Unit 3

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M.B.A. II Year – 2011‐12
Elective Subject
BA6036 - STRATEGIC INVESTMENT AND

FINANCING DECISIONS
Unit III
Prepared By S.Nagarajan / Professor / MBA
1
/ Sudharsan Engineering College
Monopolistic competition:
is a type of imperfect competition such that competing producers sell products that are differentiated from
one another as good but not perfect substitutes (such as from branding, quality, or location). In
monopolistic competition, a firm takes the prices charged by its rivals as given and ignores the pact of its
own prices on the prices of other firms.
Monopsony:
In economics, a monopsony is a market form in which only one buyer faces many sellers. It is an
examplel off imperfect
i f competition,
ii similar
i il to a monopoly,l in
i which
hi h only
l one seller
ll ffaces many b buyers. A
As
the only or majority purchaser of a good or service, the "monopsonist" may dictate terms to its suppliers in
the same manner that a monopolist controls the market for its buyers.
Monopoly
exists when a specific person or enterprise is the only supplier of a particular commodity. (This contrasts
with a monopsony which relates to a single entity's control of a market to purchase a good or service, and
with oligopoly which consists of a few entities dominating an industry) Monopolies are thus characterized
by a lack of economic competition to produce the good or service and a lack of viable substitute goods.[2]
The verb "monopolise" refers to the process by which a company gains much greater market share than
what is expected with perfect competition.
Oligopoly
is a market form in which a market or industry is dominated by a small number of sellers (oligopolists).
1
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UNIT III STRATEGIC ANALYSIS OF SELECTED INVESTMENT DECISIONS
Lease financing Reference 8 – Chapter 25
Lease vs Buy Decision
Hire Purchase and Instalment Decision
Hire Purchase Reference 8 – Page 25.22

vs Lease Decision
Mergers and Acquisition

Mergers and Acquisition
Cash vs Equity for Mergers
TEXT BOOKS
1. Prasanna Chandra, Financial Management, 7th Edition, Tata McGraw Hill, 2008.
2. Prasanna Chandra, Projects : Planning, Analysis, Financing Implementation and Review,
10th Edition, Tata McGraw Hill, New Delhi, 2009.
REFERENCES
3. Bodie, Kane, Marcus : Investment, Tata McGraw Hill, New Delhi2002.

4. Brigham E. F & Houston J.F. Financial Management, Thomson Publications, 2003.
5. I. M.Pandey, Financial Management , Vikas Publishing House, 2003. – 10th Edition
6. M.Y.Khan and P.K.Jain, Financial Management Text and Problems, Tata McGraw Hill.
Publishing Co, 2003. – 5th Edition
Additional References
7. Security Analysis and Portfolio Management – Punithavathi Pandian
8
8. M.Y.Khan
M Y Khan and P.K.Jain,
P K Jain Financial Management Text and Problems,
Problems Tata McGraw Hill
Hill.
Publishing Co, 2003. – 6th Edition
9. Financial Management – E.Gnanasekaran- Second Edition Feb 2010
Prepared By S.Nagarajan / Professor / MBS
4
/ Sudharsan Engineering College
2
lease
A written agreement under which a property owner (lessor) allows a tenant
(lessee) to use the property for a specified period of time and rent.
The lessor owns the asset and for a fee allows the lessee to use the asset.
At the end of the period of contract (lease period) the asset /equipment
reverts back to the lessor unless there is a provision for the renewal of the
contract.
It is a devise of financing the cost of an asset.
It is a contract in which a specific equipment required by the lessee is

purchased by the lessor (financier) from a manufacturer /vendor selected by
th llessee.
the
The real function of a lessor is not renting of the asset but lending of funds /
finance/ credit .
In effect lease financing is in effect a contract of lending money.
Modes of terminating a lease:
1. The lease is renewed on a perpetual basis or for a definite period.

2. The asset reverts to the lessor.
3. The asset reverts to the lessor and the lessor sells it to a third party
or to the lessee.
Risk with reference to leasing refers to the possibility of loss arising on

account of underutilization or technological obsolescence of the
equipment.
Reward means the incremental net cash flows that are generated from
the usage of the equipment over its life and the realization of the
anticipated residual value on expiry.
3
Operating Leases
• Usually not fully amortized.
• The lessor does not transfers all the risk and rewards incidental to the
ownership of the asset to the lessee.
• The cost of asset is not fully amortized during the primary lease period
• Usually require the lessor to maintain and insure the asset.
• The leaser provides services attached to the leased asset such as
maintenance, repair and technical advice.
• Lessee enjoys a cancellation option.
• Examples: computers, office equipments, automobiles, telephone etc.,
Examples computers office equipments automobiles telephone etc
Financial Leases or Full Pay Out leases
The exact opposite of an operating lease.
1.
1 Do not provide for maintenance or service by the lessor.
id f i i b h l
2. The lessor transfers all the risk and rewards incidental to the ownership of
the asset to the lessee, whether or not the title is eventually transferred.
3. Financial leases are fully amortized.
4. The lessee usually has a right to renew the lease at expiry.
5. Generally, financial leases cannot be cancelled.
6. Example: Ships, aircrafts, railway wagons, lands, building, heavy
Example: Ships, aircrafts, railway wagons, lands, building, heavy
machinery, diesel generator sets etc.,
4
Sale and Lease‐Back
• A particular type of financial lease.
• Occurs when a company sells an asset it already owns to another firm and
immediately leases it from them.
• Example: sale and lease back of safe deposit vaults by banks. Banks sell
the vaults in their custody to a leasing company at market price
substantially higher than the book value and the leasing company in turn
offers these lockers on a long term basis to the bank.
• The banks sublease these lockers to its customers.
• The lease back arrangement in sale and lease back of leasing can be in the
form of a finance lease or an operating lease.
• Two sets of cash flows occur:
– The lessee receives cash today from the sale.
– The lessee agrees to make periodic lease payments, thereby retaining
the use of the asset.
Direct lease:
The owner of the equipment are two different entities.
This can be of two types:

a. Bipartite
b Tripartite.
b. T i tit
[Miss.Kalaivani – 23-01-2012]
5
Leveraged Leases
• A leveraged lease is another type of financial lease.
• A three‐sided arrangement between the lessee, the lessor, and lenders.
g
– The lessor owns the asset and for a fee allows the lessee to use the
asset.
– The lessor borrows to partially finance the asset.
– The lenders typically use a nonrecourse loan. This means that the
lessor is not obligated to the lender in case of a default by the lessee.
Significances and Limitations or Reasons for Leasing
Advantages to the lessee
• Financing of capital goods.
• Additional source of finance.
• Less costly
• Avoids conditionality.
conditionality – on other types loans – representations in
board, conversion of debt into equity, payment of dividend etc.,
• Flexibility in structuring the rentals.
• Simplicity.
• Tax benefits.
• Obsolescence risk is averted.
g to the lessor
Advantages
• Full security.
• Tax benefit.
6
Advantages to the lessor

• Full security.
• Tax benefit.
• High profitability.
• Trading on equity – leaser may have lesser equity and
use a substantial amount of borrowing – tax benefits.
• High growth potential.
Limitations of leasing:
• Restrictions on use of equipment.

• Limitations of financial leasing
leasing.
• Loss of residual value.
• Consequences of default.
• Understatement of lessee’s asset – since the leased asset does
not form part of the lessee’s there is an effective
understatement of his assets, which may sometimes lead to
gross underestimation of the lessee.
• Double sales tax – sales tax may be charged twice.
7
[Reference 8 – Example 25.1]

XYZ Ltd., is in the business of manufacturing steel utensils. The firm is planned to
diversity and add a new product line. The firm either can buy the required
machinery or get it on lease.
The machine can be purchased for Rs 15,00,000 it is expected to have a useful life
of 5 years with a salvage value of Rs 1,00,000 after the expiry of 5 years. The
purchase can be financed by 20 % loan repayable in 5 Years annual installments
(inclusive of Interest) becoming due at the end of each year. Alternatively the
machine can be taken on year-end lease rentals of Rs 4,50,000 for 5 years.
Advise the company on the options it should choose. For your exercise, you may
assume the following:
a. The machine will constitute a separate block for depreciation purposes. The
company follows written down value method depreciation, the rate of
depreciation being 20 %.
b Tax rate is 35 % and cost of capital is 20 %.
b. %
c. Lease rentals are to be paid at the end of the year.
d. Maintaining expenses estimated at Rs 30,000 per year are to be borne by the
lessee.
Find the acceptance criterion (1) by Present Value method and (2) IRR method.
[Reference 8 – Example 25.2]
The following details relate to an investment proposal.
• Investment out lay Rs 180 L

• Useful life 3 years
• Net salvage value after 3 years Rs 18 L.
• Annual tax & relevant rate of depreciation 40 %
Alternative 1. Borrow and buy the equipment. The cost of capital is 0.12
%; marginal rate of tax is 0.35%, cost of debt., 0.17% per annum.
Alternative 2. Lease the equipment from M/s X on a three year full payout
basis @ R 444/ Rs 1000, payable annually in arrears (year end). The lease
can be renewed for a further period of 3 years at a rental of Rs
Rs18/Rs1000 payable annually in arrears.
What alternative to be taken and why?
8
[Reference 8 – Example 2-A.6]
The lease rentals for a 5 year contract are Rs 300/Rs1000 payable
annually in arrears. Assuming no salvage value compute the rate of
interest implied by the contract and develop a lease amortization plan
Hire purchase
• With a hire purchase agreement, after all the payments have been made,
the business customer becomes the owner of the equipment.
• This ownership transfer either automatically or on payment of an option to

purchase fee.
• For tax purposes, from the beginning of the agreement the business
customer is treated as the owner of the equipment and so can claim capital
allowances.
• Capital allowances can be a significant tax incentive for businesses to

invest in new plant and machinery or to upgrade information systems.
• Under a hire purchase agreement, the business customer is normally

responsible for maintenance of the equipment.
9
Hire Purchase vs Lease Financing
Ownership of the Asset:

• In lease, ownership lies with the lessor.
• The lessee has the right to use the equipment and does not have an option to
purchase.
• Whereas in hire purchase, the hirer has the option to purchase.
• The hirer becomes the owner of the asset/equipment
q p immediately
y after the last
installment is paid.
Depreciation:
• In lease financing, the depreciation is claimed as an expense in the books of
lessor.
• On the other hand, the depreciation claim is allowed to the hirer in case of hire
purchase transaction.
Rental Payments:
• The lease rentals cover the cost of using an asset.

• Normally, it is derived with the cost of an asset over the asset life.
• In case of hire purchase, installment is inclusive of the principal amount and the
interest for the time period the asset is utilized.
Hire Purchase vs Lease Financing
Duration:
Generally lease agreements are done for longer duration and for bigger assets
like land, property etc.
Hire Purchase agreements are done mostly for shorter duration and cheaper
assets like hiring a car, machinery etc.
Tax Impact:
In lease agreement, the total lease rentals are shown as expenditure by the
lessee.
In hire purchase, the hirer claims the depreciation of asset as an expense
Repairs and Maintenance:

Repairs and maintenance of the asset in financial lease is the responsibility of
the lessee but in operating lease
lease, it is the responsibility of the lessor
lessor.
In hire purchase, the responsibility lies with the hirer.
Extent of Finance: Lease financing can be called the complete financing option
in which no down payments are required but in case of hire purchase, the
normally 20 to 25 % margin money is required to be paid upfront by the hirer.
Therefore, we call it a partial finance like loans etc.
10
Lease vs. Buy Overview

When you lease a car, you don’t own it. Instead, you pay for what you use -
the difference between the value of the car when you take possession and its
value when you return it. When you buy, you pay the full purchase price and
yyou own the thing.
g
Restrictions
As you make the lease vs. buy decision you should carefully consider any
restrictions that come with a lease. When leasing, you may have:
Maximum annual mileage limits
Inability to get out of a lease and switch cars
Inability to modify or upgrade the car
Requirements to keep the car’s interior, exterior, and working parts 'like new'
Lease vs. Buy Costs

In general, you’ll have lower short term costs if you lease vs. buy. You can get
a nicer vehicle with a smaller monthly payment. However, the long term costs
are higher. In part, this is because you never own anything. By buying the
vehicle you end up with something you can sell - allowing you to recoup some
of your costs - or use until it dies.
You may also have higher costs than you expected if you lease vs. buy the
vehicle. If you exceed your mileage limit or have to repair cosmetic damage
(that you could just live with if you owned the car) your costs will rise.
Negotiation
Some people avoid the lease vs. buy decision altogether because they think
you can only negotiate when you buy. In fact, the purchase price is negotiable
even when you lease. Likewise, you can shop for different lease agreements
among a variety of vendors; you’re not limited to the auto dealer’s offerings.
11
Arguments for Leasing

• Here are some factors that would make you decide to lease vs. buy your
vehicle:
• You need a nice, new automobile (for client travel, for example)
• You know that you can satisfy the lease agreement
• You take care of your vehicles
• You do not drive more than 15,000 miles per year
Arguments for Getting a Loan

• Here are some factors that would tilt the lease vs. buy decision towards
buying:
• You are most concerned with minimizing long term costs
• You drive more than 15,000 miles per year
• You like to drive your car into the ground before replacing it
• You want the flexibility to change or sell your car at any time
12
Expansion
• Merger and Acquisition
• Asset acquisition
• Joint ventures
• Tender offer
13
Types of Takeovers
General Guidelines
Takeover
– The transfer of control from one ownership group to another
The transfer of control from one ownership group to another.
Acquisition
– The purchase of one firm by another
Merger
– The combination of two firms into a new legal entity
– A new company is created
– Both sets of shareholders have to approve the transaction.
Amalgamation
– A genuine merger in which both sets of shareholders must approve
the transaction
– Requires a fairness opinion by an independent expert on the true
value of the firm’s shares when a public minority exists
Friendly Acquisition
The acquisition of a target company that is willing
to be taken over.
Usually, the target will accommodate overtures
and provide access to confidential information to
facilitate the scoping and due diligence processes.
14
ADVANTAGES
• REDUCTION OF COMPETITION
• PUTTING AN END TO PRICE CUTTING
• ECONOMIES OF SCALE IN PRODUCTION
• RESEACH AND DEVELOPMENT
• MARKETING AND MANAGEMENT
15-1 FIGURE
Information
memorandum
Confidentiality Main due Ratified

agreement diligence
Sign letter Final sale

off intent
i t t agreementt
Approach
target
15
Friendly Takeovers
Structuring the Acquisition
In friendly takeovers, both parties have the opportunity to
g
structure the deal to their mutual satisfaction including:
1. Taxation Issues – cash for share purchases trigger capital gains so share
exchanges may be a viable alternative
2. Asset purchases rather share purchases that may:
• Give the target firm cash to retire debt and restructure financing
• Acquiring firm will have a new asset base to maximize CCA deductions
• Permit escape from some contingent liabilities (usually excluding claims
resulting from environmental lawsuits and control orders that cannot
severed from the assets involved))
3. Earn outs where there is an agreement for an initial purchase price with
conditional later payments depending on the performance of the target
after acquisition.
Hostile Takeovers
A takeover in which the target has no desire to
be acquired and actively rebuffs the acquirer and
refuses to provide any confidential information.
The acquirer usually has already accumulated an
The acquirer usually has already accumulated an
interest in the target (20% of the outstanding
shares) and this preemptive investment indicates
the strength of resolve of the acquirer.
16
Hostile Takeovers
The Typical Process
The typical hostile takeover process:
1. Slowly acquire a toehold (beach head) by open market purchase of shares at
y q ( ) y p p
market prices without attracting attention.
2. File statement with OSC at the 10% early warning stage while not trying to
attract too much attention.
3. Accumulate 20% of the outstanding shares through open market purchase
over a longer period of time
4. Make a tender offer to bring ownership percentage to the desired level
(either the control (50.1%) or amalgamation level (67%)) ‐ this offer
contains a provision that it will be made only if a certain minimum
percentage is obtained.
During this process the acquirer will try to monitor management/board
reaction and fight attempts by them to put into effect shareholder rights
plans or to launch other defensive tactics.
Classifications Mergers and
Acquisitions
1. Horizontal
• A merger in which two firms in the same industry combine.
• Often in an attempt to achieve economies of scale and/or scope.
/
2. Vertical
• A merger in which one firm acquires a supplier or another firm that
is closer to its existing customers.
• Often in an attempt to control supply or distribution channels.
3. Conglomerate
• A merger in which two firms in unrelated businesses combine.
• Purpose is often to ‘diversify’
Purpose is often to diversify the company by combining
the company by combining
uncorrelated assets and income streams
4. Cross‐border (International) M&As
• A merger or acquisition involving a Canadian and a foreign firm a
either the acquiring or target company.
17
CONGLOMERATE MERGER
UNRELATED INDUSTRIES MERGE
PURPOSE
• DIVERSIFICATION OF RISK
• Ex:Time warner‐(they were into media &
movie production) & AOL‐(leading American
website)
Contraction
• 1.Spin off‐shares in subsidiary distributed to its own
shareholders
• Kotak Mahendra Capital finance Ltd formed a
subsidiary called Kotak Mahendra Capital
Corporation by spinning off its investment division.
• 2.Split off‐ A new company is created to takeover an
existing division or unit.
• It does not result in any cash inflow to the parent
company
18
VERTICAL MERGER –
FIRMS SUPPLYING RAW MATERIALS MERGE
WITH FIRM THAT SELLS
WITH FIRM THAT SELLS
ADVANTAGE
• LOWER BUYING COST OF MATERIAL
• LOWER DISTRIBUITION COST
• ASSURED SUPPLIES AND MARKET
• COST ADVANTAGE
Mergers and Acquisition Activity
• M&A activity seems to come in ‘waves’
th
through the economic cycle domestically, or
h th i l d ti ll
in response to globalization issues such as:
– Formation and development of trading zones or
blocks (EU, North America Free Trade Agreement
– Deregulation
– Sector booms such as energy or metals
• Table 15 ‐1 on the following slide depicts
major M&A waves since the late 1800s.
19
Motivations for Mergers and
Acquisitions
Creation of Synergy Motive for M&As
The primary motive should be the creation of
The primary motive should be the creation of
synergy.
Synergy value is created from economies of
integrating a target and acquiring a company;
g g g q g p y;
the amount by which the value of the
combined firm exceeds the sum value of the
two individual firms.
Creation of Synergy Motive for
M&As
Synergy is the additional value created (∆V) :
[ 15-1] V  VAT -(VA VT )
Where:
VT = the pre‐merger value of the target firm
VA ‐ T = value of the post merger firm
VA = value of the pre‐merger acquiring firm
20
Value Creation Motivations for
M&As
Operating Synergies
Operating Synergies
1. Economies of Scale
• Reducing capacity (consolidation in the number of firms in the industry)
• Spreading fixed costs (increase size of firm so fixed costs per unit are
decreased)
• Geographic synergies (consolidation in regional disparate operations to
operate on a national or international basis)
2. Economies of Scope
• Combination of two activities reduces costs
3. Complementary Strengths
• Combining the different relative strengths of the two firms creates a firm
with both strengths that are complementary to one another.
M&A
Efficiency Increases and Financing Synergies
Efficiency Increases
– New management team will be more efficient
and add more value than what the target now
has.
– The combined firm can make use of unused
production/sales/marketing channel capacity
Financing Synergy
– Reduced cash flow variability
– Increase in debt capacity
– Reduction in average issuing costs
Fewer information problems
21
M&A
Tax Benefits and Strategic Realignments
Tax Benefits
– Make better use of tax deductions and credits
• Use them before they lapse or expire (loss carry‐back, carry‐forward
h b f h l (l b k f d
provisions)
• Use of deduction in a higher tax bracket to obtain a large tax shield
• Use of deductions to offset taxable income (non‐operating capital losses
offsetting taxable capital gains that the target firm was unable to use)
• New firm will have operating income to make full use of available CCA.
Strategic Realignments
– Permits new strategies that were not feasible for prior to the
acquisition because of the acquisition of new management skills,
acquisition because of the acquisition of new management skills,
connections to markets or people, and new products/services.
Managerial Motivations for M&As
Managers may have their own motivations to pursue M&As. The
two most common, are not necessarily in the best interest of the
firm or shareholders, but do address common needs of managers
1. Increased firm size
– Managers are often more highly rewarded financially for building a bigger
business (compensation tied to assets under administration for example)
– Many associate power and prestige with the size of the firm.
2. Reduced firm risk through diversification
• Managers have an undiversified stake in the business (unlike shareholders
who hold a diversified portfolio of investments and don’t need the firm to
be diversified) and so they tend to dislike risk (volatility of sales and profits)
) y ( y p )
• M&As can be used to diversify the company and reduce volatility (risk) that
might concern managers.
22
Empirical Evidence of Gains
through M&As
• Target shareholders gain the most
– Through premiums paid to them to acquire their shares
g p p q
• 15 – 20% for stock‐finance acquisitions
• 25 – 30% for cash‐financed acquisitions (triggering capital gains taxes for
these shareholders)
– Gains may be greater for shareholders will to wait for ‘arbs’ to
negotiate higher offers or bidding wars develop between multiple
acquirers.
Valuation Issues in Corporate
Takeovers
Mergers and Acquisitions
23
Valuation Issues
What is Fair Market Value?
Fair market value (FMV) is the highest price obtainable in an open
( ) g p p
and unrestricted market between knowledgeable, informed and
prudent parties acting at arm’s length, with neither party being
under any compulsion to transact.
Key phrases in this definition:
1. Open and unrestricted market (where supply and demand can freely
operate – see Figure 15 ‐2 on the following slide)
2. Knowledgeable, informed and prudent parties
3. Arm’s length
4. Neither party under any compulsion to transact.
Valuation Issues
Valuation Framework
15-2 FIGURE
Demand Supply
P
S1
B1
P*
Q
24
Valuation Issues
Types of Acquirers
Determining fair market value depends on the perspective of the acquirer.
Some acquirers are more likely to be able to realize synergies than others
and those with the greatest ability to generate synergies are the ones who
g y g y g
can justify higher prices.
Types of acquirers and the impact of their perspective on value include:
1. Passive investors – use estimated cash flows currently present
2. Strategic investors – use estimated synergies and changes that are forecast
to arise through integration of operations with their own
3. Financials – valued on the basis of reorganized and refinanced operations
4. Managers – value the firm based on their own job potential and ability to
motivate staff and reorganize the firm’ss operations. MBOs and LBOs
motivate staff and reorganize the firm operations MBOs and LBOs
Market pricing will reflect these different buyers and their importance at
different stages of the business cycle.
Discounted Cash Flow Analysis
Free Cash Flow to Equity
Free cash flow to equity  net income  /  non  cash items (amortization,
[ 15-2] deferred taxes, etc.)  /  changes in net working capital (not including cash
and marketable securities )  net capital expenditures
25
The General DCF Model
• Equation 15 – 3 is the generalized version of
th DCF
the DCF model showing how forecast free
d l h i h f tf
cash flows are discounted to the present and
then summed.

CF1 CF2 CF CFt
[ 15-3] V0    ... 

(1 k) (1 k)
1 2
(1 k) t 1 (1  k)t
The Constant Growth DCF Model
• Equation 15 – 4 is the DCF model for a target firm where the free
p g
cash flows are expected to grow at a constant rate for the
foreseeable future.
CF1
[ 15-4] V0 
kg
• Many target firms are high growth firms and so a multi‐stage model
may be more appropriate.
(See Figure 15 ‐3 on the following slide for the DCF Valuation Framework.)
26
Valuation Issues
Valuation Framework
15-3 FIGURE
Time Period Free Cash Flows
T
Ct VT
V0   
Terminal
Value
t 1 (1  k ) t (1  k )T
Discount Rate
The Multiple Stage DCF Model
• The multi‐stage DCF model can be amended
t i l d
to include numerous stages of growth in the
t f th i th
forecast period.
• This is exhibited in equation 15 – 5:
T
CFt VT
[ 15-5] V0   
t 1 (1  k ) (1  k )T
t
27
Valuation Issues
The Effect of an Acquisition on Earnings per Share
An acquiring firm can increase its EPS if it
acquires a firm that has a P/E ratio lower than
its own.
Accounting Implications of
Takeovers
Mergers and Acquisitions
28
Accounting for Acquisitions
Historically firms could use one of two
approaches to account for business
approaches to account for business
combinations
1. Purchase method and
2. Pooling‐of‐interest method (no longer allowed)
While more popular in other countries, the pooling
While more popular in other countries the pooling
of interest is no longer allowed by:
• CICA in Canada
• Financial Accounting Standards Board (FASB) in the
U.S. and
• Internal Accounting Standards Board (IASB)
The Purchase Method
One firm assumes all assets and liabilities and operating results
g g
going forward of the target firm.
g
How is this done?
• All assets and liabilities are expressed at their fair market value (FMV) as
of the acquisition date.
• If the FMV > the target firm’s equity, the excess amount is goodwill and
reported as an intangible asset on the left hand side of the balance
sheet.
h t
• Goodwill is no longer amortized but must be annually assessed to
determine if has been permanently ‘impaired’ in which case, the value
will be written down and charged against earnings per share.
29
Example of the Purchase Method
Acquisitor purchases Target firm for $1,250 in cash on June 30, 2006.
Target Firm
Acquisitor Pre- Target Firm (Fair Market
Merger (Book Value) Value)
Current assets 10,000 1,200 1,300
Long-term assets 6,000 800 900
Goodwill
Total Assets 16,000 2,000 2,200
Current liabilities 8,000 800 800

Long-term debt 2,000 200 250
Common stock 2,000 400 1,250
Retained earnings 4,000 600
Total Claims 16,000 2,000 2,300
Good Will in Subsequent Years
The Purchase Method
• Good
Good will is subject to an impairment test each year.
will is subject to an impairment test each year.
• This will require FMV estimating using discounted cash flow
approaches annually following the acquisition and
capitalization of good will on the balance sheet.
• Good will is changed only if it is ‘impaired’ in subsequent
years resulting in a write down and a charge against earnings.
30
Types of Takeovers
How the Deal is Financed
Cash Transaction
– The receipt of cash for shares by shareholders in
the target company.
Share Transaction
– The offer by an acquiring company of shares or a
combination of cash and shares to the target
company’s shareholders.
Going Private Transaction (Issuer bid)
– A special form of acquisition where the
purchaser already owns a majority stake in the
Acquisitions target company.
CHAPTER 15 – Mergers and
15 ‐ 61
Decide on payment mechanism:

Cash versus Stock
l Generally speaking, firms which believe that their stock is
under valued will not use stock to do acquisitions.
under valued will not use stock to do acquisitions.
l Conversely, firms which believe that their stock is over or
correctly valued will use stock to do acquisitions.
l Not surprisingly, the premium paid is larger when an
acquisition is financed with stock rather than cash.
l There might be an accounting rationale for using stock as
opposed to cash You are allowed to use pooling instead of
opposed to cash. You are allowed to use pooling instead of
purchase.
• There might also be a tax rationale for using stock. Cash
acquisitions create tax liabilities to the selling firm’s
stockholders.
31
The Exchange Ratio in a Stock

for Stock Exchange
l Correct Exchange Ratio to use in a Valuation = Value
per Share of Target Firm (with control premium and
per Share of Target Firm (with control premium and
target‐controlled synergies) / Value per Share of
Bidding Firm
l If the exchange ratio is set too high, there will be a
transfer of wealth from the bidding firm’s
stockholders to the target firm’ss stockholders.
stockholders to the target firm stockholders
l If the exchange ratio is set too low, there will be
transfer of wealth from the target firm to the
bidding firm’s stockholders.
l End of Unit 3
32

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BA6036 - STRATEGIC INVESTMENT AND

Lease financing Reference 8 – Chapter 25

Hire Purchase Reference 8 – Page 25.22

Mergers and Acquisition

3. Bodie, Kane, Marcus : Investment, Tata McGraw Hill, New Delhi2002.

It is a devise of financing the cost of an asset.

It is a contract in which a specific equipment required by the lessee is

Modes of terminating a lease:

1. The lease is renewed on a perpetual basis or for a definite period.

Risk with reference to leasing refers to the possibility of loss arising on

This can be of two types:

Advantages to the lessor

• Restrictions on use of equipment.

[Reference 8 – Example 25.1]

[Reference 8 – Example 25.2]

The following details relate to an investment proposal.

• Investment out lay Rs 180 L

What alternative to be taken and why?

[Reference 8 – Example 2-A.6]

The lease rentals for a 5 year contract are Rs 300/Rs1000 payable

annually in arrears. Assuming no salvage value compute the rate of

interest implied by the contract and develop a lease amortization plan

• This ownership transfer either automatically or on payment of an option to

• Capital allowances can be a significant tax incentive for businesses to

• Under a hire purchase agreement, the business customer is normally

Hire Purchase vs Lease Financing

Ownership of the Asset:

• The lease rentals cover the cost of using an asset.

Hire Purchase vs Lease Financing

Repairs and Maintenance:

Lease vs Buy Decision

Lease vs. Buy Overview

Lease vs. Buy Costs

Lease vs Buy Decision

Lease vs Buy Decision

Arguments for Leasing

Arguments for Getting a Loan

Hire Purchase and Instalment Decision

Hire Purchase and Instalment Decision

Confidentiality Main due Ratified

Sign letter Final sale

[ 15-1] V  VAT -(VA VT )

Time Period Free Cash Flows

Current liabilities 8,000 800 800

Decide on payment mechanism:

The Exchange Ratio in a Stock

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