FINANCING DECISIONS:

MERGERS AND ACQUISITIONS

 MEANING OF DIVERSIFICATION

• Diversification is an act of an existing entity

branching out into a new business opportunity.
This corporate strategy enables the entity to
enter into a new market segment which it does
not already operate in.
• The decision to diversify can prove to be a
challenging decision for the entity as it can lead
to extraordinary rewards with risks.
Why do Companies Diversify ?
 WHY DO COMPANIES DIVERSIFY?
• The following are the reasons why firms opt
for diversification:

• For growth in business operations

• To ensure maximum utilization of the existing
resources and capabilities
• To escape from unattractive industry
environments
ADVANTAGES OF DIVERSIFICATION
• As the economy changes, the spending
patterns of the people change. Diversification
into a number of industries or product line can
help create a balance for the entity during
these ups and downs.
• There will always be unpleasant surprises
within a single investment. Being diversified
can help in balancing such surprises.
• Diversification helps to maximize the use of
potentially underutilized resources.
• Certain industries may fall down for a specific
time frame owing to economic factors.
Diversification provides movement away from
activities which may be declining.
 DISADVANTAGES OF DIVERSIFICATION

• Entities entirely involved in profit-making

segments will enjoy profit maximization.
However, a diversified entity will lose out due
to having limited investment in the specific
segment.
• Therefore, diversification limits the growth
opportunities for an entity.
• Diversifying into a new market segment will
demand new skill sets. Lack of expertise in the
new field can prove to be a setback for the
entity.
• A mismanaged diversification or excessive
ambition can lead to a company over expanding
into too many new directions at the same time.
In such a case, all old and new sectors of the
entity will suffer due to insufficient resources
and lack of attention.
• A widely diversified company will not be able
to respond quickly to market changes.
• The focus on the operations will be limited,
thereby limiting the innovation within the
entity.
TYPES OF DIVERSIFICATION STRATEGIES

Horizontal Vertical

Conglomer
Concentric
ate
 HORIZONTAL DIVERSIFICATION
• This strategy of diversification refers to an
entity offering new services or developing new
products that appeal to the firm’s current
customer base.
• For example, a dairy company producing
cheese adds a new variety of cheese to its
product line.
 VERTICAL DIVERSIFICATION
• This form of diversification takes place when a
company goes back to a previous or next stage
of its production cycle.
• For example, a company involved in the
reconstruction of houses starts selling
construction materials and paints. It may be
forward integration or backward integration.
 CONCENTRIC DIVERSIFICATION

• In this form of a diversification strategy, the

entity introduces new products with an aim to
fully utilize the potential of the prevailing
technologies and marketing system.
• For example, a bakery making bread starts
producing biscuits.
CONGLOMERATE DIVERSIFICATION
• In this form of diversification, an entity
launches new products or services that have
no relation to the current products or
distribution channels.
• A firm may adopt this strategy to appeal to an
all-new group of customers. The high growth
scope and return on investment in a new
market segment may prompt a company to
take this option.
• A diversification must be a well thought out
step for an entity. It can boost the growth of
the firm thereby leading it towards wealth
maximization.
• However, it can also prove to be a costly
failure for certain entities. A detailed analysis
of the potential market must be conducted
before opting for diversification.
 Meaning of Mergers and Acquisition

• Mergers and acquisitions (M&A) are defined as

consolidation of companies. Differentiating the
two terms, Mergers is the combination of two
companies to form one, while Acquisitions is
one company taken over by the other. M&A is
one of the major aspects of corporate finance
world.
• The reasoning behind M&A generally given is
that two separate companies together create
more value compared to being on an
individual stand. With the objective of wealth
maximization, companies keep evaluating
different opportunities through the route of
merger or acquisition.
Mergers & Acquisitions can take place:

• By purchasing assets
• By purchasing common shares
• By exchange of shares for assets
• By exchanging shares for shares
Types of Mergers and Acquisitions:

• Mergers can be classified into three types

from an economic perspective depending on
the business combinations, whether in the
same industry or not.
• M&A may be different types:
a) Horizontal M&A: When two or more firms engaged
in similar line of activities combine.
Ex:- VODA & IDEA

b) Vertical M&A: Which occurs firms involved in

different stages of production of a single final
product.
Ex:-
a. Merger of an oil exploration unit with a refining
unit.
b. A cricket bat manufacturing company merging with
a wood production company, is Vertical mergers 22
c. Conglomerate Merger: When M&A is taken
between two or more firms that are totally
unrelated business activities.

• Ex:- Exide Life Insurance. After ING exited from

India in Jan 2013, Exide Industries acquired the
remaining 50% of the equity capital of ING
Vysya Life Insurance, thus becoming 100% stake
holder.
 Reasons for Mergers and Acquisitions:
• Financial synergy for lower cost of capital.
• Synergy Example
• For example, a company may acquire a similar
firm, allowing it to expand its product offering
and, as a result, increase its sales and revenues.
This could not have been accomplished had the
two firms remained independant.
• Improving company’s performance and
accelerate growth
•
• Economies of scale
• Diversification for higher growth products or
markets
• To increase market share and positioning
giving broader market access
• Strategic realignment and technological
change
• Tax considerations
• Under valued target
• Diversification of risk
Principle behind any M&A is 2+2=5
• There is always synergy value created by the
joining or merger of two companies. The
synergy value can be seen either through the
Revenues (higher revenues), Expenses
(lowering of expenses) or the cost of capital
(lowering of overall cost of capital).
But why would two firms decide to merge?
• There are a number of theories have been
proposed.
THEORY DETAILS OF THE THEORY

Firms merge because the value of the

1.SYNERGY THEORY combined firm is greater than the sum of
the values of the individual firms
2. UNDER VALUATION Firms merge because one firm is
THEORY undervalued

3. AGENCY THEORY Firms merge to resolve the conflicts

between shareholders and managers
 THEORY DETAILS OF THE THEORY

Firms merge in order to increase

4. MARKET POWER market share and hence profit can
THEORY
increase

5.DIVERSIFICATION Firms merge to reduce business risk

THEORY

6. GROWTH Firms merge to increase earnings

THEORY growth
• The acquisition costs include the payment
made to the target firm’s shareholders,
payment to discharge the external liabilities of
the acquired firm less cash proceeds expected
to the realized by the acquiring firm from the
sale of certain asset (s) of the target firm. The
decision criterion is ‘to go for the merger’ if
Net Present Value (NPV) is positive; the
decision would be ‘against the merger’ in the
event of the NPV being negative.
ACQUISITION AS A CAPITAL BUDGETING DECISION

• In case of a merger situation, it is implied that

the acquirer firm is ready to pay the price (in
cash or in terms of shares because it is
expecting inflows in terms of sale of assets or
in terms of operating cash flows for a number
of years.
• These inflows and outflows (all in PV terms)
can be compared to find out the NPV of the
proposal. The procedure for finding out the
NPV of the merger proposition may be found
as follows.
MV of Capital issued XXX

+ MV of debentures issued XXX

+ Liabilities undertaken XXX
+ Expense payable XXX
-Sale proceed from sale of assets XXX
Total cost of acquisition XXX XXX
Less PV of series of operating cash XXX
flows
Less PV of terminal sale of assets XXX XXX
Net Present Value XXXXX
PARTICULARS AMOUNT
PRESENT VALUE OF SALE PROCEEDS 2,89,500
(7,50,000 x 0.386)
PRESENT VALUE OF ANNUAL CASH INFLOWS 61,45,000
(10,00,000 x 6.14)
TOTAL PRESENT VALUE OF CASH INFLOWS 64,34,500
(-) Total cost of acquisition 51,00,000
NET PRESENT VALUE 13,34,500

*PRESENT VALUE IS CALCULATED @10%

 RECOMMENDATION
• The CALCULATED NPV of the proposal is
positive. Therefore, A Ltd. may go ahead with
the merger proposal.
 Determination of Combined EPSm or Post-
merger EPS
EATA  EATT TotalEarnings
Post mergerEPSor EPS
m  or
NA  NT TotalShares

• Where EATA = Earnings after taxes of the acquiring firm

• EATT = Earnings after taxes of the target firm
• NA = Number of outstanding equity shares of the acquiring firm
• NT = Number of equity shares issued to the shareholders of the
target firm
 Determination of
Market Value of Merged Firm
• Vm = EPSm × P/EA
• Where Vm = Market value of merged firm
• P/EA = Price Earnings ratio of acquiring firm
• Determination of Price Earnings (P/E) Ratio of
firm
• P/E Ratio of Acquiring Firm = MPSA / EPSA
• P/E Ratio of Target Firm = MPST / EPST
• Total Gain from Merger
• Gain = Vm – (VA + VT)
• Where VA = EPSA × P/EA
• VT = EPST × P/ET
• Gain for Acquiring Firm (GA) and Target Firm
(GT)
• GA = [Post—merger value of firm A – Pre-
merger value of firm A]
• GT = [Post—merger value of firm T – Pre-
merger value of firm T]
 Share Exchange Ratio based on
EPS or MPS or Net Assets or Net worth

Target FirmEPSor MPS or Net Assetsor Net worthT

ShareExchange Ratio =
Acquiring FirmEPSor MPS or Net Assetsor Net worth
 Relevant or Equivalent EPS
of Target Firm
• Equivalent EPS of Target Firm =
Post merger or Merged EPS X Share Exchange
Ratio
• You have been provided the following financial data of two
companies:

Particulars T Ltd. A Ltd.

10,00,00
Earnings After Tax (EAT) (Rs.) 7,00,000
0
Equity shares outstanding 2,00,000 4,00,000
Earnings per share (EPS) (Rs.) 3.50 2.50
Price-earnings (P/E) ratio (times) 10 14
Market Price per Share (MPS)
35 35
•(Rs.)
A Ltd. is the acquiring company, exchanging its shares on a 1:1
basis for T Ltd.’s shares. The exchange ratio is based on the
market prices of the shares of the two companies.
 (i) What will be the EPS subsequent (combined) to
merger?
(ii) What is the change in EPS for the shareholders
of A Ltd. and T Ltd.?
(iii)Determine the market value of the post-merger
firm.
(iv)Ascertain the profits accruing to shareholders of

both the firms.

i. Determination of Combined EPSm or
Post-merger EPS
EATA  EATT TotalEarnings
Post mergerEPSor EPS
m  or
NA  NT TotalShares

• Where EATA = Earnings after taxes of the acquiring firm

• EATT = Earnings after taxes of the target firm
• NA = Number of outstanding equity shares of the acquiring firm
• NT = Number of equity shares issued to the shareholders of the
target firm

 7,00,000 17,00,000
10,00,000
   Rs.2.833
4,00,000 2,00,000 6,00,000
i. Determination of Combined EPSm or
Post-merger EPS
EATA  EATT TotalEarnings
Post mergerEPSor EPS
m  or
NA  NT TotalShares

• Where EATA = Earnings after taxes of the acquiring firm

• EATT = Earnings after taxes of the target firm
• NA = Number of outstanding equity shares of the acquiring firm
• NT = Number of equity shares issued to the shareholders of the
target firm

 7,00,000 17,00,000
10,00,000
   Rs.2.833
4,00,000 2,00,000 6,00,000
• (ii) Change in EPS for the shareholders of A
Ltd. and T Ltd.
PARTICULARS A Ltd T Ltd
Pre-merger EPS Rs.2.500 Rs.3.500
(LESS) Post-merger EPS Rs.2.833 Rs.2.833
CHANGE IN EPS (INCREASE/DECREASE) 0.333 (0.667)
 iii. Determination of
Market Value of Merged Firm
• Vm = EPSm × P/EA
• Where Vm = Market value of merged firm
• P/EA = Price Earnings ratio of acquiring firm
 Particulars Rs.
Post-merger EPS Rs. 2.833
P/E ratio 14
Market price per share (EPS X P/E) 39.662
2,37,97,20
Total market value*
0
*TMV = 39.662 X 6,00,000
Multiplied by shares outstanding
 iv. Ascertain the profits accruing to
shareholders of both the firms.
PARTICULARS AMOUNT AMOUNT
POST-MERGER MARKET VALUE OF 2,37,97,200
THE FIRM
LESS: PRE-MERGER MARKET VALUE
“T” LTD VALUE (2,00,000 X 35) 70,00,000
“A” LTD VALUE (4,00,000 X 35) 1,40,00,000 2,10,00,000
Gain from Merger 27,97,200
 DISTRIBURTION OF
GAINS FROM MERGING.

PARTICULARS A LTD Rs. T LTD Rs.

POST MERGER MARKET
VALUE OF THE FIRMS 1,58,64,800 79,32,400
(4,00,000 X 39.662) ;
(2,00,000 X 39.662)
LESS: PRE MERGER MARKET 1,40,00,000 70,00,000
VALUE
TOTAL GAIN 18,64,800 9,32,400
END..