CORPORATE MERGERS & ACQUISITIONS:

The Issue Of Shareholders’ Wealth

Maximization Revisited

Dr. Manipadma Datta,Professor of fianance, 1

IMT, Ghaziabad
THE SCENARIO:
TATA TAKES OVER CORUS
IMMEDIATE IMPACT:
TISCO SHARE PRICE GONE DOWN SUBSTANTIALLY: 11% BY ONE
STROKE: ALTHOUGH BSE SENSEX THEN ROSE BY 18 POINTS.

Dr. Manipadma Datta,Professor of fianance, 2

IMT, Ghaziabad
EV/ EBDIT multiple as paid to Corus : 9 times

EV/ EBDIT multiple of Tata Steel : 4.6 times

EV/EBDIT multiple Mittals paid to Arcelor: 5.8 times

Dr. Manipadma Datta,Professor of fianance, 3

IMT, Ghaziabad
Mr.Ratan Tata’s argument: price of steel companies will go up soon.
It’s almost an echo of Hewlett-Packard’s the then CEO’s comment in
2001.
But the research afterwards has proven otherwise.

Dr. Manipadma Datta,Professor of fianance, 4

IMT, Ghaziabad
BUT WHAT’S THE MARKET INFORMATION?
ICRA Industry Monitor:
World steel consumption growth rates:
2006 : 8.9%
2007 : 5.2%( anticipated)
2010 : 4.2% (anticipated).

Dr. Manipadma Datta,Professor of fianance, 5

IMT, Ghaziabad
Then overproduction in steel is apprehended. And steel price is likely to
fall.

Fear factor 1. a $50 in global steel price will result in $414 m loss from
Corus acquisition

Fear factor 2. a $75 fall would lead the new firm to a loss of $846 m.

Dr. Manipadma Datta,Professor of fianance, 6

IMT, Ghaziabad
Impact of the issue of $1.7 bn preferential issue to Tata Sons:
• Addl debt on balance sheet Rs.5802.5 crore
• Equity dilution 25.1%
• Net increase in PAT Rs.374.3 crore
• But decrease in EPS by 13.1%

Dr. Manipadma Datta,Professor of fianance, 7

IMT, Ghaziabad
• How to translate the low cost opportunity? A part of that
lies in cheaper iron ore. But not allowed to export iron ore to
Britain.
• The issue of junk bonds might spoil Tata’s fund rising for
greenfield expansion.

Dr. Manipadma Datta,Professor of fianance, 8

IMT, Ghaziabad
REMINDER: CORPORATE SCANDALS THAT GAVE BIRTH TO
Sarbanes-Oxley legislation.
BUT SOX LEGISLATION HAS NOT ENSURED THAT THE BOARD OF
DIRECTORS WOULD CERTAINLY RAISE THE pertinent QUESTIONS
WITHOUT FAIL.

Dr. Manipadma Datta,Professor of fianance, 9

IMT, Ghaziabad
CORUS SHAREHOLDERS ARE BENIFITTED.

WHAT ABOUT THE TISCO LOYALS?

WE HAVE TO WAIT AND SEE.

THE QUESTION REMAINS: HAVE THEY BEEN GIVEN THE TREATMENT

ENOUGH WORTHY?
Dr. Manipadma Datta,Professor of fianance, 10
IMT, Ghaziabad
•WHAT DO WE EXPECT FROM A MERGER?
•SYNERGIES- FINANCIAL AND OPERATING and/or OTHERWISE.
•IN FACT, IT’S NOT ONLY THE EXPECTATION. IT SHOULD BE A
PRECONDTION, NECESSARY AND ESSENTIAL.
•SUCCESS STORIES ARE THERE TOO.
•BUT WHO’LL BEAR THE BURDEN OF FAILURE? AND, THAT TOO, WHY?

Dr. Manipadma Datta,Professor of fianance, 11

IMT, Ghaziabad
A few words from Mr. Warren Buffet:
“ In some mergers there truly are major synergies- though often the acquirer
pays too much too obtain them- but at other times the cost and revenue
benefits that are projected prove illusory. Of one thing, however, be certain: If a
CEO is enthused about a particularly foolish acquisition, both his internal staff
and his outside advisers will come up with whatever projections are needed to
justify his stance. Only in fairy tales are the emperors told that they are naked.”
Quoted from Annual Report, 1997, Berkshire Hathaway Inc

Dr. Manipadma Datta,Professor of fianance, 12

IMT, Ghaziabad
Buffet’s argument is fortified and vindicated by the efficient market school:
M&A only repeats what the individual shareholders can do themselves.

Dr. Manipadma Datta,Professor of fianance, 13

IMT, Ghaziabad
• THUS THE ADVANTAGES IN THE NAME OF SYNERGIES AND
DIVERSIFICATION ARE NO MORE BASED ON SOLID GROUNDS.

• WHAT’S MORE TRUE?

•SHAREHOLDERS’ VALUE MAXIMIZATION EFFORTS; or,
•AMBITION TO ACQUIRE THE CULT OF BEING COLOSSAL.

Dr. Manipadma Datta,Professor of fianance, 14

IMT, Ghaziabad
NO, I don’t propose the doomsday for M&A. It’s a reality. Despite all
arguments in its favor and/or against, M&A has come to stay. Our
purpose is to see through the euphoria, sometimes created by the
media, to see beyond corporate jingoism.
The objective is simple: to ensure the maximization and protection of
shareholders’ wealth since that’s the goal of management. That’s the
acid test of every managerial decision.

Dr. Manipadma Datta,Professor of fianance, 15

IMT, Ghaziabad
Year 2001. Hewlett-Packard took over Compaq in September.
Corporate announcement was made on 3rd September. HP stock price
dropped down by 20%. The explanation offered by the then HP CEO
Carly Fiorina : thing shouldn’t be judged on the basis of such short-
term price movement. May or may not be. But let’s have a look at the
results of the survey taken up by Mark Sirower and Sumit Sahni in
response to that comment. And, astonishingly the results speak
exactly the otherwise.
SURVEY SPAN:1995-2001
SAMPLE SIZE: 302 DEALS
AVERAGE MARKET CAP: ACQUIERER’S- $ 14.2 bn
TARGET’S - $ 5.5 bn
Dr. Manipadma Datta,Professor of fianance, 16
IMT, Ghaziabad
OBSERVATIONS:
1. On average acquirer underperformed than its peers in the industry to the
extent of -4% or more.
2. Over 60% of cases, market responded negatively to the announcements
of takeover for the acquiring company.
3. For the acquiring firms with negative reaction, things hardly changed
after a year in 75% of cases.
4. For the firms with initial positive reactions continued to perform the same
even after a year.
5. Negative performers paid moreIMT, premium
Ghaziabad to the target firms than the
Dr. Manipadma Datta,Professor of fianance, 17

positive performers.( QUITE INTERESTING!)

6. However, at the macro level, the target’s shareholders’ gain have
compensated, and at times, more than compensated the loss done
to the shareholders of the acquiring firms.
7. Selling corporates were the biggest beneficiaries.

Dr. Manipadma Datta,Professor of fianance, 18

IMT, Ghaziabad
ARE THESE RESULTS ANY INDICATION AS TO THE MARKET’S
FEAR THAT
• THE ACQUIRING FIRM WONT BE ABLE TO MAINTAIN ITS TREND
OF SUCCESS?
• THE PREMIA PAID TO THE SELLING FIRMS ARE BALLOONED
UP?

Dr. Manipadma Datta,Professor of fianance, 19

IMT, Ghaziabad
It has also been observed that the cash or part cash deals were more
positively accepted by the market than the deals done on stock
swapping only.
This is perhaps providing us a with an explanation to the question-
what makes markets so skeptical?
Cash richness was taken to be a positive financial virtue by the
market.

Dr. Manipadma Datta,Professor of fianance, 20

IMT, Ghaziabad
• MARKET IS CONCERNED ABOUT THE SHAREHOLDERS’
VALUE AT RISK(S-VAR)
• S-VAR = ( PREMIUM PAID TO THE SEELING FIRM/
MARKET VALUE OF THE ACQUIRING FIRM)
• A LESSON FOR MANAGERS: MARKET REWARDS THE
FIRMS GOING FOR CASH DEALS IN THE FORM OF
REDUCED S-VAR FOR THE FIRM.

Dr. Manipadma Datta,Professor of fianance, 21

IMT, Ghaziabad
• THE CRUX OF THE MATTER LIES IN HAVING A MATCH BETWEEN
SYNERGIES AND PREMIUM PAID.
• SO, PREMIUM ≤ VALUE OF THE SYNERGY
• OTHERWISE, BE READY TO SUFFER.
• SINCE VALUE OF SYNERGIES IS DIFFICULT TO ASCERTAIN TO
PRECISELY, BETTER TO PLAY CONSERVATIVE.

Dr. Manipadma Datta,Professor of fianance, 22

IMT, Ghaziabad
THUS WHAT APPEAR MOST IMPORTANT ARE
• APPROPRIATE VALUATION OF FIRMS;
• SWAP RATIO DETERMINATION.

Dr. Manipadma Datta,Professor of fianance, 23

IMT, Ghaziabad
MOST COMMONLY USED VALUATION TECHNIQUES
1. Discounted future earnings
2. Capitalization of earnings
3. Comparable multiples; and,
4. Assets oriented approaches like fair value, book value,
liquidation value etc.

Dr. Manipadma Datta,Professor of fianance, 24

IMT, Ghaziabad
My Prescription: FCF and/or EVA

Dr. Manipadma Datta,Professor of fianance, 25

IMT, Ghaziabad
FREE CASH FLOW VALUATION MODEL

Cost of Capital (WACC)

E D
WACC = K e * + Kd * (1 − t ) * .
D+E D+E

Dr. Manipadma Datta,Professor of fianance, 26

IMT, Ghaziabad
Thus the value of the firm

∞
FCF1 FCF2 FCFt
Value = + + ... = ∑
(1 + wacc) (1 + wacc) 2
t =1 (1 + wacc ) t

Dr. Manipadma Datta,Professor of fianance, 27

IMT, Ghaziabad
Value of Company = Present value of
cash flows during the explicit forecasting
period
+ Present Value of Cash flows beyond
the explicit forecasting period (terminal
value)

Dr. Manipadma Datta,Professor of fianance, 28

IMT, Ghaziabad
FREE CASH FLOW CHART

NET SALES +OTHER INCOME= TOTAL OPERATING INCOME

LESS: TOTAL OPERATING
EXPENSES: •Raw materials
•Wages
•Salaries
•Non-depreciation manufacturing
expenses
•Selling & distribution overheads
•Administration overheads
•Depreciation
•Other operating expenses

=NET OPERATING PROFIT

NET PERATING PROFIT * (1- Tax Rate) =NET OPERATING PROFIT
ADJ USTED FOR TAX (NOPAT)
ADD BACK: DEPRECIATION =GROSS CASH FLOW
LESS: INVESTMENT ELEMENTS
•Net increase in Capex
•Increase in Working Capital
•Increase in other operating assets, if
any.

=FREE CASH FLOW

Dr. Manipadma Datta,Professor of fianance, 29

IMT, Ghaziabad
EVA

Operating Invested Capital or OIC

Operating invested capital consists of all the operating assets, which the firm uses
to generate NOPAT. It includes the fixed assets, the working capital, and other
operating assets. If for example, we classify investments as an operating activity,
then investments will also be included as part of operating invested capital.
Similarly, capital work in progress is not used to generate the NOPAT and hence
must not be included in the operating invested capital.

Dr. Manipadma Datta,Professor of fianance, 30

IMT, Ghaziabad
Return on Operating Invested Capital

NOPATt
ROIC =
Operating Invested Capitalt −1

Dr. Manipadma Datta,Professor of fianance, 31

IMT, Ghaziabad
EVA = Operating Invested Capital * (ROIC –
WACC)

Dr. Manipadma Datta,Professor of fianance, 32

IMT, Ghaziabad
Value= OIC+ PV (EVA)

Dr. Manipadma Datta,Professor of fianance, 33

IMT, Ghaziabad
SWAP ISSUE- points to ponder
• per share offer price : market price per share of the acquiring firm
• what’s obvious is that even the worst performer demands a higher price
when negotiating for being takeover;
• hard and conscious negotiation is a safeguard;
• to see whether and how much the shares are under/over valued;
• to prevent as far as practicable the possible dilution in EPS in the merged
firm;
• PE Ratio paid ≤ PE Ratio of the acquiring firm. This may be considered to
be the limit.

Dr. Manipadma Datta,Professor of fianance, 34

IMT, Ghaziabad
A few Cautions:
• In case no synergy is expected, swap should ponder over MPS of A/
MPS of T
• But in case, it’s expected, the discounting should be done with care
• If the maximum swap ratio that is acceptable to the promoter is lower
than the maximum swap ratio that is acceptable to the other
shareholders, then it is possible that the promoter will reject some of the
mergers, which are in the interests of most of the shareholders.
• It is also possible that the maximum swap ratio acceptable to all the
shareholders is less than that is acceptable to the promoter. As we will
discuss later, it is possible that in some cases, the promoter may go
ahead with such mergers.

Dr. Manipadma Datta,Professor of fianance, 35

IMT, Ghaziabad
Net Acquisition Value = V AT−[V A+V T ] –P T −E A

V AT = COMBINED VALUE OF A and T

V A = A’s MEASURE OF ITS OWN VALUE
V T = MARKET VALUE OF THE SHARES OF T
P T= PREMIUM PAID FOR T SHARES
E A = EXPENSES FOR THE ACQUISITION PROCESS
Reorganizing the equation, we get:
NAV= [V AT−(V A+V T) ] –(P T +E A)
This means,
[V AT−(V A+V T) ] ≥ (P T +E A).
Otherwise, it would mean that the bidding firm as overpaid

Dr. Manipadma Datta,Professor of fianance, 36

IMT, Ghaziabad
Operating Synergy:
• Economies/ Diseconomies of Scale.
• Spreading / Overspreading overhead.
• Economies / Diseconomies of scope

Financial Synergy
• Risk of cash flows may decrease, particularly when cash flow
streams of are not perfectly correlated.
• Higgins and Schall: Debt coinsurance effect. If the income
streams of both the firms are perfectly positively correlated, one of
them could face the conditions of bankruptcy.
• But which one, that may not be so easy to predict. Debt holders
gain at the cost of equity holders.
• Bankruptcy cost may be lowered.

Dr. Manipadma Datta,Professor of fianance, 37

IMT, Ghaziabad
DIVERSIFICATION

• Related and unrelated diversifications

• Diversification to enter more profitable industries
• Financial benefit of diversification is there provided,
Covariance between the earnings of the merging firms is
negative; or, Cov E A, E T < 0
• Procycle and counter-cycle firm.
• Benefits of conglomerates.

Dr. Manipadma Datta,Professor of fianance, 38

IMT, Ghaziabad
Thank you all!!

Dr. Manipadma Datta,Professor of fianance, 39

IMT, Ghaziabad