Mergers & Acquisition

UNIT – 5
BY:- Dr. MANJUSHA GOEL
Assistant Professor
 Exchange Ratio
 In mergers and acquisitions (M&A), the exchange ratio measures the
number of shares the acquiring company has to issue for each
individual share of the target firm. For M&A deals that include shares
as part of the consideration (compensation) for the deal, the share
exchange ratio is an important metric. Deals can be all cash, all
shares, or a mix of the two.

 Formula

 Exchange Ratio = Offer Price for Target’s Shares / Acquirer’s

Share Price
 Example of Exchange Ratio
 Assume Firm A is the acquirer and Firm B is the target firm. Firm B
has 10,000 outstanding shares and is trading at a current price of
Rs.17.30 and Firm A is willing to pay a 25% takeover premium. This
means the Offer Price for Firm B is Rs. 21.63. Firm A is currently
trading at Rs.11.75 per share.
 To calculate the exchange ratio, we take the offer price of Rs.21.63
and divide it by Firm A’s share price of Rs.11.75.
 The result is 1.84. This means Firm A has to issue 1.84 of its own
shares for every 1 share of the Target it plans to acquire.
 Importance of the Exchange Ratio
 In the event of an all-cash merger transaction, the exchange ratio is not a useful
metric. In fact, in this situation, it would be fine to exclude the ratio from the
analysis. Often times, M&A valuation models will note the ratio as “0.000” or blank,
when it comes to an all-cash transaction.
 Alternatively, the model may display a theoretical exchange ratio, if the same value
of the cash transaction were, instead, to be carried out by a stock transaction.
 In the event of a 100% stock deal, the exchange ratio becomes a powerful metric. It
becomes virtually essential and allows the analyst to view the relative value of the
offer between the two firms.
 In the event of a split deal, where a portion of the transaction involves cash and a
portion involves a stock deal, the percentage of stock involved in the transaction
must be considered.
 Complications
 Accounting for exchange ratios becomes more difficult when analysing
the firm’s values. This is because it involves the transfer of some value
of the acquirer firm into the target firm’s owners. When an acquiring
firm offers cash to the target firm, the effect is simple. The target firm is
absorbed by the acquirer in exchange for cash.
 However, when an acquirer offers stock in its own firm for the target
firm, the valuation becomes more complex. This is because some of
the value of the acquiring firm is diluted and given to the target firm.
After the transaction, some of the value of the merged firm and its
synergies will be owned by the target firm. Thus, this must be taken
into account when calculating the proper exchange ratio to use in an
M&A transaction.
 SYNERGY
 Synergy in M&A is the approach of the business units that if they
combine their business by forming one single unit and then working
together for the accomplishment of common objective, then the total
earnings of the business can be more than the sum of earnings of
both the businesses earned individually and also the cost can be
reduced by such merger.

 Synergy is the concept that allows two or more companies to

combine together and either generate more profits or reduce costs
together. These companies believe that combining with each other
gives them more benefits than being single and doing the same.
 M&A Synergies
 A synergy arises in a merger or acquisition when the combined value of the
two firms is higher than the pre-merger value of both firms combined.
 For example, if firm A has a value of Rs.500M, firm B has a value of Rs.75M,
and the merged firm has a value of Rs.625M, there is a Rs.50M synergy for
this merger.
 Synergies arise out of cost reductions, due to efficiencies in the newly
combined firm. Alternatively, they may arise due to new net
incremental revenues brought about by the merged firm.
 There are different types of synergies. The two most common tangible types
are cost savings and revenue upside arising out of the merged firm.
 However, there are other “softer” synergies that may also arise due to a
merger. One example is a common corporate culture that will allow the
merged firm to be more easily successful.
 TYPES OF SYNERGY
 There are usually three types of synergies in mergers and acquisitions that occur among
companies.–

 1 – Revenue Synergy
 This is the first of the three types of synergy in mergers and acquisitions. If two companies go
through revenue synergy, they happen to sell more products. For example, let’s say that G Inc.
has acquired P Inc. G Inc. has been in the business of selling old laptops. P Inc. is not a direct
competitor of G Inc., But P Inc. sells new laptops quite cheaply. P Inc. is still very small in profit
and size, but they have been giving great competition to G Inc. since it is selling new laptops at a
much lesser price.

 As G Inc. has acquired P Inc., G Inc. has increased its territory from selling only used laptops to
selling new laptops in a new market. By going through this acquisition, the revenue of both of
these companies will increase, and they would be able to generate more revenue together
compared to what they could have done individually.

 And here lies the significance of revenue synergy.

 2 – Cost Synergy

 The second type of synergy in Mergers is the cost synergies. Cost synergy allows two companies to

reduce costs as a result of the merger or acquisition. If we take the same example we took above, we

would see that as a result of the acquisition of P Inc., G Inc. is able to reduce the costs of going to a new

territory. Plus, G Inc. is able to get access to a new segment of customers without incurring any

additional cost.

 Cost reduction is one of the most important benefits of cost synergy. In the case cost synergy, the rate of

revenue may not increase; but the costs would definitely get reduced. In this example, when the cost

synergy happens between G Inc. and P Inc., the combined company is able to save a lot of costs on

logistics, storage, marketing expenses, training expenses (since the employees of P Inc. can train the

employees of G Inc. and vice-versa), and also in market research.

 That’s why cost synergy is quite effective when the right companies merge together, or one
company acquires another. The merger between the National Bank of Abu Dhabi and First
Gulf Bank will result in the cost synergies of around Dh 1 billion. The cost synergies are
expected to realize over the next three years, driven by network and staff reductions,
system integration, consolidation of common business functions, etc.

 3 – Financial Synergy

 The third type of synergy in mergers and acquisitions in the Financial Synergy. If a mid-level

company goes to borrow a loan from a bank, the bank may charge more interest. But what if two

mid-level companies merge and as a result, a large company goes to borrow the loan from the

bank, they will get benefits since they would have better capital structure and better cash flow to

support their borrowings. Financial synergy is when two mid-sized companies merge together to

create financial advantages.

 By going for financial synergy, these two companies not only achieve financial advantages in

the case of borrowing loans or paying less interest, but they also are able to achieve

additional tax benefits. Plus, they are also able to increase their debt capacity and to reduce

the combined cost of capital.

 As an example, we can say that Company L and Company M have merged to create a

financial synergy. Since they are mid-level companies, and if they operate individually, they

need to pay a premium for taking loans from the banks or would never be able to reduce the

cost of capital. That’s why the merger has turned out to be quite beneficial for both of these

companies, and we can call it financial synergy in Mergers and Acquisitions.

 How are Synergies Estimated
 One approach to the way merger synergies are forecasted is by
comparing like-transactions. In other words, comparable acquisitions
are reviewed as a starting point for potential synergies.
 Initially, it may be difficult to quantitatively estimate synergies as the
operations merge as the logistic intricacies are not yet known until
post-merger. Thus, synergies may be first estimated qualitatively.
 Another approach is to look internally at the two companies and
perform as much analysis as possible. A bottom-up analysis should
be performed to see how the acquiring firm expects the target
firm’s assets and operations to line up and what cost savings can be
made.
 This second approach is more detailed and possibly more accurate,
however, it is very challenging for anyone outside of the deal to
perform themselves.
 Ways to Estimate M&A Synergies
1. Analyze headcount and identify any redundant staff members that can be eliminated (i.e. the new
company doesn’t need two CFOs).

2. Look at ways to consolidate vendors and negotiate better terms with them (i.e. purchase goods/services
at lower prices).

3. Evaluate any head office or rent savings by combining offices.

4. Estimate the value saved by sharing resources that aren’t at 100% utilization (i.e. trucks, planes,
transportation, factories, etc.).

5. Look for opportunities to increase revenue by upselling complementary products or increase prices by
eliminating a competitor.

6. Reduce professional services fees.

7. Operating efficiency improvements from sharing “best practices.”

8. Human capital improvements from “top grading” exercises and potential ability to attract superior talent at
NewCo.

9. Improve distribution strategy by serving customers with closer locations

10. Geo-arbitrage – Reduce labor costs by hiring in other countries if the target is in another country.
 Risks for Synergies
 Synergies are not effective immediately after the merger takes
place. Typically, these synergies are realized two or three years
after the transaction. This period is known as the “phase in”
period, where operational efficiencies, cost savings, and
incremental new revenues are slowly absorbed into the newly
merged firm.
 In fact, in the short term costs may actually go up as the
integration incurring one-time expenses and a short-term
inefficiency due to lack of history working together and culture
clashes. If a culture clash is too great, synergies may never be
realized.
 Synergy Valuation
 When a company acquires another business, it is often justified by the argument
that the investment will create synergies. The primary source of synergy in
an acquisition is in the presumption that the target firm controls a specialized
resource that becomes more valuable if combined with the acquiring firm’s
resources. There are two main types, operating synergy and financial synergy.

 1. Operating synergy
 Operating synergies create strategic advantages that result in higher returns on
investment and the ability to make more investments and more sustainable excess
returns over time. Furthermore, operating synergies can result in economies of
scale, allowing the acquiring company to save costs in current operations, whether
it be through bulk trade discounts from increased buyer power, or cost savings by
eliminating redundant business lines.
 Types of operating synergies to value include:
• Horizontal Integration: Economies of scale, which reduce costs,
or from increased market power, which increases profit
margins and sales.

• Vertical Integration: Cost savings from controlling the value chain

more comprehensively.

• Functional Integration: When a firm with strengths in one

functional area acquires another firm with strengths in a different
functional area, the potential synergy gains arise from
specialization in each respective functional area.
2. Financial synergy
Financial synergies refer to an acquisition that creates tax benefits,
increased debt capacity and diversification benefits. In terms of tax
benefits, an acquirer may enjoy lower taxes on earnings due to higher
depreciation claims or combined operating loss carry forwards.
Second, a larger company may be able to incur more debt, reducing its
overall cost of capital.
And lastly, diversification may reduce the cost of equity, especially if the
target is a private or closely held firm.
 Merger Gains to Shareholders
 Shareholders of the Target: The value paid for the target’s shares in excess
of the pre-merger market price is the takeover premium. The amount of the
takeover premium is a gain for the target’s shareholders.

 Shareholders of the Acquirer: The shareholders of the acquiring company

are assuming greater risk in the merger because their gains depend on the
ability of management to create synergy value that exceeds the takeover
premium.

 Gains for Shareholders acquirer = Synergies – Takeover Premium

 If synergies do not exceed the takeover premium, then value for shareholders
of the acquirer will be negative (i.e. a decline in share price).
Post Merger Valuation
Assuming that the acquiring firm has made correct estimates
in the valuation process, the following formula will calculate
the post merger value of the acquirer:

V Acq. Post-merge = V Acq. Pre-merge + V Target pre-merge + Synergies –

Cash paid to target firm shareholders
 Earnings per Share (EPS)
 Proforma earnings per share (EPS) is the calculation of EPS assuming a merger and
acquisition (M&A) takes place and all financial metrics, as well as the number of shares
outstanding, are updated to reflect the transaction. “Pro forma” in Latin means “for the sake
of form.” In this case, it refers to calculating EPS “for the sake of form” in the event of the
acquisition.
 Basic EPS is calculated by dividing a firm’s net income by its weighted shares outstanding.
The pro forma EPS, on the other hand, adds the target firm’s net income and any
additional synergies or incremental adjustments to the numerator, while adding
new shares issued due to the acquisition to the denominator.

 Proforma Earnings per Share EPS Formula:

 Here is the formula for proforma earnings per share:

 Pro Forma EPS = (Acquirer’s Net Income + Target’s Net Income +/- “Incremental
Adjustments” ) / (Acquirer’s shares outstanding + New Shares Issued)
 Earnings per Share in M&A
 Proforma EPS is used by the acquiring company to determine the financial outcome they
will have by acquiring the target or merging with the target. This allows the acquirer to
determine whether this transaction will be accretive or dilutive and cause a positive effect on
their EPS. Simply analysing an acquisition or merger on the basis of EPS is not
recommended, as there are situations where EPS can increase, but the value of the merged
firm is lower than the sum of the acquirer and target.

 What are the “Incremental Adjustments”?

 These are additional value items that are created when the two firms combine, which impact
proforma earnings per share:
• Incremental after-tax interest expenses that come from new debt financing.

• After-tax synergies (gains in assets).

• After-tax depreciation and amortization expense (from write-ups).

• Lost opportunity cost of cash balances if used to finance the acquisition.

• “Saved” after-tax interest expense from the liquidation of target’s
debt.

• “Saved” preferred stock dividend payment from liquidation or

conversion of target’s preferred stock.

 For example, a manufacturing company merges with a

transportation firm. Due to this merge, the manufacturing firm can
save on their original distribution costs, which were initially paid out
to a third party. Because they can now use the assets of the
transportation, they realize after-tax savings of Rs.50lakh. The
incremental adjustment here is an after-tax synergy arising from
those savings of Rs50lakh, which did not originally exist when the
firms were separate.
 Required Rate of Return of Merged Company
 When corporate buyers are looking at acquiring another company, the executive
team often wonders what rate of return they should be seeking on their invested
capital. Using a low rate of return could cause the buyer to overpay, and not
provide adequate compensation for the risk that the acquired company's financial
results will fall short of expectations following the transaction. A high rate of return
could mean that the buyer's offer isn't competitive, and the seller chooses another
suitor.
 Rates of return are highly subjective, and there is no "right" answer. However,
buyers should consider the following factors when developing rates of return for the
purpose of corporate acquisitions:
 (i) prevailing risk free rates
 (ii) an equity risk premium
 (iii) liquidity risk
 (iv) company-specific risk
 (v) debt capacity.
 Prevailing Risk Free Rates
Appropriate rates of return are a function of alternative investments that can be made with
available capital. Since corporate acquisitions represent long-term investment decisions, the
starting point in the rate of return analysis should be the yield on long-term government bonds,
which represents a "risk-free" investment alternative.

 Equity Risk Premium

Since corporate acquisitions represent equity investments, the next element to consider is the
premium that a buyer could expect to generate by investing in the stock market in general, as
opposed to risk-free government bonds. While equity returns fluctuate each year, over the long-
term the equity risk premium (which reflects capital appreciation and dividend income for stocks
listed on major indices such as the S&P 500).
 Liquidity Risk
Adding the yield to maturity on long-term government bonds and the equity risk premium
suggests that an equity investment should generate a return of about total of both investment per
annum, over the long term. But it's important to recognize that this represents the return on a
very liquid and highly diversified stock portfolio such as the S&P 500. Both of these elements are
missing when a buyer acquires a private company. Therefore, the rate of return has to be
adjusted accordingly.
 With respect to liquidity, an investor could sell most publicly traded shares in minutes if they no
longer wanted to be invested. However, the divestiture of a private company normally takes
between six to twelve months to complete, during which time the owners are exposed to the
risk of adverse developments which could erode the company's value. Furthermore, unlike
publicly traded stocks where the price is readily known, there's uncertainty regarding the price
that might be obtained for a private company when it's sold in the open market.

 Liquidity risk is difficult to quantify, but a benchmark that's sometimes used is based on the
observed discounts in restricted stock studies. That is, shares of public companies that are not
freely tradable for a period of about six months to 24 months are worth less than comparable
shares that can be readily liquidated.
 However, the median discount for restricted stock has been around 20% (i.e. restricted shares
are worth about 20% less than comparable shares without restrictions). Converting this
discount into rates of return for private company acquisitions suggests that target rates of
return should be increased by about 2% to compensate for liquidity risk.
 Company-specific Risk
 As previously discussed, the equity risk premium is based on a stock portfolio that enjoys the
benefits of liquidity and diversification. In the absence of diversification, buyers need to
consider company-specific risk inherent in the acquisition target. This can be highly
subjective.
 Company-specific risk can range from about 2% for larger, well-established companies with a
strong competitive advantage, to 10% (or more) for smaller companies that are dependent on
a handful of customers or certain employees (e.g. the business owner). While not an
exhaustive list, some of the factors that buyers should consider when quantifying company-
specific risk for an acquisition target include:
• whether its product and service offerings have a differential advantage, or alternatively
whether the company must compete primarily on the basis of price;
• the degree of customer concentration and repeat business;
• the breadth, depth and commitment of the management team;
• whether historical operating results have been relatively stable or volatile; and
• industry-specific risk factors such as the competitive landscape, regulations, and major
trends.
Combining the risk-free rate with the equity risk premium, liquidity risk premium and company-
specific risk premium suggests that a return on equity for a corporate acquisition should be in
the range of about 12% to 20%, with the major variable being company-specific risk. Note that
this assumes the acquisition target is an established company, as opposed to an early-stage
business or venture capital type investment, for which rates of return can be significantly higher.
 Debt Capacity
A buyer's ability to use debt in lieu of equity in order to finance an acquisition helps to reduce
the required rate of return. This is because the interest rate on debt financing is lower than the
required return on equity financing, particularly given that interest expense is tax-deductible.
Whether or not a buyer intends to use debt as a source of financing, rates of return for
corporate acquisitions should be based on the target company's ability to accommodate senior
debt in its capital structure.
Debt financing ratios are subjective, but are mainly driven by two factors that lenders look for,
being:
• the level and stability of cash flows, which are required to service interest and principal
repayments; and
• the quantum and nature of assets that can be used as security.
 It's important to note that while debt is attractive due to its low cost, the use of debt
introduces financial risk, which increases the required return on equity. This is because
debt financing ranks ahead of equity financing in its claim against the cash flows and
assets of the acquired company..
 Demerger
 Definition: Demerger is the business strategy wherein company transfers one or more of
its business undertakings to another company. In other words, when a company splits off
its existing business activities into several components, with the intent to form a new
company that operates on its own or sell or dissolve the unit so separated, is called a
demerger.

 Section 232 of the Chapter XV of Companies Act 2013 deals with mergers and
amalgamation including demergers.
 Demerger is a form of corporate restructuring which in undertaken by companies in order
to promote specialization. Companies have started practicing demerger because of the
many benefits it offers. Demerger allows a company to expand its operations in a very
systematic manner. It allows a specific division or unit to grow as a separate and a focused
entity, thereby increasing its efficiency and effectiveness. It benefits the shareholders by
providing them better opportunities to participate in the management, operations, decision
making process and profits of the applicant company as well as the resulting company.
 Demerger
 A demerged company is said to be one whose undertakings are transferred to the other
company, and the company to which the undertakings are transferred is called the
resulting company. The demerger can take place in any of the following forms:
 Spin-off: It is the divestiture strategy wherein the company’s division or undertaking is separated
as an independent company. Once the undertakings are spun-off, both the parent company and
the resulting company act as a separate corporate entities.

 Generally, the spin-off strategy is adopted when the company wants to dispose of the non-core
assets or feels that the potential of the business unit can be well explored when operating under
the independent management structure and possibly attracting more outside investments.

 Wipro’s information technology division is the best example of spin-off, which got separated from
its parent company long back in 1980’s.

 Split-up: A business strategy wherein a company splits-up into one or more independent
companies, such that the parent company ceases to exist. Once the company is split into
separate entities, the shares of the parent company is exchanged for the shares in the new
company and are distributed in the same proportion as held in the original company, depending
on the situation.

 The company may go for a split-up if the government mandates it, in order to curtail the monopoly
practices. Also, if the company has several business lines and the management is not able to
control all at the same time, may separate it to focus on the core business activity.
 Demerger can be affected by any of the following ways:-
1. Demerger by agreement between promoters; or

2. Demerger under the scheme of arrangement with approval by the Court under section 232
of Chapter XV.

 Demerger by Agreement between Promoters

Demerger may take place by agreement between promoters of the demerging company. In
such a scenario, the principle company may spin off its specific undertakings to the resulting
company. All the property, liabilities and issues of the principle company, transferred to the
resulting company immediately before the demerger, becomes the property, liabilities and
issues of the resulting company.

 DEMERGER UNDER THE SCHEME OF ARRANGEMENT WITH APPROVAL BY THE

TRIBUNALS UNDER SECTION 232 OF THE COMPANIES ACT
In order to affect a demerger, there must be a provision in the Memorandum of understanding
of the principle company. The scheme of such arrangement has to be submitted in the
respective Tribunal having jurisdiction.
 Process for Demerger
 Whenever Company plans to de-merge one of its undertaking from Main Business, then most
adoptable process is De-Merger of Company. Demerger is in fact a corporate partition of a
company into two or more undertakings, thereby retaining one undertaking with it and by
transferring the other undertaking to the resulting company or companies. It is a scheme of
business reorganization. De-merger is not defined specifically in Companies Act, 2013.
However, an explanation is given to section 230(1) of the said act prescribes it as an
arrangement for the reorganization of the company’s share capital by:
1. Consolidation of shares of different classes

2. Division of shares of different classes

3. Or both

 Demerger is mentioned in section 2(19AA) of the Income Tax Act, 1961, subject to fulfilling the
conditions stipulated in section 2(19AA) of the Income Tax Act and shares have been allotted
by the ‘resulting company’ to the shareholders of the ‘demerged company’ against the transfer
of assets and liabilities
 Steps involved in the demerger of a company
 Preparation of the Scheme of Arrangement
Scheme of arrangement or compromise is the most crucial document prepared by the Company contemplating to
de-merge entity, by which the company binds all related stakeholders on the terms of the demerger. A scheme of
arrangement would deal with aspects such as the share swap ratio (if applicable, details of the transfer of debt or
payment to creditors, transfer of employees, assets, liabilities and more. The scheme of arrangement can be
proposed by the directors of the company or the liquidator of the company. The scheme of arrangement would
have to be accepted by the shareholders, creditors, employees and all related stakeholders.
 Application in Tribunal
A demerger can be completed by making an application to the Tribunal and through orders issued by a Judge.
Hence, to commence the demerger process, an application must be filed in prescribed Form along with the
affidavits of the promoters and the following documents:
1. Memorandum and Articles of Association of the Company

2. Latest Audited Balance Sheets

3. List of Shareholders and Creditors

4. Extract of Board Resolution approving the Scheme

5. Scheme of Arrangement

6. Draft notice of Meeting, Explanatory Statements, and replacement or substitute

 Issue of Notice
A notice must be sent to the interested parties by the authorized individuals, 21 days prior to
the date of the meeting along with the proposed scheme of arrangement and proxy forms.
This notice would be publicized in specified Form through newspapers that are well
circulated among the interested parties.
 Holding of Meeting
A meeting should be held according to the guidelines of the Tribunal and the output of such
meetings should be recorded along with votes in support of or against the motion. The
chairperson of the meeting must submit a report in Form 39 within the time approved by the
Tribunal.
 Petition and Sanction of the Tribunal
A petition has to be submitted to the Tribunal for authorizing the demerger. It has to be
sanctioned by three-fourths of members/creditors to file an appeal. Once the Tribunal hears
the objections, it verifies the applicability of the scheme submitted and later issues an order.
The Tribunal would then pass an order approving the demerger in the same newspaper in
which the notice of the meeting was advertised.
THANK YOU