Corporate Restructuring

CRUM AND GOLDBERG DEFINED RESTRUCTURING OF A

COMPANY AS
“A SET OF DISCRETE DECISIVE MEASURES TAKEN IN
ORDER TO INCREASE THE COMPETITIVENESS OF THE
ENTERPRISE AND THEREBY TO ENHANCE ITS VALUE.”

BY SAURABH JAIN
CORPORATE RESTRUCTURING IN INDIA
—NEED OF THE HOUR
 INTRODUCTION                                                                              
 Corporate restructuring presents a significant challenge to companies; integrating previously distinct companies or business
units requires a clear understanding of how each organization’s process will affect communal structure, technology
requirements, and employee morale.
 Health Net, one of the nation’s largest publicly traded healthcare companies, coalitions and acquisitions helped the company
grow but also created many IT challenges. After multiple coalitions and acquisitions, lack of integration between Health Net’s
disparate systems created inefficiencies that slowed down the company’s daily process. “When core applications and systems
have a difficult time ‘talking’ to each other, the flow of data across the entire organization is slower.
 We wanted to fix that problem immediately,” says Ted Wilkinson, a director of IT at Health Net. In addition to integrating its
core applications, Health Net needed to create an integrated interface for outside vendors to access real-time claims and
eligibility information from what were previously inaccessible back-end systems. By providing this access, Health Net would
strengthen its vendor relationships and improve the quality of its service to customers. After evaluating various integration
vendors, Health Net chose TIBCO Software Inc., a leading enabler of real-time business.
 Part of connecting companies after a coalition or acquisition is fusing together diverse corporate processes and methods of
communication. For Health Net, a central associate portal was crucial to maintaining consistent communication and uniting
associate processes under a single corporate vision.
 “After growing from coalitions and acquisitions, Health Net began to feel more like a collection of separate companies rather
than a unified team,” Yamato-Tucker says. “We wanted to create a more unified feeling among the associates initiated a ‘One
Company, One Mission, One Vision’ campaign. An enterprise-wide portal was the ideal way to bring all departments and
associates together under one corporate umbrella.” Lori Hillman, a senior communications specialist at Health Net, agrees.
“The portal must be the primary communications vehicle for the entire company.”
  The portal gives associates the ability to access critical business tools, view personal benefits and paychecks, submit
suggestions, access online training resources, and perform other important tasks. “The portal has improved our level of
corporate communications,” says Yamato-Tucker. “We now have a vehicle for uniting associates across numerous geographical
locations.” According to Hillman, another benefit of the TIBCO-powered portal is the speed and ease with which they can add
new features. “If the communications department needs to add a new resource to the portal, our IT staff is able to
accommodate our needs very quickly.”
 .The  aspects dealt in this article will be helpful for the companies interested in coalition and reconstruction activities, issues
involved in coalition activities etc. The accountability on the part of purchasing company mostly involves making decision of
one kind or another. It involves choosing particular course of action after considering the possible alternatives. Whatever the
company does, it does through making coalition decision. As for as purchasing companies are concerned such decisions are
vital for improving their bottom-line,  net worth and maximizing the investors value after coalition activity has been carried
out by them. Further more, the profile of the Indian company has changed and it is trying to become a world class company.
 General framework for corporate
restructuring and reorganization
1) Reorganization of assets
a) Acquisitions
b) Sell-offs or divestitures
2) Creating new ownership relationships
a) Spin-offs
b) Split-ups
c) Equity carve-outs
3) Reorganizing financial claims
a) Exchange offers
b) Dual-class recapitalizations
c) Leverage recapitalizations (bankruptcy)
d) Financial reorganization
e) Liquidation
4) Other Strategies
a) Joint ventures
b) ESOPs and MLPs
c) Going-private transactions (LBOs)
d) Using international markets
e) Share repurchase programs
 Reorganizing of Assets

a) When one company purchases another company

and clearly establishes itself as the new owner, the
purchase is called an acquisition.

b) Divestiture, on the other hand, involves sale of a

unit or a segment of company to a third party. The
company’s assets, product lines, subsidiaries or
divisions are sold for cash or securities or a
combination of these.
 Creating New Ownership Relationships

a) In spin-offs, a company distributes all its shares in a subsidiary

to their shareholders on a pro rata basis. As a result, a new
public corporation is formed with the same ownership pattern
as that of the parent organisation. There is no money exchange
and revaluation of subsidiary’s assets. The transaction is treated
as a stock dividend and a tax-free exchange.
b) On the other hand, in a split-up, two or more new companies
are formed in place of the parent company. The parent
company is liquidated after exchanging the stocks of two or
more subsidiary companies for all the parent company's stock.
c) In equity carve-outs, some of the shares of a subsidiary are
offered for sale to the general public as a means to generate
cash for the parent organisation without losing its control.
d) In split-offs, the parent company issues its subsidiary’s shares
to the parent company’s shareholders in return for a specified
number of parent company’s shares.
 Reorganizing Financial Claims
a) An exchange offer provides one or more classes of securities, the right or
option to exchange part or their entire holding for a different class of
securities of the firm.
b) In a dual-class stock recapitalisation, firms establishes a second class
of common stock that has limited voting rights but usually with a
preferential claim to the firm’s cash flows.
c) Leverage recapitalisation involves a relatively large issue of debt that is
used for the payment of a relatively large cash dividend to non-management
shareholders or for the repurchase of common shares, or a combination of
both, thereby increasing the ownership share of the management.
d) Financial reengineering is used by the firms to limit their financial
exposure and also to facilitate merger transactions. If the firm is worth
more “dead than alive”, creditors will force the firm to liquidate. In
liquidation, the firm can be sold in parts or as a whole for an amount that
exceeds the pre- liquidation market values of the firms’ securities.
e) Voluntary liquidations are used when there is a threat of a “bust-up”
takeover.
 Other Strategies

a)Joint ventures are used to acquire complementary technological

or management resources at lower cost, or to benefit from
economies of scale, critical mass and learning curve effect. They
are often used to provide countervailing power among rivals in a
product market and among rivals for a scarce resource.
b)Employee Stock Ownership Plan (ESOP) is a type of stock
bonus plan that invests primarily in the securities of the
sponsoring employer firm. They are designed to promote
employee stock ownership and to facilitate raising of capital by
employers.
c) On the other hand, Master Limited Partnership (MLP) is a
type of limited partnership whose shares are traded publicly. The
limited partnership interests are divided into units that trade as
shares of common stock. MLPs offer investors liquidity via an
organised secondary market for trading of partnership interests.
Both ESOPs and MLPs have tax advantage and both have been
involved in takeover and takeover defense activities.
 Other Strategies
d) Going private refers to the transformation of a public corporation into a privately
held firm. A Leverage Buyout (LBO) is a general form of restructuring wherein the
managers, with the help of some outside agencies, replace the public stockholdings
with closely held equity. Sometimes, the stocks and assets are purchased by a small
group of investors especially buyout specialists or investment bankers or commercial
bankers. Usually, the incumbent management is included in the buying group. The
buyout process varies with few managers preferring the acquisition of the entire
company, while few preferring the acquisition of a division or subsidiary. When the
company’s key executives are involved in the buyout process, it is termed
management buyouts (MBOs).
e) Share repurchase program generally deals with the cash offers for outstanding
shares of common stock thereby helping in changing the capital structure of the firm.
It also helps in reducing the common stock so that the debt/equity ratio or leverage
ratio is increased.
There are four major types of share repurchase programs –
1) Fixed Price Tender Offers (FPTs)
2) Dutch Auctions (Das)
3) Transferable Put Rights (TPRs)
4) Open Market Repurchases (OMRs).
 Tools of Corporate Restructuring

· Amalgamation
· Merger
· Demerger
· Slump sale
· Acquisition
· Joint venture
· Divestment
· Strategic alliance
· Franchises
 
 Amalgamation

In amalgamation, two or more existing companies

merger together or form a new company keeping in
view their long term business interest. The transferor
companies lose their existence and their
shareholders become the shareholders of the new
company. Thus, amalgamation is a legal process by
which two or more companies are joined together to
form a new entity or one or more companies are to
be absorbed or blended with another and as a
consequence the amalgamating company loses its
existence and its shareholders become the
shareholders of the new or amalgamated company.
 Merger

A merger occurs when two companies combine to form

a single company. A merger is very similar to an
acquisition or takeover, except that in the case of a
merger existing stockholders of both companies involved
retain a shared interest in the new corporation.
One use of the merger, for example, is to combine a very
profitable company with a losing company in order to use
the losses as a tax write-off to offset the profits, while
expanding the corporation as a whole. Increasing one's
market share is another major use of the merger,
particularly amongst large corporations.
 Acquisition

By contrast, in an acquisition one company

purchases a bulk of a second company's stock,
creating an uneven balance of ownership in the new
combined company.
Compared to a merger, an acquisition is treated
differently for tax purposes, and the acquiring
company does not necessarily assume the liabilities
of the target company.
 Benefits of M & A

Mergers and acquisitions often lead to an increased

value generation for the company.
An increase in cost efficiency is affected through the
procedure of mergers and acquisitions. This is
because mergers and acquisitions lead to economies
of scale. This in turn promotes cost efficiency.
 Demerger

Demergers are situations in which divisions or

subsidiaries of parent companies are split off into their
own independent corporations.
A demerger may take the form of a
spinoff or
a split-up.
 Joint Venture

Joint ventures are new enterprises owned by two or more participants.

They are typically formed for special purposes for a limited duration.
It is a combination of subsets of assets contributed by two (or more)
business entities for a specific business purpose and a limited
duration. Each of the venture partners continues to exist as a separate
firm, and the joint venture represents a new business enterprise. It is a
contract to work together for a period of time each participant expects
to gain from the activity but also must make a contribution.
Reasons for Forming a Joint Venture
Build on company's strengths
Spreading costs and risks
Improving access to financial resources
Economies of scale and advantages of size
Access to new technologies and customers
Access to innovative managerial practices
 SELL OFF/SLUMP Sale

Selling a part or all of the firm by any one of means: sale, liquidation, spin-
off & so on. or General term for divestiture of part/all of a firm by any one
of a no. of means: sale, liquidation, spin-off and so on.

PARTIAL SELL-OFF
 A partial sell-off/slump sale, involves the sale of a business unit or
 plant of one firm to another.
 It is the mirror image of a purchase of a business unit or plant.
 From the seller’s perspective, it is a form of contraction; from the
 buyer’s point of view it is a form of expansion.

Motives for sell off

  Raising capital
  Curtailment of losses
  Strategic realignment
  Efficiency gain.
 Take Over

Takeover is a strategy of acquiring control over the

management of another company – either directly by
acquiring shares or indirectly by participating in the
management. The objective is to consolidate and
acquire large share of the market. The
 Franchising

 Franchising may be defined as a contract, either expressed or implied,

written or oral, between two persons or parties by which franchisee is
granted the right to engage in the business of offering, selling, distributing
goods and services prescribed in substantial part by franchiser. Operation
of franchisee’s business is substantially associated with franchiser’s
trademark, service mark or logo or advertisement or commercial symbol.
Franchisee pays directly or indirectly the fees to the franchiser. The
franchising may cover the entire system or a specified territory or a
specified retail outlet. Usually franchisers have standard agreements for all
their franchisees because uniformity and conformity is considered very
important.
 Franchising aims primarily at distributing goods and services that have a
high reputation in the market and involves servicing the customers and end
users. Franchisers support, train and to an extent control franchisees in
selling goods and rendering services. The most popular form of franchising
is the product distribution franchise it becomes more complicated when the
franchisee has to market the product that has to be prepared, treated,
assembled, processed or serviced in a specified way, the franchiser being
very reputed and associated with that style of servicing.
 Strategic Alliances

Any arrangement or agreement under which two or

more firms cooperate in order to achieve certain
commercial objectives is called a strategic alliance.
Strategic alliances are often motivated by
considerations such as reduction in cost, technology
sharing, product development, market access to
capital. Strategic alliances facilitate a market entry
strategy, which maximizes the potential for high
return while mitigating economic risks and other
exposures.
 DIVESTITURES

Divesture is a transaction through which a firm sells a

portion of its assets or a division to another company. It
involves selling some of the assets or division for cash or
securities to a third party which is an outsider.
MOTIVES FOR DIVESTITURES
Change of focus or corporate strategy
Unit unprofitable can mistake
Sale to pay off leveraged finance
Antitrust
Need cash
Defend against takeover
Good price.
 Strategy
 The term ‘strategy’ has been defined as “means to an end. The end concerns the purpose and
objectives of the organization. There is a broad strategy for the whole organization and a
competitive strategy for each activity.” The word ‘strategy’ is used to describe the direction that
the organization chooses to follow in order to fulfill its mission.
5 Ps of strategy
 A Plan i.e. strategy is a consciously intended course of action which a firm chooses to follow
after careful deliberations on the various options available to it. It is not the first alternative that
came to the chief executive’s mind like a flash or a dream.
 A Ploy i.e. it is a specific manoeuvre which is intended to outwit an opponent or a competition.
It is a trick, a device, a scheme or a deception to gain advantageous position before engaging
into the combat of marketing warfare.
 A Pattern i.e. it is not one decision and one solitary action; it stands for a stream of decisions
and actions to guide and tend the future course of the enterprise until it reaches its
predetermined corporate objectives.
 A Position i.e. it is a means of locating the firm in an environment full of external factors pulls
and pushes. On most of those factors, enterprise has little control and whatever influence it can
exercise is constrained by its organizational capabilities.
 A Perspective i.e. it is an ingrained way of perceiving the world around the organization and
its business operations. It is greatly influenced by the mindset of people who form the dominant
interest group and are involved in taking decisions affecting the future course that the firm
takes.
 Levels of Strategies

Strategies can be visualized to operate at three

different levels viz.
corporate level
divisional or business level
operational or functional level.
 Levels of Strategies

 Strategies at corporate level focus on the scope of business activities

i.e. what product portfolios to build, to expand and to consolidate.
 Strategies at divisional or business level are directly concerned with
the future plans of the profit centers. These are the sub-strategies as
they devolve from the grand strategies and have market orientation
because these deal with the current and future product lines and
current and future markets including overseas businesses.
 Strategies at operational or functional level target the departmental
or functional aspects of operations and look at the functional
strategies of marketing, finance, human resources, manufacturing,
information systems etc. and devise ways and means of increasing
their contribution to the other levels of strategies. It must be noted
that success of strategies at business or corporate
 Strategic Planning

Strategic planning is a disciplined effort to produce

fundamental decisions and actions that shape and guide
what an organization is, what it does, and why it does it,
with a focus on the future at the same time. A strategic
plan is visionary, conceptual and directional in nature.
Though there is no prescribed single ‘silver bullet’ for
corporate success, there is a continuous need for strategic
planning.
Importance of Strategic Planning
The strength of strategic planning is its ability to harness
a series of objectives, strategies, policies and actions
than can work together. Managing a company
strategically means thinking and accordingly taking
suitable action on multiple fronts
 Features of Strategic Planning

The salient features of strategic planning are as under:

1. It is an inclusive, participatory process in which the Board
and staff take on a ‘shared ownership’
2. It is a key part of effective management
3. It prepares the firm not only to face the future but even
shape the future in its favor.
4. It is based on quality data
5. It draws from both intuition and logic.
6. It accepts accountability to the community
7. It builds a shared vision that is value-based.
8. It helps to avoid haphazard response to environment.
9. It ensures best utilization of firm’s resources among the
product-market opportunities.
 LEVERAGED BUYOUT

 A buyout is a transaction in which a person, group of people,

or organization buys a company or a controlling share in the
stock of a company.
 Buyouts can also be negotiated with people or companies on
the outside. For example, a large candy company might buy
out smaller candy companies with the goal of cornering the
market more effectively and purchasing new brands which it
can use to increase its customer base.
 In a leveraged buyout, the company is purchased primarily
with borrowed funds. In fact, as much of 90% of the purchase
price can be borrowed. This can be a risky decision, as the
assets of the company are usually used as collateral, and if the
company fails to perform, it can go bankrupt because the
people involved in the buyout will not be able to service their
debt.
 LEVERAGED BUYOUT

 Leveraged buyouts wax and wane in popularity depending on economic

trends.
 The buyers in the buyout gain control of the company's assets, and also
have the right to use trademarks, service marks, and other registered
copyrights of the company. They can use the company's name and
reputation, and may opt to retain several key employees who can make the
transition as smooth as possible. However, people in senior management
may find that they are not able to keep their jobs because the purchasing
company does not want redundant personnel, and it wants to get its
personnel into key positions to manage the company in accordance with
their business practices.
 A leveraged buyout involves transfer of ownership consummated mainly
with debt. While some leveraged buyouts involve a company in its entirety,
most involve a business unit of a company. Often the business unit is
bought out by its management and such a transaction is called management
buyout (MBO). After the buyout, the company (or the business unit)
invariably becomes a private company.
 What Does Debt Do?

A leveraged buyout entails considerable dependence on debt.

 
What does it imply?
Debt has a bracing effect on management, whereas equity tends to have
a soporific influence. Debt spurs management to perform whereas
equity lulls management to relax and take things easy.

Risks and Rewards

The sponsors of a leveraged buyout are lured by the prospect of wholly
(or largely) owning a company or a division thereof, with the help of
substantial debt finance. They assume considerable risks in the hope
of reaping handsome rewards. The success of the entire operation
depends on their ability to improve the performance of the unit,
contain its business risks, exercise cost controls, and liquidate
disposable assets. If they fail to do so, the high fixed financial costs
can jeopardize the venture.
 Purpose of debt financing for Leveraged Buyout

The use of debt increases the financial return to the private equity sponsor.
The tax shield of the acquisition debt, according to the Modigliani- Miller theorem
with taxes, increases the value of the firm.

Features of Leveraged Buyout

Low existing debt loads;
A multi-year history of stable and recurring cash flows;
Hard assets (property, plant and equipment, inventory, receivables) that may be
used as collateral for lower cost secured debt;
The potential for new management to make operational or other improvements to
the firm to boost cash flows;

Market conditions and perceptions that depress the valuation or stock price.
Example –
-Acquisition of Corus by Tata.
-Kohlberg Kravis Roberts, the New York private equity firm, has agreed
to pay about $900 million to acquire 85 percent of the Indian software maker
Flextronics Software Systems is the largest leveraged buyout in India.
 Management buyout

In this case, management of the company buys the

company, and they may be joined by employees in the
venture. This practice is sometimes questioned because
management can have unfair advantages in negotiations,
and could potentially manipulate the value of the
company in order to bring down the purchase price for
themselves. On the other hand, for employees and
management, the possibility of being able to buy out their
employers in the future may serve as an incentive to
make the company strong.
It occurs when a company's managers buy or acquire a
large part of the company. The goal of an MBO may be to
strengthen the managers' interest in the success of the
company.
 Purpose of MBO

From management point of view:

To save their jobs, either if the business has been scheduled for closure or if
an outside purchaser would bring in its own management team.
To maximize the financial benefits they receive from the success they bring
to the company by taking the profits for themselves.
To ward off aggressive buyers.

Key considerations in MBO are fairness to shareholders price, the future

business plan, and legal and tax issues.

Benefits of MBO
It provides an excellent opportunity for management of undervalued co’s to
realize the intrinsic value of the company.
Source of tax savings: since interest payments are tax deductible, pushing
up gearing rations to fund a management buyout can provide large tax covers.
 Employees Stock Option Plan (ESOP)

An Employee Stock Option is a type of defined

contribution benefit plan that buys and holds stock.
ESOP is a qualified, defined contribution, employee
benefit plan designed to invest primarily in the stock
of the sponsoring employer.
Employee Stock Option’s are “qualified” in the sense
that the ESOP’s sponsoring company, the selling
shareholder and participants receive various tax
benefits.
With an ESOP, employees never buy or hold the
stock directly.
 Employees Stock Option Plan (ESOP)

FEATURES
Employee Stock Ownership Plan (ESOP) is an employee benefit plan.
The scheme provides employees the ownership of stocks in the company.
It is one of the profit sharing plans.
Employers have the benefit to use the ESOP’s as a tool to fetch loans from a financial institute.
It also provides for tax benefits to the employers.
The benefits for the company: increased cash flow, tax savings, and increased productivity from
highly motivated workers.
The benefit for the employees: is the ability to share in the company's success.

HOW IT WORKS?
Organizations strategically plan the ESOPs and make arrangements for the purpose.
They make annual contributions in a special trust set up for ESOPs.
An employee is eligible for the ESOP’s only after he/she has completed 1000 hours within a year
of service
After completing 10 years of service in an organization or reaching the age of 55, an employee
should be given the opportunity to diversify his/her share up to 25% of the total value of ESOP’s.
 SPIN OFF

 Spinoffs are a way to get rid of underperforming or non-core

business divisions that can drag down profits.
 Process of spin off
 1. The company decides to spin off a business division.
 2.The parent company files the necessary paperwork with
theSecurities
 and Exchange Board of India(SEBI).
 3.The spinoff becomes a company of its own and must also file
 paperwork with the SEBI.
 4.Shares in the new company are distributed to parent company
 shareholders.
 5.The spinoff company goes public.
 Notice that the spinoff shares are distributed to the parent company
 shareholders.
There are two reasons why this creates value:

 1. Parent company shareholders rarely want anything to do with the

new spinoff. After all, it's an underperforming division that was cut
off to improve the bottom line. As a result, many new shareholders
sell immediately after the new company goes public.
 2.Large institutions are often forbidden to hold shares in spinoffs
due to the smaller market capitalization, increased risk, or poor
financials of the new company. Therefore, many large institutions
automatically sell their shares immediately after the new company
goes public.
 Simple supply and demand logic tells us that such large number of
shares on the market will naturally decrease the price, even if it is
not fundamentally justified. It is this temporary mispricing that
gives the enterprising investor an opportunity for profit.
 There is no money transaction in spin-off. The transaction is treated
as stock dividend & tax free exchange.
 SPLIT – OFF & SPLIT-UP-
 Split-off:-
 Is a transaction in which some, but not all, parent company shareholders receive
shares in a subsidiary, in return for relinquishing their parent company’s share.
 In other words some parent company shareholders receive the subsidiary’s shares in
return for which they must give up their parent company shares
 Features
 A portion of existing shareholders receives stock in a subsidiary in exchange for
parent company stock.
 Split-up:-
 Is a transaction in which a company spins off all of its subsidiaries to its
shareholders & ceases to exist.
 The entire firm is broken up in a series of spin-offs.
The parent no longer exists and
Only the new offspring survive.
 In a split-up, a company is split up into two or more independent companies. As a
sequel, the parent company disappears as a corporate entity and in its place two or
more separate companies emerge.
 Squeeze-out: the elimination of minority shareholders by controlling shareholders.
 EQUITY CARVE-OUT

 A transaction in which a parent firm offers some of a subsidiaries common

stock to the general public, to bring in a cash infusion to the parent without
loss of control.
 In other words equity carve outs are those in which some of a subsidiaries
shares are offered for a sale to the general public, bringing an infusion of
cash to the parent firm without loss of control.
 Equity carve out is also a means of reducing their exposure to a riskier line
of business and to boost shareholders value.
 FEATURES OF EQUITY CARVE OUT
 It is the sale of a minority or majority voting control in a subsidiary by
 its parents to outsider investors. These are also referred to as “split-off
IPO’s”
 A new legal entity is created.
 The equity holders in the new entity need not be the same as the equity
holders in the original seller.
 A new control group is immediately created.
 Difference between Spin-off and Equity carve outs:

1. In a spin off, distribution is made pro rata to

shareholders of the parent company as a dividend, a
form of non cash payment to shareholders
In equity carve out; stock of subsidiary is sold to the
public for cash which is received by parent company
2. In a spin off, parent firm no longer has control
over subsidiary assets.
In equity carve out, parent sells only a minority
interest in subsidiary and retains control.
 Master Limited Partnership

Master Limited Partnership’s are a type of limited partnership in which the

shares are publicly traded. The limited partnership interests are divided into
units which are traded as shares of common stock. Shares of ownership are
referred to as units.
MLPs generally operate in the natural resource (petroleum and natural gas
extraction and transportation), financial services, and real estate industries.
The advantage of a Master Limited Partnership is it combines the tax benefits
of a limited partnership (the partnership does not pay taxes from the profit -
the money is only taxed when unit holders receive distributions) with the
liquidity of a publicly traded company.
There are two types of partners in this type of partnership:
1.The limited partner is the person or group that provides the capital to the
MLP and receives periodic income distributions from the Master Limited
Partnership's cash flow
2.The general partner is the party responsible for managing the Master
Limited Partnership's affairs and receives compensation that is linked to the
performance of the venture.
 HOSTILE TAKEOVER

A hostile takeover is a type of corporate takeover which is carried out

against the wishes of the board of the target company. This unique
type of acquisition does not occur nearly as frequently as friendly
takeovers, in which the two companies work together because the
takeover is perceived as beneficial. Hostile takeovers can be traumatic
for the target company, and they can also be risky for the other side, as
the acquiring company may not be able to obtain certain relevant
information about the target company.
Companies are bought and sold on a daily basis. There are two types of
sale agreements. In the first, a merger, two companies come together,
blending their assets, staff, facilities, and so forth. After a merger, the
original companies cease to exist, and a new company arises instead.
In a takeover, a company is purchased by another company. The
purchasing company owns all of the target company's assets including
company patents, trademarks, and so forth. The original company may
be entirely swallowed up, or may operate semi-independently under
the umbrella of the acquiring company
 HOSTILE TAKEOVER

Typically, a company which wishes to acquire another company approaches the target
company's board with an offer. The board members consider the offer, and then
choose to accept or reject it. The offer will be accepted if the board believes that it will
promote the long term welfare of the company, and it will be rejected if the board
dislike the terms or it feels that a takeover would not be beneficial. When a company
pursues takeover after rejection by a board, it is a hostile takeover. If a company
bypasses the board entirely, it is also termed a hostile takeover. Publicly traded
companies are at risk of hostile takeover because opposing companies can purchase
large amounts of their stock to gain a controlling share. In this instance, the company
does not have to respect the feelings of the board because it already essentially owns
and controls the firm. A hostile takeover may also involve tactics like trying to sweeten
the deal for individual board members to get them to agree.

An acquiring firm takes a risk by attempting a hostile takeover. Because the target firm
is not cooperating, the acquiring firm may unwittingly take on debts or serious
problems, since it does not have access to all of the information about the company.
Many firms also have trouble getting financing for hostile takeovers, since some banks
are reluctant to lend in these situations.
 Fighting Hostile Takeovers

If the management of a target firm does not favor a merger or considers the price offered in a proposed merger too
low, it is likely to take defensive actions toward the hostile tender offer .
Numerous strategies such as informing shareholders of the alleged damaging effects of a takeover, acquiring
another company, or attempting to sue the acquiring firm on antitrust. In addition, many other defenses exist such
as:
The white knight strategy involves the target firm finding a more suitable acquirer (the “white knight”) and
prompting it to compete with the initial hostile acquire to takeover the firm. The basic premise of this strategy is
that if being taken over is nearly certain; the target firm ought to attempt to be taken over by the firm that is
deemed most acceptable to its management.
Poison pills typically involve the issue of securities that give their holders certain rights that become effective
when a takeover is attempted. The “pill” allows the shareholders to receive special voting rights or securities that,
once issued, cause the firm to be much less desirable to the hostile acquirer.
Green mail is a strategy by which the firm repurchases through private negotiation a large block of stock at a
premium from one or more shareholders to end a hostile takeover attempt by those shareholders. Clearly
greenmail is a form of corporate black mail by the holders of a large block of shares.
Leveraged recapitalization is a strategy involving the payment of a large debt-financed cash dividend . This
strategy significantly increases the firm’s financial leverage, thereby deterring the takeover attempt. In addition, as
a further deterrent, the recapitalization is often structured to increase the equity and control of the existing
management.
Golden parachutes are special compensation agreements that the company provides to upper management.
The word golden is used because of the lucrative compensation that executives by these agreements receive. They
are provisions in the employment contracts of key executives that provide them with sizable compensation if the
firm is taken over. Golden parachutes deter hostile takeovers to the extent that the cash outflows required by these
contracts are large enough to make the takeover unattractive to the acquirer.
Shark repellents: the target corporation may enact various amendments in the corporate charter that will make
it more difficult for a hostile acquirer to bring about a change in managerial control of the target. These are anti-
takeover amendments to the corporate charter that constrain the firm’s ability to transfer managerial control of the
firm as a result of a merger. Although this defense might not prove long lasting, many firms have had these
amendments ratified by shareholders.
 Divestitures

 It is important to recognize that companies often achieve

external expansion by acquiring an operating unit – plant,
division, product line, subsidiary, etc – of another company.
In such a case the seller generally believes that the value of
the firm will be enhanced by converting the unit into cash or
some other more productive asset. The selling of some of a
firm’s assets is called divestiture. Unlike business failure, the
motive for divestiture is often positive;
 To generate cash for expansion of other product lines,
 To get rid of a poorly performing operation, to streamline the
corporation, or
 Restructure the corporation’s business consistent with its
strategic goals.
 Methods of Divestiture

 First method involves the sale of a product line to another firm.

These outright sales can be accomplished on a cash or stock swap
basis.
 A second method involves the sale of the unit to existing
management. This sale is often achieved through the use of
leveraged buyout (LBO), Sometimes divestiture is achieved through
a spin-off, which results in an operating unit becoming an
independent company. A spin-off is accomplished by issuing shares
in the operating unit being divested on a prorata basis to the parent
company’s shareholders. Such an action allows the unit to be
separated from the corporation and to trade as a separate entity.
Like outright sale, this approach achieves the divestiture objective,
although it does not bring additional cash or stock to the parent
company.
 The final and least popular approach to divestiture involves
liquidation of the operating unit’s individual assets.
 Motives for divestitures

a. A firm may divest (sell) businesses that are not part of its core
operations so that it can focus on what it does best.
b. To obtain funds. Divestitures generate funds for the firm because
it is selling one of its businesses in exchange for cash, so that it
could pay off some of its existing debt.
c. Sometimes a firm's "break-up" value is believed to be greater
than the value of the firm as a whole. In other words, the sum of
a firm's individual asset liquidation values exceeds the market
value of the firm's combined assets. This encourages firms to sell
off what would be worth more when liquidated than when
retained.
d. To divest a part of a firm may be to create stability.
e. To divest a part of the company because a division is under-
performing or even failing.
f. A sixth reason to divest could be forced on to the firm by the
regulatory authorities, example in order to create competition.
Steps in Financial Evaluation of Divestitures
 Typically, when a firm sells a division (or plant) to another company, it transfers the assets of the division along with the
liabilities of the division, with the concurrence of the creditors. This means that the selling firm (referred to hereafter as the
parent firm), in essence, transfers its ownership position in that division. To assess whether it is worth doing so from the
financial point of view, the following procedure may be followed:
 Step 1: Estimate the divisional post-tax cash flow: The parent firm should estimate the post-tax cash flow relating to the
operations of the division and the rest of the operations of the parent firm. The relevant issue in this context is: What happens to
the post-tax cash flow of the parent company with the division and without the division? The difference between the two
represents the post-tax cash flow attributable to the division.
 Step 2: Establish the discount rate for the division: The discount rate applicable to the post-tax cash flow of the division
should reflect its risk as a stand-alone business. A suggested procedure is to look at the cost of capital of a group of firms
engaged solely or substantially in the same line of business and that is about the same size and use it as proxy for the division’s
cost of capital.
 Step 3: Calculate the division’s present value: Using the discount rate determined in Step 2 calculates the present value of
the post-tax of the post-tax cash flow developed in Step 1. This represents the current worth of the cash flow generating
capability of the division.
 Step 4: Find the market value of the division-specific liabilities: The market value of the division specific liabilities is
simply the present value of the obligations arising from the liabilities of the division. Remember that the market value of the
division specific liabilities will be different from the book value of the division-specific liabilities if the contracted interest rates
on these liabilities are different from the current interest rates.
 Step 5: Deduce the value of the parent firm’s ownership position in the division: The value of the ownership
position (VOP) enjoyed by the parent firm in the division is simply: Present value of the division’s Market value of the division-
specific Cash flow minus liabilities (Step 3) (Step 4)
 Step 6: Compare the value of ownership position (VOP) with the divestiture proceeds (DP): When a parent firm
transfers the assets of a division along with its liabilities, it receives divestiture proceeds (DP) as compensation for giving up its
ownership position in the division. So, the decision rule for divestiture would be as follows:
 DP > VOP Sell the division
 DP = VOP Be indifferent,
 DP < VOP Retain the division
 MERGER

A merger occurs when two companies combine to form a single

company. A merger is very similar to an acquisition or takeover,
except that in the case of a merger existing stockholders of both
companies involved retain a shared interest in the new
corporation. By contrast, in an acquisition one company
purchases a bulk of a second company's stock, creating an
uneven balance of ownership in the new combined company.
The entire merger process is usually kept secret from the
general public, and often from the majority of the employees at
the involved companies. Since the majority of merger attempts
do not succeed, and most are kept secret, it is difficult to
estimate how many potential mergers occur in a given year. It is
likely that the number is very high, however, given the amount
of successful mergers and the desirability of mergers for many
companies.
A merger may be sought for a number of reasons, some of which are beneficial
to the shareholders, some of which are not. One use of the merger, for
example, is to combine a very profitable company with a losing company in
order to use the losses as a tax write-off to offset the profits, while expanding
the corporation as a whole. Increasing one's market share is another major
use of the merger, particularly amongst large corporations. By merging with
major competitors, a company can come to dominate the market they
compete in, giving them a freer hand with regard to pricing and buyer
incentives. This form of merger may cause problems when two dominating
companies merge, as it may trigger litigation regarding monopoly laws.
Another type of popular merger brings together two companies that make
different, but complementary, products. This may also involve purchasing a
company which controls an asset your company utilizes somewhere in its
supply chain. Major manufacturers buying out a warehousing chain in order
to save on warehousing costs, as well as making a profit directly from the
purchased business, is a good example of this. PayPal's merger with eBay is
another good example, as it allowed eBay to avoid fees they had been paying,
while tying two complementary products together.
 Tender Offer

 A "tender offer" is a popular way to purchase a majority of shares in

another company. The acquiring company makes a public offer to
purchase shares from the target company's shareholders, thus by
passing the target company's management. In order to induce the
shareholders to sell, or "tender,” their shares, the acquiring
company typically offers a purchase price higher than market value,
often substantially higher. Certain conditions are often placed on a
tender offer, such as requiring the number of shares tendered be
sufficient for the acquiring company to gain control of the target. If
the tender offer is successful and a sufficient percentage of shares
are acquired, control of the target company through the normal
methods of shareholder democracy can be taken and thereafter the
target company's management replaced. The acquiring company
can also use their control of the target company to bring about a
merger of the two companies.
 Benefits of Mergers and Acquisitions

Benefits of mergers and acquisitions are quite a handful. Mergers and acquisitions
generally succeed in generating cost efficiency through the implementation of
economies of scale. It may also lead to tax gains and can even lead to a revenue
enhancement through market share gain.

The principal benefits from mergers and acquisitions can be listed as

increased value generation,
increase in cost efficiency and
increase in market share.
Mergers and acquisitions often lead to an increased value generation for the company.
It is expected that the shareholder value of a firm after mergers or acquisitions would
be greater than the sum of the shareholder values of the parent companies.
An increase in cost efficiency is affected through the procedure of mergers and
acquisitions. This is because mergers and acquisitions lead to economies of scale. This
in turn promotes cost efficiency. As the parent firms amalgamate to form a bigger new
firm the scale of operations of the new firm increases. As output production rises there
are chances that the cost per unit of production will come down.
 CATEGORIES OF MERGER

 a. Horizontal Merger
 This class of merger is a merger between business competitors who are manufactures or distributors of the
same type of products or who render similar or same type of services for profit. It involves joining together of
two or more companies which are producing essentially the same products or rendering same or similar
services or their products and services directly compete in the market with each other. It is a combination of
two or more firms in similar type of production/distribution line of business. Horizontal mergers result in a
reduction in the number of competing companies in an industry, increase the scope for economies of scale and
elimination of duplicate facilities. However, their main drawback, is that they promote monopolistic trend in
the industrial sector as the number of firms in an industry is decreased and this may make it easier for the
industry members to collude for monopoly profits.
 b. Vertical Merger
 Vertical mergers occur between firms in different stages of production operation. In a vertical merger two or
more companies which are complementary to each other e.g. one of companies is engaged in the manufacture
of a particular product and the other is established and expert in the marketing of that product or is engaged in
production of raw material or ancillary items used by the other company in manufacturing or assembling the
final and finished product join together. In this merger the two companies merge and control the production
and marketing of the same product. Vertical merger may take the form of forward or backward merger. When a
company combines with the supplier of material, it is called a backward merger and where it combines with
the customer, it is known as forward merger. A vertical merger may result into a smooth and efficient flow of
production and distribution of a particular product and reduction in handling and inventory costs. It may also
pose a risk of monopolistic trend in the industry. As a whole the efficiency and affirmative rationale of vertical
integration rests primarily on costliness of market exchange and contracting.
 CATEGORIES OF MERGER

 c. Conglomerate Merger
 This type of merger involves coming together or two or more companies engaged in different industries and/or
services. Their businesses or services, are neither horizontally nor vertically related to each other. They lack
any commonality either in their end product, or in the rendering of any specific type of service to the society.
This is the type of merger of companies which are neither competitors, nor complimentary nor suppliers of a
particular raw material nor consumers of a particular product or consumable. In this, the merging companies
operate in unrelated markets having no functional economic relationship.
 d. Congeneric merger
 A congeneric merger is achieved by acquiring a firm that is in the same general industry but neither in the
same line of business nor a supplier or customer. An example is the merger of a machine-tool manufacturer
with the manufacture of industrial conveyor systems. The benefit of this type of merger is the resulting ability
to use the same sales and distribution channels to reach customers of both businesses. A conglomerate merger
involves the combination of firms in unrelated business. The merger of a machine-tool manufacturer with a
chain of fastfood restaurants would be an example of this kind of merger. At first glance it would appear that
such a combination could not provide any operating synergism; admittedly, synergism would be relatively
small compared to that of most vertical or horizontal combinations. But if the operating profit patterns of the
various acquired firms differ as economic changes occur, a portfolio effect might be achieved. This would make
the operating risk of the combination smaller than the risk of the firms standing by themselves. If risk is
reduced while the combination of cash flows is unchanged, the value of the combination may exceed that of its
individual components. There also may be some favorable effects resulting from flexibility of personnel and
transfer of technology, even though the firm appears to be engaged in different lines of business. In this sense
operating synergy may result from conglomerate growth.
 Motives for Merger

 Mergers may be motivated by two other factors that perhaps should not be classified under synergism. These are the opportunity
for an acquiring firm to obtain assets at a bargain price and the desire of shareholders of the acquired firm to increase the liquidity
of their holdings.
 Purchase of Assets at Bargain Price: Mergers may be explained by the opportunity to acquire assets, particularly land,
mineral rights, plant, and equipment, at lower cost than would be incurred if they were purchased or constructed at-current
market prices. If market price of many stocks have been considerably below the replacement cost of the assets they represent,
expanding firm considering constructing plants, developing mines, or buying equipment often have found that the desired assed
could be obtained cheaper by acquiring a firm that already owned and operated the asset . Risk could be reduced because the
assets were already in place and an organization of people knew how to operate them and market their products. Many of the
mergers can be financed by cash tender offers to the acquired firm’s shareholders at price substantially above the current market.
Even so, the assets can be acquired for less than their current costs of construction. The basic factor underlying this apparently is
that inflation in construction costs not fully reflected in stock prices because of high interest rates and limited optimism (or
downright pessimism) by stock investors regarding future economic conditions.
 Increased Managerial Skill or Technology: Occasionally, a firm will have good potential that it finds itself unable to develop
fully because of deficiencies in certain areas of management or an absence of needed product or production technology. If the firm
can not hire the management or develop the technology it needs, it might combine with a compatible firm that has the needed
managerial personnel or technical expertise, of course, any merger, regardless of the specific motive for it, should contribute to
the maximization of owner’s wealth.
 Increased Ownership Liquidity: The merger of two small firms or a small and a larger firm may provide the owners of the
small firm(s) with greater liquidity. This is die to the higher marketability associated with the shares of larger firms. Instead of
holding shares in a small firm that has a every “thin” market, the owners will receive shares that are traded in a broader market
and can thus be liquidated more readily. Not only does the ability to convert shares into cash quickly have appeal, but owning
shares for which market price quotations are readily available provides owners with a better sense of the value of their holdings.
Especially in the case of small, closely held firms, the improved liquidity of ownership obtainable through merger with an
acceptable firm may have considerable appeal.
 Motives for Merger

 Defense against Takeover: Occasionally, when a firm becomes the target of an unfriendly takeover, it will as a defense
acquired another company. Such a strategy typically works like this; the original target firm takes an additional debt to finance its
defensive acquisition; because of the debt load, the target firm becomes too large and too highly levered financially to be of any
further interest to its suitor. To be effective, a defensive takeover must create greater value for shareholders than they would have
realized had the firm been merged with its suitor. In addition, the stockholder-managers of the acquired firm may be offered
attractive management contracts and/or seek the opportunity to rise to positions of greater responsibility in the acquired firm
than would be possible within their small one.
 Leveraged Buyouts and Divestitures
 Before addressing the merger negotiation process and mechanics of merger analysis, it is important to understand two topics that
are closely related to mergers – LBOs and divestitures. An LBO is a method of structuring a financial merger, whereas
divestitures involve the sale of a firm’s assets.
 Leveraged Buyouts (LBOS)
 A popular technique that was widely used during the 1980s to make acquisitions is the leveraged buyout (LBO), which involves
the use of a large amount of debt to purchase a firm. LBOs are clear-cut-examples of financial merger undertaken to create a high-
debt private corporation with improved cash flow and value. Typically in the LBO 90 percent or more of the purchase price is
financed with debt. A large part of the borrowing is secured by the acquired firm’s assets, and the lenders, because of the high risk,
take a portion of the firm’s equity. Junk bonds have been routinely used to raise the large amounts of debt needed to finance LBO
transactions. Of course, the purchasers in an LBO expect to use the improved cash flow to service the large amount of junk bond
and other debt incurred in the buyout. The acquirers in LBOs are other firms or groups of investors that frequently include key
members of the firm’s existing management. An attractive candidate for acquisition through leveraged buyout should possesses
three basic attributes:
 1. It must have a good position in its industry with a solid profit history and reasonable expectations of growth.
 2. The firm should have a relatively low level of debt and a high level of “bankable” assets that can be used as loan collateral.
 3. It must have stable and predictable cash flow that are adequate to meet interest and principal payments on the debt and provide
adequate working capital. Of course, a willingness on the part of existing ownership and management to sell the company on a
leveraged basis is also needed.
 Business valuations

 Business valuation is a process and a set of procedures used to

estimate the economic value of an owner’s interest in a
business. Valuation is used by financial market participants to
determine the price they are willing to pay or receive to
consummate a sale of a business. In addition to estimating the
selling price of a business, the same valuation tools are often
used by business appraisers to resolve disputes related to
estate and gift taxation, divorce litigation, allocate business
purchase price among business assets, establish a formula for
estimating the value of partners' ownership interest for buy-
sell agreements, and many other business and legal purposes.
 Naturally, both sides of an M&A deal will have different ideas
about the worth of a target company: its seller will tend to
value the company at as high of a price as possible, while the
buyer will try to get the lowest price that he can.
 Methods of Valuation

There are, however, many legitimate ways to value companies. The

most common method is to look at comparable companies in an
industry, but deal makers employ a variety of other methods and
tools when assessing a target company. Here are just a few of them:
Comparative Ratios/Multiples - The following are two examples of
the many comparative metrics on which acquiring companies may
base their offers:  
Price-Earnings Ratio (P/E Ratio) - With the use of this ratio, an
acquiring company makes an offer that is a multiple of the earnings
of the target company. Looking at the P/E for all the stocks within
the same industry group will give the acquiring company good
guidance for what the target's P/E multiple should be.  
Enterprise-Value-to-Sales Ratio (EV/Sales) - With this ratio, the
acquiring company makes an offer as a multiple of the revenues,
again, while being aware of the price-to-sales ratio of other
companies in the industry.
 Methods of Valuation

Replacement Cost 
In a few cases, acquisitions are based on the cost of replacing the target
company. For simplicity's sake, suppose the value of a company is simply the
sum of all its equipment and staffing costs. The acquiring company can
literally order the target to sell at that price, or it will create a competitor for
the same cost. Naturally, it takes a long time to assemble good management,
acquire property and get the right equipment. This method of establishing a
price certainly wouldn't make much sense in a service industry where the key
assets - people and ideas - are hard to value and develop.

Discounted Cash Flow (DCF)

A key valuation tool in M&A, discounted cash flow analysis determines a
company's current value according to its estimated future cash flows.
Forecasted free cash flows (net income + depreciation/amortization - capital
expenditures - change in working capital) are discounted to a present value
using the company's weighted average costs of capital (WACC). Admittedly,
DCF is tricky to get right, but few tools can rival this valuation method.
Synergy: The Premium for Potential Success

For the most part, acquiring companies nearly

always pay a substantial premium on the stock
market value of the companies they buy. The
justification for doing so nearly always boils down to
the notion of synergy; a merger benefits
shareholders when a company's post-merger share
price increases by the value of potential synergy.
 What to Look for ?

It's hard for investors to know when a deal is worthwhile. The burden of
proof should fall on the acquiring company. To find mergers that have a
chance of success, investors should start by looking for some of these simple
criteria:  
A reasonable purchase price - A premium of, say, 10% above the market
price seems within the bounds of level-headedness. A premium of 50%, on
the other hand, requires synergy of stellar proportions for the deal to make
sense. Stay away from companies that participate in such contests.
Cash transactions - Companies that pay in cash tend to be more careful
when calculating bids and valuations come closer to target. When stock is
used as the currency for acquisition, discipline can go by the wayside.
Sensible appetite – An acquiring company should be targeting a company
that is smaller and in businesses that the acquiring company knows
intimately. Synergy is hard to create from companies in disparate business
areas. Sadly, companies have a bad habit of biting off more than they can
chew in mergers.
 The Real Deal

 Start with an Offer

 When the CEO and top managers of a company decide that they
want to do a merger or acquisition, they start with a tender offer. The
process typically begins with the acquiring company carefully and
discreetly buying up shares in the target company, or building a
position. Once the acquiring company starts to purchase shares in
the open market, it is restricted to buying 5% of the total outstanding
shares before it must file with the SEC. In the filing, the company
must formally declare how many shares it owns and whether it
intends to buy the company or keep the shares purely as an
investment.  
 Working with financial advisors and investment bankers, the
acquiring company will arrive at an overall price that it's willing to
pay for its target in cash, shares or both. The tender offer is then
frequently advertised in the business press, stating the offer price
and the deadline by which the shareholders in the target company
must accept (or reject) it.
 The Target's Response

Once the tender offer has been made, the target company can do one of several things:
 Accept the Terms of the Offer - If the target firm's top managers and shareholders are happy
with the terms of the transaction, they will go ahead with the deal.  
 Attempt to Negotiate - The tender offer price may not be high enough for the target company's
shareholders to accept, or the specific terms of the deal may not be attractive. In a merger, there
may be much at stake for the management of the target - their jobs, in particular. If they're not
satisfied with the terms laid out in the tender offer, the target's management may try to work
out more agreeable terms that let them keep their jobs or, even better, send them off with a
nice, big compensation package.
Not surprisingly, highly sought-after target companies that are the object of several bidders will
have greater latitude for negotiation. Furthermore, managers have more negotiating power if
they can show that they are crucial to the merger's future success.
 Execute a Poison Pill or Some Other Hostile Takeover Defense – A poison pill scheme can be
triggered by a target company when a hostile suitor acquires a predetermined percentage of
company stock. To execute its defense, the target company grants all shareholders - except the
acquiring company - options to buy additional stock at a dramatic discount. This dilutes the
acquiring company's share and intercepts its control of the company.
 Find a White Knight - As an alternative, the target company's management may seek out a
friendlier potential acquiring company, or white knight. If a white knight is found, it will offer
an equal or higher price for the shares than the hostile bidder.
 Closing the Deal
 Finally, once the target company agrees to the tender offer and regulatory
requirements are met, the merger deal will be executed by means of some
transaction. In a merger in which one company buys another, the acquiring
company will pay for the target company's shares with cash, stock or both.
 A cash-for-stock transaction is fairly straightforward: target company shareholders
receive a cash payment for each share purchased. This transaction is treated as a
taxable sale of the shares of the target company.
 If the transaction is made with stock instead of cash, then it's not taxable. There is
simply an exchange of share certificates. The desire to steer clear of the tax man
explains why so many M&A deals are carried out as stock-for-stock transactions.
 When a company is purchased with stock, new shares from the acquiring
company's stock are issued directly to the target company's shareholders, or the new
shares are sent to a broker who manages them for target company shareholders.
The shareholders of the target company are only taxed when they sell their new
shares.
 When the deal is closed, investors usually receive a new stock in their portfolios -
the acquiring company's expanded stock. Sometimes investors will get new stock
identifying a new corporate entity that is created by the M&A deal.
 Factors Dominating Situations

Market Value
Market value will dominate when there are dissenter problems. Great deviation from
market value threatens to result in litigation beyond the problem of receiving the cash
needed for dissenters. However, when ‘market’ value represent a thin or even a
supported market, only the naïve company will be trapped into reorganizing market
value.
Book Value
Book value is likely to dominate first in the case where liquidity carries a premium.
This might occur, for example, at any time when the capital market and/or the
economy as a whole have slowed down and new securities of any kind are difficult to
market at any thing approximating a reasonable price. A second situation where book
value will be dominant is where the market value of the assets of one company is well
above the market value of its shares.
Dividends
Dividend rates of the two companies are not likely to influence the terms of the merger
but can be expected to affect the form of securities used. Dividend depends on
earnings and policy as to payout. But in a merger every effort will be spent to use a
type of security which will preserve existing cash dividends for shareholders of the
acquired company. The payout policy of fused operation can not be readily determined
in advance except where the policies of both companies have been nearly the same,
thus creating an expectation that the same pattern will continue.
 Factors Dominating Situations

Earnings
Earnings are sometime stated to be the dominant single factor, and ‘earnings’ in such a
statement means historical earnings. The relevant earnings, however, are expected
further earnings and these are reflected in market value. Variability of earnings is a
factor to be considered, but his is reflected in market value and appears in the price-
earnings ratios, which reflect risk as well as growth prospects.
Dissenting Shareholders
Although a combination generally depends only upon the approval of a required
majority of the total number of shares outstanding, minority shareholders can contest
the price paid for their share, if a dissenting shareholder and the company fails to
agree as to just settlement on a voluntary basis, the shareholder can take his case to
court and demand an appraisal of his shares and a settlement in cash. After a fair-
market price has been established by the court the dissenting shareholders receives
payment in cash for his shares. If the number of dissenting shareholders is large, they
can cause considerable trouble. If the transaction is in share, the demands for cash
payments on the part of these shareholders may put a severe financial strain on the
combination. Thus, most combinations depend not only upon obtaining approval of a
required majority of shareholders but also upon minimizing the number of dissenting
shareholders by making the offer attractive to all. Dissenting shareholders may be able
to block the combination if they suspect that fraud is involved, even through the
required majority of shareholders has approved it.
 DFCF or NPV Approach

When the investment that is required to purchase the target firm is deducted
from the discounted future cash flows or earnings, this amount becomes the
NPV.
Its based on projecting the magnitude of the future monetary benefits that a
business will generate. The benefits are then discounted back to present value
to determine the current value of the future benefits.

NPV = I0- Σ FB1/(1+r) +…..=FBn/(1+r)n

Where:
FBi = future benefit in year i
r = discount rate
I0 = investment at time 0

The cash flows or earnings must be adjusted before constructing a projection

so that the projected benefits are equal to the value that a buyer would derive.
 Valuation

When we the value a business though DCF it’s a two part process.
1.Value the cash flows that have been specifically forecasted for a period over
which the evaluator feels comfortable about the accuracy of the forecast.
Typically this is five years in length.
2.Valuing the remaining cash flows as a perpetuity. This value is sometimes
referred as continuing value. The longer the specific forecast the smaller the
continuing value
Value of the Business(BV) = Value derived from the specific forecast period +
Value of the remaining cash flows

BV= FCF1/(1+r) + FCF2/(1+r)2..+FCF5/(1+r)5+FCF6/(r-g)/(1+r)5

BV= Value of Business

FCFi = free cash flow in the ith period
G = growth rate in future cash flows after the fifth year
Note that after 5th year all FCF’s are measured by treating them as a perpetuity
that is growing at a certain rate, g.
 Continuing Value

The continuing value represents the value that the business

could be expected to be sold for at the end of the specific
forecast period. We can arrive at the value by using either
perpetuity or an exit multiple.
If a higher multiple is relevant as of the date of acquisition
due to the company being in an initial high-growth phase
of its life cycle, perhaps a lower multiple, consistent with
mature firms in that industry, would be more relevant as in
exit multiple.
CV1= (10,000,000)(1.06)/(0.11-0.06) = 212,000,000
CV2= (10,000,000)(1.05)/(0.111-0.05) = 175,000,000
The extra 1% growth rate increased the CV by 21%
 Quaker Oats’ Acquisition of Snapple

Oats acquire Snapple for $1.7b in 1994

In March 97 quaker announced that it was selling snapple
for $300m to Triac Cos. (snapple, rc cola Mistic)
Oats clearly overvalued Snapple and thought that its
growth, which before the acquisition had been impressive,
would continue. Snapple used its prior growth to demand a
high premium, as it should have done.
Oats CEO William Smithburg
In 2000, Triac sold (snapple, rc cola, mistic) to cadbury for
$1 b plus the assumption of $420m of debt. This was a
great deal for Triac when one considers that it invested
only $75m in equity and borrowed the rest from debt.
 Why did Quaker Overpay?

One factor that is clear that it believed there was more

growth potential in the snapple business than what was
really there.
Snapple had grown impressively before that year but the
buyer needed to assess whether that growth was
sustainable or not.
One way to do that would be to determine how many more
food outlet Snapple could get into.
Was it already in most of the food stores that it would be
able to get into in the US markets?
Could it really increase sales significantly at the outlets it
was already in ?
 Defining FCF

FCF = EBITDA- CE-CWC-CTP

EBITDA= Earnings before interest, taxes, depreciation

& amortizations
CE= Capital Expenditure
CWC= Changes in Working Capital
CTP= Cash Taxes Paid
 Choice of Discount Rate

It requires that the riskiness of the target and the volatility

of its cash flows are assessed.
If the project is judged to be without risk, the appropriate
discount rate would be the rate offered on the treasury bills
or other short term govt securities with a maturity of up to
1 year.
Cost of capital & Discount rate
CC= Σwi ki
Where wi = the weight assigned to the particular ki.This
weight is the percentage of the total capital mix of the firm
that this source of capital accounts for.
Ki= the rate of this source of capital
 Components of Capital
 Cost of Debt
Kt = kd(1-t)
kt= the after tax cost of debt
Kd= the pretax cost of debt
T = actual corporate tax rate.

 Cost of preferred Stock

Dp/Pn

 Cost of Common Stock

Ri= Rrf+ beta(Rm-Rrf)
Ri is rate of return on equity
Rrf= risk free rate
Rm= market rate of return
Rm- Rrf= the market risk premium

Ps= Di/(Ke-g) or Ke= Di/P0+g

Ke = Capitalisation rate of stock
Di = dividend paid in the period
Ps= price of the firms stock
G= growth rate of dividends
Cr Indian scenario
Financing of m & a
Regulatory issues in cr in india