MERGERS AND ACQUISITION 1A

Introduction Mergers, Amalgamations & Takeovers all through the globe have become universal practices in the corporate world covering different sectors within the nations and across their borders for securing survival, growth, expansion and globalisation of the enterprise and achieving multitude of objectives. Meaning of terms Mergers, consolidation, takeovers, amalgamations, acquisitions, combinations, restructuring and reconstructing are some of the terms which are required to be understood in the sense these are used. In different circumstances some of these terms carry different meanings and might not be constructed as merger or takeover in application of these sense underlying the term for a particular situation. In the following paragraphs, the meaning of these terms have been explained in the light of the definition and explained in the light of the definitions and explanations given by eminent scholars and practitioners in their works. 1. Merger

Merger is defined as combination of two or more companies into a single company where one survives and the others lose their corporate existence. The survivor acquires the assets as well as liabilities of the merged company or companies. Generally, the company which survives is the buyer which retains its identity and the seller company is extinguished. Merger is also defined as amalgamation. Merger is the fusion of two or more existing companies. All assets, liabilities and stock of one company stand transferred to transferee company in consideration of payment in the form of equity shares of transferee company or debentures or cash or a mix of the two or three modes. 2. Amalgamation

Ordinarily amalgamation means merger Halsburys Laws of England describe amalgamation as a blending of two or more existing undertaking into one undertaking, the shareholders of each blending company becoming substantially the shareholders in the company which is to carry on the blended undertaking. Andhra Pradesh High Court held in S.S. Somayajulu v Hope Prudhomme & Co. the word amalgamation has no definite legal meaning. It contemplates a state of things under which two companies are so joined as to form a third entity, or one company is absorved into and blended with another company. Amalgamation does not involve a formation of a new company to carry on the business of the old company. Madras High Court held in W.A. Beardsell & Co. (P) Ltd. the world amalgamation has not been defined in the Act. The ordinary dictionary meaning of the expression is combination.
1

Judging from the context and from the marginal note of section 394, which appears in Chapter V relating to arbitration, compromise, arrangements and reconstructions, the primary object of amalgamation of one company with another is to facilitate reconstruction of the amalgamating companies and this is matter which is entirely left to the body of shareholders of the primary company which offers or intends to amalgamate with another. There is indeed an absorption by the company with which it is amalgamated, the latter being statutorily called the transferee company and the former the transferor company. In fact, the company amalgamating and the company with which it is amalgamated are so statutorily defined under section 394(1) (b) of the Companies Act, 1956. On a prima facie examination of the relevant provisions in Chapter V, it is abundantly clear that it is essentially an affair relating to the internal administration of the transferor company. Of course, there should be consensus ad litem between the transferor company and the transferee company. The initiative thus lying on the shoulders of the transferor company, it is obligatory that a scheme or arrangement should be proposed by that company and the shareholders put on notice of such intendment and objects, and they being informed of the benefits, facilities and privileges attendant upon such an obligation. Thus, amalgamation being within the scope of the decision of the body of the shareholders, such a decision if made by the body unanimously ought not to be lightly interfered with by Court. The Companies Act, 1956 vide sections 394 and 396A explains amalgamation which will be discussed separately under Legal Aspects of Merger. However, the term will be used interchangeably with merger wherever the circumstances would so require. 3. Consolidation

Consolidation is known as the fusion of two existing companies into a new company in which both the existing companies extinguish. Thus, consolidation is mixing up of the two companies to make them into a new one in which both the existing companies lose their identity and cease to exist. The mix-up assets of the two companies are known by a new name and the shareholders of two companies become shareholders of the new company. None of the consolidating firms legally survives. There is no designation of buyer and seller. An consolidating companies are DOSSOLVED. In other words, all the assets, liabilities and stocks of the consolidating companies stand transferred to new company in consideration of payment in terms of equity shares or bonds or cash or combination of the two or all modes of payments in proper mix. 4. Combination

Combination refers to mergers and consolidations as a common term used interchangeably but carrying legally distinct interpretation. All mergers, acquisitions, and amalgamations are business combinations. Types of business combination are discussed in the following paragraphs. 5. Holding company

Mergers and consolidations are distinct business combination which differs from a holding company. The relationship of the two companies when combine their resources are differently

known as parent company which holds the equity stock of the other company knows as subsidiary and controls its affairs. Section 4 of the Companies Act, 1956 defines the holding Company and subsidiary which is quite relevant in the present context. The main criteria of becoming holding company is the control in the composition of the Board of Directors in another company and such control should emerge from holding of equity shares and thereby more than 50% of the total voting power of such company. 6. Acquisition

Acquisition in general sense is acquiring the ownership in the property. In the context of business combinations, an acquisition is the purchase by one company of a controlling interest in the share capital of another existing company. An acquisition may be affected by (a) agreement with the persons holding majority interest in the company management like members of the board or major shareholders commanding majority of voting power; (b) purchase of shares in open market; (c) to make takeover offer to the general body of shareholders; (d) purchase of new shares by private treaty; (e) acquisition of share capital or one company may be either all or any one of the following form of considerations viz. means of cash, issuance of loan capital, or insurance of share capital. 7. Takeover

A takeover is acquisition and both the terms are used interchangeably. Takeover differs from merger in approach to business combinations i.e. the process of takeover, transaction involved in takeover, determination of the share exchange or cash price and the fulfilment of goals of combination all are different in takeovers than in mergers. For example, process of takeover is unilateral and the offeror company decides about the maximum price. Time taken in completion of transaction is les in takeover than in mergers, top management of the offeree company being more co-operative. 8. Reconstruction

The term reconstruction has been used in section 394 along with the term amalgamation. The term has not been defined therein but it has been used in the sense not synonymous with amalgamation. In the Butterworth publication, the term has been explained as under: By a reconstruction, a company transfers its undertaking and assets to a new company in consideration of the issue of the new companys shares to the first companys members and, if the first companys debentures are not paid off, in further consideration of the new company issuing shares or debentures to the first companys debenture holders in satisfaction of their claims. The result of the transaction is that the new company has the same assets and members
3

and, if the new company issues debentures to the first holders as the first company, the first company has no undertaking to operate and is therefore usually wound up or dissolved. Reconstructions were far more common at the end of the last century and the beginning of this century than they are now. The purposes to be achieved by them were usually on of the following: either to extend or alter the objects of a company by incorporating a new company with the wider or different objects desired; or to alter the rights attached to different classes of a companys shares or debentures by the new company issuing shares or debentures with those different rights to the original companys share or debenture holders; or to compel the members of a company to contribute further capital by taking shares in the new company on which a larger amount was unpaid than on the shares of the original company. The first two of these purposes can now be achieved without reconstruction and the third is now regarded as a species of coercion, which is strongly disapproved of by the courts and is not pursued in practice. Consequently, reconstructions for these reasons do not now occur. In Indian context, the term would cover various types of arrangements or compromises which may include merger as well as demerger. 9. Restructuring

The term restructuring is used in the corporate literature for mergers and amalgamations. The term should carry the same meaning as reconstruction as explained above. In American literature the term finds mention in the sense of industrial restructuring. Edword J. Blakely a professor at University of California, Berkeley in a jointly written paper along with Philip Shapira in Annals has discussed the industrial structuring taking place in American economy particularly the manufacturing sector being recognised and deindustrialised through changing location of capital investments, use of superior technologies and displacement of labour, etc. with objectives to maintain profitability for large corporations. The above position was observed during 1980s in developed countries but now in 1990s, the above elements of industrial restructuring are being observed in Indias industrial economy, in many industries where computerisation and use of modern technology is being inducted.

10.

Demerger or corporate splits or division

Demerger or split or division of a company are the synonymous terms signifying a movement in the company just opposite to combination in any of the forms defined above. Such types of demerger or divisions have been occurring in developed nations particularly in UK and USA. In UK, the above terms carry the meaning as a division of a company takes place when part of its undertaking is transferred to a newly-formed company or to an existing company, some of all of
4

whose shares are allotted to certain of the first companys shareholders. The remainder of the first companys shareholders. The remainder of the first companys undertaking continues to be vested in it and its shareholders are reduced to those who do not take shares in the other company; in other words, the companys undertaking, and shareholders are divided between the two companies. In USA, too, the corporate splits carry the similar features excepting difference in accounting treatment in post-demerger practices. In India, too, demergers and corporate splits have started taking place in old industrial conglomerates and big groups which are discussed in detail under a separate head. Mergers and takeovers The terms merger and takeover shall be used in this report interchangeably so far as the valuation techniques and academic orientation are concerned but the other aspects will be supported with explanations about the different routes the companies follow in embracing the business combinations through takeover or merger. Purpose of merger and acquisition The company which proposes to acquire another company is knows differently in different modes of acquisition, the familiar ones are; predator, offeror, corporate raider (for takeover bids), etc. The transferee company is also denoted as victim, offeree, acquire or target etc. The purpose for an offeror company for acquiring another company shall be reflected in the corporate objective. It has to decide the specific objectives to be achieved through acquisition. The basic purpose of merger or business combination is to achieve faster growth of the corporate business. Faster growth may be had through product improvement and competitive position i.e. enhanced profitability through enhanced production and efficient distribution of goods and services or by expanding the scope of the enterprise through empire building through acquisition of other corporate units. Other possible purposes for acquisition are short listed below:

1. 2.

Procurement of supplies To safeguard the source of supplies of raw material or intermediary product; To obtain economies of purchases in the form of discount, savings in transportation costs, overhead costs in buying department, etc. To share the benefits of suppliers economies by standardising the materials. Revamping production facilities To achieve economies of scale by amalgamating production facilities through more intensive utilisation of plan and resources;
5

To standardise product specifications, improvement of quality of product, expanding market and aiming at consumers satisfaction through strengthening after sale services; To obtain improved production technology and know how from the offeree company to reduce cost, improve quality and produce competitive products to retain and improve market share. Market expansion and strategy

3. 4. 5.

To eliminate competition and protect existing market; To obtain new market outlets in possession of the offeree; To obtain new product for diversification or substitution of existing products and to enhance the product range; Strengthening retail outlets and sale depots to reationalise distribution; To reduce advertising cost and improve public image of the offeree company; Strategic control of patents and copyrights. Financial strength To improve liquidity and have direct access to cash resources; To dispose of surplus and outdated assets for cash out of combined enterprise; To enhance gearing capacity, borrow on better strength and greater assets backing; To avail of tax benefits; To improve EPS. General gains To improve its own image and attract superior managerial talents to manage its affairs; To offer better satisfaction to consumers or users of the product.

6.

Own developmental plans

The purpose of acquisition is basked by the offeror companys own development plans. A company thinks in terms of acquiring the other company only when it has arrived at its own development plan to expand its operations having examined its own internal strength where it might not have any problem of taxation, accounting valuation, etc. but might feel resources constraints with limitation of funds and lack of skilled managerial personnel. It has to aim at a suitable combination where it could have opportunities to supplement its funs by issuance of securities; secure additional financial facilities eliminate competition and strengthen its market position. 7. Strategic purpose
6

The Acquirer Company views the merger to achieve strategic objectives through alternative type of combinations which may be horizontal, vertical, product expansional, market extensional or other specified unrelated objectives depending upon the corporate strategy. Thus, various types of combinations distinct with each other in nature are adopted to pursue this objective like vertical or horizontal combination. 8. Corporate friendliness

Although it is rare but it is true that business houses exhibit degrees of cooperative spirit despite competitiveness in providing rescues to each other from hostile takeovers and cultivate situations of collaborations sharing goodwill of each other to achieve performance heights through business combinations. The combining corporate aim at circular combinations by pursuing this objective. 9. Desired level of integration

Mergers and acquisitions are pursued to obtain the desired level of integration between the two combining business houses. Such integration could be operational or financial. This gives birth to conglomerate combinations. The purpose and the requirements of the offeror company go a long way in selecting a suitable partner for merger or acquisition in business combinations. Types of Mergers Merger or acquisition depends upon the purpose of the offeror company it wants to achieve. Based on the offerors objectives profile combination could be vertical, horizontal, circular and congromeratic as precisely described below with reference to the purpose in view of the offeror company.

1.

Vertical Combination

A company would like to takeover another company or seek its merger with that company to expand espousing backward integration to assimilate the sources of supply and forward integration towards market outlets. The acquiring company through merger of another unit attempts on reduction of inventories of raw material and finished goods, implements it production plans as per objectives and economises on working capital investments. In other words, in vertical combinations, the merging undertaking would be either a supplier or a buyer using its product as intermediary material for final production. The following main benefits accrue from the vertical combination to the acquirer company i.e. (1) it gains a strong position because of imperfect market of the intermediary products, scarcity of resources and purchased products; (2) has control over product specifications. 2. Horizontal combinations
7

It is a merger of two competing firms which are at the same stage of industrial process. The acquiring firm belongs to the same industry as the target company. The main purpose of such mergers is to obtain economies of scale in production by eliminating duplication of facilities and operations and broadening the product line, reduction in investment in working capital, elimination of competition concentration in product, reduction of advertising costs, and increase in market segments and exercise of better control on market. 3. Circular Combination

Companies producing distinct products seek amalgamation to share common distribution and research facilities to obtain economies by elimination of cost of duplication and promoting market enlargement. The acquiring company obtain benefits in the form of economies of resource sharing and diversification. 4. Conglomerate Combination

It is amalgamations of two companies engaged in unrelated industries like DCM and Modi Industries. The basic purpose of such amalgamations remains utilisation of financial resources and enlarges debt capacity through re-organising their financial structure so as to service the shareholders by increased leveraging and EPS, lowering average cost of capital and thereby raising present worth of the outstanding shares. Merger enhances the overall stability of the acquirer company and creates balance in the companys total portfolio of diverse products and production processes. 5. Within Stream Mergers

Such mergers take place when subsidiary company merges with parent company or parent company merges with subsidiary company. The former arrangement is called down stream merger whereas the latter is called up stream merger. For example, recently, the ICICI Ltd. a parent company has merged with its subsidiary ICICI Bank signifying down stream merger. Such mergers are very common in the corporate world. Another instance of up stream merger is the merger of Bhadrachalam Paper Board, subsidiary company with the parent ITC Ltd. and likewise. 6. Objectives of takeover or merger

Takeover or merger, in practice, depends upon the motives of the persons behind such move. They adopt according to their convenience the route which leads to attaining their goal of acquiring the controlling interest in the voting rights or the assets in part or in whole of the target company. Generally, the following types of decisions limit their choice for a particular firm in which takeover or merger activity could be organised: (a) (b) (c) Acquisition of shares in the target company; Acquisition of the assets of the target companys undertaking; Acquisition for full or part ownership of the target undertaking;
8

Acquisition for cash or for shares or other securities of the Offeror Company or combination of cash and variety of securities. (e) Attitude of offeror company towards its own shareholders for availing of the tax relief under the tax-laws for income, capital gains, exemptions in stamp duty, corporations tax, etc.; (f) Possibilities of friendly acquisition and the percentage of shareholding in Target Company available through persons agreeable to merger or takeover; (g) Attitude of the management (board) of the offeror company to have exclusive control of the affairs of the target company on acquisition or share the management of combined company with the direction of the target company; (h) Legal formalities to be compiled with under various corporate laws the provisions of which are attracted in effecting takeover or merger of the two or more companies; (i) Means of finance available with Offeror Company to pay off for the acquisition of shares, loan, stocks or assets of the target company; (j) The types of securities available with target company for acquisition and their possible adjustment in the capital structure of the combined company particularly of the loan stock convertible securities, warrants, options or subscription rights outstanding which require appropriate arrangements to be made by the offeror. (k) Involvement of financial institutions and banks as lenders of long-term finance and stake in the equity capital of the target company, the chances of obtaining their approval and also availing of further finance from them for the combined company. (l) Valuation of shares of Target Company, valuation of shares of combined company; (m) Favourable features in the Memorandum and Articles of Association of the two companies with powers of the Board to go for acquisition for offeror company and to get for sale of undertaking for the offeree company through takeover or merger, etc.; (n) Future plans of the combined company towards its business. Reasons for merger or takeover There is not one single reason for a merger or takeover but a multitude of reasons cause mergers and acquisitions which are precisely discussed below: (1) Synergistic operating economies

(d)

It is assumed that existing undertakings are operating at a level below optimum. But when two undertakings combine their resources and efforts they may with combined efforts produce better results than two separate undertakings because of savings in operating costs viz. combined sales offices, staff facilities, plants management, etc. which lower the operating costs. Thus, the resultant economies are known as synergistic operating economies. The worth of the combined undertaking should be greater than the sum of the worth of the two separate undertakings i.e. 2+2 = 5. Synergy means working together. The gains obtained by working together by amalgamated undertakings result into synergistic operating gains. These gains are most likely to occur in horizontal mergers in which there are more chances for eliminating duplicate facilities. Vertical and conglomerate mergers do not offer these economies.

Among others, synergy is possible in areas viz. production, finance and technology. Merger of Hindustan Computers, Hindustan Reprographics, Hindustan Telecommunications and Indian Computer Software Company into HCL Limited exhibited synergy in transfer of technology and resources to enable the company to cut down imports of components at a fabulous duty of 198%. Similarly, Eicher had the synergy advantage in merging with subsidiaries Eicher Good Earch, Eicher Farm technology and finance as the company could borrow increased funds from banks and institutions. (2) Diversification

Mergers and acquisitions are motivated with the objective to diversify the activities so as to avoid putting all the eggs in one basket and obtain advantage of joining the resources for enhanced debt financing and better serviceability to shareholders. Such amalgamations result in creating conglomeratic undertakings. But critics hold that diversification caused by merger of companies does not benefit the shareholders as they can get better returns by having diversified portfolios by holding individual shares of these companies. (3) Taxation advantages

Mergers take place to have benefits of tax laws and company having accumulated losses may merge with a profit earning company that will shield the income from taxation. Section 72A of Income Tax Act, 1961 provides this incentive for reverse mergers for the survival of sick units.

(4)

Growth advantage

Mergers and acquisitions are motivated with a view to sustain growth or to acquire growth. To develop new areas becomes costly, risky and difficult than to acquire a company in a growth sector even though the acquisition is on premium rather than investing in a new assets or new establishments. (5) Production capacity reduction

To reduce capacity of production merger is sometimes used as a tool particularly during necessary times as was in early 1980 in USA. The technique is used to nationalise traditional industries. (6) Managerial motivates

Managers benefit in rank, status and perquisites as the enterprise grows and expands because their salaries, perquisites and status often increase with the size of the enterprise. The acquirer may motivate managerial support by assuring benefits of larger size of the company to the managerial staff. The resultant large company can offer better security for salary earners. (7) Acquisition of specific assets
10

Surviving company may purchase only the assets of the other company in merger. Sometimes vertical mergers are done with the motive to secure source of raw material but acquirer may purchase the specific assets of the acquiree rather than acquiring the whole undertaking with assets and liabilities. The assets may also be acquired at a discount to obtain a going concern cheaply. There can be many situations to take over the assets of a company at discount viz. (i) the acquiree may be in possession of valuable land and property shown at depreciated value/historical costs in books of account which underestimates the current replacement value. Thus, acquirer shall be benefited by acquiring the assets of the company and selling them off subsequently; (ii) to acquire non-profit making company, close down its loss making activities and sell off the profitable sector to make gains; (iii) the existing management is incapable of utilising the assets, the acquirer might take over ungeared company and increase its debt secured on acquirees assets. (8) Acquisition by management or leveraged buyouts

The acquisition of a company can be had by the management personnel. It is known as management buyout. This practice is common in USA for over 25 years and quite in vogue in UK. Management may raise capital from the market or institutions to acquire the company on the strength of its assets, known as leveraged buyouts. (9) Other reasons

There may be many other reasons motivating mergers in addition to the above ones viz. profit enhancement for the company, achieving efficiency, increasing market power, tax and accounting opportunities, growth as a goal and many speculative goals etc. depending upon the circumstances and prevailing conditions within the company and the economy of the country. Advantages of mergers and takeovers Mergers and takeovers are permanent form of combinations which vest in management complete control and provide centralised administration which are not available in combinations of holding company and its partly owned subsidiary. These are in general the advantages which accrue to the organisation besides multitude of gains already discussed. Shareholders in the selling company gain from the merger and takeover as the premium offered to induce acceptance of the merger or takeover offers much more price than the book value of shares. Shareholders in the buying company gain in the long run with the growth of the company not only due to synergy but also due to books trapping earnings. Motivation for mergers and acquisitions
11

Mergers and acquisitions are caused with the support of shareholder, managers and promoters of the combining companies. The factors which motivate the shareholders and managers to lend support to these combinations and the resultant consequences they have to bear are briefly noted below based on the research work done by various scholars globally. (1) From the standpoint of shareholders

Investments made by shareholders in the companies subject to merger should enhance in value. The sale of shares from one companys shareholders to another and holding investment in shares should give rise to greater values i.e. the opportunity gains in alternative investments. Shareholders may gain from merger in different ways viz. from the gains and achievements of the company i.e. through (a) realisation of monopoly profits; (b) economies of scale; (c) diversification of product line; (d) acquisition of human assets and other resources not available otherwise; (e) better investment opportunity in combinations. Realisation of gains from the merger and acquisition to shareholder in the above form might not be generalised but one or more features would generally be available in each merger where shareholders may have attraction and favour merger.

(2)

From the standpoint of managers

Managers are concerned with improving operations of the company managing the affairs of the company effectively for all round gains and growth of the company which will provide them better deals in raising their status, perks and fringe benefits. Mergers where all these things are the guaranteed outcome get support from managers. At the same time, where managers have fear of displacement at the hands of new management in amalgamated company and also resultant depreciation from the merger then support from them becomes difficult. (3) Promoters gains Mergers do offer to company promoters the advantage of increasing the size of their company and the financial structure and strength. They can convert a closely-held and private limited company into a public company without contributing much wealth and without losing control. In the above example of HCL, only Hindustan Reprographics Ltd. was public company whereas the other three merging entities were private limited companies. The promoters of Hindustan Computers were allotted shares worth Rs.1.27 crores on merger in a new company called HCL equity of Rs.1.48 crores shares. This gain was against their original investment of meagre Rs.40 lakhs in Hindustan Computers and they did not invest any money extra in getting shares worth Rs.1.48 crores. Another recent example is of Jaiprakash Industries which was formed out of merger of Jaiprakash Associates and Jay Pee Rewa Cement. Jaiprakash Associates was a closely-held company. The merger enabled the promoters to have stake at 60% (Rs.39.85 crores) in
12

Jaiprakash Industries Ltd. against an investment of Rs.4.5 Crore in Jaiprakash Associates. Thus, merger invariably results into monetary gains for the promoters and their associates in the surviving company. Impact of mergers on general public Impact of mergers on general public could be viewed as aspect of benefits and costs to: (1) Consumers of the product of services; (2) Workers of the companies under combination; (3) General public affected in general having not been user or consumer of the worker in the companies under merger plan. (1) Consumers

The economic gains realised from mergers (i.e. enhanced economies and diversification leading to lower costs and better quality products) are passed on to consumers in the form of lower prices and better quality of the product which directly raise their standard of living and quality of life. The balance of benefits in favour of consumers will depend upon the fact whether or not the mergers increase or decrease competitive economic and productive activity which directly affect the degree of welfare of the consumers through changes in price levels, quality of products, after sales service, etc. (2) Workers community

The benefit or loss from mergers to worker community will depend upon the level of satisfaction of their demands, merger of companies provides in the form of employment, increased wages, environmental improvements, better living conditions and amenities. The merger or acquisition of a company by a conglomerate or other acquiring company may have the effect on both the sides of increasing the welfare in the form of enhanced quality of life or decrease the welfare by creating unemployment through retrenchment and resultant lack of purchasing power and other miseries of life. Two sides of the impact as discussed by the researchers and academicians are: first, merges with cash payment to shareholders provide opportunities for them to invest this money in other companies which will generate further employment and growth to the uplift of the economy in general. Secondly, any restrictions placed on such mergers will decrease the growth and investment activity with corresponding decrease in employment. Both workers and communities will suffer on lessening job opportunities, preventing the distribution of benefits resulting from diversification of production activity. Diversification fosters and provides opportunities for advancement in career, training in new skills amount may other alike benefits. (3) General Public

Mergers result into centralised concentration of power in small number of corporate leaders which results in the concentration of an enormous aggregation of economic power in their hands.
13

Economic power is to be understood in specific limited sense as the ability to control prices and industries output as monopolists. Such monopolists affect social and political environment to tilt everything in their favour to maintain their power and expand their business empire. These advances result into deceleration of level of welfare and well being of the general public which are subjected to economic exploitation. But in a free economy a monopolist does not stay for a longer period as other companies enter into the field to reap the benefits of high prices set in by the monopolist. This enforces competition in the market as consumers are free to substitute the alternative products. Therefore, it is difficult to generalise that mergers affect the welfare of general public adversely or favourably. Every, merger of two or more companies has to be viewed from different angles in the business practices which protects the interest of the shareholders in the merging company and also serves the national purpose to add to the welfare of the employees, consumers and does not create hindrance in administration of the Government policies. Choice for alternative modes of acquisition The foregoing discussion reveals that the various terms used in business combinations carry generally synonymous connotations and can be used interchangeably as has been indicated while explaining the meanings of these terms. All the different terms carry one single meaning of merger but each term cannot be given equal treatment in the discussion because law has created a dividing line between take-over and acquisitions by way of merger, amalgamation or reconstruction. Particularly the takeover Regulations for substantial acquisition of shares and takeovers known as SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 1977 vide section 3 excludes any attempt of merger done by way of any one more of the following modes: (a) By allotment in pursuance of an application made under a public issue; (b) Allotment pursuant to an application made by the shareholders for right issue; (c) Preferential allotment made in pursuance of a resolution passed under section 81(1A) of the Companies Act, 1956; (d) Allotment of the underwriters pursuant to underwriters agreements; (e) Inter-se-transfer of shares amongst group companies, relatives (within the meaning of section 6 of the Companies Act, 1956, Indian promoters and foreign collaborators who are shareholders/promoters; (f) Acquisition of shares in the ordinary course of business, by registered stock brokers, public financial institutions and banks on own account or as pledges; (g) Acquisition of shares by way of transmission on succession or inheritance; (h) Acquisition of shares by government companies and statutory corporations;

14

(i) Transfer of shares from state level financial institutions to co-promoters in pursuance to agreements between them; (j) Acquisition of shares in pursuance to rehabilitation schemes under Sick Industrial Companies (Special Provisions) Act, 1985 or schemes of arrangements, mergers, amalgamation, demerger, etc. under the Companies Act, 1956 or any law or regulations, Indian or foreign; (k) Acquisition of shares of company whose shares are not listed on any stock exchange. However, this exemption is not available if the said acquisition results into control of a listed company; (l) Such other cases as may be exempted from the applicability of Chapter III of SEBI regulations by SEBI. The basic logic behind substantial disclosure of takeover of a company through acquisition of shares is that the common investors and shareholders should be made aware of the larger financial stake in the company of the person who is acquiring such companys shares. The main objective of these Regulations is to provide greater transparency in the acquisition of shares and the takeovers of companies through a system of disclosure of information. Consideration of Merger and Takeover Merger and takeovers are two different approaches to business combinations. Mergers are pursued under the Companies Act, 1956 vide sections 391/394 thereof or may be envisaged under the provisions of Income-tax Act, 1961 or arranged through BIFR under the Sick Industrial Companies (Special Provisions) Act, 1985 whereas takeovers fall solely under the regulatory frame work of the SEBI (Substantial Acquisition of Shares & Takeovers) Regulations, 1997.

15

Procedure of organising takeover bids The procedure for organising takeover bids as narrated in the following paragraphs is based on international practices in particular the City Code. However, once an understanding is developed, the procedure should be streamlined in terms of the SEBI Takeover Regulations, 1997 which, of course, do not lay down the procedure but prescribe a restrictive drill to safeguard the interests of the investors and shareholder. Takeover bids are organised in a systematic way by one company offering to acquire shares of another company to gain sufficient shares and voting control of the company. The following steps generally take place in a takeover bid. (1) Collection of relevant information and its analysis

The potential bidder should collect all possible relevant information on the target or offeree company, analyse the information through experts from financial, accounting, tax and legal angles, and keep the information and appraisal results top secret. (2) Examine shareholders' profile

Potential bidder should examine the share register of the target company and see the profile of the shareholders i.e. the number and weight of institutional investors and small shareholders. If the directors of the target Company cooperate, it can also trace the dividend register to find out number of shareholders not traceable to design the course of its bid. (3) Investigation of title and searches into indebtedness

Potential bidder should also have the searches carried out in Land Registry Office and Registrar of Companies office to find out the extent of encumbrance on offeree's properties and the indebtedness. (4) Examining of articles of association

The offeror should also examine the Articles of Association of the offeree company to ascertain the extent of power of directors with regard to borrowing restrictions, etc. (5) Representation on board

The potential bidder should ensure first his entry or representation on the board of the offeree company and should win over some of the directors on the board to the suggested changes and
16

explore possibility of offer being successfully discussed on the board for takeover bid on convenient terms. This will ensure friendly takeover. (6) Press announcement

Once the board of the offeree company shows a sympathetic view, the joint preliminary announcement could be made for awareness of shareholders of the main terms of the offer. (7) Approval under FEMA

Necessary approvals under the Foreign Exchange Management Act, 1999 are required to be take by the companies, primarily under Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2000. (8) Recommendations to shareholders

Once the board of the offeree company agrees to the takeover bid it can bring to the notice of shareholders through circular, the merits of the takeover or merger and the advantages which will accrue to them from such amalgamation. In case the board does not approve of the move, the directors can also bring the fact tot he notice of the shareholders.

(9)

Improvement of conditions by offeror

In case a. group of shareholders oppose the proposal for bid, the offeror can circularise its rejoinder to the criticism of the bid and alternatively can announce improvement of the bid conditions through press. (10) Information about acceptance

The takeover offer is open for a limited time within which it should be accepted by the shareholders. The offeror should announce information about the acceptance for the knowledge of shareholders to know the response in its favour and make their own judgement. (11) Despatch of consideration

17

With a view to complete the transaction with the shareholders of the offeree company the bidder should despatch consideration for the shares in the offeree company to the shareholders who have accepted the offer and submitted valid acceptances with the share certificates or other documents of title. The offeror will take further steps for registration of shares in its own name as per provisions of the Companies Act, 1956 Stock Exchange Rules & Regulations, etc. 10. INFORMATION IN THE OFFER DOCYMENTS

The offer document should contain the following information for the shareholders of the offeree company about the offer: (1) General information

Should cover the write up about offeror's intention to continue business, employment of existing employees, major changes to be intgroduced, justification for the offer.

(2)

Identity and financial means of the offeror

Offer document must disclose fullidentity of the person making offer, their business connections and means of finance, etc., ability to run the company's business for the good of the shareholders.

(3)

Terms of the offer

Should state the acquisition of shares free from all lien, charges and encumbrances, total consideration offered for the shares in cash or kind, and the mode of payment, the basis for arriving at the said consideration like net assets value, etc., duration for which the offer to remain open, conditions attached to the offer like minimum number of shares, share for-share offer with condition of approval of shareholder required in general body, share-for-share (new share being admitted on list by stock exchange), etc. etc. (4) Information on strength of offeror

Information regarding offeror company and its shares ranking of shares for dividend, listing status, market price financial information, etc. (5) Comparative view of offeree

18

Information about offeree companyand its shares listing status, market price, financial information, etc. in comparison with offeror's own strength be furnished. (6) Profit forecast and asset valuation about offeror

The projections should be reasonable and supported by the future growth plans of the offeror. (7) Existing shareholdings in offeree company

The offerer should give details of its existing shareholdings in the offeree company. (8) Information on management pattern

Information relating to directors of offeeror and offeree company, their shareholdings, emoluments, professional skills, achievements, etc. (9) Arrangement for acceptance

The offerer should spell out for convenience of the shareholders of offeree the various arrangements it has made to materialise the acceptance viz. underwriting arrangements, appointment of merchant bankers who on behalf of offeror shall make offer to purchase from accepting shareholders for cash at a stated price, the shares and/or loan stock in the offeree company, etc. The above information should cover the following particulars required to be made in public announcement vide regulation 16 of SEBI Takeover Regulations, 1997: (i) (ii) (iii) (iv) (v) the paid up share capital of the target company, the number of fully paid up and partly paid up shares; the total number and percentage of shares proposed to be acquired from the public, subject to a minimum as specified in sub-regulation (I) of Regulation 21; the minimum offer price for each fully paid up or partly paid up share; mode of payment of consideration; the identity of the acquirer(s) and in case the acquirer is a company or companies, the identity of the promoters and, or the persons having control over such company(ies) and the group, if any, to which the company(ies) belong; the existing holding, if any, of the acquirer in the shares of the target company, including holding of persons acting in concert with him;
19

(vi)

(vii)

salient features of the agreement, if any, such as the date, the name of the seller, the price at which the shares are being acquired, the manner of payment of the consideration and the number and percentage of shares in respect of which the acquirer has entered into the agreement to acquire the shares or the consideration, monetary or otherwise, for the acquisition of control over the target company, as the case may be;

(viii) the highest and the average price paid by the acquirer or persons acting in concert with him for acquisition, if any, of shares of the target company made by him during the twelve month period prior to the date of public announcement; (ix) object and purpose of the acquisition of the shares and future plans, if nay, of the acquirer for the target company, including disclosures whether the acquirer proposes to dispose of or otherwise encumber any assets of the target company in the succeeding two years, except in the ordinary course of business of the target company:

Provided that where the future plans are set out the public announcement shall also set out how the acquirers propose to implement such future plans; the specified date as mentioned in Regulation 19; the date by which individual letters of offer would be posted to each of the shareholders; the date of opening and closure of the otter and the manner in which and the date by which the acceptance or rejection of the offer would be communicated to the shareholders; the date by which the payment of consideration would be made for the shares in respect of which .the offer has been accepted; disclosure to the effect that firm management for financial resources required to implement the offer is already in place, including details regarding the sources of the funds whether domestic i.e., from banks, financial institutions, or otherwise. or foreign i.e. from Non-resident Indians or otherwise; provision for acceptance of the offer by person(s) who own the shares but are not the registered holders of such shares; statutory approvals, if any, required to be obtained for the purpose of acquiring the shares under the Companies Act, 1956 (1 of 1956), the Monopolies and Restrictive Trade Practices Act, 1969 (54 of 1969), the Foreign Exchange Regulation Act, 1973 (46 of 1973), and/or any other applicable laws;

(x) (xi) (xii)

(xiii) (xiv)

(xv) (xvi)

(xvii) approvals of banks or financial institutions required, if any; (xviii) whether the offerer is subject to a minimum level of acceptances from the shareholders; and

20

(xix)

such other information as is essential for the shareholders to make an informed decision in regard to the offer.

In addition to the above tl1e offer should contain the following information also: (a) Specified date for the purpose of determining the names of the shareholders to whom the letter of offer should be sent. Such date shall not be later than 30th day from the date of public announcement (see regulation 19). Minimum offer price should be stated as payable and shall be ascertained in terms of regulation 20. Minimum number of shares to be acquired as specified in regulation 21 of the SEBI Takeover Regulations. The officer shall observe the general obligations laid down under regulation 22 of the SEBI Takeover Regulations.

(b)

(c)

(d)

It has been prescribed vide regulation 17 of SEBI Regulations, 1997 that public announcement of the offer or any other advertisement, circular, brochure, publicity material or letter of offer issued in relation to the acquisition of shares shall not contain any misleading information. Within 14 days from the date or public announcement, the acquirer shall file through its merchant banker with the SEBI the draft of letter of offer containing disclosures as specified by SEBI alongwith the fee of Rso 50,0000. The letter of offer shall be dispatched to the shareholders not earlier than 21 days from its submission to SEBI In case SEBI had suggested some changes, the same shall be incorporated in letter of offer before dispatch to shareholders. 11. DEFENCE AGAINST TAKEOVER BID

The Directors of the company hold command of the affairs of a company. They owe moral responsibility to protect the interest of the shareholders and also safeguard the existence of the company ensuring continuity of its business activity on profitable footing and warding off the unscrupulous corporate raiders striving to take over possession of its assets and control of its affairs. They hold fiduciary position in the company and should place all facts about tile company before the shareholders. The power of management delegated to the board must be exercised bona fide in the interest of the company. In takeover bids, it is the responsibility of the directors to take defensive measure to check them and thwart away the bids. London City Code places very stringent obligation upon the directors of an offeree company faced with an offer. They must accurately, fairly and promptly place before their shareholders all the facts necessary for forming an informed judgment as to the merits and demerits of the offer. Directors must secure their position of control against the imminent change attempt.
21

Directors have been vested with powers under section 111 of the Companies Act, 1956 to refuse registration of shares in the circumstances when it is not in the interest of the existence of the company in takeover bids, etc. Besides the above statutory power the company can take the following defensive measures to thwart away takeover bids; (1) (2) Advance preventive measures for defence. Defence in face takeover bid.

(1)

Advance preventive measures for defence

Offeree company should take precautions when it feels that takeover bid is imminent through market reports and available information so that the attempt of takeover bid by the corporate raider could be avoided successfully. Some of the prominent advance measures as derived from the experiences of the advanced nations and the prevalent laws and practices in India are discussed below.

22

A.

JOINT HOLDINGS OR JOINT VOTING AGREEMENT

Two or more major shareholders may enter into agreement for block voting or block sale of shares rather than separate voting or separate sale of shares. This agreement is entered into in collaboration with or with the cooperation of offeree companys directors who wish to exercise effective control of the company. B. INTERLOCKING SHAREHOLDINGS OR CROSS SHAREHOLDINGS

Two or more group companies acquire shares of each other in large quantity or one company may distribute shares to the shareholders of its group company to avoid threads of takeover bids. Such companies shall fall within the same management control and attract provisions of section 372 of the Companies Act, 1956. If the interlocking of shareholdings is accompanied by joint voting agreement then the joint system of advance defence could be termed as pyramiding as most safe device of defence. C. ISSUE OF BLOCK OF SHARES TO FRIENDS AND ASSOCIATES

With a view to forestall a takeover bid, the directors issue block of shares to their friends and associates to continue maintaining their controlling interest and as a safeguard to the threads of dislodging their control position. This may also be done by issue of rights shares. D. DEFENSIVE MERGER

The directors of a threadtened company may acquire another company for shares as a defensive measure to forestall the unwelcome takeover bid. For this purpose they put large block of shares of their own company in the hands of shareholders of the friendly company to make their own company least attractive for takeover bid. E. SHARES WITH NON-VOTING RIGHTS LIKE PREFERENCE SHARES

In India, so far, non-voting right shares are only of one variety i.e. preference shares or cumulative convertible preference shares as against a wide variety of restricted or weighted voting rights equity shares under English Company Law. Management may retain shares with voting rights so that takeover bid could be thwarted away without voting support. Non-voting shares are a convenient method of providing for any desired adjustment of control on a merger of two companies. F. CONVERTIBLE SECURITIES

To make the company less attractive to corporate raiders, it is necessary that its capital structure should contain loan capital by way of debentures either convertible in part or full or nonconvertible. This is so because any successful bidde cant acquire compulsorily convertible securities, options or warrants because liability towards repayments of principal and payment of interest discourages takeover bids.

23

G.

DISSEMINATION TO SHAREHOLDERS OF FAVORABLE FINANCIAL INFORMATION

To make the investors and the shareholders aware, it is necessary that true earning position of the company should be told to them through press media or direct communications to ensure continuity of their interest in the management set up of the company. The dissemination of information about the companys favourable features of operations and profitability go a long way in bringing the market price of share nearer to its true assets value. This type of behaviour on the part of the directors of the company elicit confidence of shareholders in their management and control which will in many ways help prevent any takeover bid to set in or to succeed. H. DEFERMENT OF SHAREHOLDERS CONTROL OVER THE COMPANYS ASSETS

Prudent board of directors make the chances of any takeover bid in near future dim by making the possession of the companys assets less attractive. This is possibly dine by putting the assets outside the control of the shareholders by entering into various types of financial arrangements like sale and lease back, mortgage of the assets to financial institutions for long-term loans, keeping the assets in trust for security of debenture, loan, etc. This is done with the specific approval of shareholders in their general meetings in pursuance of sections 293(1) (a) and (b) of the Companies Act, 1956. I. LONG-TERM SERVICE AGREEMENTS

Directors having specialised skills in any specific technical field may enter into contract with the company with specific approval of shareholders and/or the Central Government under the Companies Act, 1956 or the rules framed thereunder for rendering service over a period of time. There are two significant aspects of such an agreement viz. the prospective bidder would not be attracted due to the fear of non-cooperation by such directors if the company is acquired without personal involvement of such directors and secondly, the bidder will have to pay handsome compensation for terminating the agreement or the technical assistance or services provided under the said agreement might not be made available by any other outside party. In view of these circumstances the takeover game becomes unattractive to the bidders. J. OTHER PREVENTIVE MEASURES

The companies take various other preventive and precautionary measures to thwart away acquisition bids in future viz. (i) maintaining a fraction of share capital uncalled which can be called up during any emergency like takeover bid or liquidation threat. This strategy is known as Rainy day call, (ii) companies may from a group or cartel to fight against any future bid of takeover against any of their member companies and maintain a pool of funds to use it to counter the takeover bids. This technique is known an anti-takeover cartel. To sum up, the above preventive measures are only illustrative and not exhaustive as in different circumstances appropriate measures are adopted which continue adding up to the above list.

24

It may be noted that SEBI Takeover Regulations, 1997 facilitate takeover bid ensuring safeguard to the interest of the investors/shareholders. The general obligations prescribed under regulation 23 for the board of directors of the target company should be taken into consideration while using the above preventive measures as defence against takeover bids. These general obligations are operative only after the date of public announcement of the offer. As such, the above measures can be carefully adopted to thwart away the advances of the predators. (2) Defence in face of takeover bid

A company might be caught by surprise when a takeover bid is made by some outside to acquire control of its management. A company is supposed to take defensive steps when it come to comes to know that some corporate raider has been making efforts for takeover. In different circumstances, different devices for defence device or in multiple of two or more devices suiting the defence strategy planned and adopted by the board of directors of the offeree company. For defence against takeover bid two types of strategies could be suggested which are based on the experience of the developed nations viz. (a) Commercial strategies; and (b) tractical strategies. A. (i) COMMERCIAL STRATEGIES Dissemination of favourable information

To have defence against the offeror being critical of the companys past performance the target company should be ready with profits forecast and performance information to demolish the offerors arguments. The threatened company should keep their shareholders abreast of all latest developments particularly about the financial strength of the company as evidenced by market coverage, product demand, industry outlook and resultant profit forecast and value appreciation, etc. Disclosure of all these favourable aspects will keep the shareholders in good humour and they will always side with the existing management dislodging all the takeover bids. After attempt of takeover bid, the disclosure might miss the reliability and significance and invite criticism of directors keeping the shareholders in dark. (ii) Step up dividend and update share price record

The fall in the market price of shares might occur due to restrictive dividend policy of the company. The company should, therefore. This will, automatically, bolster up the price of its shares and frustrate the takeover bid, for raising expectations for higher dividend, the company should in advance declare interim dividend and meet all statutory requirements of stock exchange of giving advance information and deciding date of closure of register of members, etc. In pursuance of the provisions of the Companies Act, 1956 declaration of final dividend is to be done at the annual general meeting of a company but interim dividend can be declared by the board to indicate the clear intentions of the company for stepping up the dividend.

25

(iii)

Revaluation of Assets

Assets shown at depreciated historical costs in financial accounts understate the real value of assets. For defence strategy it is common practice to revalue the assets periodically and incorporate them in the balance sheet. Such valuation should be attested by recognized values. (iv) Capital structure reorganization

Proper capital structure is essential for enhanced profitability and brightening of the dividend prospects. Capital structure which is under geared or geared with tax inefficient preference capital instead of debenture stock or term loans exhibits poor financial performance of the company and is required to be reorganized for proper gearing and tax efficiency. Company may take suitable steps to replace preference capital by loan capital. In those cases where the company has excess liquidity there are chances of takeover raids. The company should use liquid resources for financial acquisition of assets, replacements, expansion programme, etc. or distribute the surplus to shareholders through bonus and rights issues. The company should have expert advice from financial consultants on the issue of capital restructuring before implementing any conceived plan to thwart away the takeover bid. (v) Unsuitability of offeror

Research based arguments should be prepared to show and convince the shareholders that the offeror is incapable of managing the business efficiently. The management style, the profit and dividend record of the offeror in existing companies should be focussed particularly, specific losses, skipping of dividend, lower market experience and other similar denouncing factors should be highlighted about the offeror and its associate concerns. (vi) Other commercial aspects

The target companys management in its defence strategy should, inter alia, trace out the various discouraging commercial features of the functioning of the offeror company which may convince its own shareholders to thwart away the take over bid and at the same time should highlight own favourable commercial aspects with optimistic and promising futuristic view like new product development, new business avenues, prospects and future growth, etc. B. (i) TACTICAL DEFENCE STRATEGIES Friendly purchase of shares

To stave off the takeover bid the directors of the company may persuade their friends and relatives to purchase the shares of the offeree company as they themselves cannot indulge into the game without serious violation of the existing rules and regulations or statutory prescription despite the bona fide defence against the bid. A company under the Indian law cannot purchase its own shares. Hence directors of the company have to take protective steps to persuade their friends to be shareholders in supports of their management and control of the company under threat of takeover bid.
26

(ii)

Emotional attachments, loyalty and patriotism

To ward off takeover bids, the board may make attempt to win over the shareholders through raising their emotions for continued association and attachment with the company as shareholder and raising fearsin their mind towards changes of the name of the company, independence of business and goodwill, etc. Particularly, institutional shareholders might yield to these reasoning. Similarly, takeover bid from a foreign controlled company could be warded off by invoking national interest and emotional feelings. Much will depend upon economic circumstances, political climate and the prospects of the trade in which the company is engaged. Arguments could also be made of the possible consequences which follow on takeover like retrenchment of work force, displacement of managerial, technical and financial executives, shifting work place and all possible miseries resulting from the successful takeover bid. Many times, such appeal works well to raise sentiments of shareholders to support the board of directors and confide with the management. (iii) Recourse to legal action

To dissuade the corporate raider, the target company can refuse registration of transfer of any of the grounds given under relevant sections of the Companies Act, 1956. To sum up, it is the responsibility of the directors to accept a takeover bid or thwart it away in the interest of the company. In averting the takeover bid the directors are not absolved of their liability under the law for making any wrong statements and painting in words any unrealistic position into high hopes for the future of the company. For example, profit forecasts made by them in the context of fighting off the takeover bid should be realistic, based on viable assumptions. In other words, they should not indulge in fraudulent acts against the interest of the shareholders. (iv) Operation White Knights

White knight is the term used in UK Financial markets for a bidder in acquisition pursuit. White knight enters the fray when the target company is raided by a hostile suitor. White knight offers a higher bid to the target company than the present predator who might not remain interested in acquisition and hence the target company is protected from losing to the corporate raid. While using this defence, the provisions of regulation 25 of SEBI Takeover Regulations providing a drill for competitive bids should be adhered to by the white knights, the target company and the predators. (v) Disposing of Crown Jewels

The precious assets in the company are called Crown Jewels to depict the greed of the acquirer under the takeover bid. These precious assets attract the raider to bid for the companys control. The term crown jewels was coined in USA in 1982. The company, as a defence strategy, in its own interest, sells these valuable assets at its own initiative leaving the rest of the company intact. Instead of them or mortgage them to creditors so that the attraction of free assets to the
27

predator is over. This defence is very much in vogue in UK but subject to regulations of City Code. SEBI Takeover Regulations vide regulation 23 thereof prescribes general obligations for the board of directors of the target company. Under the said regulation, it will be difficult for any target company to sell, transfer, renumber or otherwise dispose off or enter with an agreement for sale, transfer, encumbrance or for disposal of assets once the predator has made public announcement. Thus, the above defence can be used only before the predator makes public announcement of its intentions to takeover the target company. (vi) Pac-man' strategy

This term was coined in America in 1982. Under this strategy the target company attempts to takeover the hostile raider. This happens when the target company is quite larget than the predator. (vii) Compensation packages viz: Golden Parachutes or First Class Passengers strategy

The term Golden Parachute again was coined in USA and is very much in vogue since early 1980s. The term is known as first class passengers in UK. The strategy is common in UK and USA and envisages a termination package for senior executives and is used as a protection to the directors of the company against the takeover bids. This strategy is adopted as a precautionary measure by the companies in USA and UK to make the takeover bid very expensive. These compensation packages do exist in the company as both City Code in UK and Securities Exchange Commission in USA. (viii) Shark repellent character The companies change and amend their bye-laws and regulations to be less attractive for the corporate raider company. Such features in the bye-laws are called Shark Repellent character. US companies adopt this tactic as a precautionary measure against prospective bids. For example, shareholders approvals for approving combination proposal is fixed at minimum by 8095% of the shareholders and to call shareholders meeting for this purpose 75% of the board of directors consent is needed. (ix) Swallowing Poison Pills strategy There are many variants in this strategy. For example, as a tactical strategy, the target company might issue convertible securities which are converted into equity to deter the efforts of the offeror because such conversion dilutes the bidders shares and discourages acquisition. Another example, target company might raise borrowings distorting normal debt: equity ratio. (x) Green mail

A large block of shares is held by an unfriendly company, which forces the target company to repurchase the stock at a substantial premium to prevent the takeover. In a takeover bid this
28

could prove to be an expensive defence mechanism. (xi) Poison put

A covenant allowing the bond holder to demand repayment in the event of a hostile takeover. (xii) Grey knight

A friendly party of the target company who seeks to takeover the predator. To sum up, the target company may adopt a combination of various strategies for successfully averting the acquisition bid. All the above strategies are experience based and have been successfully used in developed nations, particularly in USA or UK and some of them have been tested in critical times by the companies in India also. Nevertheless, the above list is not exhaustive but only illustrative. In different circumstances and even, the scope for evolving more rapid strategies always remains for the target companies to defend their existence against takeover bids.

12.

COMBATING TAKEOVER BIDS

Indian corporates do not have adequate defense mechanism to tackle threat of a takeover bid. However, amendments in Companies Act, 1956 to effect the following changes might create factors for combating hostile takeover and also facilitate restructuring the corporates to increase global; competitiveness, viz.

(1)

Introduction of non-voting shares

Companies would be able to raise resources from the capital market without diluting the promoters stake. Value Created by Merger A merger will make economic sense to the acquiring firm if its shareholders benefit. Merger will create an economic advantage (EA) when the combined present value of the merged firms is greater than the sum of their individual present values as separate entities. For example, if firm P and firm Q merge, and they are separately worth V P and VQ, respectively, and worth VPQ in combination, then the economic advantage will occur if: VPQ > (VP + VQ) And it will equal to: EA = VPQ - (VP + VQ)
29

Suppose that firm P acquires firm Q. After merger P will gain the present value of Q i.e., VQ, but it will also have to pay a price (say in cash) to Q. Thus, the cost of merging to P is [Cash paid - VQ]. For P, the net economic advantage of merger (NEA) is positive if the economic advantage exceeds the cost of merging. Thus Net economic advantage = economic advantage cost of merging NEA = [VPQ - (VP + VQ) (cash paid VQ) The economic advantage i.e., [VPQ - (VP + VQ)], represents the benefits resulting from operating efficiencies and synergy when two firms merge. If the acquiring firm pays cash equal to the value of the acquired firm, i.e. cash paid VQ = 0, then the entire advantage of merger will accrue to the shareholders of the acquiring firm. In practice, the acquiring and the acquired firm may share the economic advantage between themselves. Example 1 Firm P has a total market value of Rs.18 Crore (12 lakh shares of Rs.150 market value per share). Firm Q has a total market value of Rs.3 Crore (5 lakh of Rs.60 market value per share). Firm P is considering the acquisition of Firm Q. The value of P after merger (that is, the combined value of the merged firms) is expected to be Rs.25 Crore due to the operating efficiencies. Firm P is required to pay Rs.4.5 Crore to acquire Firm Q. What is the net economic advantage to Firm P if it acquired Firm Q? It is the difference between the economic advantage and the cost of merger to P: NEA = [25 (18+3)] (4.5 - 3) = (4 1.5) = Rs. 2.5 Crore

The economic advantage of Rs.4 Crore is divided between the acquiring firm Rs.2.5 Crore and the target firm, Rs. 1.5 Crore. The acquiring firm can issue shared to the target firm instead of paying cash. The effect will be the same if the shares are exchanged in the ratio of cash-to-be-paid to combined value of the merged firms. In example, X = 12 + 0.18 X X - 0.18 X = 12 X = 12/0.82 = 14.63 lakh shares And the new shares price will be: 25/0.1463 = Rs.170.9. Firm Q will get 2.63 lakh shares of Rs. 170.9 each. Thus, the cost of acquisitions to Firm P remains the same: (2.63 lakh x Rs. 170.9) Rs. 3 Crore = Rs.1.5 Crore. In practice, the number of shares to be exchanged may be based on the current market value of the acquiring firm. Thus, in example 1, Firm Q may require 300,000 shares
30

(i.e., Rs.4.5 Crore/Rs. 150) of the acquiring Firm P. Now Firm P after merger will have 15 lakh shares of total value of Rs.25 Crore. The new share price will be: Rs.25/0.15 = Rs.166.67. The worth of shares given to the shareholders of Firm Q will be Rs.5 Crore (i.e., Rs.166.67 x 3 lakh). The cost of merger of Firm P is Rs.2 Crore (i.e., the value of share exchanged, Rs.5 Crore less the value of the acquired firm, Rs. 3 Crore). Thus, the effective cost of merger may be more when the merger is financed by issuing shares rather than paying cash.

Merger Negotiations: Significance of P/E Ratio and EPS Analysis In practice, investors attach a lot of importance to the earnings per share (EPS) and the price-earnings (P/E) ratio. The product to EPS and P/E ratio is the market price per share. In an efficient capital market, the market price of a share should be equal to the value arrived by the DEF technique. In reality, a number of factors may cause a divergence between these two values. Thus, in addition to the market price and the discount value of shares, the mergers and acquisitions decisions are also evaluated in terms of EPS, P/E ratio, book value etc. We have already discussed the impact of merger on these variables in the case of the merger of Sarangi Engineering Company and XL Company. In this section, we extend the discussion in a more formal manner in the context of the negotiations in terms of exchange of shares. Exchange Ratio The current market values of the acquiring and the acquired firms may be taken as the basis for exchange of shares. As discussed earlier, the share exchange ratio (SER) would be as follows: Share price of the acquired firm Pb Share exchange ratio = Share price of the acquiring firm = Pb The exchange ratio in terms of the market value of shares will keep the position of the shareholders in value terms unchanged after the merger since their proportionate wealth would remain at the pre-merger level. There is no incentive for the shareholders of the acquired firm, and they would require a premium to be paid by the acquiring company. could the acquiring company pay a premium and be better off in terms of the additional value of its shareholders? In the absence of net economic gain, the shareholders of the acquiring company would become worse-off unless the priceearnings ratio of the acquiring company remains the same as before the merger. For the shareholders of the acquiring firm to be better-off after the merger without any net economic gain either the price-earnings ratio will have to increase sufficiently higher or the share exchange ratio is low, the price-earnings into remaining the same. Let us consider the example in Example 3. Example 3 Shyama Enterprise is considering the acquisition of Rama Enterprise. The
31

following are the financial data of two companies: Shyama Enterpriseq Profit after tax (Rs. lakh) Number of shares (Lakh) EPS (Rs.) Market value per share (Rs.) Price-earnings ratio (times) Total market capitalization (Rs. lakh) 40,000 10,000 4 60 15 6,00,000 Rama Enterprise 8,000 4,000 2 15 7.5 60,000

Shyama Enterprise is thinking of acquiring Rama Enterprises through exchange of shares in proportion of the market value per share. If the price-earnings ratio is expected to be (a) pre-merger P/E ratio of Rama i.e. 7.5 (b) pre-merger P/E ratio of Shyama i.e. 15, (c) weighted average of pre-merger P/E ratio of Shyama and Rama i.e. 13.75, what would be the impact on the wealth of share-holders after merger? Since the basis of the exchange of shares is the market value per share of the acquiring (Shyama Enterprise) and the acquired (Rama Enterprise) firms, then Shyama would offer 0.25 of its shares to the shareholders of Rama: Pb Pa 15 = 60 = 0.25

In terms of the market value per share of the combined firm after the merger, the position of Ramas shareholders would remain the same; that is, their per share value would be: Rs. 60 x 0.25 = Rs.15. The total number of shares offered by Shyama (the acquiring firm) to Ramas (the acquired firm) shareholders would be: No. of shares exchanged = SER x Pre-merger number of Shares of the acquired firm (Pb/Pa) Nb = 0.25 x 4,000 = 1,000

And the total number of shares after the merger would be: N a + (SER) Nb = 10,000 + 1,000 = 11,000. The combined earnings (PAT) after the merger would be: Rs. 40,00 + Rs.8,000 = Rs. 48,000 and EPS after the merger would be: Post-merger combined PAT Post-merger combined EPS = Post-merger combined shares 40,000 + 8,000 10,000 + (0.25) 4,00 PATa + PATb = Na + (SER)Nb = Rs. 4.36

48,000 = 11,000

The earnings per share of Shyama (the acquiring firm) increase from Rs.4 to Rs.4.36, but for Ramas (the acquired firm) shareholders, it declined from Rs.2 to Rs.1.09; that is,
32

Rs.4.36 x 0.25 = Rs.1.09. Given the earnings per share after the merger, the post-merger value per share would depend on the price-earnings ratio of the combined firm. How would P/E ratio affect the wealth of shareholders of the individual companies after the merger? Table 12 shows the impact. Table 12 Rama and Shyama Enterprise: P/E Ratio Effect on value Market Value of Shyama Before After merger merger 60 60 60 32.70 65.40 60.00 Market Value of Rama Before After merger merger 15 15 15 8.18 16.35 15.00

P/E Ratio 7.50 15.00 13.75

EPS After Merger 4.36 4.36 4.36

Combined Firms Market Value Merger 32.70 65.40 60.00

Note that Ramas shareholders value in terms of their shareholding in Shyama is: MV after merger x 0.25. We can observe from Table 11 that the shareholders of both the acquiring and the acquired firms neither gain nor lose in value in terms if post-merger P/E ratio is merely a weighted average of pre-merger P/E ratios of the individual firms. The post-merger weighted P/E ratio is calculated as follows: Post-merger weighted P/E ratio: (Pre-merger P/E ratio of the acquiring firm) x (Acquiring firms pre-merger earnings / Post-merger combined earnings) + (Pre-merger P/E ratio of the acquired firm) x (Acquired firms pre-merger earnings + Post-merger combined earnings) P/Ew = (P/Ea) (PATa / PATc) + (P/Eb) x (PATb/PATc) Using Equation (5) in our example, we obtain: = (15) (40,000/48,000) + (7.5) (8,000/48,000) = 12.5 + 1.25 = 13.75. The acquiring company would lose in value if post-merger P/E ratio is less than the weighted P/E ratio. Any P/E ratio above the weighted P/E ratio would benefit both the acquiring as well as the acquired firms in value terms. An acquiring firm would always be able to improve its earnings per share after the merger whenever it acquires a company with a P/E ratio lower than its own P/E ratio. The higher EPS need not necessarily increase the share price. It is the quality of EPS rather than the quality
33

(5)

which would influence the price. An acquiring firm would lose in value if its post-merger P/E ratio is less than the weighted P/E ratio. Shyama Enterprise would lose Rs.27.30 value per share if P/E ratio after merger was 7.5. Any P/E ratio above the weighted P/E ratio would benefit both the acquiring as well as the acquired firm in value terms. When the post-merger P/E ratio is 15, Shyama gains Rs.5.40 value per share and Rama Rs.1.35. Why does Shyama Enterprises EPS increase after merger? Because it has a current P/E ratio of 15, and it is required to exchange a lower P/E ratio, i.e. SER x Pa 0.25 x 60 = EPSb =

P/E exchanged

= 7.5

Shyama Enterprises EPS after merger would be exactly equal to its pre-merger EPS if P/E ratio paid is equal to its pre-merger P/E ratio of 15. In that case, given Ramas EPS of Rs.2, the price paid would be Rs.30 or a share exchange ratio of 0.5. Thus, Shyama Enterprise would issue 0.5 x 4,000 = 2,000 shares to Rama Enterprise. The acquiring firms EPS after merger would be: Rs. 48,000/12,000 = Rs.4. It may be noticed that at this P/E ratio, Shyamas shareholders would have the same EPS as before the merger: 0.5 x Rs.4 = Rs.2. It can be shown that if the acquiring firm takes over another firm by exchanging a P/E ratio higher than its P/E ratio, its EPS will fall and that of the acquired firm would increase after the merger. Let us assume in our illustration that Shyama exchange a P/E ratio of 22.5 to acquire Rama. This implies a price of Rs.45 per share and a share exchange ratio of 0.75. The earnings per share after acquisition would be as follows: 40,000 + 8,000 Post merger EPS = 10,000 + 0.75 x 4,000 = Rs. 3.69 Thus, the acquiring firms EPS falls (from Rs. 4 to Rs. 3.69) and the acquired firms EPS increases (from Rs.2 to Rs.3.69 x 0.75 = Rs.2.77). Leveraged Buy-outs A leveraged buy-out (LBO) is an acquisition of a company in which the acquisition is substantially financed through debt. Debt typically forms 70-90 per cent of the purchase price and it may have a low credit rating. In the USA, the LBO shares are not bought and sold in the stock market, and the equity is concentrated in the hands of a few investors. Debt is obtained on the basis of the companys future earnings potential. LBOs generally involve payment by cash to the seller. When the managers buy their company from its owners employing debt, the leveraged
34

48,000 = 13,000

buy-out is called management buy-out (MBO). LBOs are very popular in the USA. It has been found there that in LBOs, the sellers require very high premium, ranging from 50 to 100 per cent. The main motivation in LBOs is to increase wealth rapidly in a short span of time. A buyer would typically go public after four or five years, and make substantial capital gains. Which companies are targets for the leveraged buy-out? In LBOs, a buyer generally looks for a company which is operating in a high growth market with a high market share. It should have a high potential to grow fast, and be capable to earning superior profits. The demand for the companys product should be known so that its earnings can be easily forecasted. A typical company for a leveraged buyout would be one which has high profit potential, high liquidity and low or no debt. Low operating risk or such companies allows the acquiring firm or the management team to assume a high degree of financial leverage and risk. Why is a lender prepared to assume high risk in a leveraged buy-out? A lender provides high leverage in a leveraged buy-out because he may have full confidence in the abilities of the managers-buyers to fully utilize the potential of the business and convert it into enormous value. His perceived risk is low because of the soundness of the company and its assumed, predictable performance. He would also guard himself against loss by taking ownership position in the future and retaining the right to change the ownership of the buyers if they fail to manage the company. The lender also expects a high return on his investment in a leveraged buy-out since the risk is high. He may, therefore, stipulate that the acquired company will go public after four or five years. A major portion of his return comes from capital gains. MBOs/LBOs can create a conflict between the (acquiring) managers and shareholders of the firm. The shareholders benefits will reduce if the deal is very attractive for the managers. This gives rise to agency costs. It is the responsibility of the board to protect the interests of the shareholders, and ensure that deal offers a fair value of their shares. Another problem of LBOs could be the fall in the price of the LBO target companys debt instruments (bonds/debentures). This implies a transfer of wealth from debenture holders to shareholders since their claim gets diluted. Debenture holders may, thus, demand a protection in the event of a LBO/MBO. They may insist for the redemption of their claims at par if ownership/control of the firm changes. Example 4 provides an example of a leverage buy-out and also explains the methodology for estimating the return and the share of ownership of the lender in such deals. Example 4 Hindustan Chemicals is a small size private limited company. The company manufactures as specialized industrial chemical. The large and medium size industrial companies are its buyers, and it commands about three-fourths of the market due to its
35

excellent quality, prompt delivery and reasonable price. The company is owned by Suraj Bhan Gupta and Mahesh Chand Goyal; both are chemical engineers and are collegedays friends. The current sales of the company are Rs.99.8 lakh, and the annual sales growth rate in the past years has been 12-13 per cent. The company has been showing good profits. It was been retaining profits and financing its activities internally without resorting to any external funding. Its earnings before interest and tax (EBIT) are Rs.18.41 lakh for the current year, giving a profit margin of 18.5 per cent and a 25 per cent return on assets. Tables 14 and 15 give summary of the companys profit and loss statements and balance sheet. Legal Measures against Takeovers The Companies Act restricts and individual or a company or a group of individuals from acquiring shares, together with the shares held earlier, in a public company to 25 per cent of the total paid-up capital. Also, the Central Government needs to be intimated whenever such holding exceeds 10 per cent of the subscribed capital. The Companies Act also provides for the approval of shareholders and the Central Government when a company, by itself or in association of an individual or individuals purchases shares of another company in excess of its specified limit. The approval of the Central Government is necessary if such investment exceeds 10 per cent of the subscribed capital of another company. These are precautionary measures against the takeover of pubic limited companies. Refusal to Register the Transfer of Shares In order to defuse situation of hostile takeover attempts, companies have been given power to refuse to register the transfer of shares. If this is done, a company must inform the transferee and the transferor within 60 days. A refusal to register transfer is permitted if: A legal requirement relating to the transfer of shares have not be compiled with; or The transfer is in contravention of the law; or The transfer is prohibited by a court order; or The transfer is not in the interest of the company and the public.

Protection of Minority Shareholders Interests In a takeover bid, the interests of all shareholders should be protected without a prejudice to genuine takeovers. It would be unfair if the same high price is not offered to all the shareholders of prospective acquired company. The larger shareholders (including financial institutions, banks and individuals) may get most of the benefits because of their accessibility to the brokers and the takeover deal makers. Before the small shareholders know about the proposal, it may be too late for them. The Companies Act provides that a purchaser can force the minority shareholder to sell their shares it:
36

The offer has been made to the shareholders of the company; The offer has been approved by at least 90 per cent of the shareholders of the company whose transfer is involved, within 4 months of making the offer, and The minority shareholders have been intimated within 2 months from the expiry of 4 months referred above.

If the purchaser is already in possession of more than 90 per cent of the aggregate value of all the shares of the company, the transfer of the shares of minority shareholders is possible if: The purchaser offers the same terms of all shareholders and The tenders who approve the transfer, besides holding at least 90 per cent of the value of shares should also form at least 75 per cent of the total holders of shares.

Guidelines for Takeovers SEBI has provided guidelines for takeovers. The guidelines have been strengthened recently to protect the interests of the shareholders from takeovers. The salient features of the guidelines are: Notification of takeover: If an individual or a company acquires 5 per cent or more of the voting capital of a company, the target company and the stock exchange shall be notified immediately. Limit to share acquisition: An individual or a company can continue acquiring the shares of another company without making any offer to other shareholders until the individual or the company acquires 10 per cent of the voting capital. Public Offer: If the holding of the acquiring company exceeds 10 per cent, a public offer to purchase a minimum of 20 per cent of the shares shall be made to the remaining shareholders through a public announcement. Offer price: Once the offer is made to the remaining shareholders, the minimum offer price shall not be less than the average of the weekly high and low of the closing prices during the last six months preceding the date of announcement. Disclosure: The offer should disclose the detailed terms of the offer, identity of the offerer, details of the offerers existing holdings in the offeree company etc. and the information should be make available to all the shareholders at the same time and in the same manner. Offer document: The offer document should contain, the offers financial information, its intention to continue the offeree companys business and to make major change and long-term commercial justification for the offer.
37

The objectives of the Companies Act and the guidelines for takeover are to ensure full disclosure about the mergers and takeovers and to protect the interests of the shareholders, particularly the small shareholders. The main thrust is that public authorities should be notified within two days. In a nutshell, an individual or company can continue to purchase the share without making and offer to other shareholders until the shareholding exceeds 10 per cent. Once the offer is make to other shareholders, the offer price should not be less than the weekly average price in the past 6 months or the negotiated price. Legal Procedures The following is the summary of legal procedures for merger or acquisition laid down in the Companies Act, 1956: Permission for merger: Two or more companies can amalgamate only when amalgamation is permitted under their memorandum of association. Also, the acquiring company should have the permission in its object clause to carry on the business of the acquired company. in the absence of these provisions in the memorandum of association, it is necessary to seek the permission of the shareholders, board or directors and the Company Law Board before affecting the merger. Information to the stock exchange: The acquiring and the acquired companies should inform the stock exchanges where they are listed about the merger. Approval of board of directors: The boards of the directors of the individual companies should approve the draft proposal for amalgamation and authorize the management of companies to further pursue the proposal. Application in the High Court: An application for approving the draft amalgamation proposal duly approved by the boards of directors of the individual companies should be made to the High Court. The High Court would convene a meeting of the shareholders and creditors to approve the amalgamation proposal. The notice of meeting should be sent to them at least 21 days in advance. Shareholders and creditors meetings: The individual companies should hold separate meetings of their shareholders and creditors for approving the amalgamation scheme. At least, 75 per cent of shareholders and creditors in separate meeting, voting in person or by proxy, must accord their approval to the scheme. Sanction by the High Court: After the approval of shareholders and creditors, on the petitions of the companies, the High Court will pass order sanctioning the amalgamation scheme after it is satisfied that the scheme is fair and reasonable. If it deems so, it can modify the scheme. The date of the courts hearing will be published in two newspapers and also, the Regional Director of the Company Law Board will be intimated.
38

Filling of the Court Order: After the Court order, its certified true copies will be filed with the Registrar of Companies. Transfer of assets and liabilities: The assets and liabilities of the acquired company will be transferred to the acquiring company in accordance with the approved scheme, with effect from the specified date. Payment by cash or securities: As per the proposal, the acquiring company will exchange shares and debentures and/or pay cash for the shares and debentures of the acquired company. These securities will be listed on the stock exchange. Accounting for Mergers and Acquisitions Mergers and acquisitions involve complex accounting treatment. A merger, defined as amalgamation in India, involves the absorption of the target company by the acquiring company, which results in the uniting of the interests of the two companies. The merger should be structured as pooling of interest. In the case of acquisition, where the acquiring company purchases the shares of the target company, the acquisition should be structured as a purchase. Pooling of Interests Method In the pooling of interests method of accounting, the balance sheet items and the profit and loss items of the merged firms are combined without recording the effects of merger. This implies that asset, liabilities and other items of the acquiring and the acquired firms are simply added at the book values without making any adjustments. Thus, there is no revaluation of assets or creation of goodwill. Let us consider an example as given in example 5.

Example 5 Firm T merges with Firm S. Firm S issues shares worth Rs. 15 crore to Firm Ts shareholders. The balance sheets of both companies at the time of merger are shown in Table 18. The balance sheet of Firm S after merger is constructed as the addition of the book values of the assets and liabilities of the merged firms. It may be noticed that the shareholders funds are recorded at the book value, although Ts shareholders received shares worth Rs.15 Crore in Firm S. They now own Firm S along with its existing shareholders. Table 18

39

Pooling of Interest: Merger of Firms S and T (Rs. crore) Combined Firm 61 21 82 28 36 18 82

Firm T Assets Net Fixed Assets Current assets Total Shareholders Fund Borrowings Current Liabilities Total Purchase Method 24 8 32 10 16 6 32

Firm S 37 13 50 18 20 12 50

Under the purchase method, the assets and liabilities of the acquiring firm after the acquisitions of the target firm are adjusted for the purchase price paid to the target company. Thus, the assets and liabilities after merger are re-valued. If the acquirer pays a price greater than the fair market value of assets and liabilities, the excess amount is shown as goodwill in the acquiring companys books. On the contrary, if the fair value of assets and liabilities is less than the purchase price paid, then this difference is recorded as capital reserve. Let us consider an example as given in Example-6. Example - 6 Firm S acquired Firm T by assuming all its assts and liabilities. The fair value of firm Ts fixed assets and current assets is Rs.26 crore. Current liabilities are valued at book value while the fair value of debt is estimated to be Rs.15 crore. Firm S raises cash of Rs.15 crore to pay to Ts shareholders by issuing shares worth Rs. 15 crore to its own shareholders. The balance sheets of the firms before acquisition and the effect of acquisition are shown in Table 19. The balance sheet of Firm S (the acquirer) after acquisition is constructed after adjusting assets, liabilities and equity. Table 19 Pooling of Interests: Merger of Firms S and T Firm T Assets Net Fixed Assets Current assets Goodwill Total Shareholders Fund Borrowings 24 8 -32 10 16 6
40

Firm S 37 13 -50 18 20 12

(Rs. crore) Combined Firm 63 20 3 86 33 35 18

Current Liabilities Total

32

50

86

The goodwill is calculated as follows: Payment to Ts shareholders Fair value of fixed assets Fair value of current assets Less: Fair value of borrowings Less: Fair value of current liabilities Fair value of net assets Goodwill 12 ____ Rs.3 Rs. 15 26 7 15 6

Financing Techniques in Mergers After the value of firm has been determined on the basis of the preceding analysis, the next step is the choice of the method of payment of the acquired firm. The choice of financial instruments and techniques of acquiring a firm usually have an effect on the purchasing agreement. The payment may take the form of either cash or securities, that is, ordinary shares, convertible securities, deferred payment plans and tender offers. Ordinary Share Financing: When a company is considering the use of common (ordinary) shares to finance a merger, the relative price-earnings (P/E) ratios of two firms are an important consideration. For instance, for a firm having a high P/E ratio, ordinary shares represent an ideal method for financing mergers an acquisition. Similarly, ordinary shares are more advantageous for both companies when the firm to be acquired has a low P/E ratio. This fact is illustrated in Table A. Table A Effect of Merger on Firm As EPS and MPS (a) Pre-merger Situation: Firm A Earnings after taxes (EAT) (Rs.) 5, 00,000 Number of shares outstanding (N) 1, 00,000 EPS (EAT/N) (Rs.) 5 Price-earnings (P/E) ratio (times) 10 Market price per share, MPS (EPS x P/E ratio) (Rs.) Total Market value of the firm (N x MPS) or (EAT x P/E ratio) (Rs.) 50,00,000 Firm B 2, 50,000 50,000 5 4 50 10,00,000

20

41

(b) Post-merger Situation Assuming share exchange ratio as 1:2.5* 1:1 7, 50,000 7, 50,000 1,20,000 6.25 10 62.50 75, 00,000 1,50,000 5 10 50 75,00,000

EATc of combined firm (Rs.) Number of shares outstanding after additional shares issues EPS (EATc/N) (Rs.) P/Ec ratio (times) MPSc (Rs.) Total Market value (Rs.) * Based on current market price per share

From a perusal of Table A certain fact stand out. The exchange ratio of 1:2.5 is based on the exchange of shares between the acquiring and acquired firm on their relative current market prices. This ratio implies that Firm A will issue 1 share for every 2.5 shares of Firm B. The EPS has increased from Rs.5 (pre-merger) to Rs.6.25 (postmerger). The post-merger market price of the share would be higher at Rs.6.25x10 (P/E ratio) = Rs.62.50. When the exchange ratio is 1:1 it implies that the shareholders of the Firm B earned a heavy premium per share Rs.30 in this case i.e. (Rs. 50 worth of shares against the post-merger situation Rs.20 worth of equity share in pre-merger situation). As shown in Table B, at such an exchange ratio, the entire merger gain (of Rs.15 lakh) accrues to the shareholders of Firm B. Evidently, this is the most favorable exchange ratio for shareholders of Firm B; the management of Firm A, in general, is not likely to agree to a more favorable exchange ratio (as it will decrease in shareholders wealth of Firm A). This is the tolerable exchange ratio from the perspective of Firm A. Likewise; the management of Firm B is not likely to agree to a share exchange ratio that is detrimental to the wealth of its shareholders. Such an exchange ratio is 1:3.25 (Table C). At this ratio the total gains accruing from the merger rests with the shareholders of Firm A. This is another set of tolerate exchange ratio from the viewpoint of Firm B. Thus, it may be generalized that the maximum and the minimum exchange ratio should be between these two sets of tolerable exchange ratio. The exchange ratio eventually negotiated/agreed upon would determine the extent of merger gains to be shared between the shareholders of the two firms. This ratio would depend on the relative bargaining position of the two firms and the market reaction of the merger move. Table B Apportionment of Merger Gains between the Shareholders of Firms A and B

42

(1) Total market value of the merged firm Less: Market value of the pre-merged Firms: Firm A Firm B 00,000 Total merger gains

Rs.75, 00,000

Rs. 50, 00,000 Rs. 10, 00,000

Rs. Rs. 15, 00,000

60,

(2) (a) Appointment of gains (assuming Share exchange ratio of 2.5:1) Firm A: Post-merger market value (1, 00,000 shares x Rs.62.50) Less: Pre-merger market value Gains for shareholders of Firm A Firm B: Post-merger market value (20,000 shares x Rs.62.50) Less: Pre-merger market value Gains for shareholders of Firm B (b) Assuming share exchange ratio of 1:1 Firm A: Post-merger market value (1,00,000 shares x Rs.50) Less: Pre-merger market value Gains for shareholders of Firm A Firm B: Post-merger market value (50,000 shares x Rs.50) Less: Pre-merger market value Gains for shareholders of Firm B Table C Determination of Tolerable Share Exchange Ratio for shareholders of Firms. Based on Total Gains Accruing to Shareholders of Firm A (a) Total market value of the merged firm (Combined earnings, Rs.7,50,000 x P/E ratio, 10 times) Less: Pre-merger or minimum post-merger value acceptable to shareholders of Firm B
43

62, 50,000 50, 00,000 12, 50,000 12, 50,000 10, 00,000 2, 50,000

25, 00,000 10, 00,000 15, 00,000

Rs.75,00,000

(b)

10,00,000

(c) (d) (e) (f)

(g) (h)

Post-merger market value of Firm A (a b) Dividend by the Number of equity shares outstanding in Firm A Desired post-merger MPS (Rs.65 lakh/1 lakh shares) Number of equity issues required to be issued in Firm A to have MPS of Rs.65 and to have post-merger value of Rs.10 lakh of Firm B, that is, (Rs. 10 lakh/Rs.65) Existing number of equity shares outstanding of Firm B Share exchange ratio (g)/(h) i.e. 50,000/15,385 for every 3.25 shares of firm B, 1 share in Firm A will be issued

65,00,000 1,00,000 Rs.65

15,385 50,000

1:3.25

Debt and Preference Shares Financing: From the foregoing discussion its is clear that financing of mergers and acquisitions with equity shares is advantageous both to the acquiring firm and the acquired firm when the P/E ratio is high. However, since some firms may have a relatively lower P/E ratio as also the requirements of some investors might be different, other types of securities, in conjunction with/in lieu of equity shares may be used for the purpose. In an attempt to tailor a security to the requirements of investors who seek dividend interest income in contrast to capital appreciation/growth, convertible debentures and preference shares might be used to finance mergers. The use of such sources of financing has certain advantages: (i) Potential earning dilution may be partially minimized by issuing convertible security. For example, assumed that the current market price of a share in the acquiring company is Rs.50 and the value of the acquired firm is Rs.50, 00,000. If the merger proposal is to be financed with equity, 1, 00,000 additional shares will be required to be issued. Alternatively, convertible debentures of the face value of Rs.100 with conversion ratio of 1.8, which imply a conversion value of Rs.90 (Rs.50 x 1.8), may be issued. To raise the required Rs.50, 00,000, 50,000 debentures convertible into 90,000 equity share would be issued. Thus, the number of shares to be issued would be reduced by 10,000, thereby reducing the dilution in EPS, which could ultimately result, if convertible security was not resorted to in place of equity shares. (ii) A convertible issue might serve the income objectives of the shareholders of the target firm without changing the dividend policy of the acquiring firm. (iii) Convertible security represents a possible way of lowering the voting power of the target company. (iv) Convertible security may appear more attractive to the acquired firm as it combined the protection of fixed security with the growth potential of ordinary shares. In brief, fixed income securities are compatible with the needs and purposes of mergers and acquisitions. The need for changing the financing leverage and the need for a variety of securities is partly resolved by the use of senior securities. Deferred Payment Plan: Under this method, the acquiring firm, besides making an
44

initial payment, also undertakes to make additional payments in future years to the target firm in the event of the former being able to increase earnings consequent to the merger. Since the future payment is linked to the firms earnings, this plan is also known as earn-out plan. Adopting such a plan ensures several advantages to the acquiring firm: (i) It emerges to be an appropriate outlet for adjusting the differences between the amount of shares the acquiring firm is willing to issue and the amount the target firm is agreeable to accept for the business; (ii) in view of the fact that fewer number of shares will be issued at the time of acquisition, the acquiring firm will be able to report higher EPS immediately; (iii) There is a build-in cushion/protection to the acquiring firm as the total payment is not made at the time of acquisition; it is contingent on the realization of the projected earnings after merger. There could be various types of deferred payments plans. The arrangement eventually agreed upon would depend on the imagination of the management of the two firms involved. One of the often used plans, for this purpose is the base-period earnout. Under this plan, the shareholders of the target firm are to receive additional shares for a specified number of future years, if the firm is able to improve its earnings vis--vis the earnings of the base period (the earnings in the previous year before the acquisition). The amount becoming due for payment, in shares, in the future years will primarily be a function of excess earnings, price-earnings ratio and the market price of the shares of the acquiring firm. The basis for determining the required number of shares to be issued as per the following Equation. (Excess earnings x P/E ratio) / Share price of Acquiring firm Example Company A has purchased Company B in the current year. Company B had its premerger earnings of Rs.3, 00,000. At the time of merger, its shareholders received an initial payment of 75,000 shares of Company A. The market value of Company A shares is Rs. 30 per share and the P/E ratio is 8. The projected post mergers earnings of Company B for the three years are Rs.3, 30,000 and Rs.4, 14,000. Assuming no changes in share prices and P/E ratio of Company A, determine the number of shares required to be issues to the shareholders of Company B during these three years. As per the agreement with Company B, they will receive shares for 3 years only. Thus, the shareholders of Company B will receive a total of 1, 37,400 shares (75,000 initially + 62,400 in the subsequent three years). In financial terms, they have received Company A, shares worth Rs.41.22 lakh (1, 37,400 shares x Rs.30). This sum is higher than the shareholders would have received initially. Assuming the P/E ratio of Company B is times (the assumption is reasonable in that the P/E ratio of Company A is 8 times: the P/E multiple of the acquiring firm is normally higher than that of the acquired firm), its valuation/purchase consideration would have been Rs.21 lakh only (Rs.3 lakh x 7 times). Clearly, there is a substantial gain to the shareholders of Company B and this gain is not at the cost of the wealth of the shareholders of Company A. evidently, the method is fair and equitable.
45

To conclude, the deferred plan technique provides a useful means by which the acquiring firm can eliminate part of the guesswork involved in purchasing a firm. In essence, it allows the merging management the privilege of hindsight. Rs. 30,000 x 8 Year 1: Rs. 90,000 x 8 Year 1: Rs. 1,14,000 x 8 Year 1: Rs.30 = 30,400 shares Rs.30 = 24,000 shares Rs.30 = 8,000 shares

Tender Offer: An alternative approach to acquire another firm is the tender offer. A tender offer, as a method of acquiring a firm, involves a bid by the acquiring firm for controlling interest in the acquired firm. The essence of this approach is that the purchase approaches the shareholders of the firm rather than the management to encourage them to sell their shares generally at a premium over the current market price. Since the tender offer is a direct appeal to the shareholders, prior approval of the management of the target firm is not required. As a form of acquiring firm, the tender offer has certain advantage and disadvantages. The disadvantages are: (i) If the target firms management attempts to block it, the cost it, the cost of executing the offer may increase substantially and (ii) the purchasing company fail to acquire a sufficient number of shares to meet the objectives of controlling the firm. The major advantages of acquisition through tender offer include: (i) if the offer is not blocked, say in friendly takeover, it may be less expensive than the normal mode of acquiring a company. This is so because it permits control by purchasing a smaller proportion of the Firm shares and (ii) the fairness of the purchase price is unquestionable as each shareholder individually agrees to part with the shares at that price.

46

CONCEPTUAL FRAMEWORK OF VALUATION

The term 'valuation' implies the task of estimating the worth/value of an asset, a security or a business. The price an investor or a firm (buyer) is willing to pay to purchase a specific asset/ security would be related to this value. Obviously, two different buyers may not have the same valuation for an

asset/business as their perception regarding its worth/value may vary; one may perceive the asset/business to be of higher worth (for whatever reason) and hence may be willing to pay a higher price than the other. A seller would consider the negotiated selling price of the asset/business to be greater than the value of the asset/business he is selling.

Evidently,

there

are

unavoidable

subjective

considerations involved in the task and process of

47

valuation. Inter-se, the task of business valuation is more awesome than that of an asset or an individual security. In the case of business valuation, the valuation is required not only of tangible assets (such as plant and machinery, land and buildings, office equipments, and so on) but also of intangible assets (like, goodwill, brands, patents, trademark and so on) as well as human resources that run/manage the business. Likewise, there is an imperative need to take into consideration recorded liabilities as well as unrecorded/contingent liabilities so that the buyer is aware of the total sums payable, subsequent to the purchase of business. Thus, the valuation process is affected by, subjective

considerations. In order to reduce the element of subjectivity, to a marked extent, and help the finance manager to carry out a more credible valuation exercise in an objective manner, the following concepts of value are explained in this Section: (i)
48

book value, (ii) market value, (iii) intrinsic value, (iv) liquidation value, (v) replacement value, (vi) salvage value, (vii) value of goodwill and (viii) fair value.

Book Value

The book value of an asset refers to the amount at which an asset is shown in the balance sheet of a firm. Generally, the sum is equal to the initial acquisition cost of an asset less accumulated depreciation. Accordingly, this mode of valuation of assets is as per the going concern principle of accounting. In other words, book value of an asset shown in balance does not reflect its current sale value.

Book value of a business refers to total book value of all valuable assets (excluding fictitious assets,
49

such as accumulated losses and deferred revenue expenditures, like advertisement, preliminary

expenses, cost of issue of securities not written off) less all external liabilities (including preference share capital). It is also referred to as net worth.

Market Value

In contrast to book value, market value refers to the price at which an asset can be sold in the market. The market value can be applied with respect to tangible assets only; intangible assets (in isolation), more often than not, do not have any sale value. Market value of a business refers to the aggregate market value (as per stock market quotation) of all equity shares "outstanding. The market value is relevant to listed companies only.

50

Intrinsic/Economic Value

The intrinsic value of an asset is equal to the present value of incremental future cash inflows likely to accrue due to the acquisition of the asset, discounted at the appropriate required rate of return (applicable to the specific asset intended to be purchased). It represents the maximum price the buyer would be willing to pay for such an asset. The principle of valuation based on the dis-counted cash flow approach (economic value) is used in capital budgeting decisions.

In the case of business intended to be purchased, its valuation is equivalent to the present value of incremental future cash inflows after taxes, likely to. accrue to the acquiring firm, discounted at the relevant risk adjusted discount rate, as applicable to the acquired business.
51

The

economic

value

indicates the maximum price at which the business can be acquired.

Liquidation Value

As the name suggests, liquidation value represents the price at which each individual asset can be sold if business operations are discontinued in the wake of liquidation of the firm. In operational terms, the liquidation value of a business is equal to the sum of (i) realisable value of assets and (ii) cash and bank balances minus the payments required to discharge all external liabilities. In general, among all

measures of value, the liquidation value of an asset/or business is likely to be the least.

Replacement Value

The replacement value is the cost of acquiring a new

52

asset of equal utility and usefulness. It is normally useful in valuing tangible assets such as office equipment and furniture and fixtures, which do not contribute towards the revenue of the business firm.

Salvage Value

Salvage value represents realisable/scrap value on the disposal of assets after the expiry of their economic useful life. It may be employed to value assets such as plant and machinery. Salvage value should be considered net of removal costs. Value of Goodwill

The valuation of goodwill is conceptually the most difficult. A business firm can be said to have 'real' goodwill in case it earns a rate of return (ROR) on invested funds higher than the ROR earned by similar firms (with the same level of risk). In
53

operational terms, goodwill results when the firm earns excess ('super') profits. Defined in this way, the value of goodwill is equivalent to the present value of super profits (likely to accrue, say for 'n' number of years in future), the discount rate being the required rate of return applicable to such business firms. The value of goodwill in terms of the present value of super profits method can serve as a useful benchmark in terms of the amount of .goodwill the firm would be willing to pay for the acquired business. In the case of mergers and acquisition decisions, the value of goodwill paid is equal to the net difference between the purchase price paid for the acquired business and the value of assets acquired net of liabilities the acquiring firm has undertaken to pay for.

Fair Value
54

The concept of 'fair' value draws heavily on the value concepts discussed above, in particular, book value, intrinsic value and market value. The fair value is hybrid in nature and often is the average of these three values. In India, the concept of fair value has evolved from case laws (and hence is more statutory in nature) and is applicable to certain specific transactions, like payment to minority shareholders.

It may be noted that most of the concepts related to value are 'stock' based in that they are guided by the worth of assets at a point of time and not the likely contribution they can make towards earnings/cash flows of the business in the future. Ideally, business valuation should be related to the cash flow generating ability of acquired business. The intrinsic value reflects the firm's capacity to generate cash flows over the long-run and, hence, seems to be
55

more aptly suited for business valuation.

In fact, in general, business firms are not acquired with the intent to sell their assets in the postacquisition period. They are to be deployed primarily for generating more earnings. However, from the conservative point of view, it will be useful to know the realisable value, market value, liquidation value and other values, if the acquiring firm has to resort to liquidation. In brief, the finance manager will find it useful to know business valuation from different perspectives. For instance, the book value may be very relevant form accounting/tax purposes; the market value may be useful in determining share exchange ratio and liquidation value may provide an insight into the maximum loss, if the business is to be wound up.

56

APPROACHES/METHODS OF VALUATION

The various approaches to valuation of business with focus on equity share valuation are examined in this Section. These approaches should not be considered as competing alternatives to the dividend valuation model. Instead, they should be viewed as providing a range of values, catering to varied needs, depending on the circumstances. The major approaches, namely, the (i) asset based approach to valuation, (ii) earnings based approach to valuation, (iii) market value based approach to valuation and (iv) the fair value method to valuation are described below.

Asset-Based Approach to Valuation

Asset-based approach focuses on determining the value of net assets from the perspective of equity
57

share valuation. What should the basis of assets valuation be, is the central issue of this approach. It should be determined whether the assets should be valued at book, market, replacement or liquidation value. More often than not, they are (and should be) valued at book value that is, original acquisition cost minus accumulated depreciation, as assets are normally acquired with the intent to be used in business and not for resale. Thus, the valuation of assets is based on the going concern concept. Some other value measure may be used depending on circumstances of the case. For instance, if the plant and machinery has outlived its economic useful life (earlier than its initial estimated period), and is not in use for production, it will be in order to value the machinery at liquidation value.

Apart from tangible assets, intangible assets, such as goodwill, patents, trademark, brands, know how,
58

and so on, also need to be valued satisfactorily. It may be useful to adopt the super profit method to value some of these assets.

To arrive at the net assets value, total external liabilities (including preference share capital)

payable are deducted from total assets (excluding fictitious assets). The company's net assets are computed as per Equation Net assets = Total assets - Total external liabilities The value of net assets is also known as net worth or equity/ordinary shareholders funds. Assuming the figure of net assets to be positive, it implies the value available to equity shareholders after the payment of all external liabilities. Net assets per share can be obtained, dividing net assets by the number of equity shares issued and outstanding. Thus,

59

Net assets per share = Net assets/Number of equity shares issued and outstanding

The value of net assets is contingent upon the measure of value adopted for the purpose of valuation of assets and liabilities. In the case of book value, assets and liabilities are taken at their balance sheet values. In the market value measure, assets shown in the balance sheet are revalued at the current market prices. For the purpose of valuing assets, and liabilities, it will be useful for a finance manager/valuer to accord special attention to the following points:

(i) While valuing tangible assets, such as plant and machinery, he should consider aspects related to technological improvements obsolescence made in the and recent capital years.

Depreciation adjustment may also be needed in

60

case the company is following unsound depreciation policy in this regard.

(ii) Is the valuation of goodwill satisfactory, given the amount of profits, capital employed and average rate of return available on such businesses? (iii) With respect to current assets, are additional provisions required for "unrealisability" of debtors? Likewise, are adjustments required for "unsaleable" stores and stock? (iv) With respect to liabilities, there is a need for careful examination of 'contingent liabilities', in particular when there is mention of them in the auditor's report, with a view to assess what portion of such liabilities may fructify. Similarly, adjustments may be required on account of guarantees invoked, income tax, sales tax and other tax liabilities that may arise.

61

The net assets valuation based on book value is in tune with the going concern principle of. accounting. In contrast, liquidation value measure is guided by the realisable value available on the winding up/liquidation of a corporate firm. Liquidation value is the final net asset value (if any) per share available to the equity shareholder. The value is given as per Equation.

Net assets per share = (Liquidation value of assets Liquidation expenses Total external

liabilities)/Number of equity shares issued and outstanding.

In the case of liquidation, assets are likely to be sold through an auction. In general, they are likely to realise much less than their market values. This apart, sale proceeds from assets are further dependent on whether the company has been
62

forced to go into liquidation or has voluntarily liquidated. In the case of the 'former' type of liquidation, the realisable value is likely to be still lower.

The net asset value (NAV) per share will be the lowest under the liquidation value measure

(Example). (Example Following is the balance sheet of

Hypothetical Company Limited as on March 31, current year:

Liabilities

Amount Assets

Am ount

Share capital

Fixed assets

Rs 150 30 120

40,000 Preference

11% shares
63

40 Less: Deprecia

of Rs 100 each, fully paid-up 1,20,000 Equity

tion

120 Current assets:

shares of Rs 100 each, fully paid-up Profit account 10% Debentures Trade creditors and loss

23 Stocks

100

20 Debtors 71 Cash and bank

50 10 160

Provision for income tax

8 Prelimina ry expense s 282

282

Additional Information: (i) A firm of professional valuers has provided the

64

following market estimates of its various assets: fixed assets Rs 130 lakh, stocks Rs 102 lakh, debtors Rs 45 lakh. All other assets are to be taken at their balance sheet values. (ii) The company is yet to declare and pay dividend on preference shares. (iii) The valuers also estimate the current sale proceeds of the firm's assets, in the event of its liquidation: fixed assets Rs 105 lakh, stock Rs 90 lakh, debtors Rs 40 lakh. Besides, the firm is to incur Rs 15 lakh as liquidation costs.

You are required to compute the net asset value per share as per book value, market value and liquidation value bases.

Solution
65

Determination of Net Asset Value per Share (Rs. Lakh) (i) Book value basis Rs. 120 Fixed assets (net) Current assets: Stock Debtors Cash and Bank Total assets Less : External liabilities: 10% Debentures Trade Creditors Provision for taxation 11% Preference Share capital Dividend on preference shares (0.11 x 20 71 8 40 4.4 143.4 100 50 10 160 280

66

Rs. 40 Lakh) Net assets available for equityholders Divided by the number of equity shares (in lakh) Net assets value per share (Rs.) (ii) Market value basis Fixed assets (net) Current assets: Stock Debtors Cash and Bank Total assets Less: External liabilities (as per details given above) Net assets available for equityholders Divided by the number of equity
67

136.6 1.2

113.83

130

102 45 10 157 287 143.4

143.6 1.2

shares (in lakh) Net assets value per equity share (Rs.) (iii) Liquidation value basis Fixed assets (net) Current Assets: Stock Debtors Cash and Bank Total assets Less : external liabilities (listed above); Less : Liquidation costs Net assets available for equityholders Divided by the number of equity shares (in lakh) Net assets value per equity share (in
68

119.67

105

90 40 10 140 245 143.4

15.0 86.6 1.2

72.17

Rs.)

The asset based approach is intuitively appealing in that it indicates the net assets backing per equity share. However, the approach ignores the future earnings/cash flow generating ability of the

company's assets. In fact, the assets acquisition by business firms are not an end in themselves; they are means to an end. The end is value maximization and firms acquire assets for the purpose of creating value. The earning based approach reckons this perspective.

Earnings Based Approach to Valuation The earnings approach is essentially guided by the economic proposition that business valuation should be related to the firm's potential of future earnings or
69

cash flow generating capacity. This approach overcomes the limitation of assets-based approach, which ignores the firm's prospects of future earnings and ability to generate cash in business valuation. Earnings can be expressed in the sense of accounting as well as financial management. Accordingly, there are two major variants of this approach: (i) earnings measure on accounting basis and (ii) earnings measure on cash flow (financial management) basis. Earnings Measure Based on Accounting

Capitalisation Method As per this method, the earnings approach of business valuation is based on two major parameters, that is, the earnings of the firm and the capatilisation rate applicable to such earnings (given the level of risk) in the market. Earnings, in the context of this method, are the normal expected annual profits. Normally to

smoothen out the fluctuations in earnings, the

70

average of past earnings (say, of the last three to five years) is computed.

Apart from averaging, there is an explicit need for making adjustments, to the profits of the past years, in extraordinary items (which are not likely to occur in the future), with a view to arriving at credible future maintainable profits. The notable examples of extraordinary/non-recurring items - include profits from the sale of land, losses due to sale of plant and machinery, abnormal loss due to major fire, theft or natural calamities, substantial expenditure incurred on the voluntury retirement scheme (not to be repeated) and abnormal results due to strikes and lock-outs of major competing firm(s). Obviously, their non-exclusion will cause distortion in determining sustainable future earnings.

Above all, it will be useful to understand the profile of

71

the business, focussing on identifying the major growth and income drivers. Are such drivers likely to continue in future years? If not, projected profits need to be discounted. Finally, additional income expected in the coming years say, due to launch of a new productshould also be considered. In brief, the valuer should try to familiarise himself or herself with all major factors/events that had affected the profits of the business in the past year(s) and are likely to affect them in the future years too.

Determination of appropriate capitalisation rate is another major requirement rate, of this approach. in

Capitalisation

normally

expressed

percentages, refers to the investment sum, that an investor is willing to make to earn a specified income. For instance, 12.5 per cent capitalisation rate implies that an investor is prepared to invest Rs 100 to earn an income of Rs 12.5 or an acquiring
72

firm is prepared to invest Rs 100 to buy the expected profits of Rs 12.5 of another business.

Given the risk return framework of financial decision making, businesses that exhibit (or are exposed to) higher business and financial risks obviously warrant a higher capitalisation factor. Conversely,

businesses carrying a low degree of risk are subject to lower capitalisation factor. There are a host of factors that affect the risk complexion including fluctuation in sales/earnings, degree of operating leverage, degree of financial leverage, nature of competition, availability of substitute products and their prices, pace of change in technology and the level of governmental regulations. Thus, there are a number of internal and external factors associated with a business that can influence the risk and, hence, the capitalisation factor.

73

The determination of the capitalisation factor is not an easy task in practice. A few guidelines/ principles may, however, be helpful to the valuer in its quantification. First, the capitalisation factor for a business firm should be higher than that of a government security (normally considered riskless). Secondly, the capitalisation factor should

match/hover around the one that is used for other firms operating in similar type of businesses. In case the valuer wants to apply different capitalisation rate, there should be weighty and convincing reasons to do so. For instance, firms having the potential and prospects of achieving abnormal growth rates (for reasons that are firm specific), vis-a-vis other firms in the industry, managed by a well known

management team (having a good track record), may have low capitalisation factor and vice versa.

Having determined the two major inputs, Equation,

74

can be used to compute the value of business ,VB, (from the perspective of share owners). VB = Future maintainable profits / Relevant capitalisation factor

Example. In the current year, a firm has reported a profit of Rs 65 lakh, after paying taxes @ 35 per cent. On close examination, the analyst ascertains that the current year's income includes: (i)

extraordinary income of Rs 10 lakh and (ii) extraordinary loss of Rs 3 lakh. Apart from existing operations, which arc-normal in nature and are likely to continue in the future, the company expects to launch a new product in the coming year.

Revenue and cost estimates in respect of the new product are as follows: Sales (Rs lakh) 60

75

Material Cost Labour Cost (additional) Allocated fixed costs Additional fixed costs

15 10 5 8

From the given information, compute the value of the business, given that capitalisation rate applicable to such business in the market is 15 per cent.

76

Solution TABLE 1

Valuation of Business (Rs lakh)

Profit before tax (Rs. 65 lakh / (10.35) Less : Extraordinary income (not likely to accrue in future) Add: extraordinary loss (nonrecurring in nature) Sales Less: Incremental costs Material Costs Labour Costs Fixed costs (additional) Expected profits before taxes Less: Taxes (0.35) Future maintainable profits after
77

Rs. 100 (10)

Rs. 60

Rs. 15 10 8 33 27 120 42 78

taxes Relevant capitalization factor Value of business (Rs 78 lakh / 0.15) 0.15 520

Some useful insights into estimate of capitalisation rate can be made by referring to the Price earnings (P/E) ratio. The reciprocal of the P/E ratio is indicative of the capitalisation factor employed for the business by the market. In Example 32.2, the P/E ratio is approximately 6.67 (1/0.15). The product of future maintainable profits, after taxes, Rs 78 lakh and the P/E multiple of 6.67 times, yield Rs 520 lakh. Given the fact that P/E ratio is a widely used measure, it is elaborated below.

Price Earnings (P/E) Ratio The P/E ratio (also known as the P/E multiple) is the method most widely used
78

by finance managers, investment analysts and equity shareholders to arrive at the market price of an equity share. The application of this method primarily requires the determination of earnings per equity share (EPS). The EPS is computed as per Equation. EPS = Net earnings available to equity shareholders during the period Number of equity shares outstanding during the period.

The net earnings/profits are after deducting taxes, preference dividend, and after adjusting for

exceptional and extraordinary items (related to both incomes and expenses/losses) and minority interest. Likewise, appropriate adjustments should be made for new equity issues or buybacks of equity shares made during the period to determine the number of equity shares.
79

The EPS is to be multiplied by the P/E ratio to arrive at the market price of equity share (MPS). MPS = EPS x P/E ratio ($2.6)

A high P/E multiple is suggested when the investors are confident about the company's future

performance/prospects and have high expectations of future returns; high P/E ratios reflect optimism. On the contrary, a low P/E multiple is suggested for shares of firms in which investors have low confidence as well as expectations of low returns in future years; low P/E ratios reflect pessimism.

The P/E ratio may be derived given the MPS and EPS. P/E ratio = MPS/EPS The future maintainable earnings/projected future earnings should also be used to determine UPS. It
80

makes economic sense in that investors have access to future earnings only. There is a financial and economic justification to compute forward or projected P/E ratios with reference to projected future earnings, apart from historic P/E ratios. This is all the more true of present businesses-that operate in a highly turbulent business environment. Witness in this context, the following: "In a dynamic business world, a firm's past earnings record may not be an appropriate guide to its future earnings. For example, past earnings may have been exceptional due to a period of rapid growth. This may not be sustainable in the future.

The P/E ratios should, however, be used with caution as the published P/E multiples are normally based on the published financial statements of corporate enterprises. Obviously, earnings are not adjusted for extraordinary items and, therefore, to
81

that extent, may be distorted. Besides, all financial fundamentals are often ignored in published data. Finally, they reflect market sentiments, moods and perceptions. For instance, if investors are upbeat about retail stocks, the P/E ratios of these stocks will be higher to reflect this optimism. This can be viewed as a weakness as well, in particular when markets make systematic errors in valuing entire sector. Assuming retail stocks have been

overvalued, this error has to be built into die valuation also.

In spite of these limitations attributed to the P/E ratio, it is the most widely used measure of valuation.- The major plausible reasons are: (i) It is intuitively appealing in that it relates price to earnings, (ii) It is simple to compute and is conveniently available in terms of published data. (iii) It can be a proxy for a number of other
82

characteristics of the. firm, including risk and growth.

Example

For facts in Example, determine the

market price per equity share (based on future earnings). Assuming: (i) The company has 1,00,000 11% Preference shares of Rs 100 each, fully paid-up. (ii) The company has 4,00,000 Equity shares of

Rs 100 each, fully paid-up. (iii) P/EE ratio is 8 times.

Solution

83

Determination of Market Price of Equity Share Rs. Future maintainable profits after taxes Less: Preference dividends (1,00,000 x 78,00,000 Rs 11) Earnings available to equity-holders Divided by number of equity shares Earnings per share (Rs 67 lakh/4 lakh) Multiplied by P/E ratio (times) Market price per share (Rs 16.75 x 8) 11,00,000 67,00,000 4,00,000 16.75 8 134

To

conclude,

the

P/E

ratios

should

be

used/interpreted with caution and care. In particular, die investors should focus on prospective/future P/E ratios, risk and growth attributes of business and comprehensive company analysis with a view to have more authentic and credible valuation.

OTHER

APPROACHES

TO

VALUE

MEASUREMENT
84

In

recent

years,

number

of

new

approaches/techniques/methods to measure value (with focus on shareholders) have been developed and practised. The two major approaches are market value added (MVA) and economic value added (EVA). They are explanied in this Section.

Market Value Added Approach (MVA) The MVA approach measures the change in the market value of the firm's equity vis-a-vis equity investment (consisting of equity share capital and retained profits). Accordingly,

MVA = Market value of firm's equity - Equity capital investment/funds (14)

Though the concept of MVA is normally used in the context of equity investment (and, hence, is of greater relevance for equity shareholders), it can
85

also be adapted (like other previous approaches) to measure value from the perspective of providers of all invested funds (i.e., including preference share capital and debt).

MVA = [Total market value of firm's securities (Equity shareholders funds + Preference share capital + Debentures)] (15)

The MVA approach cannot be used for all types of firms. It is applicable to only firms whose market prices are available. In that sense, the method has limited application. Besides, the value provided by this approach may exhibit wide fluctuations, depending on the state of the capital market/stock market in the country.

Example 7

Suppose, Supreme Industries has an

86

equity market capitalisation of Rs 3,400 crore. in current year. Assume further that its equity share capital is Rs 2;000 crore and its retained earnings are Rs 600 crore. Determine the MVA and interpret it. Solution MVA = (Rs 3,400 core - Rs 2,600 crore) = Rs 800 crore.

The value of Rs 800 crore implies that the management of Supreme Industries has created wealth/value to the extent of Rs 800 crore for its equity shareholders. Well managed companies (engaged in sunrise businesses),"having good

growth prospects, and perceived so by the investors, have positive MVA. Investors may be willing to pay more than the net worth. In contrast, companies relatively less known or engaged in businesses that do not hold future growth; potentials may have
87

negative MVA.

Example 8 Suppose, Hypothetical Limited has equity market capitalisation of Rs 900 crore in the current year. Its equity share capital and accumulated losses are of Rs 1,200 crore and Rs 200 crore respectively.

Determine the MVA of the film. Solution MVA = (Rs 900 crore - Rs 1,000 crore) = (-Rs 100 crore). The firm has negative MVA of Rs 100 crore. The investors discount its value/worth, as it is loss incurring firm.

The market value added approach reflects market expectations and is essentially a future-oriented and forward looking approach. The investors, willing to
88

pay a different price (other than one suggested by book value), are guided by the individual company's future prospects, future growth rates, risk

complexion of the firm, industry to which the firm belongs, required rate of return and so on.

Economic Value Added (EVA) The EVA method is based on the past performance of the corporate enterprise. The underlying

economic principle in this method is to determine whether the firm is earning a higher rate of return on the entire invested funds than the cost of such funds (measured in terms of the weighted average cost of capital, WACC). If the answer is positive, the firm's management is adding to the shareholders value by earning extra for them. On the contrary, if the WACG is higher than the corporate earning rate, the firm's operations have eroded the existing wealth of its equity shareholders. In operational terms, the
89

method attempts to measure economic value added (or destroyed) for equity shareholders, by the firm's operations, in a given year.

Since WACC takes care of the financial costs of all sources of providers of invested funds in a corporate enterprise, it is imperative that operating profits after taxes (and not net profits after taxes) should be considered to measure EVA. The accounting profits after taxes, as reported by the income statement, need adjustments for interest costs. The profits should be the net operating profits after taxes and the cost of funds will be product of the total capital supplied (including retained earnings) and WACC.

EVA .= [Net Operating profits after taxes - (Total capital x WACC)] (16)

The computation of EVA is illustrated in Example 9 Example 9 Following is the condensed income
90

statement of a firm for the current year: lakh) Sales revenue Less: Operating costs Less: Interest costs Earnings before taxes Less: Taxes (0.40) Earnings after taxes

(Rs

Rs 500 300 12 188 75.2 112.8

The firm's existing capital consists of Rs 150 lakh equity funds, having 15 per cent cost and of Rs 100 lakh 12 per cent debt. Determine the economic value added during the year.

Solution (i) Determination of Net Operating Profit After Taxes (Rslakh) Sales revenue
91

Rs. 500

Less : Operating Costs Operating profit (EBIT) Less: Taxes (0.40) Net operating profit after taxes (NOPAT)*

300 200 80 120

* Alternatively, [EAT, Rs 112.8 lakh + Interest Rs 12 lakh - (Tax savings on interest, Rs 12 lakh x 0.4 = Rs 4.8 lakh)]

92

(ii) Determination of WACG Equity (Rs 150 lakh x 15%) 12% Debt (Rs:100 lakh x 7.2%)* Total cost WACC (29.7 lakh/Rs 250 lakh)

Rs 22.5 lakh = 7.2 29.7 11.88%

*Cost of debt = 12% (1 - 0.4 tax rate) = 7.2 per cent

(iii) Determination of EVA EVA = NOPAT* - (Total capital x WACC) Rs 120 lakh-(Rs 250 lakh x 11.88%) Rs 120 lakh - Rs 29.7 lakh = Rs 90.3 lakh During the current year, the firm has added an economic value of Rs 90.3 lakh to the existing wealth of the equity shareholders. Essentially, the EVA approach is a modified accounting approach to determine profits earned after meeting all financial costs of all the providers of capital. Its major advantage is that this approach reflects the true
93

profit position of the firm. What may happen is that the firm may exhibit positive profits after taxes (as per the conventional income statement) ignoring costs of shareholders funds, giving an impression to the owners as well as outsiders that the firm's operations are profitable. The profit picture, in fact, may be illusory. Consider Example 10.

Example 10 For Example 53.8, assuming sales revenues are Rs 330 lakh, compute the earnings after taxes. Solution Income Statement (Conventional) (Rs lakh) Sales revenue Less: Operating costs Less: Interest costs Earnings before taxes Rs 330 300 12 18

94

Less: Taxes (0.40) Earnings after taxes

7.2 10.8

The firm has registered profits of Rs 10.8 lakh during the current year on the equity funds of Rs 150 lakh, which has financial costs of Rs 22.5 lakh. Therefore, the firm has, suffered a loss, (of Rsll.7 lakh) as the opportunity costs of equity funds invested by equity holders is more than what has been earned by the firm for them. This point is brought to the fore by the EVA approach. It is for this reason that the EVA approach is getting more attention. It is superior to the conventional approach of determining profits. Determination of EVA (Rs. lakh) (a) Sales revenue Less : Operating Costs
95

Rs. 330 300

Operating Profits Less : taxes (0.4) Net operating profits after taxes (b) EVA = Rs. 18 Lakh (Rs. 29.7 lakh, already computed above) = Rs. 11.7 lakh

30 12 18

Example 10 demonstrates that there may be a substantial difference between profits determined as per accounting approach and the EVA approach. Profits shown ass per the EVA approach are conceptually realistic than shown by traditional accounting approach. In no way, the firm can be said to have earned profits without meeting financial costs of all sources of finance. The EVA approach is in tune with the basic financial tenet of cost-benefit analysis; financial benefits have to be more than financial costs to have true profits.

96

Though the MVA and EVA are two different approaches, the MVA of the firm (in a technical sense) can be conceived in terms of the present value of all the EVA profits that the firm is expected to generate in the future.

97

Solved Problems The following particulars are available in respect of a corporate: (i) Capital employed, Rs 500 million. (ii) Operating profits, after taxes, for last three years are: Rs 80 million, Rs 100 million, Rs 90 million; current year's operating profit, after taxes, is Rs 105 million. (iii) Riskless rate of return, 10 per cent. (iv) Risk premium relevant to the-business of corporate firm, 5 per cent.

You are required to compute the value of goodwill, based on the present value of. the super profits method. Super profits are to be computed on the basis of the average profits of 4 years. It is expected that the firm is likely to earn super profits for the next 5 years only.

98

Solution Determination of goodwill, using super profit method (Rs million) Average profits (Rs 80 million + Rs 100 million + Rs 90 million + Rs 105 million = Rs 375 million)/ 4 years Less: Normal profits (Rs 500 million x 0.15) Super profits Multiplied by the PV of .annuity for 5 years at 15 percent PV of super profits/Value of goodwill 62.85 18.75 (x) 3.352 75.00 Rs. 93.75

99

100