Index Chapter No.

1 Introduction

Chapter Name

Page No.
1

Concepts / Definitions

Theories of mergers

10

Strategies of Mergers & Acquisitions

15

Defence Mechanism

23

Acquisition & Takeover Regulations - SEBI

25

Valuation

34

Legal Issues Relating to Mergers

51

De-merger & Reverse merger

57

10

Post Merger Scenario

60

11

Post Merger Integration

64

Chapter One

Introduction
Mergers, acquisitions and restructuring have become a major force in the financial and economic environment all over the world. Essentially an American phenomenon till the middle of 1970s, they have become a dominant global business theme at present. On Indian scene too corporate are seriously making at mergers, acquisitions which has become order of the day. Mergers and acquisitions (M&A) and corporate restructuring are a big part of the corporate finance world. Every day, Wall Street investment bankers arrange M&A transactions, which bring separate companies together to form larger ones. When they're not creating big companies from smaller ones, corporate finance deals do the reverse and break up companies through spin-offs, carve-outs or tracking stocks. Not surprisingly, these actions often make the news. Deals can be worth hundreds of millions, or even billions, of dollars. They can dictate the fortunes of the companies involved for years to come. For a CEO, leading an M&A can represent the highlight of a whole career. And it is no wonder we hear about so many of these transactions; they happen all the time. Next time you flip open the newspapers business section, odds are good that at least one headline will announce some kind of M&A transaction. Sure, M&A deals grab headlines, but what does this all mean to investors, it discusses the forces that drive companies to buy or merge with others, or to split-off or sell parts of their own businesses. Once you know the different ways in which these deals are executed, you'll have a better idea of whether you should cheer or weep when a company you own buys another company - or is bought by one. You will also be aware of the tax consequences for companies and for investors. If one considers available statistics, one finds that M & A activity is taking place with a very rapid pace: Acquisitions

Years
2005 06 2004 05 2003 04 2002 03 2001 02 2000 01

No. of Acquisitions Bids

868 798 833 841 1048 1174

Amount (Rs. Crore)

102904 60284 35319 32696 35086 23113

Mergers

Years
2005 06 2004 05 2003 04 2002 03 2001 02 2000 01

No. of Merger Deals

368 272 284 332 319 317

Industry-wise Trend of Number & Value of Acquisitions:

Sector
Manufacturing Food & Beverages Textiles Chemicals Non Metallic Mineral Products Metals & Metal Products Machinery Transport Equipments Miscellaneous Manufacturing Diversified Mining Coal & Lignite Crude Oil & Natural Gas Minerals Electricity Electricity Generation Electricity Distribution Services Financial Services Other Services Hotels & Tourism Recreational Services Health Services Trading Transport Services Communication Services Misc. Services Information Technology Construction

Number of Acquisitions
436 48 57 115 41 35 69 39 25 7 8 2 3 3 9 8 1 356 126 230 26 31 8 29 12 25 21 78 52

Value of Acquisitions (Rs. Crore)

45106 2528 1946 21698 6331 2091 4309 5039 687 475 914 58 844 12 3751 3751 51882 15884 35998 1859 1993 912 1086 3303 13677 3513 9657 5212

Real Estate Construction & Allied Activities Total

41 11 938

4505 706 110240

Industry-wise Trend of Number of Mergers:

Sector
Manufacturing Food & Beverages Textiles Chemicals Non Metallic Mineral Products Metals & Metal Products Machinery Transport Equipments Miscellaneous Manufacturing Diversified Mining Coal & Lignite Crude Oil & Natural Gas Minerals Electricity Electricity Generation Electricity Distribution Services Financial Services Other Services Hotels & Tourism Recreational Services Health Services Trading Transport Services Communication Services Misc. Services Information Technology Construction Real Estate Construction & Allied Activities Total * Source for Statistical Data: CMIE

Number of Mergers
136 23 24 39 9 7 20 2 12 2 2 2 2 159 90 69 3 6 2 20 2 4 19 13 13 7 6 414

Chapter Two

CONCEPTS / DEFINITIONS:
4

Important terms used in the world of mergers & acquisition, & their brief explanation: 1) Merger: Merger is defined as the combination of two or more companies into a single company where one survives and the other loses its corporate existence. The survivor acquires the assets as well as liabilities of the merged company or companies. 2) Amalgamation: Halsburys Laws of England describe amalgamation as a blending of two or more existing undertakings onto one undertaking, the shareholders of each blending company becoming substantially the share holders in the company which is to carry on the blended undertaking. Section 2 (a) of Income Tax Act defines: Amalgamation in relation to companies means the merger of two or more companies to form one company in such a manner that: 1. All the properties of the amalgamating company or companies just before the amalgamated company by virtue of amalgamation become the properties of amalgamation. 2. All the liabilities of the amalgamating company or companies just before the amalgamation become the liabilities of the amalgamation; become the liabilities of the amalgamated company by virtue of amalgamation. 3. Shareholders holding not less than three-fourth in value of shares in the amalgamating company or companies becomes the shareholders of the amalgamated company by virtue of amalgamation. The term amalgamation and merger are synonymous / Interchangeable 3) Consolidation: Technically speaking consolidation is the fusion of two existing companies into a new company in which both the existing companies extinguish. The small difference between consolidation and merger is that in merger one of the two or more merging companies retains its identity while in consolidation all the consolidating companies extinguish and an entirely new company is born. 4) Acquisitions / Takeovers: This refers to purchase of majority stake (controlling interest) in the share capital of an existing company by another company. It may be noted that in the case of takeover although there is change in management, both the companies retain their separate legal identity. Terms Takeover & Acquisition are used interchangeably. 5) Leveraged Buyouts: It means any takeover which is routed through a high degree of borrowings. In simple words a takeover with the help of debt. 6) Management Buyouts: It refers to the purchase of the corporation part or whole of shareholding of the controlling / dominant group of shareholders by the existing mangers of the company. 7) Sell Off : 5

General Term for divestiture of part or whole of the firm by any one or number of means: i.e. sale, spin off, split up etc. 8) Spin Off: A transaction in which a company distributes all the shares it owns in a subsidiary to its own shareholders on pro-rata basis & then creates a new company with the same proportional shareholding pattern as in the parent company. 9) Split Off : A transaction in which some, but not all, shareholders of the parent company receive shares in a subsidiary, for relinquishing their parent company shares. 10) Split Up : A transaction in which a company spins off, all of its subsidiaries to it shareholders and ceases to exist. 11) Equity Carve Out : A transaction in which a parent company offers some common stock of one of its subsidiaries to the general public, so as to bring in a cash infusion to the parent company without losing the control.

TYPES OF MERGERS & ACQUISITIONS:

Mergers & Acquisition can be classified into three categories: a) On the basis of movement in the industries: Horizontal Vertical Forward integration Backward integration Conglomerate b) On the basis of method or approach: Leveraged buyouts Management buyouts Takeover by workers c) On the basis of response / relation: Friendly Takeovers Hostile Takeovers

Explanation of the various types of mergers and acquisitions: 1. Horizontal Mergers: Horizontal merger involves merger of two firms operating and competing in the same line of business activity. It is performed with a view to form a larger firm, which may 6

have economies of scale in production by eliminating duplication of competitions, increase in market segments and exercise of better control over the market. It also helps firms in industries like pharmaceuticals, automobiles where huge amount is spent on R&D to achieve a critical mass and reduce unit development costs. Horizontal merger tend to be regulated by the Govt. in view of their potential for creating monopoly power and negative effect on competition. Example: India cements acquiring Raasi Cement. 2. Vertical Mergers : Vertical Mergers take place between two or more firms engaged in different stages of production. The main reason for vertical merger is to ensure ready take off of the materials, gain control over scarce raw materials, gain control over product specifications, increase in profitability by eliminating the margins of the previous supplier/ distributor and in some cases to avoid sales tax. Example: Tea Estate Ltd merging with Brooke Bond Ltd. 3. Conglomerate Mergers: Conglomerate merger refers to the merger of two or more firms engaged in unrelated line of business activity. Two important characteristics of conglomerate mergers are: i. A conglomerate firm controls a range of activities in various industries that require different skills in the specific managerial functions of research, applied engineering, production and marketing. ii. The diversification is achieved mainly by external acquisitions and mergers and not by internal development. Among conglomerate mergers three types may be distinguished: i. A product extension merger broadens the product line of firm. ii. A geographic market extension merger involves firms whose operations are conducted in non overlapping geographic areas. iii. Other conglomerate mergers involving unrelated business and do not qualify for product extension or geographic extension. Example: GNFC acquiring Gujarat Scooters.

Conglomerate mergers can be further classified as Financial Conglomerates & Managerial Conglomerates: a) Financial Conglomerates:

Financial Conglomerates provide a flow of funds to each segment of the operations, exercise controls and are the ultimate risk takers. In theory, financial conglomerates undertake strategic planning but do not participate in operating decisions. Financial conglomerates take care of five distinct economic functions: 1. It improves risk / return ratios through diversifications 2. It avoids Gamblers Ruin. Financial Conglomerates maintain economic viability with long term value. Without this form of risk reduction, or bankruptcy avoidance, the assets of the operating entity might be shifted to less productive areas. 3. It establishes system of financial planning and control which improves the quality of general and functional managerial performance. 4. If the management does not improve performance, the management is changed. 5. Better resource allocation. If management is competent but product market potentials are inadequate, executives of financial conglomerate will seek to shift resources from the unfavorable areas to areas more attractive from point of view of growth and profitability. b) Managerial Conglomerates: Managerial conglomerates not only assume financial responsibility but also play a role in Operating decisions and provide staff expertise and staff service to the operating entities. By providing managerial counsel and interactions on decisions, the managerial conglomerates increase the potential for improving performance. When any two firms of unequal management competence are combined the performance of combined firm will benefit from the impact of the superior management and total performance of combined firm will be greater that the sum of individual parts. This defines synergy in most general form. Concentric Companies The difference between managerial conglomerates and the concentric company is based on the distinction between the general and specific management functions. If the activities of the segments brought together are so correlated that there is carry over of specific management functions (research, manufacturing, finance, marketing, personnel and so on) or complementarily in relative strengths among these specific management functions, the merger should be called concentric rather than conglomerate. The concentric merger is also called product extension merger. In such a merger, in addition to transfer of general management skills, there is transfer of specific management skills, as in production, research, marketing etc. which have been neither used in different line of business. A concentric merger brings all the advantages of conglomeration without the side effects i.e, with concentric merger, it is possible to reduce the risk without venturing into areas that the management is not competent in. Consolidation Mergers: Consolidation merger involves a merger of a subsidiary company with parent company. The reasons behind such mergers are to stabilize cash flows and to make funds available for the subsidiary. In consolidation mergers, economic gains are not readily

4.

apparent as merging firms are under the same management. Still, Flow of funds between parent and the subsidiary is obstructed by other consideration of laws such as taxation laws, Companies Act etc. Therefore, consolidation can make it easier for to infuse funds for revival of subsidiaries. MERGER MOTIVES: The merger motives are as follows: (1) Growth Advantage / Combination Benefits: The companies would always like to grow and best way to grow without much loss of time and resources is to inorganically by acquisition and mergers. E.g.: Merger of SCICI with ICICI ITC Classic with ICICI Acquisition of Raasi cement by India cement Dharani Cement and Digvijay cement by Grasim Modi cement by Gujarat Ambuja. (2) Diversification: The companies could diversify into different product lines by acquiring companies with diverse products. The purpose is to diversify business risk by avoiding to put all eggs into one basket. E.g.: All Multi-product companies (3) Synergy: When the companies combine their operations and realize results greater in value than mere additions of their assets, the synergy is said to have been resulted. Combined efforts produce better results on account of i) Rationalization of operating assets of merged companies. ii) Sharing of sales outlets / distribution channels. iii) Cost reduction / savings. E.g.: Merger of Ranabaxy and Crossland Laboratories. (4) Market Dominance / Market Share/ Beat Competition: The predominant market share or market dominance has always driven the executives to look for acquiring competitive companies and create a huge market empire. E.g.: Acquisition of Tomco by Hindustan Lever Computer Associates International - Acquired around twenty software companies. Consolidation in cement industry Nicholas Piramal Ltd. has merged into itself. Technological Considerations: It refers to enhancing production capacities to derive economies of scale. E.g.: Acquisition of Corus by Tata.

(5)

(6)

Asset Tripping: When the companies are acquired for the hidden assets which are owned and these assets can be separately developed or even sold off for profit. E.g.: Textiles companies being taken over for the surplus land which could be developed for real estate / malls

(7)

Taxation Benefits / Revival Of Sick Units: Section 72 A provides for revival of sick units by allowing accumulated losses of the sick unit to be absorbed by the healthy units subject to compliances to the conditions of the provisions. Acquiring Platform: When a company would like to expand beyond geographical limits and acquire platform in the new place the best way would be to acquire the companies. E.g.: Acquisition of Parle by Coke.

(8)

Chapter Three Theories of Mergers

10

Theories provide an explanation to any phenomenon, pattern and provide basis for further action plan. The phenomenon of merger and acquisitions has been explained by different theories as under: I. Efficiency Theories a) b) c) d) e) f) II. III. V. Differential Managerial Efficiency Inefficient Management Operating Synergy Pure diversification Strategic Realignment to changing environments Under Valuation

Information and Signaling Agency Problems and managerialism Market Power

IV. Free Cash flow hypothesis VI. Taxes VII. Redistribution The explanation of the various theories is as follows: I. Efficiency Theories a) Differential Efficiency: If the management of firm A is more efficient than the management of firm B and if after firm A acquires firm B, the efficiency of firm B is brought up to the level of efficiency of firm A, efficiency is increased by merger. Features: There would be social gain as well as private gain. This may also be called managerial synergy hypothesis. Limitations: If carried to its logical extreme, it would result in only one firm in the economy, the firm with greatest managerial efficiency. Over-optimization on the part of efficient firm about its impact on acquired firm may result in excess payment of consideration or failure to improve its performance. Inefficient / under performing firms could improve performance by employing additional managerial input through direct employment / contracting.

b) Inefficient Management: Inefficient Management refers to non performance up to its potential level. It may be managed by another group more efficiently.

11

Features: Inefficient Management represents management which is inept in absolute sense. Differential management theory is more likely to be basis for horizontal merger; inefficient management theory could be basis for mergers between firms of unrelated business. Limitations: Difficult to differentiate differential management theory from inefficient theory. The theory suggests replacement of inefficient management. However empirical evidence does not support this. The theory also suggests that acquired firms are unable to replace their own managers and thus it is necessary to invoke costly merger to replace inefficient managers- This is not convincing.

c) Operating Synergy: Operating synergy or operating economies may be achieved in horizontal, vertical and even conglomerate mergers. Features: Theory is based on the assumption that economies of scale do exist in this industry and prior to merger, firms are operating at the levels of activity that fall short of achieving the potential for economies of scale. Economies of scale arise because of indivisibilities such as people, equipment overhead which provide increasing returns if spread over a large number of units of output.

d) Pure Diversification: Diversification of the firm can provide the managers and employees with job security and opportunity for promotion and other things being equal, results in lower costs. Even for owner manager diversification is valuable as risk premium for undiversified firm is higher. Diversification has value for many reasons: Demand for diversification by managers, other employees Preservation of organizational and reputation capital Financial and tax advantages Diversification helps preserving reputational capital of the firm, which will be lost if firm is liquidated. Diversification can be achieved through internal growth as well as mergers. However mergers may be preferred in certain circumstances: Mergers can provide quick diversification. Firm may lack internal growth opportunity for lack of requisite resources or due to potential excess capacity in industry. e) Strategic Realignment to Changing Environment:

12

Strategic planning is concerned with firm's environment and constituencies, not just operating decisions. The speed of adjustment through merger would be quicker than internal development. Features: Strategic planning approach to mergers implies either the possibilities of economies of scale or tapping an underused capacity in the firms present managerial capabilities. By external diversification the firm acquires management skills for augmentation of its present capabilities. A competitive market for acquisitions implies that the net present value from merger and acquisition investment is likely to be small. Nonetheless if synergy can be used as a base for still additional investments with positive net present values, the strategy may succeed.

f) Under Valuation: Some studies have attributed merger motives to under valuation of target companies. One cause of under valuation may be that management is not operating the company up to its potential (aspect of inefficient management theory.) Second possibility is that acquirer has an inside information. Hence, its bidder possesses information which general market does not have, they may place higher value on the shares than currently prevailing in the market. Another aspect of under valuation theory is the difference between the market value of assets and their replacement costs. Hence entry into new product market areas could be accomplished on a bargain basis. II. Information and Signaling: Shares of the target company in a tender offer experiences upward revaluation even if offer turns out to be unsuccessful. New information generated as a result of tender offer and the revaluation is permanent. Two forms of information: i) The tender offer disseminates the information that the target shares are undervalued and offer prompts the market to revalue the shares. ii) Offer inspires the target firm management to implement a more efficient business strategy on its own. Signaling may be involved in number of ways: Tender offer gives a signal to the market that hither to unrecognized extra values are possessed by the firm or that Future cash flow streams are likely to rise. When a bidder firm uses common stock on buying another firm, it is taken as a signal that common stock of bidder firm is overvalued. When buyer firm repurchases their shares, the market may take this as signal that the management has information that its shares are undervalued and favorable new opportunities will be achieved.

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III.

Agency problems and Managerialism : Agency problem arises when a manager owns a fraction of ownership shares of the firm. This partial ownership may cause managers to work less vigorously than other wise and / or consume more perquisites, (luxurious offices, company cars, membership of clubs) because majority owners bear most of the cost. Agency costs include: i) Cost of structuring a set of contracts ii) Cost of monitoring and controlling the behavior of agents by principals. iii) Cost of bonding to guarantee that agents will make optimal decisions or principles will be compensated for consequences of sub-optimal decisions. iv) Residual loss: i.e. welfare loss experienced, by the principals arising from the divergence between agents decisions and decisions to maximize principals warfare. This residual loss can arise because the cost of full enforcement of contracts exceeds the benefits. Takeover as solution to Agency Problems: o Agency problems can be controlled by organizational or market mechanism: o A number of compensation arrangements and market for managers may mitigate agency problems. o Stock market gives rise to external monitoring device, because stock prices summaries the implications of decisions made by managers. Low stock prices exert pressure on managers to change their behavior and to stay in line with interest of shareholders. o When these mechanisms are not sufficient, market for takeover provides an external control device of last resort. o A takeover through a tender offer or proxy fight enables outside managers to gain control of decision process of Target Company, while circumventing the existing managers and Board of Directors. Managerialism In contrast to the view that mergers occur to control agency problem, some observers consider merger as manifestation of agency problems rather than the solution. Mueller emphasizes that managers are motivated to increase the size of the firm as compensation to manager is function of the size of the firm. But empirical evidence shows that compensation is correlated with profit rate and not with level of sales.

IV.

Free Cash flow hypothesis Jenson argues that pay out of free cash flow can play an important role in dealing with conflict between managers and shareholders. Payout of free cash flow reduces the amount under control of managers and reduces their power. Further they are subject to monitoring in capital market when they seek to finance additional investment with new capital. He states that such a free cash flow must be paid out to shareholders if firm is to be efficient and to maximize share price.

14

Layout of free cash flow reduces the amount under control of managers and reduces their power. Further they are subject to monitoring in capital market when they seek to finance additional investment with new capital. Managers arrange cash flows also by issuing debts / leveraging. In leveraged buyouts, increased debt increases risk of bankruptcy cost in addition and agency costs. Optimum debt / Equity Ratio will be where the marginal cost of debt equals marginal benefit of debt. Hubris Hypothesis Roll hypothesis - that managers commit errors of over-optimism in evaluating merger opportunities due to excessive pride, animal spirit or hubris. In a takeover, bidding firm identifies potential target firm and values its assets. When valuation turns out to be below market price of the stock, no offer is made. Only when valuation of stock exceeds its Bid is made. Current market price: If there are no synergies or other takeover gains the mean valuation will be current market price. Offers are made only when valuation is too high. Takeover premium is random error, a mistake made by the error. V. Market Power Mergers increase a firms market share. It is argued that larger volume of operations through Mergers and Acquisitions result in economies of scale. But it is not clear whether this price required by the selling firm will really make acquisition route more economical method of expanding a firm's capacity either horizontally or vertically. An objection often raised against permitting a firm to increase its market share by merger is that it will result into "undue concentration" in the industry. Public policy of USA holds that when four or fewer firms amount for 40% or more of the sales in given market or line of business, an undesirable market structure or undue concentration exists. VI. Tax consideration Section 72 A of Income Tax Revival of Sick Units under SICA Reverse mergers. (Detail explanation pertaining to above is available in chapter) VII. Value increase by Redistribution Value increases under merger on account of redistribution among the stake holders of the firm. Shifts are from the Bond holders to stock holders and from labor to stock holders and / or consumers.

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Chapter Four Strategies of Mergers & Acquisitions

The various strategies are as follows: I. Mergers and Acquisitions as Managerial Strategy. Forms of Business Restructuring

Expansion Corporate Control Mergers Acquisitions Joint Venture Premium standstill Anti takeover Proxy Buy Backs agreements Amendments contests Spin offs Divestitures Equity Curve outs

Changes in ownership structure

Split Offs

Split Ups Exchange Share Going Leveraged Offers repurchases Private Buyouts

II. Mergers and Acquisitions as Management Strategy: The different views are as follows: Strategy as concept Strategy as Process Concerned with most important decisions of an enterprise. Strategic planning process - set of formal procedure - Informally in the mind managers Individual strategies, plans, Policies or procedures are utilized. Strategic planning as behavior A way of thinking - Requiring diverse inputs from all segments - Everyone must be involved Responsibility resides with Top executive.

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The process of strategic planning: 1) Monitoring environments: A key to all approaches to strategic planning is continuous monitoring of the external environments. The environments should encompass both domestic and international dimensions and include analysis of economic, technological, political, social and legal factors. Different organization may give different emphasis and weights to each of the categories. 2) Stakeholders: Strategic planning process to take into account the diverse stakeholders of organization, which have interest in the organization i.e., customers, stockholders, creditors, employees, Government, Communities, Media, Political group, Educational institutions, financial community and international entity. 3) Essential elements in strategic planning processes: i. Assessment of changes in the environment. ii. Evaluation of company capabilities and limitations. iii. Assessment of expectations of stakeholders. iv. Analysis of company, competitors, industry, domestic economy, and international economies. v. Formulation of missions, goals and policies for master strategy. vi. Development of sensitivity to critical external environmental changes. vii. Formulation of Long-range strategy programmes. viii. Formulation of internal organization performance measurements. ix. Formulation of mid-range and short run plans. x. Organization, Funding and other method to implement all preceding elements. xi. Information flow and feedback system xii. Review and evaluation process. 4) Organization cultures: How organization carries out the strategic thinking and planning processes will vary with it cultures. Strong top leadership v/s Team appraisals. Management by formal paperwork v/s Management by wandering around. Individual decisions v/s Group decisions. Rapid evaluation based on performance v/s Long term relationship based on loyalty. Rapid feed back for change v/s Formal bureaucratic rules and procedures. Risk taking encouraged v/s one mistake and you are out. Narrow responsibility v/s everyone in this is a salesman cost controller, product quality manpower or so on. viii. Learn from customers v/s we know what is best for customers. 5) Alternative strategy methodologies: i. SWOT or WOTS Up: Inventory and analysis of organization strength, weaknesses, environmental opportunities, and threats. 17 i. ii. iii. iv. v. vi. vii.

Gap Analysis: Assessment of goals v/s forecasts or projections. Top down / Bottom up: Company forecasts v/s aggregation of segments. Computer models: Opportunity for detail and complexity. Competitive Analysis: Assess customers, suppliers, new entrants, products and product substitutability. vi. Synergy : Look for complementarily vii. Logical incremental: Well supported moves from current bases. viii. Muddling through: Incremental changes selected from small no. of policy alternatives. ix. Comparative histories: Learn from experience of others. x. Delphi Technique: Iterated opinion reactions. xi. Discussion group technique: Simulating ideas by unstructured discussions aimed at consensus. xii. Adaptive Processes: Periodic reassessment of environmental opportunity and organization capability adjustment required. xiii. Environmental scanning: Continuous analysis of relevant environments. xiv. Intuition: Insights of brilliant managers. xv. Entrepreneurship: Creative leadership. xvi. Discontinuities: Crafting strategy from recognition of trend shifts. xvii. Brain storming: Free form repeated exchange of ideas. xviii. Game theory: Logical assessment of competitors actions and reactions. xix. Game playing: Assign roles and simulate scenarios. 6) Alternative Analytical framework: i. ii. iii. iv. v. vi. vii. viii. ix. x. xi. xii. xiii. xiv. xv. xvi. xvii. Product Life cycles: Introduction, Growth, maturity, and decline stages with changing opportunities and threats. Learning curve: Costs decline with cumulative volume experience resulting in first mover competitive advantages. Competitive Analysis: Industry structure, rivals reactions, supplies and customer relations, product positioning. Cost leadership : Low cost advantages Product differentiation: Develop product configuration that achieve customer preference. Value chain Analysis: Controlled cost outlays to add product characteristics valued by customers. Niche opportunities: Specialize to needs or interest of customer groups. Product breadth: Carry over of organizational capabilities. Correlation's with profitability: Statistical studies of factors associated with high profitability measures. Market share: High market share associated with competitive superiority. Product quality: Customer allegiance and price differentials for higher quality. Technological leadership: Keep at frontiers of knowledge. Relatedness matrix: Unfamiliar markets and products involve greatest risk. Focus matrix : Narrow v/s Broad Growth / share matrix: Aim for high market share in high growth markets. Attractiveness matrix : aim to be strong in attractive industries Global matrix: Aim for competitive strength in attractive countries.

ii. iii. iv. v.

7) Approaches to formulating Mergers and Acquisitions strategy: i. Boston Consulting Group

18

ii. iii. i.

The Porter Approach Adaptive Processes Boston Consulting Group: The three important concepts of BCG are as follows: Experience curve Product life cycle Portfolio balance o Experience curve: It represents a volume-cost relationship. It is argued that as the cumulative historical volume of output increases, unit cost will fall at a geometric rate. This will result from specialization, standardization, learning and scale effects. The firm with target cumulative output will have lower costs, suggesting a strategy of early entry and price policy to develop volume. o Product life cycle: Every product or a line of business proceeds through four places: Development Growth Maturity And decline During first two stages, sales and growth is rapid and entry is easy. As individual firms gain experience and as growth slows in last 2 stages, entry becomes difficult, because of cost advantages of incumbents. In declining stage of product line, (as other substitutes emerge) sales and prices decline, firms which have not achieved a favorable position on the experience curve become unprofitable and either merge or exit from the Industry. o Portfolio Approach: Rapid growth may require substantial investments. As requirements for growth diminish, profits may generate more funds than required for investments. Portfolio balances seeks to combine

Attractive investment segments ( stars) Cash generating segments (cash cows) Eliminating segments with unattractive prospects (Dogs) Overall, total cash inflows will balance and corporate investments. The Porter Approach: Michael Porter suggests the following: Select an attractive industry. Develop competitive advantage through cost leadership and product differentiation. Develop attractive value chain. ii.

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o Attractive Industry in which: Entry barriers are high. Suppliers and buyers have only modest bargaining power. Substitute products or services are few. Rivalry among 'competitors' is stable. o Unattractive Industry will have: Structural flows including plethora of substitute materials Powerful and price sensitive buyers. Excessive rivalry caused by high fixed costs and large group of competitors, many of whom are state supported. E.g.: Steel Industry. o Competitive Advantage: It may be based on cost leadership, product differentiation. Cost advantage is achieved by consideration of wide range of checklist factors including BCG's learning curve theory. o Value chain: A matrix that relates the support activities of: Infrastructure Human Resource Management Technology development Procurement Operations Marketing / Sales / Service Aim is to minimize outlays in adding characteristics valued by customers. iii. Adaptive Processes: Adaptive processes orientation involves marketing resources to investment opportunities under environmental uncertainty compounded with uncertain competitors actions and reactions. It involves ways of thinking which assess competitors actions and reactions in relation to changing environments.

ii.

8) Factors favoring external growth and diversification through Mergers and Acquisitions: i. Some goals and objectives may be achieved more speedily through an external acquisition. The cost of Building an organization internally may exceed cost of an acquisition. iii. There may be fewer risks, lower costs, or shorter time requirements involved in achieving an economically feasible market share by the external route.

20

vi. vii.

iv. The firm may not be utilizing their assets or arrangement as effectively as they could be utilized by the acquiring firm. v. The firm may be able to use securities in obtaining other companies, where as it might not be able to finance the acquisition of equivalent assets and capabilities internally. There may be tax advantages. There may be opportunities to complement capabilities of other firms. 9) Gains and Pains of Merger and Acquisition:

Gains
Financial Returns/Profitability Aligned Org Structure. iii. New approaches to conducting work. Motivated and capable talent. Desired culture. Cost Savings. 10) Planning for Merger and Acquisition:

Pains
i. Expenses / Drain on Profitability ii. Time and resource required to manager / transition. iii. Reduced work productivity and quality. iv. Unintended consequences for employees attitudes and behavior. v. Culture clash. vi. Customer concerns.

i. Search for acquisition of Target Company based on objectives of the acquirer company. ii. Services of Intermediaries a) Finding a Target company a) Consultants b) Negotiation b) Merchant bankers c) Compliance of legal formalities c) Financial Institutions d) Completion of Financial arrangement e) Closing the deals. iii. Primary investigation about Target Company. a) Industry Analysis Competition Growth Rate / Future projections Barriers to entry / Exit Mergers and acquisitions in industry and results Balance sheet and Profit and loss for Budgets and forecasts Financial ratios - Return on Assets - Return on Net worth - GP / NP - D/ E Ratio - Expense Ratio 21

b) Financial Analysis past years

Replacement cost data Valuation of Assets / Liabilities c) Management Analysis Management Assessment Business Experience Union Contract / Strike History Labour Relations / Agreements Personnel Schemes Profile of permanent employees Data on Past Sales Customer profile Major sales agreements Trends Distribution channels Product Profile Development / Disclosure Location Technology Manufacturing process Quality R&D of Senior

d)

Marketing Analysis

e)

Manufacturing

iv. Other Information - Inventory valuation, obsolescence, over valuation. - Litigation - Doubtful debts - Unrealized / Unrealizable Assets / Investments - Tax status / Assessments / Outstanding dues v. Economic Analysis - Business Cycles - Public Interest - Government Prices / Incentives - Condition of securities market vi. Comparison of Alternative Target companies and Arrival of decision as regards target company. vii. Strategy for takeover - method to be employed. - Friendly take over through negotiations - Hostile viii. Valuation of Assets and arriving at Purchase consideration. ix. Mode of Payment - Cash - Share Exchange Ratio x. Legal formalities - Takeover code - Company law

22

- Income tax / SICA / IDR / MRTP xi. Post Merger Integration.

Additional Information When are Mergers and Acquisitions Successful? If one plus one equals three - Mergers and acquisitions is successful. Do Mergers and Acquisitions always succeed? International studies suggest: 75% of all mergers fail only 25% succeed. Some findings of International Studies: (1) About 15% of Mergers and Acquisitions in USA achieve their financial objectives as measured by share value, return on Investment and Post combination profitability. [Course in Mergers and Acquisitions, American Management Association, 1997] (2) (3) Up to 75% of European Mergers end in failure. [Harper J and Cormeraic S. Journal of European Inds. Training 1995] Separate studies by McKinsey & Co. and Coopers & Lybrand report that about 70% alliances fail or fall short of expectations.

23

Chapter Five Defence Mechanism

Defene mechanisms are the tools used by a company to prevent its takeover. In order to ward off take over bid, the companies may adopt: I. Preventive Measures II. Defence strategies in the wake of take over bid. These defensive measures are elaborated below: I. Advance / Preventive Measures: a) Joint holding / Agreements between major shareholders b) Interlocking / Cross holding of shares. c) Issue of block of shares to friends and Associates. d) Defensive merger with own group company. e) Non-voting shares / Preference shares f) Convertible debentures g) Maintaining part of capital uncalled for making emergency requirements. h) Long term service agreements. II. Defence in the wake of takeover bid : a) Commercial Strategies i) Dissemination of favourable information to keep shareholders latest developments. - Market coverage - Product demand - Industries outlook and resultant profit. ii) iii) iv) v) abreast of

Step up dividend and update share price Revaluation of Assets Capital structure Re-organization Unsuitability of offertory to be highlighted while communicating with shareholders.

24

b) Tactical, defense strategies i) Friendly purchase of shares ii) Emotional attachment loyalty / participation iii) Recourse to legal action iv) Operation white Knight. White Knight enters the fray when the target company is raided by hostile suitor. White Knight offers bid to target company higher than the offer of the predator that may not remain interested in the bid. v) Disposing of Golden jewels : Precious assets of the company are called cream jewels which attract the raider. Hence as a defence strategy, company sells these assets at its own initiative leaving rest of the company intact. Raider may not remain interested thereafter.

vi) Pac-Man Strategy: In this strategy, the target company attempts to take over the raider. This happens when Target Company is higher than the predator. vii) Compensation Packages: Golden parachutes or First class passenger strategy termination package for senior executives is used as protection for Directors. viii) Shark Repellants: Companies change and amend their bye laws to make it less attractive for corporate raider. ix) Ancillary Poison Pills: Issue of convertible debentures - which when converted dilutes holding percentage of raider and makes it less attractive.

25

Chapter Six Acquisition and Takeover Regulations (SEBI Regulations)

Securities Exchange Board of India (SEBI) is a market regulator and has issued takeover guidelines popularly called takeover code as under: I. Exempted Categories: Allotment in pursuance of an application made in public issue. Allotment in pursuance of Rights Issue Preferential Allotment made in pursuance of Sec. 81 (1A) Allotment in pursuance of an underwriting agreement. Intense transfer of shares amongst Group companies Relatives Promoters / Indian promoters and foreign promoters who are shareholders Acquisition of shares in ordinary course of business by Registered stock broker of stock exchange on behalf of clients Registered market maker of a Stock Exchange Public financial institution on their own account Banks / Financial Institutions as pledge Acquisition of shares by way of transmission or succession or inheritance. Acquisition of shares by government companies Transfer of shares from state level financial institutions including subsidiaries pursuant to agreement between such FIS and Promoters. Transfer of shares venture capital funds to promoters. Under BIFR scheme Acquisition of shares of companies not listed other cases as may be exempted by SEBI. In respect of exempted cases for acquisition exceeding 15% Application to be made to SEBI within 21 days Giving details / reasons seeking exemption Payment of fee to SEBI Rs. 10,000/In respect of notification for information to public, it should be made in case of acquisition exceeding 5% of voting rights. 26

a) b) c) d) e) f) g) h) i) j) k) l) m) n)

II. Disclosure required to be made in respect of acquisition of shares / Voting rights. a) Existing shareholders holding more than 5% of shareholding / voting rights Disclosure to be made to the company within 2 months from the date of SEBI Regulations. b) Acquisition of 5% and 10% of voting rights Disclosure to be made to company within 4 working days of Receipt of intimation of allotment of shares Acquisition of shares c) Company to disclose to all stock exchanges where shares are listed Within 7 days of receipt of information. d) Continual disclosure by those who held more than 15% Within 21 days from the close of financial year e) Company to make annual disclosure Within 30 days from the close of financial year III. Substantial Acquisition / Public Announcement a) Acquisition of 15% or more shares / voting rights Public announcement b) Consolidation of holding from 15% to 75% In any year acquisition should not be more than 10% unless announcement is made. c) Conditions precedent to public announcement Appointment of Merchant Banker Timing of Announcement, within 4 working days of entering into agreement for acquisition of shares Publications of announcement : In all editions of the English daily, one Hindi daily, one Regional language daily where registered office of company is located. Copy to be submitted to: SEBI, Stock Exchange and Target Company IV. Contents of Public Announcement Offer a) Target company Existing paid up capital No. of fully paid shares No. of partly paid shares b) Total number of percentage shares of the target company to be acquired from the public by the acquirer subject to minimum of 20% of voting capital of the company. c) Minimum offer price

27

d) e) f) g)

Mode of payment of consideration. Identity of acquirer / acquirers Existing holding Agreement to acquire shares Date of Agreement Name of the seller Price of which shares are to be acquired. No. of percentage of shares to be acquired.

h) Price paid by acquirer and persons acting in concert with him, during last 12 months. The highest price The average price i) j) k) l) m) n) o) p) Object and purpose of acquisition and future plans. Date of opening of offer / closing of offer Date by which purchase consideration would be paid Disclosure to the effect that firm financial arrangement required to implement has been made. Other statutory approvals if any; Approval of Banks / Institutions Minimum level of acceptances from the shareholders Such other information as is essential for the shareholders to make informal decision. Submission of letter of offer to SEBI within 14 days from the date of public announcement made. Letter of offer not to be dispatched to shareholders. Therefore not earlier than 21 days from its submission to SEBI.

V. Specified date Acquirer to specify a date for the purpose of determining the names of the shareholders of the target company to who letter of offers have been sent. Specified date shall not be later than 30th day from the date of public announcement. VI. Minimum number of shares to be acquired: a) 20% of voting capital; b) Acquirer may take more than 20% if he so desires but in that case 50% of consideration is to be deposited in escrow account. c) Reduction of public holding below 10% The acquirer within 3 months to acquire remaining shares (Resulting into delisting of shares) Or Disinvest through an offer for sale or by public issue within a period of 6 months. d) If the shares offered are more than the shares agreed to be acquired.

Pro-rata Acquisition

28

VII. Offer Price: Acquirer is required to make a minimum offer price which may be payable in a) Cash b) By exchange / transfer of shares of the acquirer company c) Exchange / transfer of instruments with minimum 'A' grade rating from rating agency d) Combination of (a), (b) and (c). Minimum offer price shall be highest of (For frequently traded shares) a) The negotiated price under agreement for acquisition b) Highest price paid by the acquirer the concert - including public or right issue during 26 weeks prior to public announcement. c) Price paid by acquirer under preferential allotment made to him. d) Average of weekly high low during last 26 weeks. If shares are not frequently traded: Minimum price will be in consultation with Merchant Bankers based on the following factors: a) Negotiated price b) Highest price paid in past 26 weeks VIII. Directors Obligations: a) Responsibilities of Acquirer company's Directors: Directors of the company to accept responsibility for offer brochure, circulars, letter of offer or any advertising material. b) Exemption from the Liability: If any director exemption, such director to issue statement to that effect together with reasons thereof. c) Prohibition to become a Director: During the offer period, the acquirer or person acting in concert with him shall not be entitled to be appointed on the Board of Directors of Target Company. d) Offer Conditional upon minimum level of acceptances: Where an offer is conditional upon minimum level of acceptances the Acquirer Shall acquire shares from the public to the minimum extent of 20% irrespective of public response to the minimum level of acceptance (Not applicable if 50% amount payable is deposited in escrow account) Shall not acquire, during the offer period, shares in the target company except by way of fresh issue of shares of the target company. Shall be liable for penalty of forfeiture of entire escrow amount for nonfulfillment of obligations under the regulations.

29

e) Restrictions on existing Directors: Existing Director is an insider within the meaning of SEBI Regulations and such a person shall refuse himself / and not participate in any matters concurring or relating to the offer including any preparatory steps leading to the offer. f) Other Duties i. Open escrow account on or before the date of issue of public announcement of offer. ii. Make financial arrangements for fulfilling obligation. iii. To complete the procedures relating to offer within 30 days from the date of closure. iv. Prohibition of further offer of shares If acquirer has withdrawn the offer, he shall not make further offer for acquisition for a period of six months. And if he has violated SEBI rules, he cannot make offer for any listed company for a period of 12 months. v. Disclosure of acquisition within 24 hours to Stock exchanges Merchant banks Details: No. of shares, Price paid, mode of acquisition. vi. Prohibition of disposed or encumbrance of shares acquired, for 2 years unless specifically stated. IX. General Obligations of Target Company During the period offer Target Company could sell, transfer or dispose of the assets of the company issue any authorized but un-issued securities enter into material contracts List of shareholders to be furnished as required by the Acquirer: Within seven days of the request or specified date whichever is later. Once public offer is made, cannot appoint may additional director or fill in any casual vacancy by any person representing or having interest in the acquirer company. Director can send unbiased comments on the offer to shareholders but Misstatement / concealment of material information will make them liable for action. Facilitate the acquirer in verification of securities tendered for acceptances Transfer of securities in favour of the acquirer in certification of merchant bankers. X. General Obligations of Merchant Bankers

30

a) Merchant Bankers to ensure that Acquirer is able to implement the offer made in terms of public announcement of offer. Provisions relating to escrow account is made Firm arrangement of funds / money for payment through verifiable means to fulfill SEBI regulations. b) Contents of public announcement of offer and offer letter are true, fair and adequate and based on reliable sources. Filing of letter of offer with SEBI, Target company and also Stock Exchange where shares are listed. Issue of due diligence certificate Compliance with SEBI regulations Directions to Bank for release of escrow account. Report to SEBI: Within 45 days of closure of offer XI. Competitive bids a) Public announcement of competitive bid to be made within 21 days of first announcement of offer by any person b) Quantum of Competitive bid should be atleast equal to the number of shares, which was made under first offer. i. Option to First Acquirer: Revise his offer Withdraw his offer with SEBI approval Upward Revision of offer price Any time upto 7 working days prior to the date of closure of offer. Acquirer shall not have the option to change other items. Increase escrow amount upto 10% of consideration payable on revision. Public announcement in all newspapers in which original offer was made. Inform : SEBI Stock Exchange Target Company Closure of offer: When there is a competitive bid, the date of closure of original bid as well as date of closure of all subsequent bids shall be the date of closure of public offer and the last subsisting competitive bid. Withdrawal of offer: Once acquirer has made an announcement of public offer he can not withdraw unless:

ii.

iii.

iv.

31

 Withdrawal is consequent upon competitive bid by another. Statutory approvals required have been refused. The sole acquirer being natural person dies. Such circumstances which SEBI may permit. Withdrawal by o Public announcement in all publications when offer was made o Inform : SEBI, Stock Exchange and Target company

XII. Other Aspects - Escrow Account: The acquirer shall on the date of public announcement of offer create escrow account by way of security for performance obligations under SEBI rules: a) Amount : For consideration upto Rs. 100 crores Above Rs. 100 crores 25% 25% upto Rs. 100 crores and 10% thereafter For offers which are subject to minimum level of acceptances and the acquirer does not want to acquire more than 20% 50% of consideration Total consideration to be calculated for highest price.

b) Escrow Account to consist of Cash deposit with scheduled bank Bank guarantee Deposit of acceptable securities with appropriate managing with Merchant Banker. c) Conditions to be fulfilled i. Cash deposit with scheduled bank: Acquirer to empower merchant banker to issue cheque / DD as per SEBI rules. ii. Bank Guarantee To be in favour of Merchant Banker Valid for a period of public announcement plus 30 days from the closure of offer d) Escrow with Security: Empower merchant banker to dispose of security by sale or otherwise. The guarantee / Securities shall not be returned till all the obligations under SEBI Regulations are complied with. e) Increase in value of Escrow: i. Upon upward revision of offer: Additional value of 10% of consideration payable on such revision Additional deposit of 10% of value increases in consideration.

32

ii.

When Bank guarantees have been given as securities: Acquirer to give at least 1% of consideration payable by way of security f) Release of Escrow Account i. The entire amount to the acquirer upon withdrawal of offer with certificate of merchant banker. ii. Transfer of 90% to Special account opened. iii. To the acquirer, balance 10% of cash on completion of all this formalities. iv. Entire amount to Merchant Banker in the event of forfeiture due to non fulfillment of SEBI Regulations. v. In the event of forfeiture : Merchant Banker will distribute o 1/3 rd of the amount to Target company o 1/3 rd to Stock Exchange o 1/3 rd to be distributed pro-rata among shareholders who accepted the offer g) Forfeiture of Escrow Account In case of non fulfillment of obligations under SEBI regulations, SEBI shall forfeit escrow account in full or part. The merchant banker shall ensure realization of escrow account by o foreclosure of deposit o Invoking bank guarantee o Sale of security h) Payment of Consideration : Consideration payable in cash: within 21 days from the closure of offer. Open a special account with Banker to the Issue. Consideration payable in exchange of security: Acquirer to ensure that securities are actually issued and dispatched. Unclaimed balance: To be transferred to Investors Protection fund after 3 years of date of deposit.

XIII. Bailout Takeover a) What is bailout takeover? Bail out take over of financially weak but not sick unit. Financially weak: Erosion of 50% of its net worth but less than 100% Responsibility: Lead Institution to e responsible to ensure compliance of SEBI Regulations. b) Approval by Lead Institution: Taking into account financial viability Assessing requirement of funds for revival Drawing up revival package

33

c) Scheme may provide for: Change in management Exchange of shares Combination of both d) Manner of Acquisition: Invitation of offer Information to offerors o Management o Technology o Range of products o Shareholding pattern o Financial holding o Past performance e) Selection of the Party: Management competence Adequacy of Financial Resources Technical Capability f) Manner of evaluating bid: Purchase Price Track Record Financial Resources Reputation of management

34

Chapter Seven Valuation of Shares

I. Introduction to Valuation: The process of determining the current worth of an asset or a company is called valuation. There are many techniques that can be used to determine value, some are subjective and others are objective. For example, an analyst valuing a company may look at the company's management, the composition of its capital structure, prospect of future earnings, and market value of assets. Judging the contributions of a company's management would be more of a subjective valuation technique, while calculating intrinsic value based on future earnings would be an objective technique. Every asset, financial as well as real, has a value. The key to successfully investing in and managing these assets lies in understanding not only what the value is but also the sources of the value. Any asset can be valued, but some assets are easier to value than others and the details of valuation will vary from case to case. Thus, the valuation of a share of a real estate property will require different information and follow a different format than the valuation of a publicly traded stock. What is surprising, however is not the difference in valuation techniques across assets, but the degree of similarity in basic principles. There is undeniably uncertainty associated with valuation. Often that uncertainty comes from the asset being valued, though the valuation model may add to that uncertainty. A postulate of sound investing is that an investor does not pay more for an asset than its worth. This statement may seem logical and obvious, but it is forgotten and rediscovered at some time in every generation and in every market. There are those who are disingenuous enough to argue that value is in the eyes of the beholder, and that any price can be justified if there are other investors willing to pay that price. That is patently absurd. Perceptions may be all that matter when the asset is a painting or a sculpture, but investors do not (and should not) buy most assets for aesthetic or emotional reasons financial assets are acquired for the cash flows expected on them. Consequently, perceptions of value have to be backed up by reality, which implies that the price paid for 35

any asset should reflect the cash flows that it is expected to generate. The models of valuation described here attempt to relate value to the level and expected growth in these cash flows. II. Role of Valuation in Acquisition Analysis: Valuation should play a central part of acquisition analysis. The bidding firm or individual has to decide on a fair value for the target firm before making a bid, and the target firm has to determine a reasonable value for itself before deciding to accept or reject the offer. There are also special factors to consider in takeover valuation. First, the effects of synergy on the combined value of the two firms (target plus bidding firm) have to be considered before a decision is made on the bid. Those who suggest that synergy is impossible to value and should not be considered in quantitative terms are wrong. Second, the effects on value, of changing management and restructuring the target firm, will have to be taken into account in deciding on a fair price. This is of particular concern in hostile takeovers. Finally, there is a significant problem with bias in takeover valuations. Target firms may be over-optimistic in estimating value, especially when the takeover is hostile, and they are trying to convince their stockholders that the offer price is too low. Similarly, if the bidding firm has decided, for strategic reasons, to do an acquisition, there may be strong pressure on the analyst to come up with an estimate of value that backs up the acquisition. III. Need for Valuation of Shares: i. ii. iii. iv. v. vi. vii. Assessment under estate duty, wealth tax, gift tax. Purchase of block of shares including acquisition of controlling interest in the company. Formulations of schemes of amalgamation. Acquisition of interest of dissenting shareholders under reconstruction scheme. Conversion of preference shares into equity Advancing loans against security of shares Compensating shareholders on the acquisition of their shares by the government under a scheme of nationalization.

IV. Factors Affecting Valuation: Internal Factors: Rate of dividend declared Market / Current values of assets / liabilities Goodwill Market for the products Industrial relations with employees Nature of plant / machinery Nature of plant / machinery Expansion policies of the company Reputation of Management External Factors:

36

Competition Relations with Govt. Agencies Technological development Taxation parties Import / Export policy Stability of economy Stability of government in power Political climate in country V. Basis of Valuation: 1) 2) 3) 4) 5) Assets Value Capitalized Earning Power Market value Book Value Cost: Historical, Replacement / Substitution / Opportunity cost.

VI. Methods of Valuation: Analysts use a wide range of models to value assets in practice, ranging from the simple to the sophisticated. These models often make very different assumptions about pricing, but they do share some common characteristics and can be classified in broader terms. There are several advantages to such a classification -- it makes it easier to understand where individual models fit into the big picture, why they provide different results and when they have fundamental errors in logic. Thus methods of valuation of shares are classified into two parts i.e.: Historical Perspective Modern Perspective Historical Perspective: In historical perspective we use the following methods: Net Asset Method Yield Method 1) Net Asset Method: Also termed as Balance Sheet Method, Asset Backing Method or Break up value method. For instance: If assets total Rs. 50,000 and liabilities Rs. 10,000. No. of shares 20,000 Net Asset value: Rs. 2 Points to be considered: a) Proper value to be placed for Goodwill after business. b) Fictitious Assets such as Preliminary expenses, debit balance in profit and loss account etc to be excluded. c) All other assets (including non-trading assets such as investments) should be taken at market value. In absence of information about market value -- Book values may be taken.

37

d) Liabilities payable to third parties and preference share capital should be deducted from total assets. e) It should be noted that item constituting part of the equity shareholders funds (E.g. General Reserves; Profit and loss account credit balance, Debenture Redemption Fund, Dividend Equalisation fund, Contingency Reserves should not be deducted. f) Net Assets so arrived at should be divided by no. of equity shares. Illustration: Balance Sheet of M/s Prosperous Ltd. As on 31. 3. 97 Liabilities Share Capital: Authorized & Issued 6000 shares of Rs. 100 each Profit and loss account Bank overdraft Creditors Provision for taxation Proposed dividend Rs. Assets Land and Building 6,00,000 40,000 10,000 80,000 1,00,000 60,000 8,90,000 Plant and machinery Stock Sundry debtors Rs. 2,70,000 1,00,000 3,60,000 1,60,000

8,90,000

Additional information: Profit before depreciation and taxation during last five years: 1992.93 1993.94 1994.95 1,70,000 2,10,000 1,80,000 1995.96 2,20,000 1995.97 2,00,000

- On 31st March, 1997 Land and Building were valued at Rs. 2,80,000 and Plant and Machinery Rs. 1,20,000, Sundry debtors included Rs. 4,000 which were irrecoverable. - Having regard to the nature of business, a 10% return on net tangible capital employed is considered reasonable. You are required to value the shares of the company

- Valuation of Goodwill may be based on five years purchase of annual super profits. Tax rate to be assumed at 50%.

Solution: Statement showing valuation of shares Goodwill (see working note) 1,44,500 Land and Building 2,80,000

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Plant and Machinery Sundry Debtors Stock Less: Liabilities: Bank Overdraft Creditors Provision for taxation Proposed dividend Total Value per share Working note: i) Tangible capital employed: Assets at their present value: Land and Building Plant and Machinery Stock Sundry debtors Less: Liabilities Bank Overdraft Creditors Provision for tax Net tangible capital employed Less: 50% of Profits (after tax) Average capital employed ii) Goodwill: Total profits for five years Less: Bad debts Average Less: Adjustment for change in Depreciation in value of assets Land and Bldg. 2% on 10,000 Plant and Mach. 10% on 200000 Less: Taxation @ 50% Average Annual profit Less: 10% Return on Annual average Capital employed 9,80,000 4,000 9,76,000 2,80,000 1,20,000 3,60,000 1,56,000 9,16,000 10,000 80,000 1,00,000 1,90,000

1,20,000 1,56,000 3,60,000 10, 60,500 10,000 80,000 1,00,000 60,000 2,50,000 8,10,500 8,10,500 / 6000 = 135.08

7,26,000 50,000 6,76,000

1,95,000 200 2000 1,93,000 96,500 96,500 67,600

39

Average Annual super profit 5 years purchase of super profits

28,900 1,44,500

2) Yield Method The yield basis of valuation may take any of the following two forms a) Valuation based on Rate of Return b) Valuation based on Productivity factor a) Valuation based on Rate of Return The rate of return refers to the return which a shareholder earns on his investment. It may further be classified into: Rate of dividend Rate of earnings i. Valuation based on Rate of dividend: Paid up value of share

Profitable rate of dividend Normal rate of dividend

E.g.: Paid up value Normal dividend Possible Dividend : : : Rs. 80 Rs. 10 Rs. 12

Hence value 80 x 12 / 10 = Rs. 96. ii. Valuation based on Rate of Earnings Rate of earnings of company explains the effective utilization of companys assets. In case the company does not distribute 100% of its earnings among its shareholders, it is a matter of fact strengthens the financial position of the company. Paid up value of shares

Possible earnings Rate Normal earnings Rate

E.g.: Paid up value Past earning Rate Expected earning rate Value: 80 x 20 16 iii. Valuation based on Price Earning Ratio: Earning per share x Price Earning Ratio = 100 : : : Rs. 80 Rs. 16 Rs. 20

40

Earning Per share =

Profit available for Equity shareholders No. of Equity Shares

Price Earning Ratio =

Market value of a share Earning per share

E.g.: Earning per share Market value Price Earning Ratio In case EPS goes up Value of share will be iv. 10 40 04 12 12 x 4 = 48

Capitalization Factor The value of share can also be found out by finding capitalization factor or multiplication If yield expected in the market is 8% The capitalization factor is 100 / 8 i.e. 12.5% Hence if a company earns profit of Rs. 4 lakhs Total value of Business will be Rs. 50 lakhs 4 x 12.5 Value of equity share: Capitalized value of Business No. of Shares

v.

b) Valuation based on Productivity Factor: Productivity factor represents earning power of the company in relation to value of the assets employed for such earning. The factor is applied to net worth of company on the valuation data to arrive at projected earnings of the company. Projected earnings after necessary adjustments are multiplied by the appropriate capitalization factor to arrive at the value of companys business. Maturity value is divided by no. of shares to ascertain value of each share.

Procedure: 1) Ascertain average net worth of the business for relevant years 2) Ascertain the value of Net worth of business on valuation date 3) Average profit earned for the relevant years 4) Productivity factor = Average profit x 100 Average net worth 41

5) Productivity factor so obtained is applied to net worth of the business on valuation date to ascertain projected income of business in future. 6) Projected income so calculated is further adjusted by making appropriations of replacement / tax, etc. hence profit available to shareholders is arrived at. 7) The Normal rate of return for the company is ascertained by keeping in view nature and size of the undertaking. 8) Appropriate capitalization factor or multiplier based on normal rate of return is ascertained. 9) Capitalization factor is applied to projected profits to ascertain value of the undertaking. 10) Capitalized value is divided by no. of shares.

Illustration: The following figures relate to a company which has Rs. 10,00,000 in equity shares and Rs. 3,00,000 in 9% Preference shares all @ Rs. 100 each. Year 1995 1996 1997 Average Networth (excluding investments) Rs. 18,60,000 Rs. 21,50,000 Rs. 21,90,000 Adjusted Taxed Profit Rs. 1,90,000 Rs. 2,10,000 Rs. 2,50,000

The company has investments worth Rs. 2,80,000 (at market value). On the valuation date, the yield in respect of which has been excluded in arriving at adjusted taxed profit figures. It is customary to similar types of the companys to set aside 25% of taxed profits for rehabilitation and replacement purposes. On valuation date, the net worth (excluding investments) amounts to Rs. 22,50,000. The normal rate of return expected is 9%. The company has paid dividends consistently within range of 8% to 10% on equity shares over past 7 years and expects to maintain the same. Required: Ascertain value of each equity share on the basis of productivity factor applying suitable weighted averaging. Solution: Computation of Productivity Factor Year 199 5 199 6 199 7 Avg. N.W. 18,60,000 21,50,000 21,90,000 Adjusted taxed Profits 1,90,000 2,10,000 2,50,000 Weight 1 2 3 Weighted N.W. 18,60,000 43,00,000 65,70,000 Weighted adjusted taxed Profits 1,90,000 4,20,000 7,50,000

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Productivity factor:

2,26,667 x 100 = 10.68% 21,21,667 2,40,000 60,075 1,80,225 27,000 1,53,225 17,02,500 2,80,000 19,82,500 19,82,500 10,000 = Rs. 198.25

Maintainable profit: 10.68% on 22,50,000 Less: Rehabilitation / Replacement Reserve @ 25% Less: Preference dividend Profit available for shareholders Capitalized value of profit @ 9% Add: Value of Investments Total value of Assets Value of Equity shares:

B.

CCI Guidelines Fair Value Guidelines formed in 1977 / 78 made public on 13-7-1990 Valuation of shares according to the guidelines is computed after taking into account following 3 elements: 1. Net Asset Value (NAV) 2. Profit Earning Capacity value (PECV) 3. Fair value (FV) 1. Net Asset Value: Total Assets Deduct: all liabilities 1) Pref. Capital 2) Secured / unsecured creditors 3) Current liabilities 4) Contingent liabilities xx x x x x Shareholders Funds i) Equity ii) Free Reserves Total Deduct: Contingent liability 1. 2. 3. 4. Net worth xx xx xx x x x x xxx

Net worth Add: Fresh Capital Issue Face value Total NAV Per share:

xxx

x xxx M.V. / No. of shares

2. Profit Earning Capacity Value (PECV) Years 1 2 Profit Before tax Profit after tax Dividend declared

43

3 4 5 Average Profit before tax (on basic or simple or weighted average basis) :______ Deduct provision for tax _________% Average profit after tax Deduct Preference dividend Net Profit after tax Add: Contribution to profits by fresh issue Total profits after tax No. of equity shares including fresh / bonus shares EPS Capitalized EPS by Capitalization rate.

Capitalization Rate 15% in the case of manufacturing companys (which may be modified / liberalized in exceptional cases upto 12% 20% in case of trading companies

17.5% In case of intermediate companies i.e. company whose turnover from trading activity is more than 40% but less than 60% of total turnover. Contribution of Fresh Issue of Capital x Fresh Capital x Existing Profit after tax Existing networth Market value: Average Market price Year High Low 1 2 3 latest 4 Month-wise Remarks

In preceding 12 months average market price on the above basis: 3. Fair Value: Fair value is worked out by averaging NAV and PECV. Market value is not taken as direct element in calculating fair value. But if fair value arrived at by averaging NAV and PECV, is less than MV, Weightage is given for higher MV in the following manner: If market value is higher or more by i) 20% to 50% of F.V, Capitalisation rate is reduced to 12%. ii) 50% to 75% Capitalisation rate is reduced to 10%. iii) 75% and above of FV, capitalisation rate is reduced to 8%.

44

Valuation of Shares and Exchange Ratio When two or more companies are combined / merged, financial consideration, generally in the form of exchange of shares is involved. This requires relative value of each companys shares to determine a particular exchange ratio. Three Approaches: o Earnings Approach o Market value Approach o Book Value Approach 1) Earnings Approach EPS of Acquired Company EPS of Acquiring Company E.g. Earning per share of Acquiring Company is Rs. 5. Earning per share of Acquired Company is Rs. 2. Exchange ratio: 2 / 5 i.e. 4 or 4 shares of acquiring company will be given for 10 shares of acquired company or 2 shares of acquiring company for 5 shares of acquired company. 2) Market value Approach Market price per share of acquired company Market price per share of acquiring company For example: Market value of share of Company A: Rs. 50 Market value of share of Company B: Rs. 25 and if A is acquiring B Exchange Ratio : 25 / 50 = 0.5 i.e. A Ltd. will issue 1 share for 2 shares of B Ltd. 3) Capitalized Value of EPS Steps: 1) Determining Average future earnings 2) Determining Capitalisation Rate 3) Determining of market value EPS Capitalisation Rate EPS 30 Capitalisation Rate 15% Market value 30 / 50 x 100 = 200 4) Exchange Ratio Market Price per share of Acquired Company

45

Market price per share of the acquiring company 5) Book value per share Book value = Shareholders funds No. of shares = Net worth No. of shares

Exchange Ratio = Book value per share of the acquired Co. Book value per share of Acquiring Co. Modern Perspective: 1) Dividend Discount Models : Basis : The value of the stock is the present value of expected dividends on it. Rationale: The value of any asset is the present value of expected future cash flows, discounted at a rate appropriate to the riskiness of cash flows being discounted. General Model: When investors buy stock, they expect to get two types of cash flows: i) Dividends during the period they hold stock ii) Expected price at the end of holding period Since expected price is itself determined by future dividends, the value of stock is the present value of dividends through infinity. t= Value per share of stock DPSt t = 1 (1 + r) t DPSt = Expected dividend per share r = required rate of return on stock Expected dividends Required rate of return

Two inputs:

Since dividend projections cannot be made through infinity, several versions of the dividend discount model have been developed upon different assumptions about future growth. The Gordon Growth Model: Model: The Gordon Growth Model can be used to value a firm that is in Steady rate with dividends growing at a rate that is expected to stay stable in the long term. Value of stock = DPS1

46

(r g) Where DPS1 = Expected dividends one year from now r g = Required rate of return for equity investors = Growth rate in dividends for ever

Stable Growth Rate Expected normal Growth rate in economy: Expected inflation + Expected real growth In U.S. 4% + 2% = 6%

In India 8% + 6% = 14% In practical terms, the stable growth rate can not be higher than the normal growth rate in the economy in which firm operates, if valuation is done in nominal (real) terms. If the firms operations are domestic, this will be the expected growth rate in domestic economy. (For multi nationals, the relevant information will be the growth rate in world economy). Limitations: Highly sensitive to growth rate Example: Expected dividend per share : US $ 2.50 Discount rate: 15% Expected growth rate: 8%

Value of stock: 2.50 (0.15 0.08) = $ 35. 71 Two Stage Dividend Model This model allows for 2 stages of growth Initial phase when growth rate is high Subsequent steady rate: Where growth rate is stable and expected to remain so for a long term. Value of stock: PV of dividends during growth period + PV of terminal price t= n P0 = DPSt + Pn t = 1 (1 + r) t (1 + r) n Where Pn = DPSn + 1 (rn - gn) (1 + r) n

Limitations of two stage dividend discount model: i. Practical problem is in defining the length of extra ordinary growth period ii. This model assumes that growth rate is high during initial period and is transformed overnight to a lower stable rate at the end of the period. While these 47

sudden transformations in growth can happen, it is more realistic to assume that shift from high growth to stable growth happen gradually over time. iii. Overestimating or underestimating growth rate can lead to significant errors in value. i. Further modifications: H model for valuing growth: This model is based on the assumptions that: Equity growth rate starts at a high initial rate (ga) declines linearly over extraordinary growth period (which is assumed to last 2 ii. H periods) to a stable growth rate (gn) Dividend payout ratio is constant over time and is not affected by the shifting growth rates.

P0 =

DPS0 ( 1 + gn ) r - gn Stable growth

DPS x H ( ga - gn ) r - gn Extra ordinary growth

Where

P0

= Value of firm now per share

DPSt = Dividend per share in year t r ga gn = Required return to equity investor = Growth rate initially = Growth rate at the end of 2H years applied for ever after that.

Limitations: i. Growth rate is assumed to follow a structure laid out in the model deviations from the structure can cause problem. ii. Assumption of pay out ratio remaining constant in consistent. Three Stage Discount Model: This model assumes on initial period of stable high growth, second period of declining growth and a third period of stable low growth that lasts forever. t =n1 P0 = t=1 t = n2 EPS0 ( 1 + ga) x IIa +
t

DPSt + EPSn2 (1+gn) x IIn t = n1 +1 (1 + r) t (r gn) (1 + r) n Transition Stable growth

High growth EPSt DPSt ga

: Earnings per share in year t : Dividends per share in year t : Growth rate in high-growth phase ( lasts n1 years) 48

gn IIa IIn

: Growth rate in stable growth phase : Payout ratio in high growth phase : Payout ratio in stable growth phase.

2) Free Cash flows to equity discount models: Free Cash flows to Equity: The FCFE is the residual cash flows left after meeting interest and principal payments and providing for capital expenditures to both maintain existing assets and create new assets for future growth. FCFE = Net Income + Depreciation Capital spending - Working capital Principal repayments + New Debt Issues.

In a special case where capital expenditures and working capital are expected to be financed at the target debt equity ratio and principal repayments are made from new debt issues. FCFE = Net Income + (1 - ) (Capital Exp. Depreciation) + (1 - ) Working capital.

Why are Dividends different from FCFE? The FCFE is a measure of what a firm can afford to payout as dividends. a) Desire for stability b) Future investment needs c) Tax factors d) Signaling prerogatives: Increase in dividends is viewed as positive signals and decreases as negative signal. FCFE Models: The stable-growth FCFE Model: The value of equity, under the stable-growth model, is a function of expected FCFE in the next period, the stable growth rate, and the required rate of return. P0 = P0 r FCFE1 r - gn = Value of stock today = Cost of equity of the firm

FCFE1 = Expected FCFE next year

49

gn

= Growth rate in FCFE for the firm forever.

Illustration: Earnings per share : $ 3.15 Capital Exp. per share : $ 3.15 Depreciation per share : $ 2.78 Change in working capital per share : $ 0.50 Debt financing ratio : 25% Earnings, Capital expenditure, Depreciation, Working capital are all expected to grow at 6% per year. The beta for stock is 0.90. Treasury bond rate is 7.5%. Calculate value of stock.

Solution: Estimating value Long term bond rate 7.5% Cost of equity = 7.5% + (0.90 x 5.50%) = 12.45% Expected growth rate 6% Base year FCFE = Earning per share (Capital Exp. Dep.) (1 D /E Ratio) Change in working capital (1 D / E Ratio) 3.15 (3.15 2.78) (1 0.25) 0.50 (1 0.25) 2.49

= =

Value per share = 2.49 x 1.06 (0.1245 0.06) = $ 41. 3) Further modification in FCFE model Two stage FCFE model : The value of any stock is the present value of the FCFE per year for the extra ordinary growth period plus the present value of the terminal price at the end of the period. Value = PV of FCFE + PV of Terminal price t =n = FCFEt (1 + r) t + Pn (1 + r) n t=1 Where FCFEt = FCFE in year t Pn r = Price at the end of extra ordinary growth period = Required rate of return to equity investors in high growth period.

The terminal price is generally calculated using the infinite growth rate model: Pn = FCFEn + 1 ( rn - gn )

50

gn rn

= Growth rate after the terminal year forever = Required rate of return to equity investors in stable-growth period.

Three stage FCFE model - E model E-model is designed to value firms that are expected to go through three stages of growth: an initial phase of high growth rates, a transition period where growth rate declines and a steady state where growth is stable. t =n1 P0 = t= 1 Where P0 FCFEt t Pn 2 n1 n2 t=2 + L = n1 + 1

FCFEt (1 + r) t

FCFE1 (1 + r) t

Pn2 (1 + r) n

= Value of stock today = FCFE in year t = Cost of equity = Terminal price at the end of transition period = FCFEn2 + 1 / (r gn) = End of the initial high growth period = End of transition period

FCFE Valuation model v/s Dividend Discount valuation models: FCFE model is alternative to dividend discounting model. But at times both provide similar results: When result obtained from FCFE and Dividend discount model may be same: i) Where dividends are equal to FCFE. ii) Where FCFE is greater than dividends but excess cash (FCFE- dividends) is invested in projects with NPV = 0 (Investments are fairly priced) When results from FCFE and Dividend discounting models are different: i) When FCFE is greater than dividends and excess cash earns below market interest rates or is invested in negative NPV value projects, the value from FCFE will be greater than the value from discount model. ii) iii) When dividends are greater than FCFE, the firm will have to issue either new stock or new debt to pay their dividends- with attendant costs. Paying too much of dividend can lead to capital rationing constraints when good projects are rejected, resulting in loss of wealth. Conclusion: The dividend model uses a strict definition of cash flows to equity, i.e. expected dividends on stock, while FCFE model uses an expensive definition of cash flows to

51

equity as the residual cash flows after meeting all financial obligations and investment needs. When the firms have dividends that are different from FCFE, the values from two models will be different. In valuing firms for takeover or where there is reasonable chance of changing corporate control, the value from the FCFE provides the better value.

Chapter Eight Legal Issues Relating to Mergers and Acquisitions

Legal Issues Relating to Mergers and Acquisitions are as under: I. Compliance under Companies Act Companies Act does not define Amalgamation or merger. However, provisions under sections 391 to 396 deal with Arrangements and compromise apply to Mergers and Acquisitions. Section 391 Section 392 Section 393 Section 394 i. ii. iii. iv. Power to compromise or make arrangements with creditors and members Power of High Court to enforce compromises and arrangements Information as to compromise and arrangements with creditors and members Provisions for facilitating reconstructions and amalgamation of companies

Transfer to the transferee company of the whole or any part of the undertaking, property or liabilities of the transferor company The allotment or appropriation of the transferee company of any shares / debentures or other interests in the transferor company under the compromise arrangements. Continuation by the transferee company of any legal proceedings pending by or against Transferor Company. Dissolution without winding up of Transferor Company

52

v. vi.

Provision for dissenting members Other consequential / supplementary matters. Section 395 Section 396 Power to acquire shares of dissenting shareholders under the scheme approved by the majority. Power of the Central Government to provide for amalgamation in national interest.

Checklist of procedure for Amalgamation of Companies: 1) Review the Memorandum and Articles of Association of all amalgamating companies to verify : a) Power to amalgamate exists: Though these are views that such power is not necessary, it is appropriate to consider amendment of memorandum to include such powers. b) Objects of Transferee company: Should include power to carry on the business of transferor company if not amend the memorandum of transferee company by amending the objects. c) Any provisions under Articles: Requiring any special procedure to be followed or approvals to be obtained. 2) Ensure that audited Accounts for the period ending on the appointed date are ready. 3) Hold Board Meetings: For approval of amalgamation and other incidental matters including appointment of a director as authorized person to carry out various matters on behalf of the company. 4) Carry out valuation of shares for each of the company. 5) Prepare necessary schemes and papers relating to amalgamation. 6) File an application with the Court seeking approval / directions of the Court. 7) Call meetings of shareholders / creditors under direction of the Court. Companies will also have to issue necessary advertisements where required and applicable. 8) Hold the meetings, pass necessary resolutions approving amalgamation and related matters. 9) In parallel, Transferee Company may also hold on-extra ordinary general meeting for matters such as approval of issue of shares, increase of authorized share capital. File special resolution with Registrar of company. 53

10) File report of chairman of the meetings held under the courts directions within the prescribed time. 11) Petition to the court for sanctioning the scheme of amalgamation. 12) Give appropriate notice to Central Government as required under Section 394 A. 13) Obtain official Liquidators report that the affairs of the company have not been conducted in a manner prejudicial to the interests of the members of the company or the public interest. 14) Obtain the order of amalgamation of the court 15) File certified copy of the order with Registrar of companies within 30 days. 16) Issue shares to the shareholders of the transferee company and file necessary return of allotment under Section 75. Checklist for Acquisition and Divestiture of Business: 1. In case the acquirer is a company, check whether the objects permit: a) Acquisition of new business b) Carrying on of the business sought to be acquired. 2. Check whether objects of Seller Company permit sale of business. 3. Ensure compliance under Section 293 (1) (a) in case of sale of whole or substantially whole of the undertaking. 4. Where the payment is to be made by issue of shares, ensure compliance with the following by the company proposing to issue such shares : a) Where the company is a public limited company, Section 81 (1A) of the companies Act. b) Where company is a listed company, provisions relating to i) Listing agreement ii) SEBI Takeover code should be complied with c) Increase of Authorized Share Capital, where required, needs compliance. d) Filing of return of allotment as required under Section 75 of Companies Act. II. Provision of Sick Industrial Companies (Special Provisions) Act 1985: Amalgamation may be a measure for rehabilitation of a sick unit under SICA. Section 18 of SICA, envisages amalgamation of a sick company with any other company or vice versa (i.e. reverse merger) Section 18(2) of SICA gives wide powers to Board for Industrial and Financial reconstruction (BIFR) with regard to amalgamation of sick unit with healthy unit. o Change of constitution, name, memorandum, articles, Board of Directors. 54

o Alterations, reorganization or reduction of capital. o Transfer of property, assets or liabilities o Any other measure necessary to effectively carry out scheme of amalgamation. Section 32 of SICA gives BIFR wide powers to override any law except FERA and urban land ceiling Act. BIFR can pass order regardless of what any other law provides. Provisions of Companies Act regarding amalgamation are not applicable.

Approval of scheme by shareholders is not required, but shareholders of healthy company involved in the amalgamation must approve it. BIFR has power to grant benefits under Section 72 A of Income tax. Procedure under SICA: i. ii. iii. iv. v. vi. vii. Reference to SICA by sick unit Declaration of unit as sick unit Appointment of operating agency. Operating agency to examine the viability of sick unit and prepare rehabilitation scheme (including amalgamation with healthy unit) Hearing of Scheme Inviting objections to scheme before sanction. Hearing different agencies having interest in the scheme Workers Government Creditors Sanction of the scheme Power to appoint Directors on the Board Monitoring by operating Agency Scheme will sanction various benefits in interest rates, repayment period, income tax benefits, rationalization of labour, deferment of government dues etc. as may be recommended by operating agency.

viii. ix. x.

III. Foreign Exchange Management Act Extracts from RBI notification under FEMA Notification FEMA 20 / 2000 RB dated 03/05/2000: Issue and Amalgamation of shares after merger or demerger or amalgamation of Indian companies: Where a scheme of merger or amalgamation of two or more Indian companies or a reconstruction by way of demerger or otherwise of an Indian company, has been approved by courts in India the transferee company, or as the case may be, the new company, may issue shares to shareholders of the transferor company, resident outside India, subject to the following conditions: a) Percentage of shareholding of the person resident outside India in the amalgamated company does not exceed the percentage specified in the approval

55

granted by the Central Government / Reserve Bank, when it exceeds approval of RBI should be obtained. b) Transferor Company or Transferee (Amalgamated) company shall not engage in agriculture, plantation, or real estate business or trading in TDRs. c) Reporting to RBI: Amalgamated Company to file details of shares held by persons resident outside India and furnishing confirmation that all the terms and conditions stipulated by the scheme have been complied with. Report to be submitted within 30 days of issuing shares.

Stamp Duty: Stamp duty is required to be paid as per Laws of the State in which registered office of the transferor / transferee companies are situated. In Maharashtra stamp duty is 10% of the aggregate value of shares issued or allotted in exchange or other wise and the amount of consideration paid for such amalgamation. However amount of duty chargeable will not exceed: i. An amount equal to 7% of true market value of immovable property located within the state of Maharashtra of the transferor company ii. An amount equal to 0.7% of aggregate of market value of shares issued or allotted in exchange or otherwise and the amount of consideration paid for such amalgamation whichever is higher of (i) or (ii). IV. Income Tax Act: 1961 Various provisions of Income tax applicable to Mergers and Acquisitions are summarized below: Depreciation: Section 34 The amalgamated company can continue to claim future depreciation on the assets transferred to it under scheme of amalgamation. However, such depreciation be allowed on the written down value of the assets before amalgamation and not as the value of the transferor of these assets. Terminal Depreciation (Section 32 and Section 41) The transfer of assets by the amalgamating company does not amount to sale of assets provided amalgamated company is an Indian company. Hence, transfer value of assets in an Amalgamation scheme may be more or less than the written down value of assets. Such deficit or excess will neither be allowed as terminal depreciation or will be chargeable to tax as balancing charge. Capital Gains: Section 45 and Section 47

56

Transfer of Assets by an amalgamating company to an amalgamated company under the scheme of amalgamation is not considered to be transfer for the purposes of capital gains provided amalgamated company is Indian company. Expenditure on scientific Research, Acquisition of patent rights or copy rights etc: Section 35, Section 35A The amalgamated company can continue to have the benefits of writing off of expenditure on scientific research; acquisition of patents and copy rights which the amalgamating company could not enjoy because of the amalgamated company is an Indian company. Set off and Carry forward of unabsorbed depreciation and past losses: Section 72 Unabsorbed depreciation and past losses of the amalgamating company cannot be carried forward by the amalgamated company except as provided under Section 72 (A). Carry forward of losses in case of amalgamation scheme under Section 72A This section permits the amalgamated company to carry forward accumulated losses and unabsorbed depreciation of amalgamating company subject to following conditions: 1) Amalgamating company is Indian company 2) The Central Government on the recommendations of the specified Authority is satisfied that : a) Amalgamating company is not financially viable b) Amalgamation is in public interest c) Amalgamation shall facilitate rehabilitation or revival of the business of amalgamating company. 3) The benefit of carry forward would be available only when following past amalgamation conditions are fulfilled: a) Amalgamated company should continue to carry forward business of amalgamating company without any modification or reorganization except as permitted by Central Government. b) The amalgamated company should along with the return of income, furnish a certificate from the specified authority to the effect that adequate steps have been taken by the company to rehabilitation or revival of the amalgamating company. Amortization of Capital Expenditure: Section 170 The amalgamating company will have to pay taxes on income upto the date of amalgamation. The amalgamated company will have to pay tax after that date. However, in the event of default by the amalgamating company, the amount of tax not paid will be recoverable from the amalgamated company.

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Chapter Nine De-Merger & Reverse Merger

Meaning of De-merger: De-merger essentially means bonafide separation of the key business assets and reorganizing the business in such a manner that though there is separation in favour of another company, atleast 50% of the equity stake in two companies continues to be common. Section 2 (19AA) was introduced by Finance Act of 1999 defining De-Merger: De-merger means transfer in pursuance scheme of arrangement under section 391 to 394 of the companies Act by de-merged company of its one or more undertakings to any resultant company In such a manner that: All the property of the undertaking of demerged company immediately before demerger becomes the property of resultant company. All liabilities relatable to the undertaking immediately before demerger, becomes the liability of resultant company. Transfer of properties and liabilities is at book values. The resultant company issues its shares to the shareholders of demerged company in consideration of demerger on proportionate basis. Shareholders of not less than 75% of the value of shares of demerged company become the shareholders of resultant company. Transfer of undertaking is on a going concern basis De merger is in accordance with the conditions if any, notified by Central Government under Section 72 A(5). Slump Sale: Section 2 (42c): Means transfer of undertaking or unit or division or business activity as a whole for lump sum consideration without values being assigned to individual assets and liabilities. Profits or gains arising from slump sale shall be chargeable as long term capital gain. 58

i. ii. iii. iv. v. vi. vii.

 1)

Examples: Sterlite Industries and Sterlite Optical: Sterlite which was a diversified company with presence both in non-ferrous metal as well as Telecom cables decided to de-merge both the business into separate companies. The spin off was done in the ratio of 1:1. Raymonds Ltd: Raymonds sold of Cement and Steel business to become one again, a purely fabric and garment company. The whole exercise fetched Raymonds Rs. 1140 crores. This enabled it to reduce high cost debts as well as buyback its own shares. Thus financially as well as in terms of shareholder value it was a correct step. GE Shipping The company has interests in shipping, property development, trading and finance. It was decided to de-merge property development business strategically with effect from 1st April, 1999. ABB and ABB Alstom Power India Ltd. As a result of the global de-merger of ABB group and its hiring off power generation business with Alstom of France, ABB India was also de-merged in 1999. The objective was to remain in areas of power distribution and transmission services. The independent profitability of both the companies increased due to greater focus. Objectives of De-merger: i. Restructuring of business with a view to create value for new knowledge driven businesses. ii. To give a new focus to high growth business iii. Empower people in a better way. iv. Generate fresh capital from the market Reverse Merger Reverse merger takes place when a healthy company merges into a financially weak company. Under the Companies Act there is no difference between regular merger and reverse merger. It is like any other amalgamation. Reverse merger can be carried out through the High Court mode, but where one of the merging company is a sick industrial company under SICA, such merger must take place through BIFR. On Amalgamation merger automatically makes the transferee company entitled to the benefits of carry forward and set off of loss and unabsorbed depreciation of the transferor company. There is no need to comply with Section 72 of Income Tax Act. On amalgamation being effective, the weak companys name may be changed into that of a healthy company. i. Examples: Maneklal Harilal Mills Ltd. merging into Sick company Bihari Mills Ltd. 59

2)

3)

4)

ii.

Kirloskar Oil Engines Ltd. merged into Prashant Khosla Pneumatics Ltd. a sick unit. Case Study - Kirloskar Oil Engines merging into Prashant Khosla Pneumatics Ltd. 1) In April, 1994, Kirloskar Oil Engines Ltd. (KOEL) took over the management control of Prashant Khosla Pneumatics Ltd. (PKPL) a Delhi Based Company having its works at Nashik. 2) PKPL became a sick unit as on 31st March, 1994 and went into BIFR in June 1994. ICICI was appointed as Operating Agency who invited bids for PKPL for revival. KOEL made a bid although PKPL was already under its control. KOELs bid was accepted and confirmed by BIFR. 3) Main objective in the take over was to make use of PKPLs engine plant for KOELs large engine activity. 4) PKPL take over added to KOELs assets, two plants located at MIDC, Nashik on MIDC leased land of 80,000 sq. mtrs. 5) A scheme for revival of PKPL through reverse merger of KOEL with PKPL was submitted to BIFR and was sanctioned in February 1996. 6) Accordingly, KOEL merged in PKPL, and name of PKPL stood changed KOEL on 1st March, 1996 which was the effective date of amalgamation. 7) Again of merged company for 1994-95 was held in April 1996 and consolidated accounts for the year ended 31st March, 1995 were adopted. Delay of 7 months for holding AGM was condoned by BIFR. 8) This merger did not affect in any way KOEL shareholders.

9) PKPL capital of Rs. 218 lakhs was reduced by 95% to 11 lakhs and KOEL shares were exchanged for PKPL shares in the merged company in the ratio of 1 for 20. 10) PKPL shareholders were paid 5% dividend for 1994-95 and full dividend for 1995-96. 11) 56% of PKPL's capital held by its holding company was transferred at agreed price of Rs. 75 lakhs to KOEL associate company which subsequently got shares in the merged company. 12) The scheme provided for certain matters without going through the formalities under company's Act, under powers of BIFR such as - Change of name of Transferee Company from PKPL to KOEL. - Memorandum of association (MOA), articles of association (AOA) of Transferor Company becomes MOA and AOA of Transferee Company. - Auditors of Transferee Company to automatically cease to hold office and auditors of the transferor company to become auditors of the transferee company. - MD and ED of Transferor Company to continue as such in Transferee Company without reappointment and without break.

60

13) 14)

Authorized capital of Transferee Company to stand increased from Rs. 5 crores to Rs. 27 crores. Transferee Company to allot to shareholders of Transferor Company, shares in Transferee Company. Share certificates of Transferor Company not to be called back and replaced by new certificates. ICICI to be issued 4,75,000 equity shares in transferee company without complying with Section 81 (1A) and SEBI guidelines on preferential issue. Stamp duty on transfer of property and share certificates was saved. Premium payable to MIDC saved only loans for fee paid.

15) PKPL revival resulted into both the plants being operative- Direct employment to more than 300 people working.

Chapter Ten Post Merger Scenario

Key Steps to Successful Post Acquisition Management
Realistic objectives met

Immediate Actions Very clear Initial ideas Experienced Integrators

Continuous Communication

Determined follow through

Normal Co. Mgt. Inadequate tactical preparation

Wait and See

No Special communication effort

Half hearted integration

Dropping profit & dissatisfaction

61

Reasons for Strategic Success and Failure Common Strategic traps: Strategy a) Desire to move an acquisition policy or aggressive acquisition policy. Ground Result a) A policy of this kind begets unrelated and messy situation that lead to Conglomerates at best and at worst a de stabilitating complexity that can be lethal. b) More investment, more details to be resolved, unforeseen technical

b) Desire to acquire new technology hitches, more regulatory approvals all combined to keep prize out of reach. In many cases the previous owners sold out as a means to resolving this problem. c) Attractive past experience

c) Purchase of obsolete conceptparticularly past performance of aging firms. d) Synergy may be illusory and may drive away the company from their core business to related but highly dangerous area. e) Once negotiations start, desire increases. Nothing seems to deter buyer. Price increases absorbed.

d) Quest for complementaritys

e) Inability to walk away

Strategic Imperative: The first priority for successful acquisition implementation is to know precisely what you are buying and what are you going to do if and when the deal is completed. Valid strategy for successful acquisition policy: i. ii.

To obtain presence for core business. To leverage marketing: Applying a massive marketing capability to a good product line is an excellent base for an acquisition strategy. iii. To build an enlarged base iv. To reposition the business Drucker's five commandments for successful acquisitions i. The acquirer must contribute something to the acquired company ii. Common ore of unity is required. iii. Acquirer must respect the business of acquired company 62

iv. Within a year or so, acquiring company must be able to provide top management to the acquired company. v. Within the first year of merger, management's in both companies should receive promotions across the entities. Weston's Commentary on Druckers Pentalegue i. Relatedness is a necessary requirement, but complimentary is an even greater virtue. E.g.: Combining a company, strong in research but weak in marketing with a company strong in marketing but weak in research may bring blessings to both. ii. Relatedness or complementarities apply to general management functions such as research, plants control and financial manager as well as firm specific operations of production and marketing. iii. Thus companies with cash flows or managerial capabilities in excess of investment opportunities could effectively combine with companies lacking in financial or managerial resources to make the most of the prospects for growth and profits in their industries. iv. An acquiring firm will experience negative results if it pays too much. It is difficult to accurately evaluate another organization. There can be great surprises on both sides after marriage. Expectation that a firm can improve average risk return relationship in an unfamiliar market or industries is likely to be disappointed. Golden Rules of Integration i. Plan First: If you don't know what you are going to do, don't do it. ii. Implement quickly: If you are going to do it, do it immediately. iii. Communicate frankly: Cost of error is always on the side of inadequate communication. A change of plan can always be explained or admitted, with less adverse effect on morale and hence productivity, than a policy of silence. iv. Sensitivity in the treatment of people, recognition of long service and proper and generous separation arrangements all count here.

What constitutes Success? Meeting the objectives: Most companies define success as meeting their acquisition objectives. In the case of combined or integrated companies, this normally included such quantitative criteria as: Earning per share Profit before tax Revenue growth Return on assets employed Increase in Market share Increased in productivity 63

 Realization of synergy by reaping benefits of economies of scale: reduction inn expenses of cost of operation. Enhanced shareholder value: Some experts argue that real criterion is not financial data but enhanced shareholder value over a long period. Shareholder values appreciation in value of share price. Hence, increase in value of shares is perceived as increase in shareholder value.

Short lived Mergers : Some Examples a) Merger of ICICI and Anagram: When employees of Anagram Finance heard that ailing firm was to be merged with ICICI there was a sigh of relief. But two months later, reality was bitter. Out of 450 staff only 140 were repaired and all others were given pink slips with 3 months severance pay. b) Merger of Burroughs Welcome with Glaxo: After world wide merger of Burroughs Welcome with Glaxo in 1996, 150 top managers left Burroughs Welcome. c) Takeover of Merind by Wockhardt: There was exodus of top management team of Merind. d) CIBA and Sandoz merged to form Novartis: 115 out of 120 managers of new corporate office were Sandoz people with Sandoz India's erstwhile MD John Simon ailing the shareholders. e) ITC Classic with ICICI Only 47 of 120 ITC classic executives were asked to remain. Its investment arm Classic credit was shut down.

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Chapter Eleven Post Merger Integration Seven Rules by Max Habeck Fritz & Michael Tram
1) Vision: Guide post merger Integration with a clear and realistic vision derived from through business due diligence. Research Findings: a) 78% of mergers are mistakenly driven by fit, and not vision. b) Around 58% of mergers fail. What You Have To Do: Define What You Have To Do: Assess not only what you possess in terms of competitive advantages, research capabilities, and other resources but what your partner can do as well. This knowledge comes form business due diligence which is market oriented, not just finance oriented. Define Where You Want To Go: What markets do you want to be active in? Where can you bring the combined abilities of your new organization to bear, and in the process create something new and powerful? Remain Realistic: Credibility and clarity are crucial to creation of bold vision. A statement which is unclear or unrealistic will not generate enthusiasm and will not be followed. 65

Dont Copy Or Co-Opt: Best vision can not be transferred like labels from one company to another. There must be something which companys employees and customers can uniquely identify, based on the credibility and clarity of the statement. Communicate Constantly: Visions live. Whether you call them a touch stone or acid test, they serve as a control and a check on all major or minor moves your new organization may take. Proper and continual communication through out the organization will prompt your employees ask themselves: Is that us? Is that what we really want to do?, When they take decision. Let Fit Follow: If you have followed guidelines above, it seems only natural that the issues fit in all their various forms from financial to strategic should follow from the overall vision. Trying it other way around does not work.

M & A Cases That Have Failed On Account Of Lack Of Vision Or Unrealistic Vision: AT & T and NCR: In the late 1980s American Telephone and Telegraph still had assets such as Bell Labs to go with long distance telephone services it kept after the 1984 anti trust break up. The company had a grand vision of a technological synergy between its expertise in telecommunications and NCRs expertise in computer technology. After years of intense searching, hampered by management changes as well as cultural frictions, no synergies were found. The presumed fit between telecommunication equipment and computer hardware failed to turn up. AT &T spun off the remains of NCR around five years later at a loss of around $ 3.5 billion, nearly half of what it initially paid. Sony Pictures: Sony acquired Columbia Pictures in 1989 for $ 5 billion. However, Columbia had difficulties in generating the successful software to begin with. Rapidly rising salaries of stars and lack of success at box office culminated in Sony making operating loss of around $ 500 million. The company wrote off $ 2.7 billion. The losses were attributed to abandonment of large number of projects and settlement of outstanding lawsuits. However, instead of divesting the unit, Sony made management changes and imposed stricter controls. Columbia is now a part of Sony Pictures Entertainment, which represented just fewer than 10% of Sony Groups Worldwide Sales of around $ 50 billion. Successful cases of M& A driven by Vision: - MCI World.com 66

2)

Acquisition of Salomon Inc. by Citigroup Nikko Securities by Citi Bank Ford Motor Acquisition of AB Volvo.

Leadership Its Critical Establish It Quickly Research Findings: a) Leaderships urgency is often neglected. Some 39% of all companies faced a leadership vacuum because they failed to make the establishment of leadership a priority. b) A merger without strong leadership in place from its early days will drift quickly and drift is deadly. What You Have To Do: Decisively Put A Leadership Blue Print In Place Prior To Closing The Deal: Leadership patterns have to be communicated, understood and accepted. Keep The Keepers: The top managerial talent in the combined organization should have already been identified in your business due diligence. Whether you can simply convince them to stay or whether you need Golden Handcuffs, you need to lock in the top talent immediately. Act As Quickly As Your Situation Dictates: The key word here is speed. Throw out the old time table, this call for a specific feel for timing.

Case Of Merger Which Have Failed One Leadership Issue: Monsanto & American Home Products: In June 1998, Monsanto and American Home Products unveiled $ 35 billion merger plan which on surface had plenty to offer both companies. The deal would have combined Monsantos pipeline of biotechnology with marketing strength of AHP. The merger fell through due to poor struggle between Monsanto CEO Robert Shapiro and his counterpart at AHP, John Stafford.

3) Growth: Merge To Grow, Focus On Added Value & Not On Efficiency Synergies Research Findings: 76% of the companies surveyed focused too heavily on efficiency synergies. 30% of the companies virtually ignored attractive growth opportunities such as cross selling possibilities or knowledge sharing in research and development. What You Have To Do: Begin Capturing Growth Synergies As Early And As Quickly As Possible:

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Growth opportunities should follow directly from long term, growth oriented, one business vision. There are usually growth synergies i.e., potential to increase sales quickly in customer, product and /or geographic segments. These complement the savings potential in shared processes and procurement. Prioritize Areas Of Cost Savings: Your due diligence work, combined with benchmarking, should reveal where the efficiency synergies are located. Find them, prioritize them and realize them.

Synergy Suicide - Cost Reduction Is Not A Driving Force: Wells Fargo & Co / First Interstate Bancorp: These two competitors merged in $ 11.3 billion transaction in 1996, to realize efficiency synergies of $800 million from saving operating costs. These were achieved in part by reducing work force by 20%. Wells Fargo also discovered considerable saving potential in information technology. Wanting to move quickly, it set a deadline of only seven months for integrating the computer system at all First Interstate Bancorp branches. It nearly reached the goal, but the efforts harmed internal and customer relationships. The company later attributed a decline in operating profit to back office problems resulting from the first Interstate integration.

Most Successful Growth Through Mergers: Cisco Systems: This fortune 500 company has grown since its founding in 1984, thanks to a combination of organic growth and successful integration of 25 acquisitions. Cisco has almost quadrupled its revenue since 1995 to $ 8.5 billion and its net income tripled to $ 1.3 billion. It holds a market share of around 80% routers and switches which form the internet infra structure. Making mergers is and will continue to be absolutely essential for Cisco to maintain its rapid growth and enhance its competitive advantages.

4) Early Wins : Act, Get Results & Communicate Make Tangible, Positive Moves : Research Findings: a) Very few companies attempt to achieve early wins in an external or outward looking area, such as in their relationship with suppliers or customers. b) 61% of the merged companies search for early wins in the wrong place by focusing on job shedding, factory closings or other inward looking cost moves. The emotion attached to such moves can back fire and quickly turn them into early losses. What You Have To Do: Do Your Due Diligence: You can only get early wins if you have done your due diligence properly.

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Design Early Wins According To The Buy-In Needs: You need the sensitivity to know what you need and what your situation is, to identify more precisely where you should look and to determine how substantial a move you should make. In this case, it is better to err on safer side of something small and manageable. Look Internally, But Above All Look External: Early wins in outward looking areas such as customers and suppliers can have a high impact, but are often neglected at the expense of internal focused early wins. Focus On Assets, Customers And Knowledge: These are rich sources of early wins. Get Cost Cutting Out Of The Way As Quick As Possible: But do not sell these as early wins. Gather Information By Asking And Listening: This gets constituencies involved. Communicate Complete Tasks Quickly: But without any exaggeration

5) Cultural Differences: Handle A Soft Issue With Hard Measures: Cultural imposition is not always the option. It is often more suitable to compound the cultures or even let them remain separate. Research Finding: a) It is common to blame cultural differences when merger fail. b) Cultural imposition is the norm. What You Have To Do: Develop The Strategy For Cultural Integration Before Merger: Decide if you are going to impose one of the cultures leave them separate, or create a compound culture. Before imposing culture be sure that the new culture is better than the one it replaces. Put The Leadership Team In Place Quickly: Minimize uncertainty and a cultural void the leadership team must behave as a cohesive group. Perform Through Cultural Assessment: Understand the differences between two cultures, identify potential barriers and misunderstandings. Legitimize and discuss the differences. Include organizational system such as HR, reporting and IT in this assessment.

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Decide What You Want The New Culture To Be: If you are creating a compound culture, define what you want the new culture to be and why actively encourage the emergence of something entirely new which builds on the strengths of both partners. Build Links Between The Two Organizations: There is nothing like working together to build understanding. ANCHOR NEW CULTURE THROUGH A CULTURAL CURRENCY: Set up a system of incentives and penalties to enforce and encourage the new norms and processes. Make sure the new leadership team acts as role models to continually reinforce the desired level of behaviour. Deal firmly with people who try to undermine the new direction. Have Patience It takes time for people to adjust to a new cultural reality.

6) Communication: Real Force Behind Buy In, Orientation And Expectations: Plan Your Communication According To Timing And Target, Get Word Out, And Actively Obtain Feed Back: Research Findings: a) 86% of companies said they failed to communicate their new alliance sufficiently in their merger integration plan. b) Most commonly cited barrier to merger integration is failure to achieve employee commitment. Some 37% of respondents cited this as the primary obstacle to overcome, well ahead of obstructive behaviour and culture barriers. Remember That You Are Always Communicating: Non communication is still communication because it sends messages you are just not in control of what the messages are, and the grapevine will decide. The grapevine is the single most effective communications medium in your company. Give it good reasons to circulate positive messages. Follow A Framework To Help You Manage The Complexity: Understand all your stakeholders, know your own communication goals, write a plan, craft messages positively and effectively, pick appropriate media. Then actively obtain feedback to know when you have achieved your goals. Set high standards and make sure you have channels of access. Check your commitment to your message and your ability to communicate it consistently, firmly and honestly. What You Have To Do Recognize That All Your Merger Goals Depend On Communication: You have to persuade other people to believe in your vision and to act to bring it about. This is a communication task, pure and simple.

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Know Your Communication Goals: At all times, with all stock holders, be consciously aware of your own goal for the communication. This also involves knowing your constituencies, including employees, unions, investors, customers, suppliers, the financial community, the local and state governments. Be Flexible: Use all your skills to make the best choices about how to communicate most effectively. Use more than one medium and be prepared to change how you communicate whenever necessary. Listen Use whatever method you can to understand whether you have achieved your communication goals. Dialogue is the richest form of feed back, but it is certainly not the only one. Indirect indicators such as personal behavior, levels of absenteeism and of course, share price also tell you how your message has been heard. Projects, Then

7) Risk Management: Be Proactive, Not Reactive. Prioritize Identify, Categorize and Embrace Risks And Do It Continuously.

Research Findings: 32% of merging companies actively pursue formal risk management. Some of these employ risk management so efficiently that it has become a source for both early wins and long term growth. What You Have To Do: Assess Your Situation: Then priorities your post merger integration projects according to their business criticality and their complexity. Derive The Risks Inherent In Your Projects: By making assumptions regarding those issues Categorize Your Risks: According to high, medium, low Pin point the showstoppers which can spell death to your merger plans. Vigorously Attack Those Risks You Can Overcome: Minimize the importance of the ones which are not as easily and quickly overcome. Monitor Process Diligently: Repeat it from the beginning on a regular basis. Every move you make changes your internal circumstances and your external circumstances are constantly changing as well. This is fluid, dynamic process, not a one time solution.

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