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Mergers and Acquisitions

Unit 1

Unit 1

Introduction to Mergers and Acquisitions

Structure: 1.1 Introduction Objectives 1.2 Meaning of Mergers and Acquisitions Merger or amalgamation Acquisition 1.3 Motives behind Mergers and Acquisitions Sensible reasons Dubious reasons for mergers 1.4 Advantages and Disadvantages of Mergers and Acquisitions Advantages of mergers and acquisitions Disadvantages of mergers and acquisitions 1.5 Types of Mergers and Acquisitions 1.6 Historical Overview of M & A Activity 1.7 Steps to a Successful Merger 1.8 Summary 1.9 Glossary 1.10 Terminal Questions 1.11 Answers 1.12 Case Study

1.1 Introduction
One of the main objectives of any company or business organisation is to achieve growth. Without growth a business cannot stay profitable and endure in a highly competitive environment. In this unit, you will learn about mergers and acquisitions and the role they play in business. You will appreciate how and why a business house has to pursue inorganic or external growth as much as organic growth (growth achieved internally), in order to remain viable. Objectives: After studying this unit, you should be able to: explain mergers and acquisitions describe the motives behind mergers and acquisitions
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state the advantages and disadvantages of mergers and acquisitions explain different types of mergers discuss historical overview of Merger and Acquisition Activity describe the steps of a successful merger

1.2 Meaning of Mergers and Acquisitions


1.2.1 Merger or amalgamation Merger is defined as a combination where two or more than two companies combine into one company. In this process one company survives and others lose their corporate existence. The survivor acquires assets as well as liabilities of the merged company or companies. In another form of merger, one company purchases another company for cash and integrates the purchased company with itself. Amalgamation is a synonym of merger, especially in Indian law. Section 2(1A) 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. Shareholders holding not less than nine-tenth in the value of the shares in the amalgamating company or companies become shareholders of the amalgamated company. Merger may take two forms: merger through absorption and merger through consolidation. Absorption: Absorption is grouping two or more companies into an existing company. All companies except one lose their identity in a merger through absorption. Merger of Tata Chemical Ltd and Tata Fertilisers Ltd is an example of absorption. Tata Chemical Ltd (buyer) survived after the merger while Tata Fertiliser Ltd (seller) was closed down. Assets, shares and liabilities of Tata Fertiliser Ltd were transferred to Tata Chemicals Ltd. Consolidation: Consolidation is known as the fusion of two or more than two companies into a new company in which all the existing companies are legally dissolved and a new company is created. The consolidated entity is
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known by a new name and the shareholders of the dissolving companies become shareholders of the new company. Merger of Hindustan Computers Ltd, Hindustan Instruments Ltd, Indian Software Ltd and Indian Reprographics Ltd to form HCL, a new company, is an example of consolidation. 1.2.2 Acquisition The term "acquisition" refers to the procurement of assets by one company from another company. In an acquisition, both companies may continue to exist. An acquisition, also known as a takeover, is the buying of one company (the target) by another. An acquisition may be friendly or hostile. In the former case, the companies cooperate in negotiations. In the latter case, the takeover target is unwilling to be bought or the target's Board has no prior knowledge of the offer. Acquisition usually refers to a purchase of a smaller firm by a larger one. Sometimes, a smaller firm will acquire management control of a larger or longer established company and keep its name for the combined entity. This is known as a reverse takeover. In this unit and throughout the SLM, we will use the words merger and acquisition interchangeably to mean a business transaction where one company acquires another company. The terms "demerger", "spin-off" and "spin-out" are used to indicate a situation where one company splits into two, generating a second company. Examples of some mergers and acquisitions: Aditya Birla group-owned HINDALCO acquired NOVELLIS for US$6 billion. TATA MOTORS acquired LAND ROVER for $2.3 billion. Takeover of European Steel major CORUS for $12.2 Billion by TATA STEEL, the biggest ever acquisition by an Indian company. Self 1. 2. 3. Assessment Questions Growth achieved internally is termed as organic growth. (True/False) Amalgamation is a synonym of merger. (True/False) Consolidation is known as the fusion of two or more companies into a new company. (True/False) 4. Growth achieved by M & A is termed as organic growth. (True/False)
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5. Acquisitions mean acquiring all the assets and liabilities of another company. (True/False) 6. Deal between Tata Motors and Land Rover was a kind of merger. (True/False) 7. An acquisition may be friendly or hostile. (True/False)

1.3 Motives behind a Merger or acquisition


Multiple factors lead to a merger or acquisition. Mostly, it is for the increase in economies of scale. The idea is that the resultant larger firm can produce units more cheaply than previously independent companies. Economies of scale can be efficiently achieved through the sharing of technology, resources and the elimination of duplication and waste. Economies of scale could be a good reason for merger. But there are many examples to show that combining separate entities into a single, more efficient operation is not easy. 1.3.1 Sensible reasons A merger can be rated as sensible when it adds value, i.e. it creates additional benefit to the parties involved. From this standpoint, some of the sensible reasons in favour of mergers are: Strategic benefits: If a firm has decided to enter or expand in a particular industry, acquisition of a firm engaged in that industry, rather than dependence on internal expansion, may offer several strategic advantages. As a pre-emptive move it can prevent a competitor from establishing a similar position in that industry. It offers a special timing advantage because the merger alternative enables a firm to leapfrog several stages in the process of expansion. It may entail less risk and even less cost. In a saturated market, simultaneous expansion and replacement makes more sense than creation of additional capacity through internal expansion. Economies of scale After the merger of companies, achieving economies is easy as operations of different firms are combined. This achievement is possible due to the efficient and proper usage of distribution networks, production capacities, research and development facilities, engineering services, data processing systems etc. As the scope for utilising resources is far greater in horizontal
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mergers, economies of scale are mostly prominent in those. In vertical mergers, main sources of benefits are better coordination of activities, higher market power and lower inventory levels. Even in conglomerate mergers, possibility of cutting down of elimination of some overhead expenses is present. A company may use its specific skills sets or assets to widen the scope of activities. For example, Proctor and Gamble can enjoy economies of scale if it acquires a consumer product company that benefits from P&Gs highly regarded consumer marketing skills. Economies of vertical integration Economies of vertical integration can be achieved when more firms, which are at different levels of production, get merged. An example would be, a company engaged in oil production when merged with a company engaged in refining oil and marketing could improve control and coordination. It may not be a good idea to involve in vertical integration as the company may not get benefitted from the merger if it is producing units in-house. In this case the outsourcing with the help of better performing suppliers in respective segments may not be useful. Complementary resources It is sensible to merge companies with complementary resources. Consider this example. A small company with a new product will need the help of a company with good engineering capability and better marketing network. When these firms come together, it would be easy for manufacturing and marketing the new product. With the help of complementary resources, these firms are worth more together than they are separately. Tax shield Utilising tax shields in a better way is possible when a company with unabsorbed depreciation and/or accumulated losses merges with a better performing company. The loss-incurring firm has to wait till it makes profit, to get the tax set-off advantage. But if it merges with a profit-making firm, its accumulated losses and/or absorbed depreciation can be set off against the profits of the profit making firm and tax benefits can be realised faster. Reduction of indirect taxes may be another source of tax savings. When Polyeofins Industries, which supplies 40,000 tonnes of ethylene to NOCIL,
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merged with NOCIL, a substantial savings in sales tax and excise duty was achieved. Utilisation of surplus funds Company in a mature market could be generating good revenue but opportunities for investing may not be available. Such a firm ought to distribute generous dividends and even buy back its shares. However, most management prefer making further investments, even though they may not be profitable. This is when merger through cash compensation with other companies become helpful. This helps in using surplus funds efficiently. Managerial effectiveness Managerial efficiency increases due to mergers. This happens when the poor performing team is replaced with better performing team. Another benefit from merging two companies is that there could be greater similarity between shareholders and managers. This could lead to the creation of a disciplined and better working environment. If managers feel that poor performance of their firm may lead to a merger, they would work hard for better performance. Often a firm, plagued with managerial inadequacies, can gain immensely from the superior management that is likely to emerge as a consequence of the merger. 1.3.2 Dubious reasons for mergers Diversification Risk reduction by diversification is a common reason behind mergers. The degree of risk reduction will depend on the correlation of earnings of both entities. Risk reduction is greater if the correlation is negative and is higher if correlation is positive. The value of this motive to the investors is questionable because any investor who wants to reduce risk can create a portfolio by diversifying between two companies. The merger is not necessary for investor to get benefitted by the positives of diversification. As a matter of fact, his/her home-made diversification offers better flexibility. Investor can combine stocks of both firms in any percentage as he/she does not have limitations of sticking to a fixed proportion.

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Lower financing costs Many argue that the consequence of larger size and greater earnings stability is to reduce the cost of borrowing for the merged firm. The reason for this is that the creditors of the merged firm enjoy better protection than those of the independent firms. If two firms, A and B, merge, the creditors of the merged firm are protected by the equities of both. While this additional protection reduces the cost of debt, it imposes an extra burden on the shareholders. Shareholders of firm A must support the debt of firm B, and vice versa. In an efficiently operating market, the benefit to shareholders from lower cost of debt would be offset by the additional risk borne by them and there would be no net gain. Earnings growth A merger may create appearance of growth in earnings. This may stimulate a price increase if the investors are fooled. Example: Company A acquires company B. The pre-merger financial position shows that A has superior growth prospects and commands a price earnings multiple (P/E) of 20. B on the other hand has inferior growth prospects and has a P/E of 10. The merger is not expected to create any additional value. The exchange ratio is fixed at 1:2 that is, 1 share of A is given in exchange for two shares of B. Situation 1 The market is smart: The financial position of A after the merger is better and the earnings per share rises, but the market recognises that the growth prospect of the combined firm will not be as bright as that of A alone. So the market price per share remains unchanged and the P/E ratio falls. Here the market value of the combined company is simply the sum of the market values of the merging companies. Situation 2 The market is foolish: It may regard the increase in earnings per share of A as reflection of true growth and so the market price of A will rise and the P/E ratio will stay the same. Self Assessment Questions 8. Economies of scale are most prominent in the case of _____________. 9. Most common reason behind mergers is to achieve _________ through diversification. 10. One of the many potential benefits of merger is an increase in _______ .
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11. A company may use a specific __________ or assets to widen the scope of its activities.

1.4 Advantages and Disadvantages of Mergers and Acquisitions


1.4.1 Advantages of mergers and acquisitions Mergers and acquisitions are strategic decisions leading to the maximising of company's growth by enhancing its production and sales. They provide many benefits which are not available in combinations like joint ventures or other strategic alliances. The benefits of M & A are: 1. From the standpoint of shareholders: Shareholders may gain from mergers through economies of scale, which helps in lowering of cost. This results in increased profits, better investment opportunities which is not available otherwise, and the increment in the value of share caused by the premium paid by the acquiring company to the acquirer company. 2. From the standpoint of Promoters: Promoters get the advantage of increasing the size of the company, restructuring the financial composition of the firm and altering its strength as per their requirement. Promoters can change a private company into a public company without much investment and without losing control. 3. From the standpoint of Managers: Managers often look forward to mergers as an opportunity to enhance their status financially and otherwise. They are also concerned about the overall growth of the company and are ready to support mergers where these benefits are seen to accrue. On the other hand managers work against combinations that generate fear about their future. 4. From the standpoint of Consumers: The benefits of mergers get passed to the consumers in the form of better products and services at lower prices supported by enhanced after sales and service. 1.4.2 Disadvantages of mergers and acquisitions A merger has disadvantages too. One of the disadvantages is that a merger must be approved by the stockholders of the firm. Typically, two-thirds (or even more) of the votes are required for approval. Obtaining the necessary votes can be time-consuming and difficult. Furthermore, the cooperation of the management of the target firm is a necessity. This cooperation is not easy or cheap. There can also be diseconomies of scale if the business
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becomes too large. Clashes of culture between different types of businesses could happen and reduce the effectiveness of the integration. Merger may create a conflict of objectives between the different businesses. In view of sharing of services, staff positions may come down and this will result in employee dissatisfaction. A merger can be extremely beneficial to all stakeholders of a business but if handled wrongly it can cause serious disruption all round. Self Assessment Questions 12. Acquisitions and mergers are strategic decisions. (True/False) 13. The decision of M & A requires approval by one-third of shareholders voting. (True/False)

1.5 Types of Mergers and Acquisitions


Mergers and acquisitions can take several forms. 1. Horizontal: It is a merger of two competing firms engaged in the production of similar products or providing similar services. The acquiring firm belongs to the same industry as the target company. The main purpose of such mergers is to obtain economies of scale in production by eliminating duplication of facilities, widening the product line, reduction in investment, elimination of competition in product market, increase of market share, reduction in advertising costs etc. 2. Concentric: This is a variation of horizontal mergers. It is a combination of two firms that are not in the same industry but operate in related industrial segments. For instance a company with a chain of restaurants may acquire a hotel company. The major difference here is that the merging companies are not competitors, like in the case of horizontal mergers. Examples are: (a) PHOENIX ELECTRIC (INDIA) and PHOENIX LAMPS (INDIA) (b) VIDEOCON NARMADA ELECTRONICS and VIDEOCON INTERNATIONAL LTD (c) BANK of MADURA and ICICI (d) Acquisition of BLUE DART by DHL WORLDWIDE

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(e) Acquisition of THOMSON SA of France by VIDEOCON INDIA in a deal worth $ 290 million (f) INDIAN AIRLINES and AIR INDIA 3. Vertical: When two or more companies, involved in different stages of activities like production or distribution, combine with each other the combination is called a vertical merger. An example can be the combination of a car manufacturing company and piston (that is generally bought and used by the car manufacturing company) manufacturing company. The acquiring company attempts to reduce inventories of raw material and finished goods, implements its production plans as per the objectives and economises on working capital requirements. There are two types of vertical combinations. a) Forward Integration: In this kind of vertical combination a manufacturer combines with its customer. For example, TV manufacturer merges with TV marketing company. b) Backward Integration: In this kind of vertical combination a manufacturer combines with the supplier of input material. For example, the combination of a car manufacturing company with a piston manufacturing firm. The following are some of the benefits to the acquirer company that accrue from vertical combinations: a) The company can safeguard the source of supplies of raw materials or intermediary product. b) The company can get the benefits of savings in transportation costs, overhead costs in buying department, etc. c) The company has control over input specifications and quality. 4. Circular combination: Companies engaged in the production of different products seek combination to share common marketing, distribution or research facilities in order to generate economies. The acquiring company obtains benefits of resources sharing. Another major advantage is achievement of diversification. A variation of circular combination is managerial conglomerates, which denote combination of general managerial talent of two different companies across all functions.

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Examples are: (a) STANDARD EQUITY FUND and DR REDDY'S LABORATORIES (b) KARNATAKA SCOOTERS and BROOKE BOND (INDIA) LTD 5. Conglomerate: This is the combination of companies engaged in unrelated businesses. The basic purpose of such a combination is lowering of cost of capital, optimum utilisation of financial resources and enlarging debt capacity. Conglomerates are used to smooth out fluctuations in the earnings of different businesses. The idea is to diversify and minimise the overall risk. A typical example would be the merging of a cement company, an electronics company, a finance company and a garment manufacturing company. A real life example is Voltas Ltd. Self Assessment Questions 14. Under __________ the acquiring firm belongs to the industry of the target company. 15. Conglomerate merger is the combination of companies engaged in ___________. 16. Combination of two or more companies involved in different stages of activities is called _____________. 17. Vertical combination is of two types _____________ and backward integration. 18. Combinations of companies engaged in the production of different products are called ___________.

1.6 Historical Overview of M & A Activity


Mergers and acquisitions were at an all-time high from the late 1990s to 2000. They slowed down till 2005 a direct result of the economic slowdown. The reason was simple: companies did not have the cash to buy other companies. In 2004-05, however, economies, businesses and corporate profits revived, which meant that businesses had cash. The end of 2004 saw several deals: Sprint combining with Nextel, K-Mart Holding Corp buying Sears, Roebuck & Co., Johnson & Johnson planning to buy Guidant. The Telecom, Banking and Software industries are potential areas for merger activity.

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Mergers continue to grow at an ever-increasing pace. The United States Federal Trade Commission reports that the number of filings in 1999 was almost three times the number received in 1993. This same trend is being experienced worldwide. Web property deals tripled from 140 in 1998 to 450 in 1999 with an incredible increase of 700% in dollar spending from 1998 to 1999. Acquisition of Time Warner by America Online was the highest acquisition in terms of amount spent. This being more than three times the total spent in 1998/1999. As per the prediction of webmerger.com, online mergers and acquisitions alone would touch the trillion-dollar mark in 2006. Mergers are not just between the internet-related businesses but across industries. Regulatory agencies are alarmed about mergers. According to Richard G. Parker(Senior Deputy Director, Bureau of Competition at the Federal Trade Commission (FTC)), antitrust enforcement agencies worldwide are in constant and increasing contact with each other on individual merger cases and on general cases of mutual enforcement interest. The reason for this alarm is the reduction of competition or the rise of monopolies. Deals that once approved with negotiated settlements or divestitures are now outright rejects. (FTC Weighs Stricter Policy on Mergers, Wall Street Journal, January 12, 2000) Self Assessment Questions 19. Web property deals increased three-fold from 140 in 1998 to 450 in 1999 with an incredible increase of 700%. (True/False) 20. America Onlines acquisition of Time Warner was valued at more than three times the total 1998/1999 M & A spending. (True/False) Activity 1: Discuss the acquisition of Zain Telecoms (based out of Kuwait) African business by Bharti Airtel.

1.7 Steps to a Successful Merger


Mergers need careful planning to achieve financial goals, reduce problems and for profit-making. Drop in productivity is expected to be around 50% as people from different workplaces have differences of opinion. Even a successful merger can take
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three months to three years for the completion of recovery process in an organisation. For employees, possibility of changes and uncertainty at workplace can create stress. This affects judgments, perceptions, and interpersonal relationships. Often reduced communication and increased centralisation as part of restructuring in companies creates space for rumours and insecurity in employees. During these times, employees do not have much access to senior level managers. Active intervention is necessary to maintain the level of productivity and to assure employees. Some suggestions for a smoother restructuring and transition are: Circulate a consistent message in the combining entities from top down. Maintain consistent accountability and compensation throughout the company for similar positions. Find out new ways of structuring the company to bridge corporate culture differences. Establish gaugeable objectives, especially in areas, which will be working together for a common goal. Revamp the compensation plan to recognise the additional work required by transition. Plan different ways for people to get to know each other. Self Assessment Questions 21. For the success of a merger_________ among the merging businesses is very important. 22. Productivity drops by as much as _____________ have been reported.

1.8 Summary
A merger or amalgamation should be considered only after careful examination of the merits and demerits, and ensuring overall positive value addition. A fundamental truth is that the amalgamation of two weak entities is seldom likely to create a strong entity.

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The best mergers are those of organisations with different strengths and weaknesses, wherein the entities work to double the strengths and cancel out the weaknesses. The first stage of any merger or amalgamation must be a thorough review by each organisation of the other, which is commonly known as the due diligence process. The Boards/Committees of each entity need to meet one-on-one, keeping out unhelpful external pressure groups and lobbies. Together, they need to explore the prospects and benefits of the merger and agree upon the due diligence process to occur in a manner acceptable to both parties.

1.9 Glossary
Merger: Merger is a grouping of two or more companies into one company. Acquisition: The term acquisition refers to the acquisition of assets by one company from another company. Spin-off: An independent company carved out of another company (of which it was a part) through a sale. Conglomerate: businesses Combination of companies engaged in unrelated

1.10 Terminal Questions


1. 2. 3. 4. 5. 6. Explain the meaning of mergers and acquisitions. What are the key motives behind a merger or an acquisition? List the advantages and disadvantages of mergers and acquisitions. Explain the types of mergers. Discuss the historical Overview of Merger and Acquisition Activity What are the steps for successful mergers?

1.11 Answers
Self 1. 2. 3. 4. Assessment Questions True. True. True. False.
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5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22.

True. False. True. Horizontal mergers. Risk reduction. Managerial effectiveness. Set of skills. True. False. Horizontal merger. Unrelated businesses. Vertical merger. Forward integration. Circular combination. True. True. Cultural integration. 50%.

Terminal Questions 1. Merger is the combination of two or more companies and acquisition is the acquisition by a company of assets of another company. For more details, refer section 1.2. 2. One of the main reasons of M & A is to achieve economies of scale. Other reasons are strategic benefits, tax benefits etc. For more details, refer section 1.3. 3. Mergers and acquisitions are strategic decisions leading to the maximising of company's growth by enhancing its production and sales. For more details, refer section 1.4. 4. The different types of mergers are horizontal, vertical, conglomerate and circular. For more details, refer section 1.5. 5. Mergers and acquisitions were at an all-time high from the late 1990s to 2000. For more details, refer section 1.6. 6. Refer to 1.7 For a successful merger there should be proper coordination and culture integration. For more details, refer section 1.7.

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1.12 Case Study


Overseas Acquisition by an Indian Information Technology company (News item in May 06) A major overseas acquisition by an Indian IT company has come not from Wipro or Infosys, but from a Bangalore-based mid-sized IT products company, Subex Systems (Subex). The telecom software products company recently announced that it was acquiring UK-based telecom products company Azure Solutions for US$140 million in a cash-cum-stock deal. The cash component of the deal is rather meagre at about 23% of the deal size with the balance in stocks. Subhash Menon, Chairman, Subex, said, The small portion of the cash will be paid through our internal accruals. The acquisition will result in the merger of the two entities and henceforth Subex Systems will be known as Subex Azure. Mr. Menon will head the joint firm. The integration process will take around 10 months starting June 06. Subex will also make a fresh issue of shares which will include a GDR of ` 13 crore. This will take its current paid-up capital from ` 23 crore to ` 36 crore. It had earlier raised $10m (` 45 crore) through a GDR issue. Subex scrip which gained almost 25% in the last month, closed at ` 630.30 on Tuesday, showing a gain of 15.25% against Mondays close of ` 546.90. Azure, which spun off from BT in 2003, is a private company and has reported revenues of $31m (` 140 crore) for FY06 and has investees such as New Venture Partners, Doughty Hanson Technology Ventures and Intel Capital. Post-merger, the holding of the venture capitalists in Subex Azure will stand at 34.5% with Mr Menons stake at 12% and the rest with the Indian public, ESOPs and financial institutions. The merger will also see a total headcount of 500 with 200 coming in from Azure. However, there is likely to be a certain amount of rationalisation of manpower.

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This merger will also bring an order pipeline of 100m (` 800 crore) for Azure and $80m (` 344 crore) for Subex, though the conversion rate of these orders is likely to be around one-third. This deal strengthens Subexs position in the revenue maximisation space of telecom sector. While Subex offers products in this area, Azures portfolio is in the interconnect billing and fraud management space. It also gives it combined access to 150 telecom networks in 60 countries and brings it the business of BT. BT is a customer of Azure and generates business of around 10m (` 80 crore). The real returns from this acquisition will accrue only during FY08 for which Subex has given a guidance of $100m (R450 crore) of product revenues and a net profit of $33m (` 148.50 crore). For FY06, Subex reported revenues of ` 181.21 crore with a net profit of ` 39.14 crore. Commenting on the deal, NASSCOM President Kiran Karnik said, This is a sign of something small getting bigger and Indian companies wanting to compete globally. Question Discuss the case given above. Hint: The deal will bring a lot of opportunities for the company and strengthen Subexs position in the revenue maximisation space of telecom sector.
(source: "The biggest overseas acquisition by an Indian IT co.(Software)", The Economic Times, April 26 2006 Issue)

References: Pandey I. M., 2010, 9th Edition Financial Management, Vikas Publishing House, New Delhi Godbole Prasad G., 2010,Mergers, Acquisitions and Corporate Restructuring, Vikas Publishing House, New Delhi Chandra Prasanna, 2007, Financial management, Tata McGraw Hill Publication, New Delhi Maheshwari S. N., 2002. Management Accounting, Sultan Chand & Sons, New Delhi
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Ravi Kishor, 2002. Financial Management, Taxmann Publication, New Delhi, Das & Basu, 2004, Corporate Restructing, Tata McGraw Hill Publication, New Delhi Sudarsanam Sudi, 2009. Creating Value from Mergers and Acquisitions, Pearson Education, New Delhi Weston J. F., Mitchell M. L., & Mulherin J. H., 2004, Fourth Edition Takeovers, Restructuring, and Corporate Governance, Pearson Education, New Delhi

E-References: www.legalserviceindia.com

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