Mergers and Amalgamations

According to Prof. L.H.Haney, merger is, “a form of business organization which is established by
the outright purchase of the properties of constituents, organizations and the merging or
amalgamating of such properties into a single business unit”.

In a merger, one business unit acquires the other business unit. The acquiring company retains its
entity while the acquired loses its entity.

Examples of Mergers

 Acquisition of Modern Foods, Kissan, Tata Oil Mills Co., Ltd (TOMCO), Kwality
Walls etc., by Hindustan Level Limited(HLL).
 Acquisition of ANZ Grindlays Indian operations by Standard Chartered, Times
Bank by HDFC Bank, Bank of Madura by ICICI Bank,
 Acquisition of Voltas and Allwyn by Electrolux. Subsequently Electrolux’s – Indian
operations were acquired by Videocon International.
 Recent international mergers include – acquisition of Gillette by P&G,
Betapharma by Ranbaxy, IBM’s PC division by Lenovo, Compaq by Hewlett
Packard(HP) etc.

Amalgamation
In Amalgamation, two or more companies combine to create a new company. All the combining
companies lose their separate existence and entity. The new company takes over all existing
assets and liabilities of the companies amalgamated. The new company allots its shares to the
shareholders of the amalgamating companies.

Example of Amalgamation
For e.g. Arcelor, the world’s largest steel company (which has been since been acquired by Mittal
Steel) came into being as a result of amalgamation. French steel company Usinor amalgamated
with Aceralia of Spain and Arbed of Luxembourg in the year 2002 and the new company formed
out of this amalgamation was named as Arcelor.

Differences between Merger & Amalgamation

Though mergers and amalgamations are form of complete consolidation there are certain
differences between them. They are given in the following table:

Points of
Acquisition Merger
distinction

Two or more
independent units One unit acquires another. Generally the larger and
1. Formation
combine together to financial stronger unit takes over a smaller unit.
form a new unit.
 The acquirer retains the identity whereas the
The combining units acquired company looses its identity. For e.g. when
2. Identity lose their individual HDFC Bank acquired Times Bank, the acquirer
identity. (HDFC Bank) retained the identity whereas the
acquired (Times Bank) lost its identity.

Shareholders of all
the combining units
become Shareholders of the acquired company become the
3. Shareholders
shareholders in the share holders of the acquiring company.
newly created
enterprise.

Shares of the newly

created entity is
Shares of the acquirer company is given to the
4. Shares given to the
shareholders of the acquired company.
shareholders of the
combining units.

The initiative to
amalgamate is
5. Initiative Initiative is generally taken by the acquirer.
generally taken by
the combining units.

Mergers
A merger is the combination of two companies into one by either closing the old entities into one
new entity or by one company absorbing the other. In other words, two or more companies are
consolidated into one company.

A merger is a financial activity that is undertaken in a large variety of industries: healthcare,

financial institutions, private investments, industrials, and many more. There are two main types of
mergers: horizontal and vertical.

Horizontal mergers occur when two businesses in the same industry combine into one. This type
of combination can cause anti-trust issues depending on the industry. For instance, GM and Ford
may not be allowed to merge because of anti-trust laws.

Vertical mergers occur when two businesses in the same value chain or supply chain merge. For
example a hamburger restaurant might merge with a cow farm.

Determination of Exchange Ratio

In mergers and acquisitions (M&A), the share exchange ratio measures the number of shares
the acquiring company has to issue for each individual share of the target firm. For M&A deals that
include shares as part of the consideration (compensation) for the deal, the share exchange ratio
is an important metric. Deals can be all cash, all shares, or a mix of the two.

Formula
Exchange Ratio = Offer Price for the Target’s Shares / Acquirer’s Share Price

Exchange Ratio example

Assume Firm A is the acquirer and Firm B is the target firm. Firm B has 10,000 outstanding shares
and is trading at a current price of $17.30 and Firm A is willing to pay a 25% takeover premium.
This means the Offer Price for Firm B is $21.63. Firm A is currently trading at $11.75 per share.

To calculate the exchange ratio we take the offer price of $21.63 and divide it by Firm A’s share
price of $11.75.

The result is 1.84x. This means Firm A has to issue 1.84 of its own shares for every 1 share of the
Target it plans to acquire.

Importance of the Exchange Ratio

In the event of an all-cash merger transaction, the exchange ratio is not a useful metric. In fact, in
this situation, it would be fine to exclude the ratio from the analysis. Often times, M&A valuation
models will note the ratio as “0.000” or blank, when it comes to a full cash transaction.
Alternatively, the model may display a theoretical exchange ratio, if the same value of the cash
transaction were instead to be carried out by a stock transaction.

However, in the event of a 100% stock deal, the exchange ratio becomes a powerful metric. It
becomes virtually essential and allows the analyst to view the relative value of the offer between
the two firms.

In the event of a split deal, where a portion of the transaction involves cash and a portion involves
a stock deal, the percentage of stock involved in the transaction must be considered. Excluding
any cash effects, what is the actual exchange ratio based on the stock. Additionally, M&A models
may want to also show what this transaction would look like if there was a 100% stock deal.

Evaluation of Synergy
When a company acquires another business, it is often justified by the argument that the
investment will create synergies. The primary source of synergy in an acquisition is in the
presumption that the target firm controls a specialized resource that becomes more valuable if
combined with the acquiring firm’s resources. There are two main types, operating synergy and
financial synergy, and this guide will focus on the latter.

Value can be created, for example, through revenue enhancement, cost reductions, increased
operating cash flow, improved managerial decision making, or the sale of redundant assets.
However, the value created from proposed synergies also may have an additional investment cost
as well.

Synergy takes the form of revenue enhancement and cost savings.

When two companies in the same industry merge, such as two banks, combined revenues tend to
decline to the extent that the businesses overlap in the same market and some customers become
alienated.

For the merger to benefit shareholders, there should be cost-saving opportunities to offset the
revenue decline. In other terms, the synergies deriving from the merger must exceed the initially
lost value.

As a rule of thumb, synergy is a business combination where 2+2 = 5.

Many analysts, however, do not consider these incremental investments or “hidden” costs when
performing a pricing analysis or valuation of a potential target. Failure to consider the hidden costs
often causes the overvaluation of a potential target, which may lead to destroying value rather
than creating it.

Synergy appeared due to acquisition should include higher results then it was originally expected.

Acquisition process should be well-planned. Mark Sirower, the US leader of the Merger &
Acquisition Strategy and Commercial Diligence practice, named 4 components which should take
place in order to achieve successful synergies:

 Strategic vision
 Operating strategy
 Systems integration
 Power and culture

The buyer should pay out the premium to shareholders of merged company. The higher the
premium, the lower the potential benefit for the buyer. Therefore, synergies should not be
intangible. It should be carefully forecast and discounted from net cash flows which are feasible
within the chosen time frame.

Post-merger integration issues, as well as competitors’ reactions, can contribute to the hidden
costs of an acquisition.

Besides the positive impact of revenue enhancements, cost reductions, and other efficiencies,
valuation analysts need to price them in, too.

Operating Synergy & Financial Synergy

Sources of Operating Synergy
Operating synergies are those synergies that allow firms to increase their operating income,
increase growth or both. We would categorize operating synergies into four types:

 Economies of scale that may arise from the merger, allowing the combined firm
to become more cost-efficient and profitable.
 Greater pricing power from reduced competition and higher market share, which
should result in higher margins and operating income.
 Combination of different functional strengths, as would be the case when a firm
with strong marketing skills acquires a firm with a good product line
 Higher growth in new or existing markets, arising from the combination of the two
firms. This would be case when a US consumer products firm acquires an
emerging market firm, with an established distribution network and brand name
recognition, and uses these strengths to increase sales of its products.

Operating synergies can affect margins and growth, and through these the value of the firms
involved in the merger or acquisition.

Sources of Financial Synergy

With financial synergies, the payoff can take the form of either higher cash flows or a lower cost of
capital (discount rate). Included are the following:

 A combination of a firm with excess cash, or cash slack, (and limited project
opportunities) and a firm with high-return projects (and limited cash) can yield a
payoff in terms of higher value for the combined firm. The increase in value
comes from the projects that were taken with the excess cash that otherwise
would not have been taken. This synergy is likely to show up most often when
large firms acquire smaller firms, or when publicly traded firms acquire private
businesses.
 Debt capacity can increase, because when two firms combine, their earnings and
cash flows may become more stable and predictable. This, in turn, allows them to
borrow more than they could have as individual entities, which creates a tax
benefit for the combined firm. This tax benefit can either be shown as higher cash
flows, or take the form of a lower cost of capital for the combined firm.
 Tax benefits can arise either from the acquisition taking advantage of tax laws or
from the use of net operating losses to shelter income. Thus, a profitable firm that
acquires a money-losing firm may be able to use the net operating losses of the
latter to reduce its tax burden. Alternatively, a firm that is able to increase its
depreciation charges after an acquisition will save in taxes, and increase its
value.

Clearly, there is potential for synergy in many mergers. The more important issues are whether
that synergy can be valued and, if so, how to value it.

Empirical Evidence on Synergy

Synergy is a stated motive in many mergers and acquisitions. Bhide (1993) examined the motives
behind 77 acquisitions in 1985 and 1986, and reported that operating synergy was the primary
motive in one-third of these takeovers. A number of studies examine whether synergy exists and,
if it does, how much it is worth. If synergy is perceived to exist in a takeover, the value of the
combined firm should be greater than the sum of the values of the bidding and target firms,
operating independently.

V(AB) > V(A) + V(B)

where

V(AB) = Value of a firm created by combining A and B (Synergy)

V(A) = Value of firm A, operating independently

V(B) = Value of firm B, operating independently

Studies of stock returns around merger announcements generally conclude that the value of the
combined firm does increase in most takeovers and that the increase is significant. Bradley, Desai,
and Kim (1988) examined a sample of 236 inter-firms tender offers between 1963 and 1984 and
reported that the combined value of the target and bidder firms increased 7.48% ($117 million in
1984 dollars), on average, on the announcement of the merger.

This result has to be interpreted with caution, however, since the increase in the value of the
combined firm after a merger is also consistent with a number of other hypotheses explaining
acquisitions, including under valuation and a change in corporate control. It is thus a weak test of
the synergy hypothesis. The existence of synergy generally implies that the combined firm will
become more profitable or grow at a faster rate after the merger than will the firms operating
separately. A stronger test of synergy is to evaluate whether merged firms improve their
performance (profitability and growth) relative to their competitors, after takeovers. On this test, as
we show later in this chapter, many mergers fail.

Post-Merger EPS
Proforma earnings per share (EPS) is the calculation of EPS assuming a merger and acquisition
(M&A) takes place and all financial metrics, as well as the number of shares outstanding, are
updated to reflect the transaction. “Pro forma” in Latin means “for the sake of form.” In this case, it
refers to calculating EPS “for the sake of form” in the event of the acquisition.

Basic EPS is calculated by dividing a firm’s net income by its weighted shares outstanding. The
pro forma EPS, on the other hand, adds the target firm’s net income and any additional synergies
or incremental adjustments to the numerator, while adding new shares issued due to the
acquisition to the denominator.

Pro Forma EPS = (Acquirer’s Net Income + Target’s Net Income +/- “Incremental Adjustments”) /
(Acquirer’s shares outstanding + New Shares Issued)

“Incremental Adjustments”?

These are additional value items that are created when the two firms combine, which impact
proforma earnings per share:

 Incremental after-tax interest expenses that come from new debt financing.
 After-tax synergies (gains in assets).
  After-tax depreciation and amortization expense (from write-ups).
 Lost opportunity cost of cash balances if used to finance the acquisition.
 “Saved” after-tax interest expense from the liquidation of target’s debt.
 “Saved” preferred stock dividend payment from liquidation or conversion of
target’s preferred stock.

Q. XYZ Ltd. is considering merger with ABC Ltd. XYZ Ltd.’s shares are currently traded at Rs. 25.
It has 2,00,000 shares outstanding and its profits after taxes (PAT) amount to Rs. Rs. 4,00,000.
ABC Ltd. Has 1,00,000 shares outstanding. Its current market price is Rs. 12.50 and its PAT are
Rs. 1,00,000. The merger will be effected by means of a stock swap (exchange). ABC Ltd. has
agreed to a plan under which XYZ Ltd. will offer the current market value of ABC Ltd.’s shares:

(i) What is the pre-merger earnings per share (EPS) and P/E ratios of both the companies?

(ii) If ABC Ltd.’s P/E ratio is 8, what is its current market price? What is the exchange ratio? What
will XYZ Ltd.’s post-merger EPS be?

(iii) What must the exchange ratio be for XYZ Ltd.’s that pre and post-merger EPS to be the
same?

Post Merger Price of share

Accounting for Amalgamations

The provisions of Accounting Standard (AS-14) on Accounting for Amalgamations issued by the
Institute of Chartered accountants of India need to be referred to in this context.

The two main methods of financing an acquisition are cash and share exchange:
Cash: This method is generally considered suitable for relatively small acquisitions. It has two
advantages:

(i) The buyer retains total control as the shareholders in the selling company are completely
bought out.

(ii) The value of the bid is known and the process is simple.

Let us consider 2 Companies A & B whose figures are stated below:

Assume Company A intends to pay Rs.12,00,000/- cash for Company B.

If the share price does not anticipate a merger:

The share price in the market is expected to accurately reflect the true value of the company.

The cost to the bidder Company A = Payment – The market value of Company B

= Rs.12 lakhs – Rs.9 lakhs

= Rs.3 lakhs.

Company A is paying Rs.3 lakhs for the identified benefits of the merger.

If the share price includes a speculation element of Rs.2/- per share:

The cost to Company A = Rs.3,00,000 + (60,000 x Rs.2)

= Rs. 3,00,000 + Rs. 1,20,000

= Rs. 4,20,000/-

Worth of Company B = (Rs. 15 – Rs. 2) × 60,000

= Rs. 13 × 60,000

= Rs. 7,80,000/-

This can also be expressed as: Rs. 12,00,000 – Rs. 4,20,000 = Rs. 7,80,000/-

Share exchange: The method of payment in large transactions is predominantly stock for stock.
The advantage of this method is that the acquirer does not part with cash and does not increase
the financial risk by raising new debt. The disadvantage is that the acquirer’s shareholders will
have to share future prosperity with those of the acquired company.

Suppose Company A wished to offer shares in Company A to the shareholders of Company B

instead of cash:

Amount to be paid to shareholders of Company B = Rs. 12,00,000

Market price of shares of Company A = Rs. 75/-

No. of shares to be offered = Rs. 12,00,000 / Rs. 75 = 16,000

Now, shareholders of Company B will own part of Company A, and will benefit from any future
gains of the merged enterprise.

Their share in the merged enterprise = 16,000 / (1,00,000 + 16,000) = 13.8%

Further, now suppose that the benefits of the merger has been identified by Company A to have a
present value of Rs. 4,00,000/-,

The value of the merged entity = Rs. 75,00,000 + (Rs. 9,00,000 + Rs. 4,00,000) = Rs. 88,00,000/-

True cost of merger to the shareholders of Company A: