh shares to pay Rs 1060 lakh to XL. After merger, S would have 175.8 lakh shares outstanding (157.5 lakh + 18.3 lakh). In the combined firm, XL's shareholders would hold about 10.4 per cent of shares. XL's shares are valued at Rs 1,060 lakh and the value of S's shares at the current market price is Rs 9,1041akh ( 157.5 lakh x Rs 57.8). Thus, the post-merger value of the combined firm is Rs 10,404 lakh; per share value being: Rs 10,164/175.8 = Rs 57.8. Thus, there is no loss, no gain to S's shareholders. S would be offering 18.3 lakh shares for 25 lakh outstanding shares of XL, which means 0.73 shares of S for one share of XL. The book value of S's share in 1998 is Rs 27.49 while that of XL is Rs 29.2. Thus, S could offer 0.94 shares for each outstanding share of XL without

diluting its present book value. Since it is exchanging only 0.73 share, its book value should Impact on Earnings per Share Would S's EPS be diluted Iflt exchanged 18.31akh shares to XL? Or. what is the maximum number of shares which S could exchange without diluting its EPS? Let us assume the earnings of both firms at 1998 level. We can calculate the maximum number of S's shares to be exchanged for XL's shares without diluting the former company's EPS after merger as follows:

Table 7: S ENGINEERING COMPANY: IMPACT OF MERGER ON EPS Ss (the acquiring firms) PAT before the merger(PATa) XLs (the acquired firm) PAT if merged with S (PATb) PAT of the combined firms after (PATa + PATb = PATc) Ss EPS before the merger (EPSa) (Rs.) Maximum number of Ss shares maintaining EPS of Rs. 2.56(486/2.56) ()lakh Ss (the acquiring firm) outstanding shares before merger (Na) (lakh) 403 83 486 2.56 189.8 157.5

Maximum number of shares to be exchanged without diluting EPS: (189.8 157.5) 32.3 (lakh)

We can also directly calculate the maximum number of shares as follows: Maximum number of shares to be exchanged without EPS dilution = (Acquiring firms postmerger earnings/Acquiring firm's pre-merger earnings) - Acquiring firms pre-merger number of shares (PATa + PATb)/ EPSa - Na (403 + 83)/2.56 - 157.5 = 32.31akh Thus, S (the acquiring firm) could exchange 1.29 (ie.32.3/25) of its shares for one share of XL (the acquired firm) without diluting its BPS after merger. Since it is exchanging 0.73 shares, its BPS after merger would be as shown below: S's PAT after merger (Rs 4031akh + Rs 831akh) 486 Number of shares after merger (157.5 + 18.3) S's EPS after merger 175.8 2.76

Table 8 summarizes the effect of the merger of XL with S on BPS, market value and priceeaming ratio with an exchange ratio of 0.73. Table 8 MERGER OF XL WITH S: IMPACT ON EPS, BOOK VALUE, MARKET VALUE AND P/E RATIO S (before merger) XL PAT(Rs. Lakh) No. of shares (lakh) EPS (Rs.) Market Value per share (Rs.) P/E Ratio (times) 403.00 157.50 2.56 57.80 22.58 83.00 25.00 3.32 24.90 7.50 S(after merger) 486.00 175.80 2.76 57.80 20.94

Total Market Capitalisation (Rs. Lakh) 9104.00

1060.00 10164.00

Notes: (a) In line 2 S's number of shares after merger would be: 157.5 + (0.73 x 25) = 1.75.8 lakhs. (b) In line 6, the value of XL's share is based on its evaluation by S reflecting future growth and cost savings. At the current market value of Rs 24.9, market capitalisation in Rs 622.5 lakhs. (c) Market value per share after merger would be: Rs 10,164/175.8 = Rs 57.8 It is observed that for XL's (the acquired firm) pre-merger EPS of Rs 3.32, the price paid is Rs 42.4. Thus, the price-earnings ratio paid to XL is: Rs 42.4/3.32 = 12.8 times. Since the price-earnings ratio exchanged is less than S's (the acquiring firm) price-earnings ratio of 22.6, its EPS after merger increases. However, in terms of value, there is no change. In fact, the post merger price-earnings ratio falls to: Rs 57.8/Rs 2.76 = 20.94 times. We can notice from Table 8 that .after merger the market value per share is Rs 57.8 and total capitalisation increases to Rs 10,164Iakhs, more by Rs 4381akhs of the sum of the capitalization of individuals firms (Rs 57.8 x 157.5 lakhs plus Rs 24.9 x 25 lakhs) = Rs 9,104 lakhs + Rs 622.5 lakhs = Rs 9,726.50 lakhs. This increased wealth, however, does not benefit the shareholders of S since it is entirely transferred to XL's shareholders as shown below: -, Total capitalisation of XL's shareholders after merger (Rs lakh) 1,060 Total capitalisation of XL's shareholders before merger (Rs 24.9 x 25 lakh) (Rs lakh) 622 Net gain (Rs lakh) = 438

Would the shareholders of S gain if there was no economic gain from the merger and the exchange ratio was in terms of the current market price of the two companies shares? The market price share exchange ratio (SER) would be: Share price of acquired firm / Share price of the acquiring firm Pb/ Pa = 24.9 / 57.8 = 0431

Table 9 summaries the impact of the share exchange in terms of the current market price. This implies that no premium is paid to XL. Table 9 MERGER OF XL WITH S: IMPACT ON EPS, BOOK VALUE, MARKET VALUE AND P/E RATIO; WITHOUT MERGER GAIN (EXCHANGE RATIO 0.431) S before merger XL PAT (Rs. Lakh) No. of shares (lakh) EPS (Rs.) Market Value per share (Rs.) P/E Ratio (times) 403.00 157.50 2.56 57.80 22.58 83.00 25.00 3.32 24.90 7.50 S after merger 486.00 168.30 2.89 57.80 20.00

Total Market Capitalisation (Rs. Lakh) 9104.00

622.50 9726.50

We find that there is no gain from the merger in terms of the market value. However, S is able to increase its EPS. The reason is that its profit after tax increases by 20.6 per cent after merger while the number of shares increases by 6.9 per cent only. The price earnings ratio declines as there p is no change in the market value per share and EPS increases after merger: P/E = Rs 57.6/2.89 = 20. This is known as the "bootstrapping phenomenon", and it creates an illusion of benefits from the merger. Once again, it may be noticed that the priceearnings ratio exchanged by the acquiring firm (S), Rs 24.9/Rs 3.32 = 7.5 is less than its price-earnings ratio, and this resulted in higher EPS for the acquiring firm. In case of XL' s merger with S, there is expected to be increase in XL' s capitalisation due to improvement in profit margin and operating efficiencies. We have seen earlier that if the

exchange ratio is 0.73, the entire gain is transferred to the shareholders of XL. Possibly, XL's shares would remain 'under-valued', if it is not acquired by S. Can a negotiation take place so that the shareholders of S also gain from the increased wealth from merger? Let us assume economic gain (Rs 1, 060- Rs 622 = Rs 438 lakh) and exchange ratio in terms of the current market value of two companies i.e., 0.431. The effect is shown in Table 10. Table 10 MERGER OF XL WITH S: IMPACT ON EPS, MVPS AND P/E RATIO; WITH MERGER GAINS (EXCHANGE RATIO 0.431) S (before merger) XL PAT (Rs. Lakh) No. of shares (lakh) EPS (Rs.) Market Value per share (Rs.) P/E Ratio (times) 403.00 157.50 2.56 57.80 22.58 83.00 25.00 3.32 24.90 7.50 S(after merger) 486.00 168.30 2.89 50.39 21.40

Total Market Capitalisation (Rs. Lakh) 9104.00

1060.00 10164.00

It is observed from Table 10 that the market value of S's share is expected to be higher (Rs 60.4) after merger as compared to the before-merger value (Rs 57.8). The net increase in wealth is shared by shareholders of both XL and S as shown below: Gain to S's (the acquiring firm) shareholders (Pab -Pa)Na = (60.4- 57.8) x 157.5 Gain to XL's (the acquired firm shareholders) Pab x (SER)Nb-Pb x Nb=60.4 x 10.8-24.9 x 25 Total gain: Pab (Na+ (SER) Nb) - (P a x Na + Pb x Nb) = 60.4 (157.5 + 0.431 x 25) - (57.8 x 157.5+ 24.9 x 25) 438 29 409

Thus, the distribution of the merger gain between the shareholders of the acquiring and target companies can be calculated as follows: Merger gain = Gain to the acquiring company's shareholders + Gain to the acquired company's shareholders = (Pab - Pa) Na + Pab x SER (Nb) -Pb x Nb (3) where

Pab is the price per share after merger, Pa before-merger share price of the acquiring company, Pb before-merger share price of the target company, Na before-merger number of shares of the acquiring company, Nb before-merger number of shares of the target company and SER is the share exchange ratio. Using Equation (3), the merger gain for the shareholder of S and XL in Illustration 2 can be computed as follows: 1 ,060 - 622 = (60.4- 57.8) 157.5 + [60.4 x (24.9/57.8) (25) -24.9 x 25] 438 = 2.60 x 157.5 + [60.4 x (0.43) 25- 24.9 x 25.] = 409 + 29 = 438. We may observe that the market value per share of the combined firm (Pab) is higher than that of the acquiring or the acquired firm because of the operating economies and improved margin in the operation of the acquired firm. Thus the total gain is also equal to the fair value of XL's shares. ; (Rs 1 ,060 lakh) minus the current market capitalization (Rs 622) i.e. Rs 438.

MERGER NEGOTIATIONS: SIGNIFICANCE OF P/E RATIO AND EPS ANALYSIS In practice, investors attach a lot of importance to the earnings per share (EPS) and the priceearnings (P/E) ratio. The product of EPS and P/E ratio is the market price per share. In an efficient capital market, the market price of a share should be equal to the value arrived by the DCF technique. In reality, a number of factors may cause a divergence between these two values. Thus, in addition to the market price and the discount value of shares, the mergers and acquisitions decisions are also evaluated in terms of EPS, P/E ratio, book value etc. We have already discussed the impact of merger on these variables in the case of the merger of S Engineering Company and XL Company (Illustration 2). In this section, we extend the discussion in a more formal manner in the context of the negotiations in terms of exchange of shares. Exchange Ratio The current market values of the acquiring and the acquired firms may be taken as the basis for exchange of shares. As discussed earlier, the share exchange ratio (SER) would be as follows; Share price of the acquired firm / Share price of the acquiring firm = Pb/ Pa 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. There is no incentive for the shareholders of the acquired firm, and they would require a premium to be paid by the acquiring company. Could the acquiring company pay a premium and be better off in terms of the additional value of its shareholders? In the absence of net economic gain, the shareholders of the acquiring company would become worse-off unless the price-earnings ratio of the acquiring company remains the same as before the merger. For the shareholders of the acquiring firm to be better-off after the merger without any net economic gain either the price-earnings ratio will have to increase sufficiently higher or the share exchange ratio is low, the price-earnings ratio remaining the same. Let us consider the example in Illustration 3. S Enterprise R Enterprise PAT (Rs.) 40000 8000

No. of shares EPS (Rs.) Market Value per share (Rs.) P/E Ratio (times)

10,000 4 60 15

4,000 2 15 7.5 60,000

Total Market Capitalisation (Rs.) 6,00,000

S Enterprise is thinking of acquiring R Enterprises through exchange of shares in proportion of the market value per share. If the price-earnings ratio is expected to be (a) pre-merger P/E ratio of R i.e. 7.5, (b) pre-merger P/E ratio of S i.e. 15, (c) weighted average of pre-merger P/E ratio of S and R i.e. 13.75, what would be the impact on the wealth of shareholders after merger? Since the basis of the exchange of shares is the market value per share of the acquiring (S Enterprise) and the acquired (R Enterprise) firms, then S would offer 0.25 of its shares to the shareholders of R: Pb/Pa = 15/60 = 0.25 In terms of the market value per share of the combined firm after the merger, the position of R's shareholders would remain the same: that is, their per share value would be: Rs 60 x 0.25 = Rs 15. The total number of shares offered by S (the acquiring firm) to R's (the acquired firm) shareholders would be: No. of shares exchanged = SER x Pre-merger number of shares of the acquired firm = (P b/ Pa) Nb = 0.25 X 4,000 = 1,000 And the total number of shares after the merger would be: Na+ (SER) Nb = 10,000 + 1,000 = 11,000. The combined earnings (PATc) after the merger would be: Rs 40,000 + Rs 8,000 = Rs 48,000 and EPS after the merger would be: Post-merger combined/ Post-merger combined shares = (PATa + PATb)/ ( Na + (SER)Nb) (40,000 + 8,000) / (10,000 + 0.25 x 4000) = 48000 / 11000 = 4.36

The earnings per share of S (the acquiring firm) increased from Rs 4 to Rs 4.36, but for R's (the acquired firm) shareholders, it declined from Rs 2 to Rs 1.09; that is, Rs 4.36 x 0.25 = Rs 1.09. Given the earnings per share after the merger, the post-merger market value per share would depend on the price-earnings ratio of the combined firm. How would P/E ratio affect the wealth of shareholders of the individual companies after the merger? Table 12 shows the impact. Table 11 R AND S ENTERPRISES: P/E RATIO AND EFFECT ON VALUE P/E Ratio EPS after merger Combined firms value merger 7.50 15.00 13.75 4.36 4.36 4.36 32.70 65.40 60 Market Market Market Market

market value of S value of S value of R value of R after before merger 60 60 60 after merger 32.70 65.40 60 before merger 15 15 15 after merger 8.18 16.35 15

We can observe from Table 11 that the shareholders of both the acquiring and the acquired firms neither gain nor lose in value terms if post-merger P/E ratio is merely a weighted average of pre-merger P/E ratios of the individual firms. The post-merger weighted P/E ratio is calculated as follows: Post-merger weighted P/E ratio: (Pre-merger P/E ratio of the acquiring firm) x (Acquiring firm's pre-merger earnings + Postmerger combined earnings) + (Pre-merger P/E ratio of the acquired firm) x (Acquired firm's pre-merger earnings + Post-merger combined earnings) P/Ew = (PlEa) (PATa/PATc) + (P/Eb) x (PATb/PATc) Using Equation (5) in our example, we obtain: = ( 15) (40.000/48,000) + (7.5) (8,000/48,000) = 12.5 + 1.25 = 13.75 The acquiring company would lose in value if post-merger P/E ratio is less than the weighted P/E ratio. Any P/E ratio above the weighted P/E ratio would benefit both the acquiring as well as the acquired firms in value terms. An acquiring firm would always be able to improve its earnings per share after the merger whenever it acquires a company with a P/E ratio lower (5)

than its own P/E ratio. The higher EPS need not necessarily increase the share price. It is the quality of EPS rather than the quantity which would influence the price. An acquiring firm would lose in value if its post-merger P/E ratio is less than the weighted P/E ratio. S Enterprise would lose Rs 27.30 value per share if P/E ratio after merger was 7.5 Any P/E ratio above the weighted P/E ratio would benefit both the acquiring as well as the acquired firm in value terms. When the post-merger P/E ratio is 15, S gains Rs 5.40 value per share and Rs 1.35. Why does S Enterprise's EPS increase after merger? Because it has a current P/E ratio of 15, and it is required to exchange a lower P/E ratio. i.e. P/E exchanged = (SER x Pa)/ EPSb = (0.25 X 60 ) / 2 = 7.5 S Enterprise's EPS after merger would be exactly equal to its pre-merger EPS if P/E ratio paid is equal to its pre-merger P/E ratio of 15. In that case, given R's EPS of Rs 2, the price paid would be Rs 30 or a share exchange ratio of 0.5. Thus, S Enterprise would issue 0.5 x 4.000 = 2,000 shares to R Enterprise. The acquiring firm's EPS after merger would be: Rs 48,000/12.000 = Rs 4. It may be noticed that at this P/E ratio. S's shareholders would have the same EPS as before the merger: 0.5 x Rs 4 = Rs 2. It can be shown that if the acquiring firm takes over another firm by exchanging a P/E ratio higher than its P/E ratio. its EPS will fall and that of the acquired firm would increase after the merger. Let us assume in our illustration that S exchanges a P/E ratio of 22.5 to acquire R. This implies a price of Rs 45 per share and a share exchange ratio of 0.75. The earnings per share after acquisition would be as follows: Post Merger EPS (40,000 + 8,000 )/ (10,000 + 0.75 * 4,000) = 48,000/ 13000 = Rs 3.69 Thus, the acquiring firm's EPS falls (from Rs 4 to Rs 3.69) and the acquired firm's EPS increases (from Rs 2 to Rs 3.69 x 0.75 = Rs 2.77). Earnings Growth At share exchange ratio, based on the current market values, S's (the acquiring firm) EPS falls. Should it acquire R? It can acquire R if its (R's) future earnings are expected to grow at a higher rate. After acquisition, S's EPS would increase faster than before since the future growth rate would be the weighted average of the growth rates of the merging firms. Let us assume that S's EPS is expected to grow at 6 percent and R's at 5 percent. The weighted EPS growth for S would be: Gw = 0.06 x 40,000/ 48,000 + 0.15 x 8000/ 48000 = 0.075 or 7.5 %

Thus, the formula for weighted growth in EPS can be expressed as follows: Weighted Growth in EPS = Acquiring firm's growth x (Acquiring firm's pre-merger EPS/combined firm's EPS) + Acquired firm's growth x (Acquired firm's pre-merger EPS/combined firm's EPS) Gw = Ga x EPSa/ EPSb + Gb x EPSb/ EPSc where Gw is the weighted average growth rate after the merger, Ga and EPSa are growth rate and earnings per share respectively of the acquiring firm before the merger, Gb and EPSb are growth rate and the earnings per share of the acquired firm before the merger, EPSc earnings per share of the combined firm after merger. Table 12 shows the future EPS of S with and without merger. Table 12 : Ss EPS with and without the merger (Rs. ) Year Without merger (G = 6%) With merger (G = 7.5%) 0 1 2 3 4 5 6 7 8 4.00 4.24 4.49 4.76 5.05 5.35 5.67 6.01 6.38 3.69 3.97 4.26 4.58 4.93 5.30 5.69 6.12 6.58

We can see from Table 12 that without merger, Ss current EPS of Rs 4.00 would grow at 6 per cent per year and with merger the diluted EPS of Rs 3.69 would grow at 7.5 per cent (the weighted average growth rate). S's EPS with merger would remain depressed until six years after merger. Its EPS, however, would start growing faster after six years. In fact, S has a higher P/E ratio which is an indication of the investors' expectation of high future growth. Therefore, it is more likely that it would grow rapidly. Under such situation, it would not pay any premium to R. At a share exchange ratio of 0.25, S's EPS after merger would be Rs 4.36. Assume that its earnings are expected to grow at 24 per cent and R' sat 15 per cent. How would Ss EPS behave with or without merger? This is shown in Table 13. It. may be observed that merger would help the acquiring company to grow rapidly (than without merger) for seven years after merger. After seven years, the position would reverse.

Thus, the company would either acquire other companies with lower P/E ratios, or improve its operating, efficiency and continue growing.

Table 13: Ss EPS with and without merger Without Merger (G= 24%) With Merger ( G= 22.5%) 0 1 2 3 4 5 6 7 8 9 4 4.96 6.15 7.63 9.64 11.73 14.54 18.03 22.36 27.72 4.36 5.34 6.54 8.01 9.82 12.03 14.73 18.05 22.11 27.08 33.18

10 34.37

From calculation in Tables 12 and 13 we see that the important factors influencing the earnings growth of the acquiring firm in future are:y y

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

y y y

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 BUYOUTS A leveraged buy-out (LBO) is an acquisition of a company in which the acquisition is substantially financed through debt. Debt typically forms 70-90 per cent of the purchase price and it may have a low credit rating. In the USA, the LBO shares are not bought and sold in the stock market, and the equity is concentrated in the hands of a few investors.2 Debt is obtained on the basis of the company's future earnings potential. LBOs generally involve payment by cash to the seller. When the managers buy their company from its owners employing debt, the leveraged buyout is called management buy-out (MBO). LBOs are very popular in the USA. It has been found there that in LBOs, the sellers require very high premium, ranging from 50 to 100 per cent. The main motivation in LBOs is to increase wealth rapidly in a short span of time. A buyer would typically go public after four or five years, and make substantial capital gains. In LBOs, a buyer generally looks for a company which is operating in a high growth market with a high market share. It should have a high potential to grow fast, and be capab to le earning superior profits. The demand for the company's product should be known so that its earnings can be easily forecasted. A typical company for a leveraged buyout would be one which has high profit potential, high liquidity and low or no debt. Low operating risk of such companies allows the acquiring firm or the management team to assume a high degree of financial leverage and risk. Why is a lender prepared to assume high risk in a leveraged buy-out? A lender provides high leverage in a leveraged buy-out because he may have full confidence in the abilities of the managers-buyers to fully utilise the potential of the business and convert it into enormous value. His perceived risk is low because of the soundness of the company and its assumed, predictable performance. He would also guard himself against loss by taking ownership position in the future and retaining the right to change the ownership of the buyers if they fail to manage the company. The lender also expects a high return on his investment in a leveraged buy-out since the risk is high. He may, therefore, stipulate that the acquired company will go public after four or five years. A major, portion of his return comes from capital gains. MBOs/LBOs can create a conflict between the (acquiring) managers and shareholders of the firm. The shareholders' benefits will reduce if the deal is very attractive for the managers. This gives rise to agency costs. It is the responsibility of the board to protect the interests of

the shareholders and ensure that the deal offers a fair value of their shares. Another problem of LBOs could be the fall in the price of the LBO target company's debt instruments (bonds/debentures). This implies a transfer of wealth from debenture holders to shareholders since their claim gets diluted. Debenture holders may, thus, demand a protection in the event of a LBO/MBO. They may insist for the redemption of their claims at par if the ownership/control of the firm changes. TENDER OFFER A tender offer is a formal offer to purchase a given number of a company's shares at a specific price. The acquiring company asks the shareholders of the target company to "tender" their shares in exchange for a specific price. The price is generally quoted at a premium in order to induce the shareholders to tender their shares. 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. The shareholders are generally approached through announcement in the financial press or through direct communication individually. They mayor may not react to a tender offer. Their reaction exclusively depends upon their attitude and sentiment and the difference between the market price and the offered price. The tender offer mayor may not be acceptable to the management of the target company. In September 1989, Tata Tea Ltd. (1TL), the largest integrated tea company in India, made an open offer for controlling interest to the shareholders of the Consolidated Coffee Ltd. (CCL).1TL's Chairman, Darbari Seth, offered one share in 1TL and Rs 100 in cash (which is equivalent of Rs 140) for a CCL share which was then quoting at Rs 88 on the Madras Stock Exchange. TTL's decision is not only novel in the Indian corporate sector but also a trend setter. TTL had notified in the financial press about its intention to buyout some tea estates and solicited offers from the share- holders concerned The management of the target company generally do not approve of tender offers. The major reason is the fear of being replaced. The acquiring company's plans may not be compatible with the best interests of the shareholders of the target company, The management of the target company can try to convince its shareholders that they should nost tender their shares since the offer value is not enough in the light of the real value of

shares, i.e. the offer is too low comparative to its real value. The management may use techniques to dissuade its shareholders from accepting tender offer. For example, it may lure them by announcing higher dividends. If this helps to raise the share price due to psychological impact or information content, then the shareholders may not consider the offer price tempting enough. The company may issue bonus shares and/or rights shares and make it difficult for the acquirer to acquire controlling shares. The target company may also launch a counter-publicity programme by informing that the tender is not in the interest of the shareholders. If the shareholders are convinced, then the tender offer may fail. The target company can follow delay tactics and try to get help from the regulatory authorities such as the Securities and Exchange Board of India (SEBI), or the Stock Exchanges of India. Defensive Tactics A target company in practice adopts a number of tactics to defend itself from hostile takeover through a tender offer. These tactics include a divestiture or spin-off, poison pill, greenmail, white knight, crown jewels, golden parachutes, etc.y

Divestiture: In a divestiture the target company divests or spins off some of its businesses in the form of an independent, subsidiary company. Thus, it reduces the attractiveness of the existing business to the acquirer.

y

Crown jewels: When a target company uses the tactic of divestiture it is said to sell the crown jewels. In some countries such as the UK, such tactic is not allowed once the deal becomes known and is unavoidable.

y

Poison pill: An acquiring company itself could become a target when it is bidding for another company. The tactics used by the acquiring company to make itself unattractive to a potential bidder is called poison pills. For example, the acquiring company may issue substantial amount of convertible debentures to its existing shareholders to be converted at a future date when it faces a takeover threat. The task of the bidder would become difficult since the number of shares to have voting control of the company will increase substantially-

y

Greenmail: Greenmail refers to an incentive offered by management of the target company to the potential bidder for not pursuing the takeover. The management of the target company may offer the acquirer for its shares a price higher than the market price-

y

White knight: A target company is said to use a white knight when its management offers to be acquired by a friendly company to escape from a hostile takeover. The possible motive for the management of the target company to do so is not to lose the management of the company. The hostile acquirer may replace the management.

y

Golden parachutes: When a company offers hefty compensations to its managers if they get ousted due to takeover, the company is said to offer golden parachutes. This reduces their resistance to takeover.

ACCOUNTING FOR MERGERS AND ACQUISITIONS Mergers and acquisitions involve complex accounting treatment. A merger, defined as amalgamation in India, involves the absorption of the target company by the acquiring company, which results in the uniting of the interests of the two companies. .The merger should be structured as pooling of interest. In the case of acquisition, where the acquiring company purchases the shares of the target company, the acquisition should be structured as a purchase. 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 assets, liabilities and other items of the acquiring and the acquired firms are simply added at the book values without making any adjustments. Thus, there is no revaluation of assets or creation of goodwill. Let us consider an example as given in ILLUSTRATION 5 Firm T merges with Firm S. Firm S issues shares worth Rs 15 crore to Firm Ts shareholders. The balance sheets of both companies at the time of merger are shown in Table 14. The balance sheet of Firm S after merger is constructed as the addition of the book values of the assets and liabilities of the merged firms. It may be noticed that the shareholders funds are recorded at the book value, although T's shareholders received shares worth Rs 15 crore in Firm S. They now own Firm S along with its existing shareholders. Table 14 POOLING OF INTERESTS: MERGER OF FIRMS S ANDT Firm T Firm S Combined Firm Assets Net Fixed Assets Current Assets Total Shareholders Funds Borrowings Current Liabilities Total 24 8 32 10 16 6 32 37 13 50 18 20 12 50 61 21 82 28 36 18 82

Purchase Method Under the purchase method, the assets and liabilities of the acquiring firm after the acquisition of the target firm are adjusted for the purchase price paid to the target company. Thus, the assets and liabilities after merger are revalued. If the acquirer pays a price greater than the fair market value of assets and liabilities, the excess amount is shown as goodwill in the acquiring company's books. On the contrary, if the fair value of assets and liabilities is less than the purchase price paid, then this difference is recorded as capital reserve. Let us consider an example as given in Illustration 6. ILLUSTRATION 6 Firm S acquires Firm T by assuming all its assets and liabilities. The fair value of Firm T's fixed assets and current assets is Rs 26 crore and Rs 7 crore. Current liabilities are valued at book value while the fair value of debt is estimated to be Rs 15 crore. Firm S raises cash of Rs 15 crore to pay to Ts shareholders by issuing shares worth Rs 15 crore to its own shareholders. The balance sheets of the firms before acquisition and the effect of acquisition are shown in Table 15. The balance sheet of Firm S (the acquirer) after acquisition is constructed after adjusting assets, liabilities and equity. Table 15 :POOLING OF INTERESTS: MERGER OF FIRMS S ANDT Firm T Firm S Firm S after the merger Assets Net fixed assets Current assets Goodwill Total 24 8 32 37 13 50 18 20 12 50 63 20 3 86 33 35 18 86

Shareholders Fund 10 Borrowings Current liabilities Total 16 6 32

The goodwill is calculated as follows:

Payment to Ts shareholders Fair value of fixed assets Fair value of current assets Less: Fair value of borrowings Less: Fair value of current liabilities Fair value of net assets Goodwill

Rs. 15 Rs. 26 Rs. 7 Rs. 15 Rs. 6 Rs. 12 Rs. 3

The Case: ICICI and Bank of MaduraThe take over of Bank of Madura (BoM) by ICICI Bank has been the second success story in the banking industry after the take over of Times bank by HDFCBank

last year. The Board of

Directors of ICICI Bank and Bank of Madura (BoM) approved the merger of the two banks at their respective meetings held on 11thDecember and agreed to a share swap ratio of two shares of ICICI Bank for one share of BoM.

The amalgamation scheme was placed for approval at the meeting of shareholders of the two banks on January 19 .The proposed date of merger was February 1, 2001. ICICI Bank Limited has fixed Wednesday, April 11, 2001 as the 'Record Date' to determine the shareholders of Bank of Madura Limited who would be entitled to receive the equity shares of ICICI Bank.

ICICI Bank was third time lucky after two earlier attempts of merger. The first was a proposed merger with Centurion Bank, which fizzled out after the banks promoters asked for higher valuations, the second a recent reverse merger with parent ICICI.

The integration exercise was scheduled to be completed by September 2001. Before we move onto why the two banks decided to merge. Let us look at why ICICI decided to merge with Bank of Madura? ICICI Bank had been scouting for a private banker for merger. Though it had 21 percent of stake, the choice of Federal bank, was not lucrative due to the employee size (6600), per employee business is as low at Rs.161 lakh and a snail pace of technical up gradation. While, BOM had an attractive business per employee figure of Rs.202 lakh, a better technological edge and had a vast base in southern India when compared to Federal bank. Some key financials of both the banks: Financial Standings of ICICI Bank and Bank of Madura (Rs. in crore) Parameters ICICI Bank 19992000 Net worth 1129.90 1998-99 308.33 Bank of Madura 1999-2000 1998-99 247.83 211.32

Total Deposits Advances Net profit Share capital Capital Adequacy Ratio Gross Advances NPAs/ Gross

9866.02 5030.96 105.43 196.81 19.64% 2.54%

6072.94 3377.60 63.75 165.07 11.06% 4.72% 2.88%

3631.00 1665.42 45.58 11.08 14.25% 11.09% 6.23%

3013.00 1393.92 30.13 11.08 15.83% 8.13% 4.66%

Net NPAs /Net Advances 1.53%

Source: Compiled from Annual reports (March 2000) of ICICI Bank and BOM

Crucial Parameters: How they stand Book value of Market price on Name of Bank on the day the day of Earnings Dividend P/E ratio Profit per

employee (in lakh)

the Bank of

merger announcement of per share paid (in %) merger 131.60 38.7 55%

announcement Bank Madura ICICI Bank of 183.0

1999-2000 3% 1.73

58.0

169.90

5.4

15%

7.83

Source: Business Line, December 10, 2000and January 28, 2001.

Reasons for the merger:y

BoM was bankrupt (with assets which are Rs.350 crore behind liabilities) and had a leverage of 41 times. If it were to be brought up to a point where its assets were 10% ahead of liabilities, which is broadly consistent with the Basle Accord, this would require an infusion of Rs.800 crore of equity capital, which would be impossible for them to raise.

y

BoM had a network, which ICICI Bank wanted. They had many regional branches, which would help ICICI increase their reach in the regional markets.

y

Financial consolidation was becoming necessary for the growth of BoM. The merger with a new private sector bank, particularly a financially and technological strong bank like ICICI would add to shareholder value and enhance career opportunities for the employees besides providing first rate, technology based, modern banking services to customers

y

A major problem for old banks is funds. Reserve Bank of India has asked several South India based banks to raise their paid-up capital to Rs 50 crore by March 2001. This could also be one of the reasons that they merged.

y y

BoM is extremely strong in the south and this merger would help ICICI grow in that area. ICICI wanted to increase their client base.

Benefitsy

For BoM, the most significant benefit would be the brand equity it would acquire by becoming a part of the ICICI group, with the most overt advantage being technology infusion.

y

BoM would not have been able to raise the Rs800 crore that it needs to get the assets 10% ahead of its liabilities, but after the merger with ICICI this amount will be infused into the bank.

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The shareholders of both the banks will benefit. Although the swap ratio favours BoM the ICICI bank shareholders still earn a higher Earning per Share (EPS).o On post merger, ICICI Bank's equity shall be Rs.220.36 crores while its annual

total income would be about Rs.1,700 crores with expected net profit of Rs.192

crores giving an annualised EPS of Rs.8.70 as compared to an EPS of Rs.7.90 as on 30 September. 2000 Hence it has been seen that even after issue of shares in exchange ratio of 2:1 the financial performance of the bank shall improve, thus improving the bottom line of the bank.o Even the shareholders of Bank of Madura stand to gain, as now they will have

double quantity of ICICI Bank shares. The share price of Bank of Madura had a 52-week high/low of Rs.165 and Rs.65 prior to announcement of merger, with the average being Rs.120.after the merger; the value of one share shall rise to anything between Rs.280 to Rs.300, since the share price of ICICI Bank rules above Rs.150. So the shareholders of this bank have almost trebled their worth.

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ICICI Banks growth prospects had improved, as it would now get access to the branch network of Bank of Madura.o The bank was looking at a branch network of 350-400, which would have taken at

least five years to achieve. BoM has a branch network of 263 while ICICI Bank has 106 branches so totally they would have 363 branches, which would enable them to serve their customers better. Thus the merger would provide this network immediately and would enable them spread their network to 16 States.o The enhanced branch network will enable the Bank to focus on micro -finance

activities through self-help groups, in its priority sector initiatives through its acquired 87 rural and 88 semi-urban branches. The cost of setting up the branches would have been Rs2-2.6b. Of these branches, 50-60 are located in major cities where ICICI Bank did not have a significant presence. On an average, Bank ofo Madura s metropolitan branches have mobilized deposits of over Rs300m

whereas ICICI Bank has been mobilizing deposits of over Rs1b per branch. ICICI Bank expects to generate the same amount of deposits from the acquired branches without incurring the set-up costs.

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Larger Client base: To get an additional 1.2 million customers, which is BoM's client base now, it would have required a minimum of two years. Hence they get 1.2 million customers in one go, this is significant especially when viewed in the light that ICICI Bank took almost 7 years to build a customer base of 1.9m.Thus, the merger enables ICICI to have an aggregate of 2.7 million customer base and a combined asset base of Rs.16, 000 crore, cross selling opportunities for assets and other products, and good cash management services.

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BoM is strong in south India states and ICICI is very strong in Central and North Indian states, which would give a complacent advantage to both the banks. The south has a high rate of economic development. This merger has enabled ICICI Bank to gain a size and presence, which on its own would have taken around 2-3 years. Moreover, it also opens up the south Indian market for the bank where it had a very low presence earlier. The south is considered to be a big retail market, which has been untapped by the new generation private sector banks. This merger will provide ICICI Bank with a significant lead in this region. Whereas it would give BoM a chance to explore the Northern Terrotories.

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Financial Capability: The amalgamation will enable them to have a stronger financial and operational structure, which is suppose to be capable of greater resource/deposit mobilization. And ICICI will emerge as one of the largest private sector banks in the country.

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Tech edge: The merger will enable ICICI to provide ATMs, Phone and the Internet banking and financial services and products to a large customer base, with expected savings in costs and operating expenses.

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An Acquisition at a fair value.. ICICI Bank issued 23m shares (which increased its equity from Rs1.97b to 2.2b) to Bank of Madura shareholders in an all-stock swap deal. The ICICI Bank stock was quoting at an average of Rs140-150 during that period which means that the total deal was worth Rs3.25-3.5b.

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BoM would not have to close down due to bankruptcy. It gets a new lease on life. An opportunity to improve fee-based income The merger will help ICICI Bank to improve its fee-based income. Bank of Madura was one of the active players in cash management services and was even used by some of the foreign banks because of its efficient service standards. ICICI Bank can use this client base to substantially shore up its fee-based income, which is expected to be the differentiating factor in the revenue models of banks in the future.

Problems in the merger:y

The employees and staff of the two banks had no clue whatsoever and were `surprised and shocked' in their own words when the merger was announced. Hence they might make the merger process more tiresome for the management. The surprise element is said to have hit even the top management of Bank of Madura who are reported to have been "caught unawares" by the developments set in motion by the owners/directors of the two banks.

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It is a merger of a 57-year old BOM, south based old generation bank with a fast growing tech savvy new generation bank this in itself has enough problems.

y

Managing rural branches : ICICIs major branches are in major metros and cities, whereas BOM spread its wings mostly in semi urban and city segments of south India. There is a task ahead lying for the merged entity to increase dramatically the business mix of rural

branches of BOM. On the other hand, due to geographic location of its branches and level of competition, ICICI Bank will have a tough time to cope with.y

Managing Software: Another task, which stands on the way is technology. While ICICI Bank, which is a fully automated entity is using the package, Banks 2000; BOM has computerized 90 percent of its businesses and was conversant with ISBS software. The BOM branches are supposed to switch over to Banks 2000. Though it is not a difficult task, with 80 percent computer literate staff would need effective retraining which involves a cost. The ICICI Bank needs to invest Rs.50 crore, for upgrading BOMs 263 branches.

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Managing Human resources: One of the greatest challenges before ICICI Bank is managing human resources. When the head count of ICICI Bank is taken, it is less than 1500 employees; on the other hand, BOM has over 2500. The merged entity will have about 4000 employees which will make it one of the largest banks among the new generation private sector banks. The staff of ICICI Bank are drawn from 75 various banks, mostly young qualified professionals with computer background and prefer to work in metros or big cities with good remuneration packages. While under the influence of trade unions most of the BOM employees have low career aspirations. The announcement by H.N. Sinor, CEO and MD of ICICI, that there would be no VRS or retrenchment, creates a new hope amongst the BOM employees. It is a tough task ahead to manage. On the other hand, their pay would be revised upwards. It is a Herculean task to integrate the two work cultures.

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Managing Client base: The client base of ICICI Bank, after merger, will be as big as 2.7 million from its past 0.5 million, an accumulation of 2.2 million from BOM. The nature and quality of clients is not of uniform quality. The BOM has built up its client base for a long time, in a hard way, on the basis of personalized services. In order to deal with the BOMs clientele, the ICICI Bank needs to redefine its strategies to suit to the new clientele. The sentiments or a relationship of small and medium borrowers is hurt, it may be difficult for them to reestablish the relationship, which could also hamper the image of the bank.

Effect / how the integrated company would look:y

The total assets of the merged entity would prove to be roughly Rs.17, 345 crore and the liabilities would prove to be Rs.16, 517 crore. The merged entity would hence need roughly Rs.800 crore of fresh equity capital in order to come up to a point where assets were atleast 10% ahead of liabilities as mentioned above. The volatility of assets of the merged entity proves to be around 0.12

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ICICI would become the no. 1 private bank in the country and would beat its competitor HDFC bank.

(FY01)

HDFC BANK + TIMES BANK 116.5 46.3 1.4 131 207

ICICI BANK + BANK OF MADURA 163.7 70.3 3.2 389 510 Illustration 15

Deposits (Rs b) Advances (Rs b) No. of retail accounts (m) Branches ATMs

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Increased NPAs

Illustration 16 For the FY01 ICICIs net NPAs would increase marginally to 1.44% of customer assets, because of the assets quality of the BoM as the assets and liabilities are combined as of 31st March 01. However ICICI has taken steps to control the NPA. To control its NPAs as a matter of policy, unlike earlier, the bank has given credit approval authority to only selected branches, which

would be having the required expertise to assess the credit risk. While the approval would be only at selective branches, which was not the case earlier, actual disbursement can be from other branches for locational convenience. It has also decided as a matter of policy to extend advances to only top rung companies in each sector. These new policy measures we believe would go a long way in improving the quality of assets in future and keeping NPAs under check.y

Share holding pattern. Category ICICI ADS Resident Indians BoM Shareholders FIIs Others Total % 46.99 14.41 6.14 10.68 17.26 4.52 100 Illustration 17

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Rationale for the swap ratio. The ICICI Bank-Bank of Madura (BoM) swap ratio is 2 shares of ICICI to one share of BoM, though it is in favour of BoM, it has to be viewed in the light that the book value of the latter's shares is about 3.8 times that of the acquiring bank. The book value per share of ICICI Bank is Rs 61.90 while that of BoM is Rs 232.80 and this was a major factor in determining the exchange ratio. The operating profit margin of BoM is also higher at 33.3 per cent, than that of ICICI Bank, whose margin works out to 31.8 per cent. The net profit margin of ICICI Bank is 16.8 per cent and that of BoM is 13 per cent.

To sum up I would like to say that if ICICI Bank is not able to achieve synergies and increase the projected growth targets after the acquisition of BoM, it will adversely affect the future growth of ICICI Bank also.

BibliographyBooksy

Mergers and Takeovers a Compendium Bombay Chartered Accountants Society Mergers and Acquisitions Hitt , Harrison and Ireland Financial Management IM pande

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Newspapersy y y y y

Financial Express The Economic Times Business Standard The Hindu Business Line The Times of India

Magazinesy y

Business Today The Economist

Websitesy y y y y y y y ywww.icfai.com www.mckinsey.com www.mergersindia.com www.uva.edu www.google.com www.altavista.com www.yahoo.com www.valuenotes.com www.krchoksey.com