MF 0011 Mergers and Acquisitions

8/3/2019 MF 0011 Mergers and Acquisitions

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MF 0011 Mergers and AcquisitionsSet- 1

Q.1 What are the basic steps in strategic planning for amerger?

Ans. Basic steps in Strategic planning in Merger :

Any merger and acquisition involve the following critical

activities in strategic planning processes .Some of the essential

elements in strategic planning processes of mergers and

acquisitions are as listed here below :

1. Assessment of changes in the organization environment

2. Evaluation of company capacities and limitations

3. Assessment of expectations of stakeholders

4. Analysis of company, competitors, industry, domestic

economy and international economies

5. Formulation of the missions, goals and polices

6. Development of sensitivity to critical external environmental

changes

7. Formulation of internal organizational performance

measurements

8. Formulation of long range strategy programs

9. Formulation of mid-range programmes and short-run plans

10. Organization, funding and other methods to implement all of

the proceeding elements


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11. Information flow and feedback system for continued

repetition of all essential elements and for adjustment and

changes at each stage

12. Review and evaluation of all the processes

In each of these activities, staff and line personnel have

important Responsibilities in the strategic decision making

processes. The scope of mergers and acquisition set the tone for

the nature of mergers and acquisition activities and in turn

affects the factors which have significant influence over these

activities. This can be seen by observing the factors considered

during the different stages of mergers and acquisition activities.

Proper identification of different phases and related activities

smoothen the process of involved in merger

Q.2 What are the sources of operating synergy?

Ans.Sources of Operating Synergy

Operating synergies are those synergies that allow firms to

increase their operating income, increase growth or both. We

would categorize operating synergies into four types:

1 .Economies of scale

That may arise from the merger, allowing the combined firm to

become more cost-efficient and profitable. Economics of scales

can be seen in mergers of firms in the same business

For example : two banks combining together to create a largerbank. Merger of HDFC bank with Centurian bank of Punjab can

be taken as an example of cost reducing operating synergy. Both

the banks after combination can expect to cut costs considerably

on account of sharing of their resources and thus avoiding

duplication of facilities available.

2.Greater pricing power

from reduced competition and higher market share,which should

result in higher margins and operating income. This synergy is


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also more likely to show up in mergers of firms which are in the

same line of business and should be more likely to yield benefits

when there are relatively few firms in the business. When there

are more firms in the industry ability of firms toexercise

relatively higher price reduces and in such a situation the

synergy doesnot seem to work as desired.

An example

of limiting competition to increase pricing power is the

acquisition of universal luggage by Blow Plast. The two

companies were in the same line of business and were in direct

competition with each other leading to a severe price war and

increased marketing costs. After the acquisition blow past

acquired astrong hold on the market and operated under near

monopoly situation.Another example is the acquisition of

Tomco by Hindustan Lever

3.Combination of different functional strengths

, combination of different functional strengths may enhance the

revenues of each merger partner there by enabling each

company to expand its revenues. The phenomen on can be

understood in cases where one company with an established

brand name end s its reputation to a company with upcomingproduct line or a company. A company with strong distribution

network merges with a firm that has products of great potential

but is unable to reach the market before its competitors can do

so. In other words the two companies should get the advantage

of the combination of their complimentary functional strengths.

4.Higher growth

in new or existing markets, arising from the combination of thetwo firms. This would be case when a US consumer products

firm acquires an emerging market firm, with an established

distribution network and brand name recognition, and uses these

strengths to increase sales of its products .Operating synergies

can affect margins and growth, and through these the value of

the firms involved in the merger or acquisition .Synergy results

from complementary activities. This can be understood with the

following example


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Example :

Consider a situation where there are two firms A and B. Firm A

is having substantial amount of financial resources (having

enough surplus cash that can be invested somewhere) while firm

B is having profitable investment opportunities ( but is lacking

surplus cash). If A and B combine with each other both can

utilize each other strengths, for example here A can invest its

resource in the opportunities available to B. note that this can

happen only when the two firms are combined with each other

or in other words they must act in a way as if they are one.

Q.3 Explain the process of a leveraged buy out.

Ans. In the realm of increased globalized economy, mergers and

acquisition s have assumed significant importance both with the

country as well as across the boarders. Such acquisitions need

huge amount of finance to be provided. In search of an ideal

mechanism to finance and acquisition, the concept of Leverage

Buyout (LBO) has emerged. LBO is a financing technique of

purchasing a private company with the help of borrowed or debt

capital. The leveraged buyout are cash transactions in naturewhere cash is borrowed by the acquiring firm and the debt

financing represents 50% or more of the purchase price.

Generally the tangible assets of the target company are used as

the collateral security for the loans borrowed by acquiring firm

in order to finance the acquisition. Some times, a proportionate

amount of the long term financing is secured with the fixed

assets of the firm and in order to raise the balance amount of the

total purchase price, unrated or low rated debt known as junkbond financing is utilized.

Modes of purchase

There are a number of types of financing which can be used in

an LBO. These include :

Senior debt : this is the debt which ranks ahead of all other debt

and equitycapital in the business. Bank loans are typically

structured in up to three trenches: A, B and C


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The debt is usually secured on specific assets of the company,

which means the lender can automatically acquire these assets if

the company breaches its obligations under the relevant loan

agreement; therefore it has the lowest cost of debt. These

obligations are usually quite stringent. The bank loans are

usually held by a syndicate of banks and specialized funds.

Typically, the terms of senior debt in an LBO will require

repayment of the debt in equal annual instalments over a period

of approximately 7 years.

Subordinated debt :

This debt ranks behind senior debt in order of priority on any

liquidation. The terms of the subordinated debt are usually less

stringent than senior debt. Repayment is usually required in one

bullet payment at the end of the term. Since subordinated debt

gives the lender less security than senior debt, lending costs are

typically higher. An increasingly important form of

subordinated debt is the high yield bond, often listed on Indian

markets. High yield bonds can either be senior or subordinated

securities that are publicly placed with institutional investors.

They are fixed rate, publicly traded, long term securities with alooser covenant package than senior debt though they are

subject to stringent reporting requirements.

Mezzanine finance :

This is usually high risk subordinated debt and is regarded as a

type of intermediate financing between debt and equity and an

alternative of high yield bonds. An enhanced return is madeavailable to lenders by the grant of an equity kicker which

crystallizes upon an exit. A form of this is called a PIK which

reflects interest paid in kind, or rolled up into the principal,

and generally includes an attached equity warrant.

Loan stock :

This can be a form of equity financing if it is convertible into

equity capital. The question of whether loan stock is tax


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deductible should be investigated thoroughly with the

companys advisers.

Preference share :

This forms part of a companys share capital and usuallygives

preference shareholders a fixed dividend and fixed share of the

company sequity.

Ordinary shares :

This is the riskiest part of a LBOs capital structure. However,

ordinary shareholders will enjoy majority of the upside if the

company is successful.

Q.4 What are the cultural aspects involved in a merger. Give

sufficient examples.

Ans. The value chains of the acquirer and the acquired, need to

be integrated in order to achieve the value creation objectives of

the acquirer. This integration process has three dimensions: the

technical, political and cultural. The technical integration is

similar to the capability transfer discussed above. The

integration of social interaction and political relationships

represents the informal processes and systems which influence peoples ability and motivation to perform. At the time of

integration, the acquirer should have regard to these political

relationships, if acquired employees are not to feel unfairly

treated. An important aspect of integration is the cultural

integration of the acquiring and acquired firms. The culture of

an organization is embodied in its collective value systems,

beliefs, norms, ideologies myths and rituals. They can motivate people and can become valuable sources of efficiency and

effectiveness. The following are the illustrative organizational

diverse cultures which may have to be integrated during post-

merger period :Strong top leadership versus Team approach

Management by formal paper work versus management by

wandering around Individual decision versus group consensus

decision Rapid evaluation based on performance versus Long

term relationship based on loyalty Rapid feedback for changes


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versus formal bureaucratic rules and procedures Narrow career

path versus movement through many areas Risk taking

encouraged versus one mistake you are out Risky activities

versus low risk activities Narrow responsibility arrangement

versus Everyone in this company is salesman (or cost

controller, or product quality improver etc.) Learn from

customer versus We know what is best for the customer The

above illustrative culture may provide basis for the classification

of organizational culture. There are four different types of

organizational culture as mentioned below:

Power

- The main characteristics are: essentially autocratic and

suppressive of challenge; emphasis on individual rather

than group decision making

Role

- The important features are: bureaucratic and

hierarchical; emphasis on formalrules and procedures;

values fast, efficient and standardized culture service

Task/achievement

- The main characteristics are: emphasis on team

commitment; task determines organization of work;flexibility and worker autonomy; needs creative

environment

Person/support

- The important features are: emphasis on equality; seeks

to nurture personal development of individual

Members Poor cultural fit or incompatibility is likely to

result in considerable fragmentation ,uncertainty and cultural

ambiguity, which may be experienced as stressful byorganizational members. Such stressful experience may lead

to their loss of morale, loss of commitment, confusion and

hopelessness and may have adys functional impact on

organizational performance. Mergers between certain types

can be disastrous. Differences in culture may lead to

polarization, negative evaluation of counterparts, anxiety and

ethnocentrism between top management teams of the

acquired and acquiring firms. In assessing the advisability of


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an acquisition, the acquirer must consider cultural risk in

addition to strategic issues .The differences between the

national and the organizational culture influence the cross-

border acquisition integration. Thus, merging firms must

consciously and proactively seek to transform the cultures of

their organizations.

Q.5 Study a recent merger that you have read about and

discuss the synergies that resulted from the merger.

Ans. Synergy is the additional value that is generated by the

combination of two or more than two firms creating

opportunities that would not be available to the firms

independently. There are two main types of synergy

Operating synergy, Financial synergy

Operating Synergy

Operating synergies are those synergies that allow firms to

increase their operating income, increase growth or both. We

would categorize operating ynergies into four types:

1.Economies of scalethat may arise from the merger, allowing the combinedfirm

to become more cost-efficient and profitable. Economics of

scales can beseen in mergers of firms in the same business

For example :

two banks combining together to create a larger bank. Merger

of HDFC bank with Centurian bank of Punjab can be taken

as an example of costreducing operating synergy. Both the

banks after combination can expect to cutcosts considerablyon account of sharing of their resources and thus

avoidingduplication of facilities available.

2.Greater pricing power

from reduced competition and higher market share,which

should result in higher margins and operating income. This

synergy is also more likely to show up in mergers of firms

which are in the same line of business and should be more

likely to yield benefits when there are relatively few firms in


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the business. When there are more firms in the industry

ability of firms to exercise relatively higher price reduces and

in such a situation the synergy does not seem to work as

desired.

An example of limiting competition to increase pricing

power is the acquisition of universal luggage by Blow Plast.

The two companies were in the same line of business and

were in direct competition with each other leading to a severe

price war and increased marketing costs. After the acquisition

blow past acquired as trong hold on the market and operated

under near monopoly situation .Another example is the

acquisition of Tomco by Hindustan Lever.

3.Combination of different functional strengths

, combination of different functional strengths may enhance

the revenues of each merger partner thereby enabling each

company to expand its revenues. The phenomenon can be

understood in cases where one company with an established

brand name lendsits reputation to a company with upcoming

product line or a company. A company with strong

distribution network merges with a firm that has products ofgreat potential but is unable to reach the market before its

competitors can do so .In other words the two companies

should get the advantage of the combination of their

complimentary functional strengths.

4.Higher growth

in new or existing markets, arising from the combination of

the two firms. This would be case when a US consumer products firm acquires an emerging market firm, with an

established distribution network and brand name recognition,

and uses these strengths to increase sales of its

products.Operating synergies can affect margins and growth,

and through these the value of the firms involved in the

merger or acquisition.Synergy results from complementary

activities. This can be understood with the following example

Example :


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Consider a situation where there are two firms A and B. Firm

A is having substantial amount of financial resources (having

enough surplus cash that can be invested somewhere) while

firm B is having profitable investment opportunities ( but is

lacking surplus cash). If A and B combine with each other

both can utilize each other strengths, for example here A can

invest its resourcein the opportunities available to B. note

that this can happen only when the two firms are combined

with each other or in other words they must act in a way as if

they are one.

Financial Synergy

With financial synergies, the payoff can take the form of

either higher cash flow s or a lower cost of capital (discount

rate). Included are the following:1. A combination of a firm with excess cash, or cash

slack, (and limit e d project opportunities) and a firm

with high-return projects (and limited cash) can yield a

payoff in terms of higher value for the combined

firm .The increase in value comes from the projects thatwere taken with the excess cash that otherwise would

not have been taken. This synergy is likely to show up

most often when large firms acquire smaller firms, or

when publicly traded firms acquire private businesses.2. 25Debt capacity can increase, because when two firms

combine, their earnings and cash flows may become

more stable and predictable. This,in turn, allows them

to borrow more than they could have as individualentities, which creates a tax benefit for the combined

firm. This tax benefit can either be shown as higher

cash flows, or take the form of a lower cost of capital

for the combined firm.3. 26Tax benefits can arise either from the acquisition

taking advantage of tax laws or from the use of net

operating losses to shelter income. Thus, a profitable

firm that acquires a money-losing firm may be able to


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use the net operating losses of the latter to reduce its tax

burden. Alternatively, a firm that is able to increase its

depreciation charges after an acquisition will save in

taxes, and increase its value. Clearly, there is potential

for synergy in many mergers. The more important

issues are whether that synergy can be valued and, if so,

how to value it. This result has to be interpreted with

caution, however, since the increase in the value of the

combined firm after a merger is also consistent with a

number of other hypotheses explaining acquisitions,

including under valuation and a change in corporate

control. It is thus a weak test of the synergy hypothesis.

The existence of synergy generally implies that the

combined firm will become more profitable or grow at

a faster rate after the merger than will the firms

operating separately. A stronger test of synergy is to

evaluate whether merged firms improve their

performance (profitability and growth) relative to their

competitors ,after takeovers. On this test, as we show

later in this chapter, many mergers fail.

Q.6 What are the motives for a joint venture, explain with

an example of a joint venture.

Ans:-As there are good business and accounting reasons to

create a joint venture with a company that has

complementary capabilities and resources ,such as

distribution channels, technology, or finance, joint venturesare becoming an increasingly common way for companies to

form strategical liances. In a joint venture, two or more

parent companies agree to share capital, technology,

human resources, risks and rewards in a formation of a new

entity under shared control. Broadly, the important reasons

for forming a joint venture can be presented below:

Internal Reasons to Form a JV


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- Spreading Costs: You and a JV partner can share costs

associated with marketing, product development, and

other expenses, reducing your financial burden

- Opening Access to Financial Resources: Together

you and a JV partner might have better credit or more

assets to access bigger resources for loans and grants

than you could obtain on your own.

- Connection to Technological Resources: You might

want access to technological resources you couldn't

afford on your own, or vice versa.Sharing innovative

and proprietary technology can improve products, as

well as your own understanding of technological

processes.

- Improving Access to New Markets: You and a JV

partner can combine customer contacts and together

even form a joint product that accesses new markets.

- Help Economies of Scale:

Together you and a JV partner can develop products or

services that reduce total overall production expenses. Bringyour product to market cheaper where the customer can enjoy

the cost savings.

- External Reasons to Form a JV

1. Develop Stronger Innovative Product: Together you

and a JV partner may be able to share ideas to develop a

product that is more competitive in your industry.

2. Improve Speed to Market: With shared access to

financial,technological, and distribution resources, you

and a JV partner can get your joint product to market

faster and more efficiently.Strategic Move Against

Competition: A JV may be able to better compete

against another industry leader through the combination

of markets, technology,and innovation.


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Strategic Reasons

- Synergistic Reasons: You may find a JV partner with

whom you can create synergy, which produces a greater

result together than doing it on your own.

- Share and Improve Technology and Skills: Two

innovative companie s can share technology to improve

upon each other's ideas and skills.

- Diversification - There could be many

diversification reasons: access to inversemarkets, development of diverse products,

diversify the innovative working force, etc.

Don't let a JV opportunity pass you by because

you don't think it will fit in with your own

small business. Small and big companies alike

can benefit from the reasons listed above.

Analyze how your company can benefit

internally, externally, and strategically, and

then find a joint venture partner that will fit

with your needs

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MF 0011 Mergers and Acquisitions

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