Module 1

MERGERS

Introduction:
In todays global business environment, companies may have to grow to survive A merger occurs when one firm assumes all the assets and all the liabilities of another.

A merger is just one type of acquisition. One company can acquire another in several other ways, including purchasing some or all of the companys assets or buying up its outstanding shares of stock.

The United Kingdom Financial Reporting Standard 6 defines the term merger as: Merger is a business combination which results in the creation of a new reporting entity formed from the combining parties, in which the shareholders come together in a substantially equal partnership for the mutual sharing of risks and benefits of the combined entity; and in which no party to the combination, in substance, obtains control over any other. A majority vote of shareholders is generally required to approve a merger.

Some of the potential advantages of mergers and acquisitions include;

1. 2. 3. 4.

achieving economies of scale, combining complementary resources, garnering tax advantages, and eliminating inefficiencies.

Economies of Scale:
There are several types of economy of scale: technical economies, when producing the good by using expensive machinery intensively
managerial economies, by employing specialist managers financial economies, by borrowing at lower rates of interest commercial economies, by buying materials in bulk

marketing economies, spreading the cost of advertising and promotion

research and development economies, from developing better products

There are sometimes problems that can affect integrated firms. These are known as diseconomies of scale firms are too big to operate effectively decisions take too long to make
poor communication occurs

Other reasons for considering growth through acquisitions include;

1. obtaining proprietary rights to products or services, 2. increasing market power by purchasing competitors, 3. shoring up weaknesses in key business areas, 4. penetrating new geographic regions, or providing managers with new opportunities for career growth and advancement.

Since mergers and acquisitions are so complex, however, it can be very difficult to evaluate the transaction, define the associated costs and benefits, and handle the resulting tax and legal issues.

Major Mergers and Acquisitions in India

Recently the Indian companies have undertaken some important acquisitions. Some of those are as follows: Hindalco acquired Canada based Novelis. The deal involved transaction of $5,982 million. Tata Steel acquired Corus Group plc. The acquisition deal amounted to $12,000 million. Dr. Reddy's Labs acquired Betapharm through a deal worth of $597 million. Ranbaxy Labs acquired Terapia SA. The deal amounted to $324 million. Suzlon Energy acquired Hansen Group through a deal of $565 million.

The acquisition of Daewoo Electronics Corp. by Videocon involved transaction of $729 million.
HPCL acquired Kenya Petroleum Refinery Ltd.. The deal amounted to $500 million. VSNL acquired Teleglobe through a deal of $239 million. When it comes to mergers and acquisitions deals in India , the total number was 287 from the month of January to May in 2007. It has involved monetary transaction of US $47.37 billion.

Out of these 287 merger and acquisition deals, there have been 102 cross country deals with a total valuation of US $28.19 billion.

What is merger?
Merger or amalgamation contemplates joining two or more companies to form a new company, an altogether a new entity or absorbing of one or more companies by an existing company. The term merger and amalgamation are used synonymously.
Co. A + Co. B New Co. C

Figure 1 Co. A and Co. B = Transferor/Amalgamating Company New Co. C = Transferee/Amalgamated Company
Co. A + Co. B + Co.C Existing Co.As

Figure 2 Co. B and Co. C = Transferor/Amalgamating Company Co. A = Transferee/Amalgamated Company

Varieties of Mergers:
Horizontal merger Two companies that are in direct competition in the same product lines and markets. Vertical merger A customer and company or a supplier and company. Think of a cone supplier to an ice cream maker. Market-extension merger: Two companies that sell the same products in different markets. Product-extension merger: Two companies selling different but related products in the same market. Conglomeration: Two companies that have no common business areas.

 Horizontal Merger Ameritrade's acquisition of Datek is an example of horizontal merger. Both of these companies are pioneers in online brokerage industry and are former competitors. The combined company will have 2.7 million client accounts and will facilitate 164,000 trades per day. The objective is to increase market share and create an industry powerhouse.

 Backward Vertical Integration American Technology's acquisition of HST Inc. is an example of backward vertical integration, one of two types of vertical mergers. American Technology is a high-tech producer of branded components while HST is a designer and manufacturer of technologically advanced components for branded consumer products. American Technology currently uses HST as an outsourced manufacturer of its HSS and NeoPlanar components. The deal is considered a backward vertical integration because American Technology purchases a critical supplier of "raw materials".

 Forward Vertical Integration Disney's acquisition of American Broadcasting Company (ABC) is an example of forward vertical integration, type of vertical merger. Disney is a leading provider of family entertainment while ABC is a broadcasting company with news, cable, and entertainment networks. With this acquisition Disney hopes to boost its primary business of family entertainment. The deal is a forward vertical integration because Disney purchases a distribution network for its products.

 Product Extension Merger Broadcom's acquisition of Mobilink Telecom Inc. is an example of product extension merger. Broadcom manufactures chips for IEEE 802.11b wireless LAN and Bluetooth personal area network hardware while Mobilink makes chips and product designs for GSM (Global System for Mobile Communications) handsets and is completing certification of GPRS (General Packet Radio Service) high-speed wireless networking chips. Its products will complement Broadcom's wireless offerings.

 Market Extension Merger RBC Centura's acquisition of Eagle Bancshares Inc. is an example of market extension merger. Eagle Bancshares, headquartered in Atlanta, Georgia, has 283 employees, approximately 90,000 accounts and assets of US$1.1 billion. It owns and operates Tucker Federal Bank, the 10th largest bank in metropolitan Atlanta in terms of deposit market share. The acquisition of Eagle Bancshares is another step in RBC's North American growth strategy. Eagle provides further geographic diversification for RBC and enables RBC to gain a footprint in Atlanta, one of the fastest growing markets in the United States.

 Conglomerate Merger Kelso's acquisition of Nortek is an example of conglomerate merger. The two companies are totally unrelated. Nortek Inc. is a leading international designer, manufacturer and marketer of building products while Kelso & Company, L.P. is a private equity firm based in New York City.

From the perspective of how the merge is financed, there are two types of mergers: purchase mergers and consolidation mergers

Purchase Mergers - As the name suggests, this kind of merger occurs when one company purchases another one. The purchase is made by cash or through the issue of some kind of debt instrument, and the sale is taxable. Acquiring companies often prefer this type of merger because it can provide them with a tax benefit. Acquired assets can be written-up to the actual purchase price, and the difference between book value and purchase price of the assets can depreciate annually, reducing taxes payable by the acquiring company

 Consolidation Mergers - With this merger, a brand new company is formed and both companies are bought and combined under the new entity. The tax terms are the same as those of a purchase merger.

Theories of Merger:
Theories of mergers are the explanation for why merger exist. They are: I. Efficiency theories a. Differential management efficiency b. inefficient management c. operating synergy d. pure diversification e. strategic realignment to changing environments f. undervaluation II. Information and Signaling III. Agency problems and managerialisim

IV. V.

Free cash flow hypothesis Market power

VI.
VII.

Taxes
Redistribution

I. Efficiency theories:
These theories hold that mergers and other forms of asset redeployment have potential for social benefits. They generally involve improving the performance of incumbent managent or achieving a form of synergy. Most or all of the efficiency theories have been incorporated in the model of conglomerate mergers.

a.

Differential management efficiency: The theory suggest that there are firms with below average efficiency or that are not operating up to their potential, however defined.
Firms operating in similar kinds of business activity would be most likely to be the potential acquirers.

Acquiring firms have the managerial know how for improving the performance of the acquired firm.
The differential efficiency explanation can be formulated more vigorously and may be called a managerial synergy hypothesis.

If a firm has an efficient management team whose capacity is in excess of its current managerial input demand. The firm may be able to utilize the extra managerial resources by acquiring a firm that is inefficiently managed due to shortage of such resources.

b. inefficient management : The inefficient management theory may be difficult to distinguish from the differential efficiency theory. So inefficient management is simply not performing up to its potential. Another control group might be able to manage the assets of this area of activity more effectively. Several observations made on the theory : First, the theory assumes that owners of acquired firms are unable to replace their own managers.

Second, if the replacement of incompetent managers were

the sole motive for mergers.

Third, the managers of the acquirig firm will be replaced after the merger. c. operating synergy: It can be achieved in horizontal, vertical, and even in conglomerate mergers. This assume that economies of scale do exist in the industry and that prior to the merger,

Economies of scale arise because of indivisibilities, such aspeople, equipment, and overhead, which provide increasing returns if spread over a large number of units of output. d. pure diversification: Diversification may have value for many reasons, including demand for diversification by managers and employees, preservation of organizational and reputational capital, and financial and tax advantages. Financial Synergy: this argues that the cost of capital function may be lowered for a number of reasons. If the cash flow streams of the two companies are not perfectly correlated, bankruptcy probabilities may be lowered.

 Another widely discussed proposition is that the debt capacity of the combined firm can be greater than the sum of the two firms capacity before their merger and this provides tax savings on investment income. e. strategic realignment to changing environments: Strategic planning is concerned with firms environment and constituencies, not just operating decisions. On the other hand, a competitive market for acquisitions implies that the net present value from m & a investments is likely to be small.

Undervaluation: One cause of undervaluation may be that managemnt is not operating the company up to its potential. This is then an aspect of the inefficient management theory. A second possibility is that the acquirers have inside information. This theoryis the difference between the market value of asset and their replacement costs. II. Information and Signaling: it disseminates information that the target shares are undervalued and the offer prompts the market to revalue those shares. The other is that the offer inspires target firm management to implement a more efficient business strategy on its own. :

III. Agency problems and managerialisim: An agency problem arises when managers own only a fraction of the ownership shares of the firm. And it arises because contracts between managers (decision or control agents) and owners (risk bearers). Resulting (agecy) costs include: 1. Costs of restrucuring a set of contracts 2. Costs monotoring and controlling the behavior of agents by principals 3. Costs of bonding to guarantee that agents will make optimal decisions. 4. The welfare loss experienced by principals. The managerialism explanation for conglomerate mergers was set forth most fully by Mueller. He hypothesizes that managers are motivated to increase thesize of their firms.

 Hubris Hypothesis:
Roll (1986) hypothesis that managers commit errors of overoptimistic in evaluating merger opportunities due to excessive pride, animal spirits, or hubris. When the valuation turns out to be below the market price, no offer is made. only when the valuation exceeds the current market price, a bid and enters the takeover sample. IV. Free cash flow hypothesis: Michael Jenson observes that among more than adozen separate forces involved in takeover activity in the last decade, inadequate attention has been given to the payout of free cash flow.

 Market power: increasing market shares really means increasing the size of the firm relative to other firms in an industry. Tax consideration: some mergers may be motivated by tax minimising opportunities. Whether tax consideration induce mergers, however there are alternative method of achieving equivalent tax benefits. For Ex: The Economic Recovery Tax Act of 1981 provided for the sale of tax credits. Carry over of net operating losses Other tax incentivesss

Value creation in Horizontal Merger:

1. 2. 3. Revenue enhancement: Increased market power Network externalties Leveraging marketing resources and capabilities Cost savings: Reduction of excess capacity Scale economies in production, marketing, sales and distribution, logistics, branding, R & D Scope economies in branding, marketing, distribution, production, logistics Learning economies

1. 2.
3. 4.

1. 2.

New growth opportunities Creating new capabilities and resources Creating new products, markets processes

Value creation in vertical mergers:

A vertical chain links the various stages from the sourcing of new raw materials and other inputs to production and delivery of output to final consumer. The benefit and cost of using competitive spot market and those of long term contracts with suppliers are examined. Two broad types of efficiencies are considered: technical efficiency and coordination efficiency.

Value creation in conglomerate merger:

Economic 1.Market power 2.Efficient internal capital market Strategy 1.Resources and capabilities transfer Finance theory 1.Efficient diversification 2.Bankruptcy risk reduction 3.Agency cost

 Management 1. Management entrenchment 2. Personal risk reduction 3. Private control benefits.