MF 0011 Mergers and Acquisitions

Set- 1 Q.1 What are the basic steps in strategic planning for a merger? Ans. Basic steps in Strategic planning in Merger : Any merger and acquisition involve the following critical activities in strategic planning processes .Some of the essential elements in strategic planning processes of mergers and acquisitions are as listed here below : 1. Assessment of changes in the organization environment 2. Evaluation of company capacities and limitations 3. Assessment of expectations of stakeholders 4. Analysis of company, competitors, industry, domestic economy and international economies 5. Formulation of the missions, goals and polices 6. Development of sensitivity to critical external environmental changes 7. Formulation measurements of internal organizational performance

8. Formulation of long range strategy programs 9. Formulation of mid-range programmes and short-run plans 10. Organization, funding and other methods to implement all of the proceeding elements

11. Information flow and feedback system for continued repetition of all essential elements and for adjustment and changes at each stage 12. Review and evaluation of all the processes In each of these activities, staff and line personnel have important Responsibilities in the strategic decision making processes. The scope of mergers and acquisition set the tone for the nature of mergers and acquisition activities and in turn affects the factors which have significant influence over these activities. This can be seen by observing the factors considered during the different stages of mergers and acquisition activities. Proper identification of different phases and related activities smoothen the process of involved in merger Q.2 What are the sources of operating synergy? Ans. Sources of Operating Synergy Operating synergies are those synergies that allow firms to increase their operating income, increase growth or both. We would categorize operating synergies into four types: 1 .Economies of scale That may arise from the merger, allowing the combined firm to become more cost-efficient and profitable. Economics of scales can be seen in mergers of firms in the same business For example : two banks combining together to create a larger bank. Merger of HDFC bank with Centurian bank of Punjab can be taken as an example of cost reducing operating synergy. Both the banks after combination can expect to cut costs considerably on account of sharing of their resources and thus avoiding duplication of facilities available. 2. Greater pricing power from reduced competition and higher market share,which should result in higher margins and operating income. This synergy is

also more likely to show up in mergers of firms which are in the same line of business and should be more likely to yield benefits when there are relatively few firms in the business. When there are more firms in the industry ability of firms toexercise relatively higher price reduces and in such a situation the synergy doesnot seem to work as desired. An example of limiting competition to increase pricing power is the acquisition of universal luggage by Blow Plast. The two companies were in the same line of business and were in direct competition with each other leading to a severe price war and increased marketing costs. After the acquisition blow past acquired astrong hold on the market and operated under near monopoly situation.Another example is the acquisition of Tomco by Hindustan Lever 3.Combination of different functional strengths , combination of different functional strengths may enhance the revenues of each merger partner there by enabling each company to expand its revenues. The phenomen on can be understood in cases where one company with an established brand name end s its reputation to a company with upcoming product line or a company. A company with strong distribution network merges with a firm that has products of great potential but is unable to reach the market before its competitors can do so. In other words the two companies should get the advantage of the combination of their complimentary functional strengths. 4. Higher growth in new or existing markets, arising from the combination of the two firms. This would be case when a US consumer products firm acquires an emerging market firm, with an established distribution network and brand name recognition, and uses these strengths to increase sales of its products .Operating synergies can affect margins and growth, and through these the value of the firms involved in the merger or acquisition .Synergy results from complementary activities. This can be understood with the following example

Example : Consider a situation where there are two firms A and B. Firm A is having substantial amount of financial resources (having enough surplus cash that can be invested somewhere) while firm B is having profitable investment opportunities ( but is lacking surplus cash). If A and B combine with each other both can utilize each other strengths, for example here A can invest its resource in the opportunities available to B. note that this can happen only when the two firms are combined with each other or in other words they must act in a way as if they are one. Q.3 Explain the process of a leveraged buy out. Ans. In the realm of increased globalized economy, mergers and acquisition s have assumed significant importance both with the country as well as across the boarders. Such acquisitions need huge amount of finance to be provided. In search of an ideal mechanism to finance and acquisition, the concept of Leverage Buyout (LBO) has emerged. LBO is a financing technique of purchasing a private company with the help of borrowed or debt capital. The leveraged buyout are cash transactions in nature where cash is borrowed by the acquiring firm and the debt financing represents 50% or more of the purchase price. Generally the tangible assets of the target company are used as the collateral security for the loans borrowed by acquiring firm in order to finance the acquisition. Some times, a proportionate amount of the long term financing is secured with the fixed assets of the firm and in order to raise the balance amount of the total purchase price, unrated or low rated debt known as junk bond financing is utilized. Modes of purchase There are a number of types of financing which can be used in an LBO. These include : Senior debt : this is the debt which ranks ahead of all other debt and equitycapital in the business. Bank loans are typically structured in up to three trenches: A, B and C

The debt is usually secured on specific assets of the company, which means the lender can automatically acquire these assets if the company breaches its obligations under the relevant loan agreement; therefore it has the lowest cost of debt. These obligations are usually quite stringent. The bank loans are usually held by a syndicate of banks and specialized funds. Typically, the terms of senior debt in an LBO will require repayment of the debt in equal annual instalments over a period of approximately 7 years. Subordinated debt : This debt ranks behind senior debt in order of priority on any liquidation. The terms of the subordinated debt are usually less stringent than senior debt. Repayment is usually required in one bullet payment at the end of the term. Since subordinated debt gives the lender less security than senior debt, lending costs are typically higher. An increasingly important form of subordinated debt is the high yield bond, often listed on Indian markets. High yield bonds can either be senior or subordinated securities that are publicly placed with institutional investors. They are fixed rate, publicly traded, long term securities with a looser covenant package than senior debt though they are subject to stringent reporting requirements. Mezzanine finance : This is usually high risk subordinated debt and is regarded as a type of intermediate financing between debt and equity and an alternative of high yield bonds. An enhanced return is made available to lenders by the grant of an equity kicker which crystallizes upon an exit. A form of this is called a PIK which reflects interest paid in kind, or rolled up into the principal, and generally includes an attached equity warrant. Loan stock : This can be a form of equity financing if it is convertible into equity capital. The question of whether loan stock is tax

deductible should be investigated thoroughly with the companys advisers. Preference share : This forms part of a companys share capital and usuallygives preference shareholders a fixed dividend and fixed share of the company sequity. Ordinary shares : This is the riskiest part of a LBOs capital structure. However, ordinary shareholders will enjoy majority of the upside if the company is successful. Q.4 What are the cultural aspects involved in a merger. Give sufficient examples. Ans. The value chains of the acquirer and the acquired, need to be integrated in order to achieve the value creation objectives of the acquirer. This integration process has three dimensions: the technical, political and cultural. The technical integration is similar to the capability transfer discussed above. The integration of social interaction and political relationships represents the informal processes and systems which influence peoples ability and motivation to perform. At the time of integration, the acquirer should have regard to these political relationships, if acquired employees are not to feel unfairly treated. An important aspect of integration is the cultural integration of the acquiring and acquired firms. The culture of an organization is embodied in its collective value systems, beliefs, norms, ideologies myths and rituals. They can motivate people and can become valuable sources of efficiency and effectiveness. The following are the illustrative organizational diverse cultures which may have to be integrated during postmerger period :Strong top leadership versus Team approach Management by formal paper work versus management by wandering around Individual decision versus group consensus decision Rapid evaluation based on performance versus Long term relationship based on loyalty Rapid feedback for changes

versus formal bureaucratic rules and procedures Narrow career path versus movement through many areas Risk taking encouraged versus one mistake you are out Risky activities versus low risk activities Narrow responsibility arrangement versus Everyone in this company is salesman (or cost controller, or product quality improver etc.) Learn from customer versus We know what is best for the customer The above illustrative culture may provide basis for the classification of organizational culture. There are four different types of organizational culture as mentioned below: Power - The main characteristics are: essentially autocratic and suppressive of challenge; emphasis on individual rather than group decision making Role - The important features are: bureaucratic and hierarchical; emphasis on formalrules and procedures; values fast, efficient and standardized culture service Task/achievement - The main characteristics are: emphasis on team commitment; task determines organization of work; flexibility and worker autonomy; needs creative environment Person/support - The important features are: emphasis on equality; seeks to nurture personal development of individual Members Poor cultural fit or incompatibility is likely to result in considerable fragmentation ,uncertainty and cultural ambiguity, which may be experienced as stressful by organizational members. Such stressful experience may lead to their loss of morale, loss of commitment, confusion and hopelessness and may have adys functional impact on organizational performance. Mergers between certain types can be disastrous. Differences in culture may lead to polarization, negative evaluation of counterparts, anxiety and ethnocentrism between top management teams of the acquired and acquiring firms. In assessing the advisability of

an acquisition, the acquirer must consider cultural risk in addition to strategic issues .The differences between the national and the organizational culture influence the crossborder acquisition integration. Thus, merging firms must consciously and proactively seek to transform the cultures of their organizations. Q.5 Study a recent merger that you have read about and discuss the synergies that resulted from the merger. Ans. Synergy is the additional value that is generated by the combination of two or more than two firms creating opportunities that would not be available to the firms independently. There are two main types of synergy Operating synergy, Financial synergy Operating Synergy Operating synergies are those synergies that allow firms to increase their operating income, increase growth or both. We would categorize operating ynergies into four types: 1.Economies of scale that may arise from the merger, allowing the combinedfirm to become more cost-efficient and profitable. Economics of scales can beseen in mergers of firms in the same business For example : two banks combining together to create a larger bank. Merger of HDFC bank with Centurian bank of Punjab can be taken as an example of costreducing operating synergy. Both the banks after combination can expect to cutcosts considerably on account of sharing of their resources and thus avoidingduplication of facilities available. 2.Greater pricing power from reduced competition and higher market share,which should result in higher margins and operating income. This synergy is also more likely to show up in mergers of firms which are in the same line of business and should be more likely to yield benefits when there are relatively few firms in

the business. When there are more firms in the industry ability of firms to exercise relatively higher price reduces and in such a situation the synergy does not seem to work as desired. An example of limiting competition to increase pricing power is the acquisition of universal luggage by Blow Plast. The two companies were in the same line of business and were in direct competition with each other leading to a severe price war and increased marketing costs. After the acquisition blow past acquired as trong hold on the market and operated under near monopoly situation .Another example is the acquisition of Tomco by Hindustan Lever. 3.Combination of different functional strengths , combination of different functional strengths may enhance the revenues of each merger partner thereby enabling each company to expand its revenues. The phenomenon can be understood in cases where one company with an established brand name lendsits reputation to a company with upcoming product line or a company. A company with strong distribution network merges with a firm that has products of great potential but is unable to reach the market before its competitors can do so .In other words the two companies should get the advantage of the combination of their complimentary functional strengths. 4.Higher growth in new or existing markets, arising from the combination of the two firms. This would be case when a US consumer products firm acquires an emerging market firm, with an established distribution network and brand name recognition, and uses these strengths to increase sales of its products.Operating synergies can affect margins and growth, and through these the value of the firms involved in the merger or acquisition.Synergy results from complementary activities. This can be understood with the following example Example :

Consider a situation where there are two firms A and B. Firm A is having substantial amount of financial resources (having enough surplus cash that can be invested somewhere) while firm B is having profitable investment opportunities ( but is lacking surplus cash). If A and B combine with each other both can utilize each other strengths, for example here A can invest its resourcein the opportunities available to B. note that this can happen only when the two firms are combined with each other or in other words they must act in a way as if they are one. Financial Synergy With financial synergies, the payoff can take the form of either higher cash flow s or a lower cost of capital (discount rate). Included are the following: 1. A combination of a firm with excess cash, or cash slack, (and limit e d project opportunities) and a firm with high-return projects (and limited cash) can yield a payoff in terms of higher value for the combined firm .The increase in value comes from the projects that were taken with the excess cash that otherwise would not have been taken. This synergy is likely to show up most often when large firms acquire smaller firms, or when publicly traded firms acquire private businesses. 2. 25Debt capacity can increase, because when two firms combine, their earnings and cash flows may become more stable and predictable. This,in turn, allows them to borrow more than they could have as individual entities, which creates a tax benefit for the combined firm. This tax benefit can either be shown as higher cash flows, or take the form of a lower cost of capital for the combined firm. 3. 26Tax benefits can arise either from the acquisition taking advantage of tax laws or from the use of net operating losses to shelter income. Thus, a profitable firm that acquires a money-losing firm may be able to

use the net operating losses of the latter to reduce its tax burden. Alternatively, a firm that is able to increase its depreciation charges after an acquisition will save in taxes, and increase its value. Clearly, there is potential for synergy in many mergers. The more important issues are whether that synergy can be valued and, if so, how to value it. This result has to be interpreted with caution, however, since the increase in the value of the combined firm after a merger is also consistent with a number of other hypotheses explaining acquisitions, including under valuation and a change in corporate control. It is thus a weak test of the synergy hypothesis. The existence of synergy generally implies that the combined firm will become more profitable or grow at a faster rate after the merger than will the firms operating separately. A stronger test of synergy is to evaluate whether merged firms improve their performance (profitability and growth) relative to their competitors ,after takeovers. On this test, as we show later in this chapter, many mergers fail. Q.6 What are the motives for a joint venture, explain with an example of a joint venture. Ans:-As there are good business and accounting reasons to create a joint venture with a company that has complementary capabilities and resources ,such as distribution channels, technology, or finance, joint ventures are becoming an increasingly common way for companies to form strategical liances. In a joint venture, two or more parent companies agree to share capital, technology, human resources, risks and rewards in a formation of a new entity under shared control. Broadly, the important reasons for forming a joint venture can be presented below: Internal Reasons to Form a JV

Spreading Costs: You and a JV partner can share costs associated with marketing, product development, and other expenses, reducing your financial burden Opening Access to Financial Resources: Together you and a JV partner might have better credit or more assets to access bigger resources for loans and grants than you could obtain on your own.

Connection to Technological Resources: You might want access to technological resources you couldn't afford on your own, or vice versa.Sharing innovative and proprietary technology can improve products, as well as your own understanding of technological processes. - Improving Access to New Markets: You and a JV partner can combine customer contacts and together even form a joint product that accesses new markets. - Help Economies of Scale: Together you and a JV partner can develop products or services that reduce total overall production expenses. Bring your product to market cheaper where the customer can enjoy the cost savings. - External Reasons to Form a JV
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Develop Stronger Innovative Product: Together you and a JV partner may be able to share ideas to develop a product that is more competitive in your industry. Improve Speed to Market: With shared access to financial,technological, and distribution resources, you and a JV partner can get your joint product to market faster and more efficiently.Strategic Move Against Competition: A JV may be able to better compete against another industry leader through the combination of markets, technology,and innovation.

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Strategic Reasons
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Synergistic Reasons: You may find a JV partner with whom you can create synergy, which produces a greater result together than doing it on your own. Share and Improve Technology and Skills: Two innovative companie s can share technology to improve upon each other's ideas and skills.

- Diversification - There could be many diversification reasons: access to inverse markets, development of diverse products, diversify the innovative working force, etc. Don't let a JV opportunity pass you by because you don't think it will fit in with your own small business. Small and big companies alike can benefit from the reasons listed above. Analyze how your company can benefit internally, externally, and strategically, and then find a joint venture partner that will fit with your needs