MERGER BASICS

LEARNING OBJECTIVE
After reading this chapter you should be able to:
Understand the basics merger as a form of corporate restructuring
Define and conceptualize the concept of Merger
Understand the different Types of Mergers
Understand the Merger Movements in India and abroad
Spot out the Factors Affecting Merger
Narrate the of Theories of Merger
Point out the Impact of Mergers on Stakeholders



















2
In this chapter Introduction, Definition of merger and acquisition, history of merger and
acquisition, Types of merger, difference between merger and acquisition, difference
between acquisition and takeover,
Merger and Acquisition Process, Significance of merger and acquisition,
Requirement of merger and acquisition, Motives behind merger and acquisition,
Benefits of merger and acquisition, Limitations of merger, Impact of merger
and acquisition, Financial accounting for merger and acquisition, Merger and
acquisition strategies, Merger and acquisition laws, Merger and acquisition in
India, Merger and acquisition in world have been included
2.1 INTRODUCTION
As discussed in the previous chapter, a business firm may expand its business by either
internally or externally. In internal expansion, the firm grows gradually over time in
normal course of business through acquisition of new assets, replacement of the
technologically obsolete equipments and the establishment of new lines of products. It
is otherwise known as organic growth, the essential feature of which is the
reinvestment of the previous years retained profit in the existing business, together
with finance provided by shareholders. An organic growth provides more corporate
control, encourages internal entrepreneurship and protects organisational cultures and
core values. It also provides managers with a better understanding of their own firm
and assets, and internal investment is likely to be better planned and efficient. However,
this type of growth is a slower as compared its counterpart inorganic growth. In
external expansion or inorganic growth, a firm acquires a running business and grows
overnight through corporate combinations. These combinations are in the form of
mergers, acquisitions, amalgamations and takeovers; which have now become
important features of corporate restructuring. They have been playing an important
role in the external growth of a number of leading companies the world over. They have
become popular because of the enhanced competition, breaking of trade barriers, free
flow of capital across countries and globalization of businesses. In the wake of economic
reforms, Indian industries have also started restructuring their operations around their
core business activities through merger, acquisition and takeovers because of their
increasing exposure to competition both domestically and internationally.
The present era is known as the era of competition and in this era, companies go for
merger to avoid the competition and to enjoy sometimes monopoly. Mergers and
acquisitions (M & As) have been a very important strategy for entry into a new market
as well as for expansion. Corporate India is waking up to the new millennium
imperative of mergers and acquisitions in a desperate search for a panacea for facing
the global competition. This is hardly surprising as stiff competition is, in a sense,
implicit in any bid to integrate the national economy with the global economy. The
ongoing process of liberalization has exposed the unproductive use of capital by the
Indian corporate both in public and private sectors. Consolidation through mergers and
acquisitions (M & As) is considered as one of the best way of restructuring structure of
corporate units.
The concept of mergers and acquisitions has become very much popular after 1990s,
when India entered in to the Liberalization, Privatization and Globalization (LPG) era.
The winds of LPG are blowing over all the sectors of the Indian economy but its
maximum impact is seen in the industrial sector. It caused the market to become hyper-
competitive. As competition increased in the economy, so to avoid unhealthy
competition and to face international and multinational companies, Indian companies
are going for mergers and acquisitions.
2.2 CONCEPT AND DEFINITION
Both the terms merger and acquisition mean a corporate combination of two
separate companies to form one company and they are often used synonymously in
practice, but there are slightly different meanings between them.
MERGER
In a merger activity, it usually takes place when two separate firms which have similar
size agree to form a new single company. Then both companies stocks will cease to
exist and the newly created companys stock will be issued in its place. This kind of
activity is often referred as a merger of equals (www.investopedia.com). A typical
example of a major merger is the merger between AOL and Time Warner in 2000.
In India, the term Merger is not defined under any Indian law neither under the
Companies Act 1956 nor under the Income Tax Act 1961 even. Simply put, a merger is a
combination of two or more distinct entities into one; the desired effect being not just
the accumulation of assets and liabilities of the distinct entities, but to achieve several
other benefits such as, economies of scale, acquisition of cutting edge technologies,
obtaining access into sectors /markets with established players, etc. Generally, in a
merger, the merging entities would cease to be in existence and would merge into a
single surviving entity.
Very often, the two expressions Merger and Amalgamation are used synonymously.
But there is, in fact, a difference. Merger generally refers to a circumstance in which the
assets and liabilities of a company (merging company) are vested in another company
(the merged company). The merging entity loses its identity and its shareholders
become shareholders of the merged company. On the other hand, an amalgamation is an
arrangement, whereby the assets and liabilities of two or more companies
(amalgamating companies) become vested in another company (the amalgamated
company). The amalgamating companies all lose their identity and emerge as the
amalgamated company; though in certain transaction structures the amalgamated
company may or may not be one of the original companies. The shareholders of the
amalgamating companies become shareholders of the amalgamated company.
According to the Oxford Dictionary the expression merger or amalgamation means
Combining of two commercial companies into one and Merging of two or more
business concerns into one respectively. A merger is just one type of acquisition. One
company can acquire another in several other ways including purchasing some or all of
the companys assets or buying up its outstanding share of stock.
ACQUISITION
While in the case of an acquisition, one company is purchased by another one and no
new company is formed subsequently. From a legal point of view, the target company
ceases to exist, the acquirer occupies the business of the target firm and the acquirer's
stock continues to be traded. In addition, the acquiring firm collects all asset and gains
of the target company as well as the liability (www.investopedia.com). An example of a
major acquisition is Manulife Financial Corporation's acquisition of John Hancock
Financial Services Inc in 2004 (www.investopedia.com).
2.3 TYPES OF MERGERS AND ACQUISITIONS
MERGERS
There are mainly four types of mergers based on the competitive relationships between
the merging parties:
1) Horizontal Mergers
2) Vertical Mergers
3) Conglomerate Mergers
(1) Horizontal Merger
Horizontal mergers refer to combination of two or more firms that operate and compete
in a similar kind of business and are in same stage of industrial process. Horizontal
mergers raise three basic competitive issues. The first is the elimination of competition
between the merging firms, which, depending on their size, may be significant. The
second is that the unification of the merging firms operations may create substantial
market power and could enable the merged entity to raise prices by reducing output
unilaterally. The third problem is that by increasing concentration in the relevant
market, the transaction may strengthen the ability of the markets remaining
participants to co-ordinate their pricing and output decisions. The fear is not that the
entities will engage in secret collaboration but that the reduction in the number of
industry members will enhance co-ordination of behaviour.
Horizontal merger provides economies of scale from the larger combined unit;
eliminates competition, thereby putting an end to price cutting wars, possibility of
starting R&D, effective marketing and management. For example in the Aerospace
industry, Boeing merged with McDonald Douglass to create the Worlds largest
aerospace company. Another Compaq acquired Digital Equipment and then itself was
acquired by Hewlett Packard (hp). Glaxo Wellcome Plc. and SmithKline Beecham Plc.
Mega merger resulted in the largest drug manufacturing company globally. The merger
created a company valued at $182.4 billion and with a 7.3 per cent share of the global
pharmaceutical market. The two companies have complementary drug portfolios, and
the merger helped them pool their research and development funds and the merged
company a bigger sales and marketing force.
2) Vertical Mergers
Vertical merger is a combination of two or more firms involved in different stages of
production or distribution of the same product. For example, the merger of a company
engaged in the construction business with a company engaged in production of brick or
steel would lead to vertical integration. Companies stand to gain on account of lower
transaction costs and synchronization of demand and supply. Moreover, vertical merger
helps a company to move towards greater independence and self-sufficiency. The
downside of a vertical merger involves large investments in technology in order to
compete effectively.
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. And there are two
benefits: first, the vertical merger internalizes all transactions between manufacturer
and its supplier or dealer thus converting a potentially adversarial relationship into
something more like a partnership. Second, internalization can give the management
more effective ways to monitor and improve performance. Vertical mergers may also be
anticompetitive because their entrenched market power may impede new business
from entering the market.
Unlike horizontal mergers, which have no specific timing, vertical mergers take place
when both firms plan to integrate the production process and capitalise on the demand
for the product. Forward integration takes place when a raw material supplier finds a
regular procurer of its products; while backward integration takes place when a
manufacturer finds a cheap source of raw material supplier. For example, merger of
Usha Martin and Usha Beltron enhanced shareholder value, through business synergies.
The merger also enabled both the companies to pool their resources and to streamline
business and finance with operational efficiencies and cost reduction and also helped in
development of new products that require synergies.
3) Conglomerate Merger
A conglomerate merger is a merger between firms that are involved in totally unrelated
business activities. One example of conglomerate merger would be Phillip Morris, a
tobacco company which acquired General Foods in 1985.
There are two types of conglomerate mergers: pure and mixed. Pure conglomerate
mergers involve companies with nothing in common, while mixed conglomerate
mergers involve companies that are looking for product extensions or market
extensions. A conglomerate merger occurs when the companies are not competitors and
do not have a buyer seller relationship and is made up of a number of different,
seemingly unconnected businesses. In a conglomerate, one company owns a controlling
stake in a number of smaller companies, which conduct business separately. Each of a
conglomerate's subsidiary businesses runs independently of the other business
divisions, but the subsidiaries' management reports to senior management at the parent
company. The largest conglomerates diversify business risk by participating in a
number of different markets, although some conglomerates elect to participate in a
single industry - for example, mining. These are the two philosophies guiding many
conglomerates:
a) By participating in a number of unrelated businesses, the parent corporation is
able to reduce costs by using fewer resources.
b) By diversifying business interests, the risks inherent in operating in a single
market are mitigated.
History has shown that conglomerates can become so diversified and complicated that
they are too difficult to manage efficiently. Since the height of their popularity in the
period between the 1960s and the 1980s, many conglomerates have reduced the
number of businesses under their management to a few choice subsidiaries through
divestiture and spin-offs.
Conglomerate transactions take many forms, ranging from short term joint ventures to
complete mergers. Whether a conglomerate merger is pure, geographical or a product
line extension, it involves firms that operate in separate market. Conglomerate
transactions ordinarily have no direct effect on competition. This type of diversification
can be achieved mainly by external acquisition and mergers and is not generally
possible through internal development. The basic purpose of such merger is the
effective utilization of unutilized financial resources and enlarging debt capacity
through re-organising their financial structure so as to maximize shareholders earnings
per share (EPS), lowering the cost of capital and thereby raising maximizing value of the
firm and the share price.
4] Other types
Apart from the above-discussed three (Horizontal, Vertical and Conglomerate) types of
mergers, the following are the few other forms of mergers:
a) Within Stream Mergers: This type of mergers takes place when a subsidiary
company merges with parent company or parent company merges with subsidiary
company. The former type of merger is known as Downstream merger, whereas
the latter is known as Upstream merger. For example, recently, ICICI Ltd., a parent
company has merged with its subsidiary ICICI Bank signifying downstream merger.
Instance of upstream merger is the merger of Bhadrachelam Paper Board,
subsidiary company with the parent ITC Ltd., and like.
b) Circular Combination: Companies producing distinct products seek amalgamation
to share common distribution and R&D facilities to obtain economies by
elimination of cost on duplication and promoting market enlargement. The
acquiring company obtains benefits in the form of economies of resource sharing
and diversification.
c) Cross Boarder Mergers: It refers to mergers across the national boundaries
involving substantial cash flow into other countries. It seems that cross-border
mergers have an increasing trend over the past few years due to the globalization
and the development of the internet. With the advent of globalization, companies
prefer to seek a competitive area that is worldwide in scale in order to have
customers worldwide through cross- border mergers. The typical example is the
biggest cross-border M & A at the beginning of 21st century -Vodafone (UK)
acquired Mannesmann AG (Germany) and it has a record of worth $203 billion.
However, regardless of which type of mergers, the main goal is to create the value of the
combined companies greater than the value of the two single entities and the success
relies on the synergy effect of the new company (www.investopedia.com).
TYPES OF ACQUISITIONS
An acquisition or takeover may be of two types: friendly and hostile depending on
Offeror Companys approach.
a) Friendly takeover: Also commonly referred to as negotiated takeover, a friendly
takeover involves an acquisition of the target company through negotiations
between the existing promoters and prospective investors. This kind of takeover is
resorted to further some common objectives of both the parties.
b) Hostile takeover: A hostile takeover can happen by way of any of the following
actions: if the target companys board rejects the offer, but the bidder continues to
pursue it or the bidder makes the offer without informing the board beforehand.
The acquisition of one company (called the target company) by another (called the
acquirer) that is accomplished not by coming to an agreement with the target
company's management, but by going directly to the companys shareholders or
fighting to replace management in order to get the acquisition approved. A hostile
takeover can be accomplished through either a tender offer or a proxy fight.
c) Leveraged Buyouts: These are a form of takeovers where the acquisition is funded
by borrowed money. Often the assets of the target company are used as collateral
for the loan. This is a common structure when acquirers wish to make large
acquisitions without having to commit too much capital, and hope to make the
acquired business service the debt so raised.
d) Bailout Takeovers: Another form of takeover is a bail out takeover in which a
profit making company acquires a sick company. This kind of takeover is usually
pursuant to a scheme of reconstruction/rehabilitation with the approval of lender
banks/financial institutions. One of the primary motives for a profit making
company to acquire a sick/loss making company would be to set off of the losses of
the sick company against the profits of the acquirer, thereby reducing the tax
payable by the acquirer. This would be true in the case of a merger between such
companies as well.
2.4 DISTINCTION BETWEEN MERGER AND ACQUISITION
Difference between Merger and Acquisition is delicate. It is true that the terms Mergers
and Acquisitions are used in a way that it seems, both are synonymous. But, the fact is
that, there is a slight difference in the two concepts.
In case of a Merger, two firms, together, form a new company. After merger, the
separately owned companies become jointly owned and get a new single identity. When
two firms get merged, stocks of both the concerns are surrendered and new stocks in
the name of new merged company are issued.
Generally, Mergers take place between two companies of more or less of same size. In
these cases, the process is called Merger of Equals. But, in case of Acquisition, one firm
takes over another and establishes its power as the single owner. Here, generally, the
firm which takes over is the bigger and stronger one. The relatively less powerful
smaller firm loses its existence after Acquisition and the firm which takes over, runs the
whole business by its' own identity. Unlike Merger, in case of Acquisition, the stocks of
the acquired firm are not surrendered. The stocks of the firm that are bought by the
public earlier continue to be traded in the stock market. But, often Mergers and
Acquisitions become synonymous, because in many cases, the big firm may buy out a
relatively less powerful one and thus compels the acquired firm to announce the
process as a Merger. Although, in reality an Acquisition takes place, the firms declare it
as a Merger to avoid any negative impression.
Another difference between Merger and Acquisition is that, when a deal is made
between two companies in friendly terms, it is proclaimed as Merger, even in case of a
buyout. But, if it is an unfriendly deal, where the stronger firm swallows the target firm,
even when the target company is not willing to be purchased, then it is called an
Acquisition.
2.5 DISTINCTION BETWEEN ACQUISITION AND TAKEOVER
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
entities, but there may be a change in control of the companies. When an acquisition is
'forced' or 'unwilling', it is called a takeover. In an unwilling acquisition, the
management of the 'target' company would oppose a move of being taken over. But,
when managements of acquiring and target companies mutually and willingly agree for
the takeover, it is called acquisition or friendly takeover.
Under the Indian Monopolies and Restrictive Practices Act, takeover means acquisition
of not less than 25 percent of the voting power in a company. While in the Companies
Act (Section 372), a company's investment in the shares of another company in excess
of 10 percent of the subscribed capital can result in takeovers. An acquisition or
takeover does not necessarily entail full legal control. A company can also have effective
control over another company by holding a minority ownership.
2.6 EVOLUTION MERGERS AND ACQUISITIONS / MERGER MOVEMENTS
The history of merger waves spans the twentieth century during which time there have
been several merger waves in the US, and UK each of which has been distinctly different
from the others.
2.6.1 MERGER WAVES IN UNITED STATES (USA)
Historians refer to five waves of mergers in the U.S. starting from 1890s. The starting
date and duration of each of these waves are not specific, although the ending dates for
those ended in wars or in panics, crashes or other financial disasters. Indeed, it may be
more accurate to say that mergers are an integral part of market capitalism and there
were continuous merger activities since the evolution of the industrial economy in the
late 19
th
Century, with short interruptions when fundamental forces turned exogenous
merger factors negative.
The First Merger Wave (1897 -1904)
The first US merger wave began at the end of the
nineteenth century and continued until 1904. It is
generally thought to have been triggered by the
combination of a rising stock market and the
introduction of the Sherman Antitrust Act (1890), which
was designed to prohibit any contract that would limit
trade between different states and countries, but was not
designed specifically to deal with the growing
phenomenon of merger and acquisition activity. It was
also unable to prohibit any merger or acquisition that
was organized using a stock for stock exchange. Worse yet, the Sherman Act made it
possible for companies to form near monopolies without any regulatory interference.
Naturally, many companies sought to take advantage of this situation and the first US
merger wave began as a result. During this time 1800 firms disappeared in this merger
wave and approximately 71 formerly competitive industries were converted into virtual
monopolies during this wave; a massive reorganization of the industrial landscape of
the United States.
The merger activity peaked in 1899, began its downturn in 1901 (Table1) as some
combinations failed to realize their expectations and almost ended in 1903, when
severe economic recession set in. The turn of the century was a period of rapid
Table1
First Merger Wave
Year
No. of
Mergers
1897 69
1898 303
1899 1208
1900 340
1901 423
1902 379
1903 142
1904 79
economic expansion in the US economy. The first merger wave during 1897 to 1904
was characterized by Horizontal Mergers, which increased concentration in a number of
industries. This merger period is known for its role in creating large monopolies. The
main motivational factors attributed to the first merger movement are:
- Obtaining economies of scale
- Merging for monopoly, and
- Promotion of failing firms
The distinguishing feature of first wave is that some of todays industrial giants like,
General Electric, Navistar International, Du-Pont Inc., Standard Oil, Eastman Kodak and
American Tobacco Inc. were originated during this wave. Another notable feature of this
wave was investment bankers seeking to establish monopoly control over certain
industries created huge holding companies or trusts. Examples of the trusts formed
during this period are J. P. Morgans, U.S. Steel Corporation and other giant firms such as
Standard Oil, American Sugar Refining Company, and the American Tobacco Company.
By 1904 more than 300 such trusts had been formed, and they controlled more than
40% of the nations industrial capital.
The Second Merger Wave (1922-29)
The second period of business combination activity, fostered by the federal government
during World War I, continued through the 1920s. Like the first one, the second merger
wave also began with upturn in the business activity in 1922 and ended with the onset
of a severe economic slowdown in 1929. In an effort to sustain the war effort, the
government encouraged business combinations to obtain greater standardization of
materials and parts and to discourage price competition. After the war, it was difficult to
reverse this trend, and business combinations continued.
These combinations were efforts to obtain better integration of operations, reduce
costs, and improve competitive positions rather than attempts to establish monopoly
control over an industry. This type of combination is called vertical integration because
it involves the combination of a company with its suppliers or customers. For example,
Ford Motor Company expanded by acquiring a glass company, rubber plantations,
cement plant, a steel mill, and other businesses that supplied its automobile
manufacturing business. From 1925 to 1929, more than 1,200 combinations took place,
and about 7,000 companies disappeared in the process. The difference between these
two periods (first and second merger waves) can be
described as "mergers for monopoly" and "mergers for
oligopoly".
The Merger Wave during 1940s
The level of merger and acquisition activity fluctuated
throughout the 1940s and 1950s without ever rising to the
extreme levels that characterize a wave. In 1950 the Celler-
Kefauver Act was introduced which extended the Clayton
Act and prohibited any merger or acquisition that was
designed to give one firm a substantial degree of market
power. As a result the number of horizontal deals was
reduced to the bare minimum. This Act marked the first
step towards merger regulations as they exist worldwide
Table 2
Third Merger Wave
Year No. of Mergers
1963 1361
1964 1950
1965 2125
1966 2377
1967 2975
1968 4462
1969 6107
1970 5152
today with the emphasis on maintaining consumer choice in the market place.
The Third Merger Wave (1963-1970)
The next US wave activity began at the end of the 1950s and lasted until the middle of
the 1970s as the US economy underwent a strong period and the stock market again
rose markedly. This resulted in the third US merger wave of the last century as
profitable companies found them with large cash flows, which they were unwilling to
pay out to shareholders in the form of dividends, and so turned to the market for
corporate control as a way of utilizing these funds.
Throughout this period, the majority of deals were friendly arrangements and stock was
the primary medium of exchange. The most notable feature of this merger wave was the
predominance of conglomerate deals as companies
actively sought to expand into new markets and areas.
The strength of this trend is illustrated by the fact that the
number of conglomerate firms increased from 8.3% of
Fortune 500 firms in 1959 to 18.7% in 1969. This change
is almost certainly due to the provisions of the Celler-
Kefauver Act, which made horizontal mergers unpopular.
The oil crisis of 1973 resulted in a sharp increase in
inflation and a worldwide economic downturn, which
marked the end of this merger wave. Around 6000
mergers took place in the US economy during this period
and lead to disappearance of around 25,000 firms.
The Fourth Merger Wave (1981-1989)
The fourth US merger wave took place in the 1980s and exceeded all of the preceding
waves in both the volume of transactions and in the size of the deals. Another notable
characteristic of this wave was the much higher degree of
hostility as companies that were previously considered
untouchable, as their sheer size would make them safe,
became the targets of unwelcome acquisition bids and
fought vigorously to defend themselves. Almost half of all
major US companies were the recipients of an unsolicited
takeover bid in the 1980s which is a clear indicator of the
volume of transactions taking place during this particular
wave.
This period was featured several unique and interesting
features. Firstly, it was a period of mega-mergers. Some of
the largest firms in the world (Fortune 500 firms) became
the target of acquirers. Secondly, Investment bankers
played an aggressive role in M&As activities by providing
specialized advisory services to the concerned firms.
Thirdly, the concept of using debts to finance acquisitions
(Leveraged Buy Out) was emerged during this period. Moreover this merger wave also
featured innovations in acquisition techniques and investment vehicles. The investment
bank, Drexel Burnham Lambert pioneered the growth of the junk bond market.
Table 3
Fourth Merger Wave
Year No. of Mergers
1981 2395
1982 2346
1983 2533
1984 2543
1985 3001
1986 3336
1987 2032
1988 2258
1989 2366
Table 4
Fifth Merger Wave
Year No. of Mergers
1990 2074
1991 1877
1992 2574
1993 2663
1994 2997
1995 3510
1996 5848
1997 7800
1998 7809
1999 9278
2000 9566
2001 7528
The Fifth Merger (Mega merger) Wave: 1992 onwards
The most recent merger wave, in the 1990s, was the
biggest one of all, vastly exceeding all of the previous
waves in both number of transactions and value.
Whilst the trend towards horizontal deals continued,
in every other respect the 1990s merger wave was
very different to its predecessor. This wave was
almost entirely friendly with just 4% of deals being
denoted as hostile

and the popularity of stock as the
medium of exchange increased by approximately 50%
compared to the previous merger wave. One potential
explanation for the change in nature of deals from the
hostility of the 1980s to the more restrained activity of
the 1990s is due to improvements in corporate
governance. With the level and effectiveness of
monitoring increasing greatly, it became much more
difficult for managers to enter into highly risky deals
and forced them to consider more carefully whether to
enter the market for corporate control at all and, in
the event that they decided to proceed, how they
would enter the market. Faced with these sorts of
constraints, many managers would think very
carefully before attempting a merger or acquisition.
2.6.2 MERGER WAVES IN UK
Merger waves in the UK have a far shorter history
than those occurring in the US. Nothing parallel to a substantial merger wave emerged
before the 1960s although there was a small wave in the 1920s that was inspired by the
widespread introduction of mass production technologies in the UK following the end of
the First World War.
The first real merger wave in the UK was in the 1960s and coincided with the
internationalization of the World economy. The British government decided that large
firms were needed to compete effectively on the international stage and to achieve this
goal the Industrial Reorganization Corporation (IRC) was created with a brief to
encourage the development of such companies through horizontal mergers which made
up the majority of mergers in this wave. Amongst the top 200 manufacturing companies
in 1964, 39 (19.5%) were involved in merger or acquisition activity within the next five
years.
The next period of excessive merger and acquisition activity took place in the 1980s and
marked a change in emphasis when compared to the previous waves. Prior to this time
the waves had been mostly about increasing the size of companies but in the 1980s the
emphasis changed to the control of corporate assets as a commodity. During this period,
the most recent development in merger and acquisition policy took place. Between the
introduction of the Mergers and Monopolies Act in 1965 and 1985 there were 3540
mergers and acquisitions. Throughout the early part of the 1980s the stock market was
rising sharply reflecting growing profits and business confidence. The financial services
industry had just been deregulated which further contributed to the growth of the wave.
This period of excessive restructuring also incorporated some features of merger and
Table 5
M &As Announcements in
India
Year Number
Change
(%)
1988 15 -
1989 18 20.0
1990 25 38.9
1991 71 184.0
1992 135 90.1
1993 288 113.3
1994 363 26.0
1995 430 18.5
1996 541 25.8
1997 636 17.6
1998 730 14.8
1999 765 4.79
2000 1177 53.86
2001 1045 -11.21
2002 838 -19.81
2003 834 -0.48
Source: collected from various
business dailies, monthly review of
Indian economy, CMIE data base.
acquisition activity previously unseen in the UK and imported from the US; increased
hostility, the use of leverage and a large number of buy-outs all of which took place in
this wave but had not previously been notable features of the market for corporate
control in the UK. The London Stock Exchange suffered a major crash in 1987 but this
was not enough to stop the wave, however, which had sufficient momentum to keep
going until 1989.
The most recent merger wave in the UK took place in the 1990s and was again spurred
on by deregulation of more British industries coupled with the policy of privatizing
Government owned assets which took place through the last years of the 1980s and the
early 1990s, as typified by the sales of British Telecom (1984), British Gas (1986) and
British Rail (1993). These changes resulted in the need for extensive restructuring on
many difference levels of British industry and prompted the merger wave. Unlike the
1980s there was relatively little hostility during this period and many companies
changed their perspective on mergers and acquisitions to take a more balanced
approach when compared to the excesses of the previous decade.
In the UK, horizontal mergers were the dominant form between 1954 and 1965 and
since then there has been a trend towards diversified merger. The value of assets
acquired through diversified merger rose to 33 percent in 1972 from 5 percent in 1966.
The merger wave since 1980s witnessed divestments on a large scale. In 1992 it was
accounted for 31 percent of all acquisitions and mergers.
2.6.3 MERGER WAVES: THE INDIAN EXPERIENCE
In earlier years, India was a highly regulated economy. To set-up an industry various
licenses and registration under various enactments were required. The scope and mode
of corporate restructuring was, therefore, very limited due to restrictive government
policies and rigid regulatory framework.
Consequent upon the raid of DCM Limited and Escorts Limited launched by Swaraj Paul,
the role of the financial institutions became quite important. In fact, Swaraj Pauls bids
were a fore-runner and constituted a watershed in the corporate history of India. The
Swaraj Paul episode also gave rise to a whole new trend. Financially strong
entrepreneurs made their presence felt as industrialists Ram Prasad Goenka, M.R.
Chabria, Sudarshan Birla, Srichand Hinduja, Vijay Mallya and Dhirubhai Ambani and
were instrumental in corporate restructuring.
The real opening up of the economy started with the Industrial Policy, 1991 whereby
continuity with change was emphasized and main thrust was on relaxations in
industrial licensing, foreign investments, and transfer of foreign technology etc. For
instance, amendments were made in MRTP Act, within all restrictive sections
discouraging growth of industrial sector. With the economic liberalization, globalization
and opening up of economies, the Indian corporate sector started restructuring to meet
the opportunities and challenged of competition.
The unleashing of Indian economy has opened up lucrative and dependable
opportunities to business community as a whole. The absence of strict regulations
about the size and volume of business encouraged the enterprises to opt for mergers
and amalgamations so as to produce on a massive scale, reduce costs of production,
make prices internationally competitive etc. Today despite the sluggish economic
scenario in India, merger and amalgamation deals have been on the increase. The
obvious reason is as the size of the market shrinks, it becomes extremely difficult for
all the companies to survive, unless they cut costs and maintain prices. In such a
situation, merger eliminates duplication of administrative and marketing expenses. The
other important reason is that it prevents price war in a shrinking market. Companies,
by merging, reduce the number of competitors and increase their market share.
Table-5 exhibits a sharp rise in the overall merger and acquisition activity in the Indian
corporate sector. While there were 58 mergers and takeover from 1988 to 1990, the
number rose to 71 in 1991 and 730 in 1998. There was a jump in the number of merger
and takeover activities in India from 1988 to 1993, the average rate of increase being
around 89 percent for the five-year period. Since then the rate of rise had maintained an
average of 20.5 per cent. After 2001 year the M&A trend has shown declining. But there
was substantial growth in the year 2000-01, with the total number of M&As deals 1177
which is 54 percent higher than the previous year total deals.
2.7 MOTIVES/BENEFITS OF MERGERS & ACQUISITIONS
Mergers and acquisitions are resorted to by the corporate entities due to more than one
reason. Some of the significant motives for mergers include the following:
(a) Faster Growth
Broadly there are two alternatives available for growth of a corporate entity as long as
investment opportunities exist. Organic route of growth takes time. Organizations need
place, people, regulatory approval and other resources to expand into newer product
categories or geographical territories. On the other hand, inorganic route, acquisition of
another organization with complementary products or geographic spread provides all
these resources in a much shorter time, enabling faster growth.
(b) Synergy
It is regarded as the most popular motive for M & A. Synergy occurs when the whole is
greater than sum of its parts. For example, in terms of math it could be represented as
1+1=3 or as 2+2=5. Within the context of mergers, synergy means the performance
of firms after a merger (in certain areas and overall) will be better than the sum of their
performances before the merger. For example, a larger merged company may be able to
order larger quantities from suppliers and obtain greater discounts due to the size of
the order. In this context, there can be three types of synergy: operating, financial, and
managerial.
Illustration: There are two firms Bharat Ltd and Hindustan Ltd are planning to
merge, whose per-merger values are Rs.420 lakhs, and Rs. 200 lakhs. They are
merging with the objective of savings with present value of Rs.50 lakhs. For
acquiring Hindustan Ltd. Firm Bharat Ltd will be required to pay Rs.220 lakhs
(consisting of Rs. 180 lakhs in the form of equity shares and Rs.40 lakhs in the
form of cash). Besides the purchase consideration the Bharath Ltd. need to incur
acquisition cost of Rs. 10 lakhs. Determine the value of the gain, costs, and net
gain from merger.
Solution:
Cost = Purchase Value + Acquisition cost Pre-merger value of Hindustan Ltd.
Cost = Rs. 220 lakhs + Rs.10 lakhs Rs.200 lakhs = Rs. 30 lakhs.
Net Gain = Expected savings Cost = Rs.40 lakhs Rs.30 lakhs; = Rs.10 lakhs.
Operating Synergy
It arises from the combination of the acquirer and targets operations.
Increased revenue and/or market share: This would typically occur when the buyer
takes over a major competitor, reducing its competition and thus building up its market
power by capturing increased market share. If it has a dominant enough position, it
could then exercise greater power in setting prices as well.
Economy of scale: A combined company can usually cut its fixed costs by removing
duplicate departments, teams and operations, thus lowering the companys costs
relative to the same revenue stream, which would result in increasing profit margins.
Economies of Scope: When two or more business units in different industries share
resources such as manufacturing facilities, distribution channels, advertising
campaigns, R&D cost, they may be able to realize economies of scope: the cost
reductions associated with sharing resources across businesses. For example Procter &
Gamble can enjoy economies of scope if it acquire a consumer product company that
benefits from its highly regarded marketing skills and also helps in obtaining the
benefits of economies of scale.
Cross-selling: This refers to the complementary products an acquiring company can sell
to the customers of its acquired company. As an example, a bank buying a stock broker
could sell its banking products to the stock broker's customers. At the same time, the
broker could poach the bank's customers for brokerage accounts.
Geographical, product, or other diversification: Diversification of any kind can usually
smooth the earnings results of a company. This, in turn, helps in smoothing the stock
price of a company, giving conservative investors more confidence in investing in the
company.
Financial synergy
The following are the financial synergy available in the case of mergers:
Better credit worthiness: This helps the combined company to purchase the goods on
credit, obtain bank loan and raise capital in the market easily.
Lower cost of capital: The investors consider big firms as safe from their investment
point of view and expect lower rate of return for the capital supplied by them. So the
cost of capital reduces after the merger.
Enhancement of the debt capacity: After the merger the earnings and cash flows of the
combined entity become more stable than before. This increases the capacity of the
company to borrow more funds.
Increase in P/E ratio and value per share: The liquidity and marketability of the security
increases after the merger. The growth rate as well as earnings of the firm will also
increase due to various economies after the merged company. All these factors help the
company to enjoy higher P/E in the market.
Low floatation cost: Small companies have to spend higher percentage of the issued
capital as floatation cost when compared to a big firm.
Raising of capital: After the merger due to increase in the size of the company and better
credit worthiness and reputation, the company can easily raise the capital at any time.
Managerial synergy
There are cases where firms interested to merge with another company with the idea of
getting benefit through managerial effectiveness. This is one of the potential gains of
mergers is an increase in managerial effectiveness. This may happen if a more effective
management team replaces the existing management team, which is performing poorly.
Often, a company, with managerial inadequacies, can gain immensely from the superior
management that is likely to emerge as a consequence to the merger. Having greater
similarity between the interests of managers and the shareholders is another benefit of
merger.
(c) Diversification of risk
Diversification is another major motive in the case of conglomerate mergers. Merger
between two companies, which are unrelated businesses, would be able to reduce the
risk, increase rate of return on investment, and thereby increase market value of the
firm. In other words, conglomerate mergers helps in stabilizing or smoothen overall
corporate income, which would otherwise fluctuate due to seasonal or economic cycles
or product life cycle stages. In operational terms, the greater the combination of
statistically independent, or negatively correlated businesses or income streams of the
merged companies, the higher will be the reduction in the business risk and greater will
be the benefit of diversification or vice versa.
An example of diversification through mergers to reduce total risk and improve
profitability is that RPG Enterprises of Goenka Group. The group started its takeover
activity in 1979. It comprises of a large number of companies, most of which have been
takeover. The strategy has been to look out for any foreign disinvestments, or any cases
of sick companies, which could prove right targets at low takeover prices. In 1988, RPG
took over ICIM and Harrisons Malayalam Limited. Acquiring ICIM has provided an easy
access to the electronics industry.
(d) Limiting or Elimination of Competition
Acquisitions, especially horizontal mergers are undertaken to destroy competition and
establish a critical mass. This might increase the bargaining power of the company with
its suppliers and customers. Economies of scale may also be generated in the process.
Example of this could be VIPs takeover of Universal Luggage and its thereafter putting
an end to Universals massive price discounting, which was eating their profits. The HP
and Compaq merger also created the largest personal computers company in India.
Internationally, as well this move was supposed to put IBM under immense pressure.
(e)Protection against a hostile takeover
Defensive acquisition is one of the strategies to avoid hostile takeover. It makes itself
less attractive to the acquiring company. In such a situation, the target company will
acquire another company as a defensive acquisition and finance such an acquisition
through adding substantial debt. Due to the increased debt of the target company, the
acquiring company, which planned the hostile takeover, will likely lose interest in
acquiring the now highly leveraged target company. Before a defensive acquisition is
undertaken, it is important to make sure that such action is better for shareholders
wealth than a merger with the acquiring company which started off the whole process
by proposing a hostile takeover.
(f) Tax Benefits
Certain mergers take place just to get the benefit of tax shields. Tax benefits are
available for a firm, which acquires a firm that is running with cumulative losses or
unabsorbed depreciation. The firm with accumulated losses or unabsorbed depreciation
may not be able to get the benefit of tax shield. Section 72A of Income Tax Act, 1961
provides tax shield incentive for reverse mergers for the survival of sick units. However,
when it merges with a profit-making firm, its accumulated losses can be set off against
the profits of the profit-making firm and tax benefits can be quickly realized. An
example of a merger to reduce tax liability is the absorption of Ahmedabad Cotton Mills
Limited (ACML) by Arbind Mills in 1979. ACML was closed in August 1977 due to labor
problem. At the time of merger in April 1979, saved about Rs.2 crore in tax liability for
the next two years after the merger because it could set-off ACMLs accumulated loss
against its profits.
Illustration: Dream well Company acquires Well Do Company. At the date of
acquisition the accumulated losses of Well Do Company are Rs.500 lakhs. Dream
Well Company is running with a profit record due to the well experienced
management. The expected earnings before tax of Dream Well Company over
three year period are Rs.150 lakhs, Rs.250 lakhs, and Rs.350 lakhs for the years
1,2, and 3 respectively. Determine the present value of tax gains to accrue on
account of merger to Dream Well Company, if the company is in the tax bracket
of 35 per cent and 12 per cent discount rate.
Solution: Present Value of Tax Gain
Particulars
Years (Rs. in lakhs)
1 2 3
Earnings Before Tax 150 250 350
Less: Recovery of Loss 150 250 100*
Tax Benefit (Recovery of Loss x Tax Rate) 52.5 87.5 35.0
Present Value Factor at 12 per cent 0.893 0.797 0.712
Present Value of Tax Shield 46.8825 69.7375 24.92
Total Present Value of Tax benefit to Dream Well Company 144.54
* (Rs.500 lakhs accumulated loss of firm Well Do Company Rs.150 lakhs, Rs.250
lakhs loss adjusted in the year 1 and 2 respectively).

3.2.7 IMPACT OF MERGERS
The word restructure particularly M&A has been symbolic with conflict, dislocation and
economic and financial pain or gain. It is largely perceived in terms of its external
consequences for investors, employees, competitors, suppliers, and host communities.
The impact of mergers on general public could be viewed as aspects of benefits and
costs to (1) Shareholders (2) Organisation Culture (3) Consumers, (4) Workers or
Employees, and (5) General Public.
1. Shareholders
Increasing the shareholders value is generally a prime objective of most of M&As. The
value to shareholders through M&As could be increased either by cutting the costs by
combining similar assets in the merging concerns or by enhancing the revenue by
focusing on enhancing capabilities and revenues, and combining complementary
competencies. However most of the studies on the impact of M&As on shareholders
wealth reveal that on an average, M&As consistently benefit the target companys
shareholders, but not the acquirers shareholders. Various consulting firms have also
estimated that from one-half to two-thirds of M&As do not come up to the expectations
of those transacting them, and many resulted in divestitures.
2. Organisation Culture
Every organization has its own culture and some traditional activities. As organization
culture is the part of employees identity, if the cultural issues are not effectively
addressed, it may lead to loss of commitment among employees resulting in lost
opportunities to retain qualified personnel and motivate individuals. A merger deal,
which may appear to be perfectly sound from financial point of view, may fail miserably
if cultural and human issues are not properly addressed in the newly created entity.
Merger of New Bank of India with Punjab National Bank is a classic case of cultural
differences on account of which the merged entity suffered a lot immediately following
the merger.
3. Consumers
Mergers are beneficial to the consumers of products or services, only when the merger
realized economic (i.e., enhanced economies, and diversification which lead to
manufacture better quality products at lower prices) gains. These economic benefits are
transferred to the consumers in the form of lowers prices, and better quality products
or services, which directly raise their standard of living and quality of life. While
mergers are going to be costly when they create monopoly or minimize competition
among companies. Creating monopoly or limiting competition leads to produce low
quality products or provides low quality services like; no after sales services at
reasonably high prices.
4. Workers
Workers or employees community are benefited from M&As as the restructuring helps
in satisfying their demands in the form of employment, increased wages, improved
working environment, better living conditions and amenities. But the M&As of a
company by a conglomerate or other acquiring company may have the effect on both
sides of increasing welfare in the form of enhanced quality of life and also decrease the
welfare in the form of retrenchment of some employees, which would result purchasing
power and makes their life miserable one. Moreover, mergers often lead to higher
workloads being placed on remaining staff, with companies requiring flexibility in terms
of working hours, mobility and skills, excellent and highly motivated employees of the
merged entity may feel frustrated and may resign or they may not give their best to the
organization. So the retention of best talent and also motivation of the staff in the game
has become a major challenge for the companies. Mergers also have brought about a
change in the nature and quality of employment in the different sector.
5. General Public
As we have read in the above that mergers or acquisitions create monopoly or limit the
competition. This will ultimately lead to centralized concentration of power in small
number of corporate leaders, which results in the concentration of an economic
aggregation of economic power in their hands. Here economic power means, the ability
to control products prices and industries output as monopolists. Generally such
monopoly affects social and political environment to lean everything in their favor with
objective of maintaining power and expand their business empire. This advances lead to
economic exploitation. But in a free economy a monopolist does not stay for a long
period as other corporate enter into this field to reap the benefits of high prices set in by
the monopolist. Entry of new companies in this business enforces competition in the
market, which will help to consumers to substitute the alternative products. Therefore
M&As costly to the public when it creates monopoly.
Put in simple M&As are dangerous, when there is elimination of healthy competition;
concentration of economic power; and adverse effects on national economy. However,
mergers are essential for the fast growth of the organisations. At the same time the
dangers of mergers are more than off-set by advantages of mergers. This is possible
only when every M&A proposal must be examined keeping in view the advantages and
dangers, thereby allowing mergers or acquisitions that help to a group of stakeholders.
WHY DO MERGERS FAIL?
It's no secret that plenty of mergers don't work. Those who advocate mergers will argue
that the merger will cut costs or boost revenues by more than enough to justify the price
premium. It can sound so simple: just combine computer systems, merge a few
departments, use sheer size to force down the price of supplies and the merged giant
should be more profitable than its parts. In theory, 1+1 = 3 sounds great, but in practice,
things can go awry.
Statistics show that roughly half of acquisitions are not successful. Mergers fail quite
often and fail to create value for shareholders of the acquirers. A definite answer as to
why mergers fail to generate value for acquiring shareholders cannot be provided
because mergers fail for a host of reasons. Some of the important reasons for failures of
mergers are discussed below:
Excessive premium
In a competitive bidding situation, a company may tend to pay more. Often highest
bidder is one who overestimates value out of ignorance. Though he emerges as the
winner, he happens to be in a way the unfortunate winner. This is called Winners
Curse hypothesis. When the acquirer fails to achieve the synergies required
compensating the price, the M&A fails. More you pay for a company, the harder you will
have to work to make it worthwhile for your shareholders. When the price paid is too
much, how well the deal may be executed, the deal may not create value.
Acquisition indigestion
A mismatch in the size between acquirer and target has been found to lead to poor
acquisition performance. Many acquisitions fail either because of 'acquisition
indigestion' by buying too big targets or failed to give the smaller acquisitions the time
and attention it required.
Lack of research
Acquisition requires gathering a lot of data and information and analyzing it. It requires
extensive research. A carelessly carried out research about the acquisition causes the
destruction of acquirer's wealth.
Diversification
Very few firms have the ability to successfully manage the diversified businesses.
Unrelated diversification has been associated with lower financial performance, lower
capital productivity and a higher degree of variance in performance for a variety of
reasons including a lack of industry or geographic knowledge, a lack of focus as well as
perceived inability to gain meaningful synergies. Unrelated acquisitions, which may
appear to be very promising, may turn out to be big disappointment in reality.
Previous Acquisition Experience
While previous acquisition experience is not necessarily a requirement for future
acquisition success, many unsuccessful acquirers usually have little previous acquisition
experience. Previous experience will help the acquirers to learn from the previous
acquisition mistakes and help them to make successful acquisitions in future. It may
also help them by taking advice in order to maximize chances of acquisition success.
Those serial acquirers, who possess the in house skills necessary to promote acquisition
success as well trained and competent implementation team, are more likely to make
successful acquisitions.
Unwieldy and Inefficient
Conglomerate mergers proliferated in 1960s and 1970. Many conglomerates proved
unwieldy and inefficient and were wound up in 1980s and 1990s. The unmanageable
conglomerates contributed to the rise of various types of divestitures in the 1980s and
1990s.
Poor Cultural Fits
Cultural fit between an acquirer and a target is one of the most neglected areas of
analysis prior to the closing of a deal. However, cultural due diligence is every bit as
important as careful financial analysis. Without it, the chances are great that mergers
will quickly amount to misunderstanding, confusion and conflict. Cultural due diligence
involve steps like determining the importance of culture, assessing the culture of both
target and acquirer. It is useful to know the target management behaviour with respect
to dimensions such as centralized versus decentralized decision making, speed in
decision making, time horizon for decisions, level of team work, management of conflict,
risk orientation, openness to change, etc. It is necessary to assess the cultural fit
between the acquirer and target based on cultural profile. Potential sources of clash
must be managed. It is necessary to identify the impact of cultural gap, and develop and
execute strategies to use the information in the cultural profile to assess the impact that
the differences have.
Poor Strategic Fit
A Merger will yield the desired result only if there is strategic fit between the merging
companies. Mergers with strategic fit can improve profitability through reduction in
overheads, effective utilization of facilities, the ability to raise funds at a lower cost, and
deployment of surplus cash for expanding business with higher returns. But many a
time lack of strategic fit between two merging companies especially lack of synergies
results in merger failure. Strategic fit can also include the business philosophies of the
two entities (return on investment v/s market share), the time frame for achieving
these goals (short-term v/s long term) and the way in which assets are utilized. For
example, P&G Gillette merger in consumer goods industry is a unique case of
acquisition by an innovative company to expand its product line by acquiring another
innovative company, which was, described analysts as a perfect merger.
Striving for Bigness
Size no doubt is an important element for success in any business. Therefore there is a
strong tendency among managers whose compensation is significantly influenced by
size to build big empires. Size maximizing firms may engage in activities, which have
negative net present value. Therefore when evaluating an acquisition it is necessary to
keep the attention focused on how it will create value for shareholders and not on how
it will increase the size of the company.
Faulty evaluation: At times acquirers do not carry out the detailed diligence of the target
company. They make a wrong assessment of the benefits from the acquisition and land
up paying a higher price.
Poorly Managed Integration: Integration of the companies requires a high quality
management. Integration is very often poorly managed with little planning and design.
As a result implementation fails. The key variable for success is managing the company
better after the acquisition than it was managed before. Even good deals fail if they are
poorly managed after the merger.
Failure to Take Immediate Control: Control of the new unit should be taken immediately
after signing of the agreement. ITC did so when they took over the BILT unit even
though the consideration was to be paid in 5 yearly instalments. ABB put new
management in place on day one and reporting systems in place by three weeks.
Failure to Set the Pace for Integration: The important task in the merger is to integrate
the target with acquiring company in every respect. All function such as marketing,
commercial; finance, production, design and personnel should be put in place. In
addition to the prominent persons of acquiring company the key persons from the
acquired company should be retained and given sufficient prominence opportunities in
the combined organization. Delay in integration leads to delay in product shipment,
development and slow down in the company's road map. Acquisition of Scientific Data
Corporation by Xerox in 1969 and AT&T's acquisition of computer maker NCR
Corporation in 1991 were troubled deals, which resulted in large write offs. The speed
of integration is extremely important because uncertainty and ambiguity for longer
periods destabilizes the normal organizational life.
Incomplete and Inadequate Due Diligence : Lack of due diligence is lack of detailed
analysis of all important features like finance, management, capability, physical assets
as well as intangible assets results in failure. ISPAT Steel is a corporate acquirer that
conducts M&A activities after elaborate due diligence.
Ego Clash: Ego clash between the top management and subsequently lack of
coordination may lead to collapse of company after merger. The problem is more
prominent in cases of mergers between equals.
Merger between Equals: Merger between two equals may not work. The Dunlop Pirelli
merger in 1964, which created the world's second largest tier company, ended in an
expensive divorce. Manufacturing plants can be integrated easily, human beings cannot.
Merger of equals may also create ego clash.
Over Leverage: Cash acquisitions results in the acquirer assuming too much debt. Future
interest cost consumes too great a portion of the acquired company's earnings
(Business India 2005).
Incompatibility of Partners: Alliance between two strong companies is a safer bet than
between two weak partners. Frequently many strong companies actually seek small
partners in order to gain control while weak companies look for stronger companies to
bail them out. But experience shows that the weak link becomes a drag and causes
friction between partners. A strong company taking over a sick company in the hope of
rehabilitation may itself end up in liquidation.
Limited Focus: If merging companies have entirely different products, markets systems
and cultures, the merger is doomed to failure. Added to that as core competencies are
weakened and the focus gets blurred the fallout on bourses can be dangerous. Purely
financially motivated mergers such as tax driven mergers on the advice of accountant
can be hit by adverse business consequences. The Tatas for example, sold their soaps
business to Hindustan Lever.
Failure to Get Figures Audited: It would be serious mistake if the takeovers were
concluded without a proper audit of financial affairs of the target company. Though the
company pays for the assets of the target company, it also assumes responsibility to pay
all the liabilities. Areas to look for are stocks, saleability of finished products,
receivables and their collectibles, details and location of fixed assets, unsecured loans,
claims under litigation, loans from the promoters, etc. When ITC took over the
paperboard making unit of BILT near Coimbatore, it arranged for comprehensive audit
of financial affairs of the unit. Many a times the acquirer is mislead by window-dressed
accounts of the target.
Failure to Get an Objective Evaluation of the Target Company' Condition: Risk of failure
will be minimized if there is a detailed evaluation of the target company's business
conditions carried out by the professionals in the line of business. Detailed examination
of the manufacturing facilities, product design features, rejection rates, and distribution
systems, profile of key people and productivity of the workers is done. Acquirer should
not be carried away by the state of the art physical facilities like a good head quarters
building, guest house on a beach, plenty of land for expansion, etc.
Failure of Top Management to Follow-Up: After signing the M&A agreement the top
management should not sit back and let things happen. First 100 days after the takeover
determine the speed with which the process of tackling the problems can be achieved.
Top management follow-up is essential to go with a clear road map of actions to be
taken and set the pace for implementing once the control is assumed.
Mergers between Lame Ducks: Merger between two weak companies does not succeed
either. The example is the Stud backer- Packard merger of 1955 when two ailing
carmakers joined hands. By 1964 both companies were closed down.
Lack of Proper Communication: Lack of proper communication after the announcement
of mergers will create lot of uncertainties. Apart from getting down to business quickly
companies have to necessarily talk to employees and constantly. Regardless of how well
executives communicate during a merger or an acquisition, uncertainty will never be
completely eliminated. Failure to manage communication results in inaccurate
perceptions, lost trust in management, morale and productivity problems, safety
problems, poor customer service, and defection of key people and customers. It may
lead to the loss of the support of key stakeholders at a time when that support is needed
the most.
Failure of Leadership Role: Some of the role leadership should take seriously are
modelling, quantifying strategic benefits and building a case for M&A activity and
articulating and establishing high standard for value creation. Walking the talk also
becomes very important during M&As.
Inadequate Attention to People Issues: Not giving sufficient attention to people issues
during due diligence process may prove costly later on. While lot of focus is placed on
the financial and customer capital aspects, not enough attention is given to aspects of
human capital and cultural audit. Well conducted HR due diligence can provide very
accurate estimates and can be very critical to strategy formulation and implementation.
Strategic Alliance as an Alternative Strategy: Another feature of 1990s is the growth in
strategic alliances as a cheaper, less risky route to a strategic goal than takeovers.
Loss of Identity: Merger should not result in loss of identity, which is a major strength
for the acquiring company. Jaguar's car image dropped drastically after its merger with
British Leyland.
Diverging from Core Activity: In some cases it reduces buyer's efficiency by diverting it
from its core activity and too much time is spent on new activity neglecting the core
activity.
Expecting Results too quickly: Immediate results can never be expected except those
recorded in red ink. Whirlpool ran up a loss $100 million in its Philips white goods
purchase. R.P. Goenka's takeovers of Gramophone Company and Manu Chhabria's
takeover of Gordon Woodroffe and Dunlops fall under this category.

Assessment Questions
1. Why do Firms Merge?
2. Why do Mergers and Acquisitions quite often fail? List the important reasons for
failures of mergers.















































--------------------------------------------------------------------------------------------
Acquisitions

LEARNING OBJECTIVE
After reading this chapter you should be able to:
Know the background on acquisitions
Define and conceptualize the concept of acquisitions
Understand the process of an acquisition
Narrate the Steps in an acquisition
Know the Prerequisites for success
Know the procedure of Valuing a target firm
Narrate the Methods of Payment for the target firm



















4



This section the historical background of acquisition, process of acquisition, how to
develop acquisition strategy, the matters relating to the valuation of the synergies,
amount paid to the target firm, and the accounting consideration involved in merger
and acquisition.
Firms are acquired for a number of reasons. In the 1960s and 1970s, firms such as Gulf
and Western and ITT built themselves into conglomerates by acquiring firms in other
lines of business. In the 1980s, corporate giants like Time, Beatrice and RJR Nabisco
were acquired by other firms, their own management or wealthy raiders, who saw
potential value in restructuring or breaking up these firms. In the 1990s, we saw a wave
of consolidation in the media business as telecommunications firms acquired
entertainment firms and entertainment firms acquired cable businesses. Through time,
firms have also acquired or merged with other firms to gain the benefits of synergy, in
the form of either higher growth, as in the Disney acquisition of Capital Cities, or lower
costs.
Acquisitions seem to offer firms a short cut to their strategic objectives, but the process
has its costs. In this chapter, we examine the four basic steps in an acquisition, starting
with establishing an acquisition motive, continuing with the identification and valuation
of a target firm, and following up with structuring and paying for the deal. The final and
often the most difficult step is making the acquisition work after the deal is
consummated.
Background on Acquisitions
When we talk about acquisitions or takeovers, we are talking about a number of
different transactions. These transactions can range from one firm merging with
another firm to create a new firm to managers of a firm acquiring the firm from its
stockholders and creating a private firm. We begin this section by looking at the
different forms taken by acquisitions, continue the section by providing an overview on
the acquisition process and conclude by examining the history of the acquisitions in the
United States.
The Process of an Acquisition
Acquisitions can be friendly or hostile events. In a friendly acquisition, the managers of
the target firm welcome the acquisition and, in some cases, seek it out. In a hostile
acquisition, the target firms management does not want to be acquired. The acquiring
firm offers a price higher than the target firms market price prior to the acquisition and
invites stockholders in the target firm to tender their shares for the price.
In either friendly or hostile acquisitions, the difference between the acquisition price
and the market price prior to the acquisition is called the acquisition premium. The
acquisition price, in the context of mergers and consolidations, is the price that will be
paid by the acquiring firm for each of the target firms shares. This price is usually based
upon negotiations between the acquiring firm and the target firms managers. In a
tender offer, it is the price at which the acquiring firm receives enough shares to gain
control of the target firm. This price may be higher than the initial price offered by the
acquirer, if there are other firms bidding for the same target firm or if an insufficient
number of stockholders tender at that initial price. For instance, in 1991, AT&T initially
offered to buy NCR for $80 per share, a premium of $ 25 over the stock price at the time
of the offer. AT&T ultimately paid $110 per share to complete the acquisition.
There is one final comparison that can be made and that is between the price paid on
the acquisition and the accounting book value of the equity in the firm being acquired.
Depending upon how the acquisition is accounted for, this difference will be recorded as
goodwill on the acquiring firms books or not be recorded at all.
Steps in an Acquisition
There are four basic and not necessarily sequential steps, in acquiring a target firm. The
first is the development of a rationale and a strategy for doing acquisitions, and the
understanding of what the strategy requires in terms of resources. The second is the
choice of a target for the acquisition and the valuation of the target firm, with premiums
for the value of control and any synergy. The third is the determination of how much to
pay on the acquisition, how best to raise funds to do it, and whether to use stock or cash.
This decision has significant implications for the choice of accounting treatment for the
acquisition. The final step in the acquisition, and perhaps the most challenging one, is to
make the acquisition work after the deal is complete.
Developing an Acquisition Strategy
Not all firms that make acquisitions have acquisition strategies, and not all firms that
have acquisition strategies stick with them. In this section, we consider a number of
different motives for acquisitions and suggest that a coherent acquisition strategy has to
be based on one or another of these motives. These motives were studied in detail in the
last chapter, as the motives behind merger and motives behind acquisitions are same.
Firms that are undervalued by financial markets can be targeted for acquisition by those
who recognize this mis-pricing. The acquirer can then gain the difference between the
value and the purchase price as surplus. For this strategy to work, however, three basic
components need to come together.
A capacity to find firms that trade at less than their true value: This capacity would
require either access to better information than is available to other investors in the
market, or better analytical tools than those used by other market participants.
Access to the funds that will be needed to complete the acquisition: Knowing a firm is
undervalued does not necessarily imply having capital easily available to carry out the
acquisition. Access to capital depends upon the size of the acquirer large firms will
have more access to capital markets and internal funds than smaller firms or individuals
and upon the acquirers track record a history of success at identifying and acquiring
under valued firms will make subsequent acquisitions easier.
Skill in execution: If the acquirer, in the process of the acquisition drives the stock price
up to and beyond the estimated value, there will be no value gain from the acquisition.
To illustrate, assume that the estimated value for a firm is $100 million and that the
current market price is $75 million. In acquiring this firm, the acquirer will have to pay
a premium. If that premium exceeds 33% of the market price, the price exceeds the
estimated value, and the acquisition will not create any value for the acquirer.
While the strategy of buying under valued firms has a great deal of intuitive appeal, it is
daunting, especially when acquiring publicly traded firms in reasonably efficient
markets, where the premiums paid on market prices can very quickly eliminate the
valuation surplus. The odds are better in less efficient markets or when acquiring
private businesses.
Acquire poorly managed firms and change management Some firms are not managed
optimally and others often believe they can run them better than the current managers.
Acquiring poorly managed firms and removing incumbent management, or at least
changing existing management policy or practices, should make these firms more
valuable, allowing the acquirer to claim the increase in value. This value increase is
often termed the value of control.
Prerequisites for Success
While this corporate control story can be used to justify large premiums over the
market price, the potential for its success rests on the following.
a) The poor performance of the firm being acquired should be attributable to
the incumbent management of the firm, rather than to market or industry
factors that are not under management control.
b) The acquisition has to be followed by a change in management practices, and
the change has to increase value. As noted in the last chapter, actions that
enhance value increase cash flows from existing assets, increase expected
growth rates, increase the length of the growth period, or reduce the cost of
capital.
c) The market price of the acquisition should reflect the status quo, i.e., the
current management of the firm and their poor business practices. If the
market price already has the control premium built into it, there is little
potential for the acquirer to earn the premium. In the last two decades,
corporate control has been increasingly cited as a reason for hostile
acquisitions.
Choosing a Target firm and valuing control/synergy
Once a firm has an acquisition motive, there are two key questions that need to be
answered. The first relates to how to best identify a potential target firm for an
acquisition, given the motives. The second is the more concrete question of how to value
a target firm.
Choosing a target firm
Once a firm has identified the reason for its acquisition program, it has to find the
appropriate target firm.
a) If the motive for acquisitions is under valuation, the target firm must be under
valued. How such a firm will be identified depends upon the valuation
approach and model used. With relative valuation, an under valued stock is one
that trades at a multiple (of earnings, book value or sales) well below that of
the rest of the industry, after controlling for significant differences on
fundamentals. Thus, a bank with a price to book value ratio of 1.2 would be an
undervalued bank, if other banks have similar fundamentals (return on equity,
growth, and risk) but trade at much higher price to book value ratios. In
discounted cash flow valuation approaches, an under valued stock is one that
trades at a price well below the estimated discounted cash flow value.
b) If the motive for acquisitions is diversification, the most likely target firms will
be in businesses that are unrelated to and uncorrelated with the business of
the acquiring firm. Thus, a cyclical firm should try to acquire counter-cyclical
or, at least, non-cyclical firms to get the fullest benefit from diversification.
c)
vary depending upon the source of the synergy. For economies of scale, the
target firm should be in the same business as the acquiring firm. Thus, the
acquisition of Security Pacific by Bank of America was motivated by potential
cost savings from economies of scale. For functional synergy, the target firm
should be strongest in those functional areas where the acquiring firm is weak.
For financial synergy, the target firm will be chosen to reflect the likely source
of the synergy a risky firm with limited or no standalone capacity for
borrowing, if the motive is increased debt capacity, or a firm with significant
net operating losses carried forward, if the motive is tax benefits.
d) If the motive for the merger is control, the target firm will be a poorly managed
firm in an industry where there is potential for excess returns. In addition, its
stock holdings will be widely dispersed (making it easier to carry out the
hostile acquisition) and the current market price will be based on the
presumption that incumbent management will continue to run the firm.
e) If the motive is managerial self-interest, the choice of a target firm will reflect
managerial interests rather than economic reasons.
Valuing the Target Firm
The valuation of an acquisition is not fundamentally different from the valuation of any
firm, although the existence of control and synergy premiums introduces some
complexity into the valuation process. Given the inter-relationship between synergy and
control, the safest way to value a target firm is in steps, starting with a status quo
valuation of the firm, and following up with a value for control and a value for synergy.
a. Status Quo Valuation
We start our valuation of the target firm by estimating the firm value with existing
investing, financing and dividend policies. This valuation, which we term the status quo
valuation, provides a base from which we can estimate control and synergy premiums.
In particular, the value of the firm is a function of its cash flows from existing assets, the
expected growth in these cash flows during a high growth period, the length of the high
growth period and the firms cost of capital.
b. The Value of Corporate Control
Many hostile takeovers are justified on the basis of the existence of a market for
corporate control. Investors and firms are willing to pay large premiums over the
market price to control the management of firms, especially those that they perceive to
be poorly run. This section explores the determinants of the value of corporate control
and attempts to value it in the context of an acquisition.
Determinants of the Value of Corporate Control
The value of wresting control of a firm from incumbent management is inversely
proportional to the perceived quality of that management and its capacity to maximize
firm value. In general, the value of control will be much greater for a poorly managed
firm that operates at below optimum capacity than for a well managed firm. The value
of controlling a firm comes from changes made to existing management policy that can
increase the firm value. Assets can be acquired or liquidated, the financing mix can be
changed and the dividend policy reevaluated, and the firm can be restructured to
maximize value. If we can identify the changes that we would make to the target firm,
we can value control. The value of control can then be written as:
Value of Control = [Value of firm, optimally managed - Value of firm with current
management]
The value of control is negligible for firms that are operating at or close to their optimal
value, since a restructuring will yield little additional value. It can be substantial for
firms operating at well below optimal, since a restructuring can lead to a significant
increase in value.
c. Valuing Operating Synergy
There is a potential for operating synergy, in one form or the other, in many takeovers.
Some disagreement exists, however, over whether synergy can be valued and, if so,
what that value should be. One school of thought argues that synergy is too nebulous to
be valued and that any systematic attempt to do so requires so many assumptions that
it is pointless. If this is true, a firm should not be willing to pay large premiums for
synergy if it cannot attach a value to it.
While valuing synergy requires us to make assumptions about future cash flows and
growth, the lack of precision in the process does not mean we cannot obtain an
unbiased estimate of value. Thus we maintain that synergy can be valued by answering
two fundamental questions.
(1) What form is the synergy expected to take? Will it reduce costs as a percentage of
sales and increase profit margins (e.g., when there are economies of scale)? Will it
increase future growth (e.g., when there is increased market power) or the length of the
growth period? Synergy, to have an effect on value, has to influence one of the four
inputs into the valuation process cash flows from existing assets, higher expected
growth rates (market power, higher growth potential), a longer growth period (from
increased competitive advantages), or a lower cost of capital (higher debt capacity).
(2) When will the synergy start affecting cash flows? Synergies can show up
instantaneously, but they are more likely to show up over time. Since the value of
synergy is the present value of the cash flows created by it, the longer it takes for it to
show up, the lesser its value.
Once we answer these questions, we can estimate the value of synergy using an
extension of discounted cash flow techniques. First, we value the firms involved in the
merger independently, by discounting expected cash flows to each firm at the weighted
average cost of capital for that firm. Second, we estimate the value of the combined firm,
with no synergy, by adding the values obtained for each firm in the first step. Third, we
build in the effects of synergy into expected growth rates and cash flows and we value
the combined firm with synergy. The difference between the value of the combined firm
with synergy and the value of the combined firm without synergy provides a value for
synergy.
d. Valuing Financial Synergy
Synergy can also be created from purely financial factors. We will consider three
legitimate sources of financial synergy - a greater tax benefit from accumulated losses
or tax deductions, an increase in debt capacity and therefore firm value and better use
for excess cash or cash slack. We will begin the discussion, however, with
diversification, which though a widely used rationale for mergers, is not a source of
increased value by itself.
Structuring the Acquisition
Once the target firm has been identified and valued, the acquisition moves forward into
the structuring phase. There are three interrelated steps in this phase. The first is the
decision on how much to pay for the target firm, synergy and control built into the
valuation. The second is the determination of how to pay for the deal, i.e., whether to
use stock, cash or some combination of the two, and whether to borrow any of the funds
needed. The final step is the choice of the accounting treatment of the deal because it
can affect both taxes paid by stockholders in the target firm and how the purchase is
accounted for in the acquiring firms income statement and balance sheets.
Deciding on an Acquisition Price
The value determined in consideration of synergy and control represents a ceiling on
the price that the acquirer can pay on the acquisition rather than a floor. If the acquirer
pays the full value, there is no surplus value to claim for the acquirers stockholders and
the target firms stockholders get the entire value of the synergy and control premiums.
This division of value is unfair, if the acquiring firm plays an indispensable role in
creating the synergy and control premiums.
Consequently, the acquiring firm should try to keep as much of the premium as it can
for its stockholders. Several factors, however, will act as constraints. They include:
1. The market price of the target firm, if it is publicly traded, prior to the acquisition:
Since acquisitions have to base on the current market price, the greater the current
market value of equity, the lower the potential for gain to the acquiring firms
stockholders. For instance, if the market price of a poorly managed firm already reflects
a high probability that the management of the firm will be changed, there is likely to be
little or no value gained from control.
2. The relative scarcity of the specialized resources that the target and the acquiring firm
bring to the merger: Since the bidding firm and the target firm are both contributors to
the creation of synergy, the sharing of the benefits of synergy among the two parties
will depend in large part on whether the bidding firm's contribution to the creation of
the synergy is unique or easily replaced. If it can be easily replaced, the bulk of the
synergy benefits will accrue to the target firm. If it is unique, the benefits will be shared
much more equitably. Thus, when a firm with cash slack acquires a firm with many
high-return projects, value is created. If there are a large number of firms with cash
slack and relatively few firms with high-return projects, the bulk of the value of the
synergy will accrue to the latter.
3. The presence of other bidders for the target firm: When there is more than one bidder
for a firm, the odds are likely to favor the target firms stockholders. Bradley, Desai, and
Kim (1988) examined an extensive sample of 236 tender offers made between 1963 and
1984 and concluded that the benefits of synergy accrue primarily to the target firms
when multiple bidders are involved in the takeover. They estimated the market-
adjusted stock returns around the announcement of the takeover for the successful
bidder to be 2% in single bidder takeovers and -1.33% in contested takeovers.
Payment for the Target Firm
Once a firm has decided to pay a given price for a target firm, it has to follow up by
deciding how it is going to pay for this acquisition. In particular, a decision has to be
made about the following aspects of the deal.
1. Debt versus Equity: A firm can raise the funds for an acquisition from either debt or
equity. The mix will generally depend upon both the excess debt capacities of the
acquiring and the target firm. Thus, the acquisition of a target firm that is significantly
under levered may be carried out with a larger proportion of debt than the acquisition
of one that is already at its optimal debt ratio. This, of course, is reflected in the value of
the firm through the cost of capital. It is also possible that the acquiring firm has excess
debt capacity and that it uses its ability to borrow money to carry out the acquisition.
Although the mechanics of raising the money may look the same in this case, it is
important that the value of the target firm not reflect this additional debt. The
additional debt has nothing to do with the target firm and building it into the value will
only result in the acquiring firm paying a premium for a value enhancement that
rightfully belongs to its own stockholders.
2. Cash versus Stock: There are three ways in which a firm can use equity in a
transaction. The first is to use cash balances that have been built up over time to finance
the acquisition. The second is to issue stock to the public, raise cash and use the cash to
pay for the acquisition. The third is to offer stock as payment for the target firm, where
the payment is structured in terms of a stock swap shares in the acquiring firm in
exchange for shares in the target firm. The question of which of these approaches is best
utilized by a firm cannot be answered without looking at the following factors.
The availability of cash on hand: Clearly, the option of using cash on hand is
available only to those firms that have accumulated substantial amounts of
The perceived value of the stock: When stock is issued to the public to
raise new funds or when it is offered as payment on acquisitions, the acquiring
firms managers are making a judgment about what the perceived value of the
stock is. In other words, managers who believe that their stock is trading at a
price significantly below value should not use stock as currency on
acquisitions, since what they gain on the acquisitions can be more than what
they lost in the stock issue. On the other hand, firms that believe their stocks
are overvalued are much more likely to use stock as currency in transactions.
The stockholders in the target firm are also aware of this and may demand a
larger premium when the payment is made entirely in the form of the
acquiring firms stock.
Tax factors; when an acquisition is a stock swap, the stockholders in the target
firm may be able to defer capital gains taxes on the exchanged shares. Since
this benefit can be significant in an acquisition, the potential tax gains from a
stock swap may be large enough to offset any perceived disadvantages.
The final aspect of a stock swap is the setting of the terms of the stock swap, i.e., the
number of shares of the acquired firm that will be offered per share of the acquiring
firm. While this amount is generally based upon the market price at the time of the
acquisition, the ratio that results may be skewed by the relative mis-pricing of the two
firms securities, with the more overpriced firm gaining at the expense of the more
under priced (or at least, less overpriced) firm. A fairer ratio would be based upon the
relative values of the two firms shares.

Summary
Acquisition refers to the acquiring of ownership right in the property and asset without
any combination of companies. Thus in acquisition two or more companies may remain
independent, separate legal entity, but there may be change in control of companies.
Acquisition results when one company purchase the controlling interest in the share
capital of another existing company in any of the following ways:
a) Controlling interest in the other company. By entering into an agreement with a
person or persons holding
b) By subscribing new shares being issued by the other company.
c) By purchasing shares of the other company at a stock exchange, and
d) By making an offer to buy the shares of other company, to the existing
shareholders of that company.
There are four basic and not necessarily sequential steps, in acquiring a target firm. The
first is the development of a rationale and a strategy for doing acquisitions, and the
understanding of what the strategy requires in terms of resources. The second is the
choice of a target for the acquisition and the valuation of the target firm, with premiums
for the value of control and any synergy. The third is the determination of how much to
pay on the acquisition, how best to raise funds to do it, and whether to use stock or cash.
This decision has significant implications for the choice of accounting treatment for the
acquisition. The final step in the acquisition, and perhaps the most challenging one, is to
make the acquisition work after the deal is complete.
Once a firm has an acquisition motive, there are two key questions that need to be
answered. The first relates to how to best identify a potential target firm for an
acquisition, given the motives. The second is the more concrete question of how to value
a target firm.
The valuation of an acquisition is not fundamentally different from the valuation of any
firm, although the existence of control and synergy premiums introduces some
complexity into the valuation process. Given the inter-relationship between synergy and
control, the safest way to value a target firm is in steps, starting with a status quo
valuation of the firm, and following up with a value for control and a value for synergy.
Assessment Questions
1. What do you mean by acquisition? Discuss different steps involved in the process
of acquisition.
2. How a target firm is valued?
3. Enumerate different methods of payment to a target firm under acquisition.