Merger and Acquisition: A Strategic Valuation Approach

Introduction

A merger is a combination of two corporations in which only one corporation survives and the merged corporation goes out of subsistence. Alternatively, in merger two corporations combine and share their resources in order to accomplish mutual objectives and both companies bring their own shareholders, employees, customers and the community at large. Acquisition takes place when one firm is purchasing the assets or shares of another company.

Mergers are often categorised as horizontal, vertical, or conglomerate. A horizontal merger is one that takes place between two firms in the same line of business whereas vertical merger involves companies at different stages of production. The buyer expands backwards in the direction of the source of the raw material or forward in the direction of the customer. The last one, i.e., conglomerate merger involves companies in unrelated line of business. This distinction is very much necessary to make and understand the reasons for the mergers.

The scale and the pace at which merger activities are coming up are remarkable. The recent booms in merger and acquisitions suggest that the organisations are spending a significant amount of time and money either searching for firms to acquire or worrying about whether some other firm will acquire them. Also, mergers are regarded as one of the activities the purpose of business expansion or a measure of external growth in contrast to internal growths. The recent phenomenon booms in mergers and acquisitions would increase at a much faster rate in near future because the world markets are becoming more integrated because of open trade policies and hence more and more companies are adopting and forming strategic alliances in order to compete in the competitive world and to maintain their market shares.

Merger and acquisition decision is an investment decision. This is the most important decision, which influences both the acquiring firm and the target firm, which is to be acquired. An organization cannot make that crucial decision without incisive analysis by financial planners and corporate managers. The acquiring firm must correctly value the firm to be acquired and the acquired firm must get the returns for the goodwill they have created over the years in the market. Growth through acquisition is occurring in an unprecedented number of companies today as strategic acquisitions replace the once-prevalent hostile takeovers by corporate raiders. In the current business environment, it is vital to understand how to blend strategic and financial concepts to evaluate potential acquisitions.

Motives
The findings from the theoretical material and the empirical investigation will be analysis both horizontally and vertically according to the following: -

There are two types of motives involved in merger and acquisition and these are Explicit and Implicit motives.

Explicit Motives

•  Synergy: Synergy means that the merged firm will have a greater value than the sum of its parts as a result of enhanced revenues and the cost base. 
• Economies of Scale: Economic of scale refer to the reduction in unit cost achieved by producing a large volume of a product. Horizontal mergers aim at achieving economies of scale. This phenomenon continues while the firm grows to its optimal size, after which a firm experiences diseconomies of scale.
• Economies of Vertical Integration: Economies of vertical integration are achieved in vertical mergers. It makes coordination of closely related operating activities easier.
• Entry to New Markets and Industries: A firm that wants to enter a new market but lacks the know-how can do so through the purchase of an existing player in that product or geographical market. This makes the two firms worth more together than separately.
  
• Tax Advantages: Past losses of an acquired subsidiary can be used to minimize present profits of the parent company and thus lower tax bills. Thus, firms have a reason to buy firms that have accumulated tax losses.
  Diversification: One of the reasons for conglomerate mergers is diversification of risk. There are two types of risks associated with businesses- systematic and unsystematic risk. Systematic variability cannot be removed by diversification and hence mergers are not able to eliminate this risk. Though, unsystematic risk can be spread through mergers.
• Managerial Motives: The management team of the acquiring firm tends to benefit from the merger activity. The four most important managerial motives for merger are empire building, status, power and remuneration.

Implicit Motives

1.      Hubris: It is like a maturity test for the owners and the company boards of directors when they see the opportunity to form a new business cycle.

2.      Excess of Money: When a company has excess of money, the question of what to do with it eventually comes up and this leads towards merger and acquisition.

An acquisition valuation programme can be segregated into five distinct steps like:

Step 1: Establish a motive for the acquisition.
Step 2: Choose a target.
Step 3: Value the target with the acquisition motive built in.
Step 4: Choose the accounting method for the merger/acquisition - purchase or pooling.
Step 5: Decide on the mode of payment - cash or stock.

Evaluations

Implicit Motives

• Financing Mergers

The triangle in the figure provides a view of acquisition financing mechanism. As the options for financing the acquisition would increase, the layers in the triangle would also increase. But the basic question that arises or the consideration that comes is whether the transaction should be made in cash or stock as it has different effect on the various stakeholders of both the organizations the acquiring firm as well as the target firm. The influence of method of payment on post-merger financial performance is ambiguous.

Post merger performance maybe affected by the means of payment in the takeover. There are mainly two ways, in which mergers can be financed,

• Cash
• Stock

Using cash for payment helps the acquirer's shareholders to retain the same level of control over the company. Another obvious reason of financing mergers through cash is the simplicity and preciseness that gives a greater chance of success. Another advantage of using cash to the target's shareholders is that it is more certain in its value. Also, the recipients can spread their investments by purchasing a wide-ranging portfolio. There is also a disadvantage to target shareholders. They may be liable to pay capital gains tax. This is payable when a gain is realised.

• Estimating Cost When the Merger is Financed by Stock
  
  The cost depends on the value of the shares in the new company received by the shareholders of the selling company.

Cost = N * P of AB - PV of B

Where,
N = the number of shares received by the sellers
P of AB = price per share of the merged firm
PV of B = present value of B (selling firm)

Workings Of Mergers

1. Merger Accounting

A merger can be either treated as a purchase or a pooling of interests. Under this method, assets of the acquired firm must be reported at the fair market value on the books of the acquiring firm. Under this method, goodwill, which is the excess of the purchase price over the sum of the fair market values of the individual assets acquired, is generated. Under the second method, pooling of interests, the assets of the merged firm are valued at the same level as they were carried out in acquired and acquiring firms.

2. Tax Considerations

An acquisition can be taxable or tax-free. In a taxable acquisition, shareholders of the selling firm are treated for tax purposes as having sold their shares and are liable to pay tax on any capital gains or losses. In a tax-free acquisition, the selling shareholders are viewed as exchanged their old shares for similar ones, and they do not experience any capital gains or losses. The taxes paid by the merged firm also depend on the tax-status of the acquisition. There is no revaluation of assets in a tax-free acquisition, whereas, in a taxable acquisition, the assets are devalued and any increase or decrease is treated as a taxable gain or loss.

3. The Impact of Mergers

Mergers have a universal impact, practically everyone from society, shareholders, employees, and directors to financial institutions. Society can benefit from the merger if it results in producing goods at low costs due to economies of scale or improved management. The acquiring shareholders usually get poor returns and therefore very small average gains. However, target shareholders usually gain from mergers, as the acquirers have to pay a substantial premium over the pre-bid share price to convince target shareholders to sell. Employees may gain or lose from a merger activity. Mergers generate significant gains to the target firm's stockholders and buyers generally break even, there are positive benefits from mergers. The yardstick to measure a successful merger is the profit level. Profitability is the only overall significant identifier.