Unit – 5

Mergers and Acquisition

Merger

A merger is a business deal where two existing, independent companies combine to form a new,
singular legal entity. Mergers are voluntary. Typically, both companies are of a similar size and
scope and both stand to gain from the transaction.

 ‘Mergers are a way for companies to expand their reach, expand into new segments, or
gain market share.
 A merger is the voluntary fusion of two companies on broadly equal terms into one new
legal entity.
 The five major types of mergers are conglomerate, co generic, market extension,
horizontal, and vertical.

Types of Mergers

There are a variety of ways for companies to merge. The most common types include:

Horizontal

A merger is considered horizontal if the two companies already offer the same products or
services. Horizontal mergers help companies reduce competition and dominate the market. For
example, gas giant Exxon combined with gas giant Mobil back in 1998 to form ExxonMobil. At
the time, that horizontal deal valued the new company at $81 billion.

Market Extension

A market extension merger is a horizontal merger that allows two companies that sell the same
product to operate in a new market. For example, if a U.S. regional bank in the east merged with
a U.S. regional bank in the west to form the U.S. Bank of the East and West, that would be a
market extension merger. These types of consolidations help companies drive more revenue by
expanding where they do business.

Vertical

A merger is considered vertical if the two companies operate within each other’s supply chain.
Think of a home construction company purchasing a window pane manufacturer or a winery
buying a glass bottle manufacturer. Vertical mergers help companies reduce costs because they
effectively cut out the middleman.
Conglomerate

A merger is considered a conglomerate acquisition if the companies operate in separate

industries and, at face value, have little to nothing in common from a business perspective. Think
of a clothing company combining with a snack food manufacturer. Conglomerate mergers open
up cross-selling opportunities, market extensions, and increased operational efficiencies.

Cogeneric

A merger is considered cogeneric if the companies offer different products or services, but
operate in the same sphere and sell to the same customer base. Cogeneric mergers allow
companies to sell new products, which is why they’re also known as product extension mergers.
So, for instance, famous ketchup manufacturer H. J. Heinz Co. was able to make revenue off of
The Kraft Foods Group’s popular macaroni and cheese (and vice versa) once the companies
merged to form The Kraft Heinz Company back in 2015.

SPAC

A special purpose acquisition company (SPAC) is a publicly traded shell company made with the
singular intent of merging with a private company. That merger allows the private company to
go public. SPACs are an increasingly popular alternative to a traditional initial public offering
(IPO). Learn more about SPACs.

Pros and Cons of Mergers

Here are some of the most common advantages and disadvantages of mergers from a business
perspective.

Pros

 They can turbocharge growth. As we mentioned earlier, mergers help companies launch
new products or enter new markets, often more cheaply or efficiently than they would be
able to do so on their own.
 They help companies achieve economies of scale. That is, mergers enable companies to
reach a size and scale that comes with cost reductions — essentially the business version
of buying in bulk.
 They give companies access to capital, as they’re essentially pooling their budgets and
resources together. Merging companies have the option of consolidating operations and,
by extension, driving more dollars to the bottom line.
Cons
  They’re costly and time-consuming. Mergers are complex legal transactions and there are
lots of steps both sides must take — and fund — before two companies can become
one.
 They’re stressful. Mergers are often associated with layoffs or significant changes in
existing workplace culture, so they can affect performance, turnover, and management
of the companies’ respective workforce.
 They don’t always pan out. There are a number of ways in which a merger can go
sideways. For instance, they’re subject to anti-trust laws. The federal government could
take legal steps to block a deal if it was concerned the new company would form a
monopoly and lessen competition in the market.

Acquisition
An acquisition is a business transaction that occurs when one company purchases and gains
control over another company. These transactions are a core part of mergers and acquisitions
(M&A), a career path in corporate law or finance that focuses on the buying, selling, and
consolidation of companies.

 An acquisition is a business combination that occurs when one company buys most or
all of another company's shares.
 If a firm buys more than 50% of a target company's shares, it effectively gains control of
that company.
 An acquisition is often friendly, while a takeover can be hostile; a merger creates a
brand new entity from two separate companies.
 Acquisitions are often carried out with the help of an investment bank, as they are
complex arrangements with legal and tax ramifications.
 Acquisitions are closely related to mergers and takeovers.
Types of Acquisitions

Companies consolidate for a variety of reasons and in a number of ways. The most common
types of acquisitions include:

Horizontal Acquisition

A horizontal acquisition occurs when a company buys another company that offers similar
products or services. So, for instance, if one streaming network were to purchase another
streaming network, that would be considered a horizontal acquisition.

Real-world examples include:

 Facebook purchasing Instagram for $1 billion in 2012

 Verizon Wireless purchasing British telecommunications company Vodafone for $130
billion in cash and stock in 2013
  Marriott International forming the world’s largest hotel chain upon acquiring Starwood
Hotels and Resorts Worldwide for $13 billion in 2016
Vertical Acquisition

A vertical acquisition occurs when a company buys another company that produces a product in
its existing supply chain. So, for instance, if a streaming network purchases a film or television
production company, that would be considered a vertical acquisition.

Real-world examples include:

 Swedish furniture company Ikea continually buying acres of forest

 CVS Health Corporation’s 2018 $69 billion purchase of Aetna
 Online retail giant Amazon purchasing grocer Whole Foods Market for $13.7 billion in
2017
Congeneric Acquisition

A congeneric acquisition occurs when one company buys another company that offers different
products or services, but caters to the same customer base. So if a streaming network were to buy
a smart television manufacturer, that would be considered a congeneric acquisition.

Real-world examples include:

 Consumer goods giant Procter & Gamble Co. purchasing razor-and-battery company
Gillette for $57 billion in 2005
 Coca-cola buying Glaceau, the maker of Vitaminwater, for $4.1 billion in 2007
Conglomerate Acquisition

A conglomerate acquisition occurs when one company buys another company from a completely
separate industry. So if a streaming network buys a crayon company, that would be considered a
conglomerate acquisition.

Real-world examples include:

 Microsoft acquiring professional networking site LinkedIn for $26.2 billion in 2016
 Multinational holding firm Berkshire Hathaway buying Heinz for $23.3 billion in 2013

Pros and Cons of Acquisitions

There are many reasons why a company might decide to acquire another company — or to allow
another company to acquire it. Understanding these reasons, along with the potential drawbacks
of an acquisition, are important if you’re interested in pursuing a career in M&A.
Pros

 They can increase market share. Acquisitions are often one of the quickest ways to
enter a new market. Say you’re a grocery company with stores on the East Coast and
want to expand to West Coast metros. You could consider acquiring a grocery chain that
has stores in your desired locations. Alternately, you could offer a new product to juice
sales by acquiring a company that already manufactures that product.
 They can lower costs. Acquisitions help companies reach economies of scale — cost
reductions that occur when production increases. While complex, you can effectively
think of this economics concept as the business equivalent of buying in bulk.
 They reduce or eliminate competition. If our fictional streaming network, for instance,
were to buy another streaming network, they would acquire (and, by extension, no
longer have to compete for) its customers.
Cons

 They take time. While potentially a way to accelerate growth, acquisitions are still
complex legal arrangements, subject to internal and external negotiations, investigations,
audits, and reviews. They can take months or, even, a few years to complete.
 They cost money. The acquirer has to pay for the target company in cash, stock, and/or
borrowed funds (known as a leveraged buyout). There are also legal fees and tax
implications associated with each deal. (Get familiar with the legal side of M&A with
the Latham & Watkins Mergers and Acquisitions Virtual Experience Program.)
 They can be mispriced. While M&A professionals rely on a variety of business
valuation methods, it still can be tricky to pinpoint how much exactly a company is
worth. Valuations, after all, are subject to market and economic conditions outside a
business’ control. Given that inherent volatility, there’s generally at least some risk
associated with each transaction.

Key Differences between Merger vs Acquisition

The terms merger and acquisition essentially refer to the consolidation of two or more business
entities for the purpose of achieving better synergies. The motives for entering into either
contract include expanding operations, gaining a higher market share, reducing costs, or boosting
profits. However, there are several prominent differences between the two, as summarized in the
following table:

Merger Acquisition
Procedure Two or more individual One company completely takes over the operations
companies join to form a new of another.
business entity.
 Merger Acquisition
Mutual A merger is agreed upon by The decision of acquisition might not be mutual; in
Decision mutual consent of the case the acquiring company takes over another
involved parties. enterprise without the latter’s consent, it is termed as
a hostile takeover.

Name of The merged entity operates The acquired company mostly operates under the
Company under a new name. name of the parent company. In some cases,
however, the former can retain its original name if
the parent company allows it.

Comparative The parties involved in a The acquiring company is larger and financially
Stature merger are of similar stature, stronger than the target company.
size, and scale of operations.

Power There is dilution of power The acquiring company exerts absolute power over
between the involved the acquired one.
companies.

Shares The merged company issues New shares are not issued.
new shares.

Exchange Ratio

The exchange ratio is the relative number of new shares that will be given to
existing shareholders of a company that has been acquired or that has merged with another.
After the old company shares have been delivered, the exchange ratio is used to give
shareholders the same relative value in new shares of the merged entity.

KEY TAKEAWAYS

 The exchange ratio calculates how many shares an acquiring company needs to issue for
each share an investor owns in a target company to provide the same relative value to
the investor.
 The target company purchase price often includes a price premium paid by the acquirer
due to buying 100% control of the target company.
 The intrinsic value of the shares and the underlying value of the company are considered
when coming up with an exchange ratio.
 There are two types of exchange ratios: a fixed exchange ratio and a floating exchange
ratio.
Understanding the Exchange Ratio

An exchange ratio is designed to give shareholders the amount of stock in an acquirer

company that maintains the same relative value of the stock the shareholder held in
the target, or acquired company. The target company share price is typically increased
by the amount of a "takeover premium," or an additional amount of money an acquirer
pays for the right to buy 100% of the company's outstanding shares and have a 100%
controlling interest in the company.

Relative value does not mean, however, that the shareholder receives the same number
of shares or same dollar value based on current prices. Instead, the intrinsic value of the
shares and the underlying value of the company are considered when coming up with an
exchange ratio.

Formula

Exchange Ratio = Offer Price for 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 1.84. This means Firm A has to issue 1.84 of its own shares for every 1 share of the
Target it plans to acquire.
Synergy

Synergy is the concept that the combined value and performance of two companies will be
greater than the sum of the separate individual parts. Synergy is a term that is most commonly
used in the context of mergers and acquisitions (M&A). Synergy, or the potential financial
benefit achieved through the combining of companies, is often a driving force behind a merger.

KEY TAKEAWAYS

 Synergy is the concept that the value and performance of two companies combined will
be greater than the sum of the separate individual parts.
 If two companies can merge to create greater efficiency or scale, the result is what is
sometimes referred to as a synergy merge.
 The expected synergy achieved through a merger can be attributed to various factors,
such as increased revenues, combined talent and technology, and cost reduction.
 In addition to merging with another company, a company can also create synergy by
combining products or markets, such as when one company cross-sells another
company's products to increase revenues.
 Companies can also achieve synergy between different departments by setting up cross-
disciplinary workgroups in which teams work cooperatively to increase productivity and
innovation.
#1 – Revenue Synergy
This is the first of the three types of synergy in mergers and acquisitions. If two companies go
through revenue synergy, they sell more products.
For example, let’s say that G Inc. has acquired P Inc. G Inc. has been selling old laptops. P Inc. is
not a direct competitor of G Inc., But P Inc. sells new laptops cheaply. P Inc. is still very small in
profit and size, but they have been giving great competition to G Inc. since it sells new laptops at
a much lesser price.
As G Inc. has acquired P Inc., G Inc. has increased its territory from selling only used laptops to
selling new laptops in a new market. By going through this acquisition, the revenue of both of
these companies will increase, and they would be able to generate more revenue together
compared to what they could have done individually.

#2 – Cost Synergy
The second type of synergy in Mergers is the cost synergies. Cost synergy allows two companies
to reduce costs due to the merger or acquisition. If we take the same example we took above; we
would see that due to the acquisition of P Inc., G Inc. can reduce the costs of going to a new
territory. Plus, G Inc. can access a new segment of customers without incurring any additional
cost.
Cost reduction is one of the most important benefits of cost synergy. In the case of cost synergy,
the rate of revenue may not increase; but the costs would get reduced. In this example, when the
cost synergy happens between G Inc. and P Inc., the combined company can save a lot of costs
on logistics, storage, marketing expenses, training expenses (since the employees of P Inc. can
train the employees of G Inc. and vice-versa), and also in market research.
That’s why cost synergy is quite effective when the right companies merge or one company
acquires another.

#3 – Financial Synergy
The third type of synergy in mergers and acquisitions is Financial Synergy. If a mid-level
company borrows a loan from a bank, the bank may charge more interest. But what if two mid-
level companies merge, and as a result, a large company goes to borrow the loan from the bank?
They will get benefits since they would have a better capital structure and cash flow to support
their borrowings.
Financial synergy is when two mid-sized companies merge together to create financial
advantages.
For example, we can say that Company L and Company M have merged to create a financial
synergy. Since they are mid-level companies, and if they operate individually, they need to pay a
premium for taking loans from the banks or would never reduce the cost of capital. So that’s why
the merger has turned out to be quite beneficial for both of these companies, and we can call it
financial synergy in Mergers and Acquisitions.

Benefits of synergy

Synergy often involves two entities or parts with complementary resources or capabilities. It then
brings mutual benefits, especially when joint work or activities support the same goal.
 In general, synergy creates added value and enables higher returns from

 Cost savings. For example, manufacturers can reduce the cost of building a distribution network by
acquiring a distributor.
 Growth opportunities. International companies often collaborate with local companies to seize
opportunities for growth. They then formed a joint venture.
 Stronger market position. A company acquires a company that produces complementary products.
The acquisition allows it to expand its product offering. As a result, it could generate more income
than they can do independently.
 Increased bargaining position. Mergers lead to more significant business size. That improves the
bargaining position, not only to suppliers but also to customers.
 Strengthened competence. Take, for example, the formation of a team from the marketing, the
production, and the research and development divisions. Team formation increases effectiveness
by sharing perceptions and experiences, insights, and knowledge.
 Better decision making. Forming a team with diverse knowledge will produce more ideas, more
creative solutions, increased acceptance of decisions by group members
 Financial benefits. Being bigger reduces the cost of capital because, when borrowing money, the
company pays a smaller premium than the small company.

Why Synergy fail?

Even though synergy is ideal, however, it is difficult in practice. Business downsizing and
divestment are partly its failure results.

 Resistance to change. Mergers, for example, increase uncertainty about the future of core
employees. They aren’t sure whether, after the merger, still in the same position or not. If a merger
puts its position at risk, they will tend to resist.
 Corporate culture conflicts. It is a classic problem in mergers and acquisitions. Cultural conflicts
give rise to disharmony and reduce productivity.
 Slower decision. Decision making needs to pay attention to the interests of each group or entity.
The process is usually more time-consuming and more expensive than individual decision making.
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:

Return on investment

Return on investment (ROI) is similar to ROE, except it accounts for the acquisition price and
the sale price of a business. You calculate it by subtracting the sale price from the acquisition
price and dividing that difference by the acquisition price; the result is a percentage. If you
acquire a company for $10 million and sell it for $15 million, the ROI is 50 percent.

Demerger
It has been defined as a split or division. As the same suggests, it denotes a situation opposite to
that of merger. Demerger or spin-off, as called in US involves splitting up of conglomerate
(multi-division) of company into separate companies.

This occurs in cases where dissimilar business is carried on within the same company, thus
becoming unwieldy and cyclical almost resulting in a loss situation. Corporate restructuring in
such situation in the form of demerger becomes inevitable. Merger of SG chemical and Dyes
Ltd. with Ambalal Sarabhai enterprises Ltd. (ASE) has made ASE big conglomerate which had
become unwieldy and cyclic, so demerger of ASE was done.

part from core competencies being main reason for demerging companies according to their
nature of business, in some cases, restructuring in the form of demerger was undertaken for
splitting up the family-owned large business empires into smaller companies.

Demerger also occur due to reasons almost the same as mergers i.e. the desire to perform better
and strengthen efficiency, business interest and longevity and to curb losses, wastage and
competition. Undertakings demerge to delineate businesses and fix responsibility, liability and
management so as to ensure improved results from each of the demerged unit.

Demerged Company, according to Section (19AA) of Income Tax Act, 1961 means the company
whose undertaking is transferred, pursuant to a demerger to a resulting company.

Resulting company, according to Section2(47A) of Income Tax Act,1961 means one or more
company, (including a wholly owned subsidiary thereof) to which the undertaking of the
demerged company is transferred in a demerger, and the resulting company in consideration of
such transfer of undertaking issues shares to the shareholders of the demerged company and
include any authority or body or local authority or public sector company or a company
established, constituted or formed as a result of demerger.