Q1

Valuation of ABC based on P/E = P/E * Earnings (PAT) = 553 * 10 = 5530 Crore

Or value of one share = 5530/7.45 = 742.28

Similarly, valuation of XYZ = 80*8 = 640 Crore

value of one share = 640/7.1 = 90.14

So, swap ratio = 742.28/ 90 = 1 share of ABC in exchange of 8.23 shares of XYZ

…….

Swap ratio based on NAV = (4837/ 7.45) / (727 / 7.1) = 6.34

Issues in valuation

Appropriate selection of valuation method, growth rate, opportunity cost etc.

Valuation of intangible assets

Identification of synergies, availability of near perfect information

Q2

Year 0 1 2 3 4 5

Earnings (at g = 15%) 553 635.95 731.3425 841.0439 967.2005 1112.281

Shareholders' wealth at avg P/E 6359.5 7313.425 8410.439 9672.005 11122.81

ABC
ltd EPS 85.36242 98.16678 112.8918 129.8256 149.2994
Share price projection at post-
938.9866 1079.835 1241.81 1428.081 1642.293
merger P/E
Earnings (at g = 10%) 80 88 96.8 106.48 117.128 128.8408

Shareholders' wealth at avg P/E 704 774.4 851.84 937.024 1030.726

XYZ
ltd EPS 12.39437 13.6338 14.99718 16.4969 18.14659
Share price projection at post-
136.338 149.9718 164.969 181.4659 199.6125
merger P/E

Effect of differential PEs of merging partners

If the acquiring firm has higher PE than the target firm, overall PE post merger would reduce for the
acquiring firm, which increases the earnings for shareholders. Similarly, target firm’s share price increases
in anticipation of higher PE post-merger

Q3
Enterprise value = 7.1*190 = 1349 crore

Assuming cost of capital = 15%, growth rate after 5 years of 5% (to calculate terminal value), and
neglecting liabilities, XYZ should grow at 29.80 % to justify valuation of 190 per share

Q4

Assuming conservative growth rate of 10% for XYZ, growth rate after 5 years of 5% (to calculate terminal
value), and neglecting liabilities:

Enterprise value = 685.15 crore

Or value per share = 685.15 / 7.1 = 96.5

ABC should not pay more than 96.5 for a share of XYZ ltd

Q5

Assuming growth rate would follow optimistic scenario (as acquirer’s are bullish), their stocks are
currently undervalued (15% growth rate without merger vs 20% growth rate with merger), ABC should
pay to the XYZ shareholders in cash either with their excess cash reserve or through cheap debt financing

Issues in merger accounting

In a merger or acquisition, the liabilities of the target firm must be settled, and its owners compensated
with cash or awarded shares or share options in the combined entity. This could spell doom for the
acquiring entity if the target company has many outstanding liabilities or has issued too many shares.
Also, paying premium to shareholders create goodwill on the assets side. Use of different accounting by
both the firms can create inefficiency in post-merger accounting

Q6
Strategy of risk arbitragers during takeover – They take long positions in the target stock, hoping that
takeover will go through. They are usually hedged by taking short position on acquirer’s stocks

Q7
Steps in a Merger

There are three major steps in a merger transaction: planning, resolution, implementation.
1. Planning, the most complex part of the merger process, entails the analysis, the action plan, and the
negotiations between the parties involved. The planning stage may last any length of time, but once it is
complete, the merger process is well on the way.
More in detail, the planning stage also includes:

 signing of the letter of intent;

 the appointing of advisors who play the role of consultants, examining the strengths, weaknesses,
opportunities, and threats of the merger;
 detailing the timetable (deadline), conditions (share exchange ratio), and type of transaction (merger
by integration or through the formation of a new company);
 expert report on the consistency of the share exchange ratio, for all of the companies involved.
2. The resolution is simply management's approval first, then by the shareholders involved in the merger
plan.
The resolution stage also includes:

 the Board of Directors calling an extraordinary shareholders’ meeting whose item on the agenda is
the merger proposal;
 the extraordinary shareholders’ meeting being called to pass a resolution on the item on the agenda;
 any opposition to the merger by creditors and bondholders within 60 days of the resolution;

3. Implementation is the final stage of the merger process, including enrolment of the merger deed in the
Company Register.
Normally medium-sized/big mergers require one year from the start-up of negotiations to the closing of
the transaction. This is because, in addition to the time needed technically, there are problems relating to
the share exchange ratio between the merging companies which is rarely accepted by the parties without
drawn-out negotiations.
During the merger process, share prices will adjust to the share exchange ratio. On the effective date of
the merger, financial intermediaries will enter the new shares with the new quantities in the dossiers. The
shareholders may trade without constraint the new shares and benefit from all rights (dividends, voting
rights).

The ABC management could start with the objective of merger, and address a few questions as:

1. Does the merger make strategic sense to ABC given its current business operations?
2. What is the worth of XYZ and other acquisitions offer at table?
3. What are the likely risks as different culture?
4. Does it add shareholders value?

So, to address these issues company ABC could form a committee with top management and cross-
functional team. Make detailed timeline, state the clear terms and conditions, examine the positives and
negatives repercussions of deal, financial projections. Prepare a detailed report on this.

Second stage involve presenting it to Board and shareholders of ABC. Share the likely positive benefit the
company derives from the merger. Get the shareholders on board. Resolve the conflicts or doubts.

Finally, prepare the legal framework and structure of the deal merging XYZ. Take it to government
authorities for approvals under the acts. Implement the merger and enter the new shares.

Q8

Since both the companies hold shares in other company, effectively ABC would be taking control over
remaining 80% of XYZ, as it already holds 20% share of XYZ. If the shareholders of XYZ are given shares
of ABC with the given swap ratio, Mr. K would impart higher control in the new entity as value of ABC is
around 8 times that of XYZ.