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In business or economics a merger is a combination of two companies into one larger company. Such actions are commonly voluntary and involve stock swap or cash payment to the target. Stock swap is often used as it allows the shareholders of the two companies to share the risk involved in the deal. A merger can resemble a takeover but result in a new company name (often combining the names of the original companies) and in new branding; in some cases, terming the combination a "merger" rather than an acquisition is done purely for political or marketing reasons.
Classifications of mergers
1. Horizontal merger - Two companies that are in direct competition and share the same product lines and markets. 2. Vertical merger - A customer and company or a supplier and company. Think of a cone supplier merging with an ice cream maker. 3. Market-extension merger - Two companies that sell the same products in different markets. 4. Product-extension merger - Two companies selling different but related products in the same market. 5. Conglomeration - Two companies that have no common business areas. There are two types of mergers that are distinguished by how the merger is financed. Each has certain implications for the companies involved and for investors: 1. Purchase Mergers - As the name suggests, this kind of merger occurs when one company purchases another. The purchase is made with cash or through the issue of some kind of debt instrument; the sale is taxable. Acquiring companies often prefer this type of merger because it can provide them with a tax benefit. Acquired assets can be written-up to the actual purchase price, and the difference between the book value and the purchase price of the assets can depreciate annually, reducing taxes payable by the acquiring company. We will discuss this further in part four of this tutorial.
2. Consolidation Mergers - With this merger, a brand new company is formed and both companies are bought and combined under the new entity. The tax terms are the same as those of a purchase merger. 3. Accretive mergers are those in which an acquiring company's earnings per share (EPS) increase. An alternative way of calculating this is if a company with a high price to earnings ratio (P/E) acquires one with a low P/E. 4. Dilutive mergers are the opposite of above, whereby a company's EPS decreases. The company will be one with a low P/E acquiring one with a high P/E.
However, on average and across the most commonly studied variables, acquiring firms' financial performance does not positively change as a function of their acquisition activity.[3] Therefore, additional motives for merger and acquisiiton that may not add shareholder value include: 1. Diversification: While this may hedge a company against a downturn in an individual industry it fails to deliver value, since it is possible for individual shareholders to achieve the same hedge by diversifying their portfolios at a much lower cost than those associated with a merger. 2. Manager's hubris: manager's overconfidence about expected synergies from M&A which results in overpayment for the target company. 3. Empire-building: Managers have larger companies to manage and hence more power. 4. Manager's compensation: In the past, certain executive management teams had their payout based on the total amount of profit of the company, instead of the profit per share, which would give the team a perverse incentive to buy companies to increase the total profit while decreasing the profit per share (which hurts the owners of the company, the shareholders); although some empirical studies show that compensation is linked to profitability rather than mere profits of the company.
the EPS then it should be avoided. It should be kept in mind that while analyzing the effect of the merger on the EPS not only immediate effect but also future effect should be considered 3. Dividend based valuation : dividend can be used to calculate the value of the shrae and thus the value of the firm can be calculated. The value can be calculated using the following formula : Value = D1 / (Ke - g) D1 = expected dividend Ke = cost of equity share G = Growth rate 4. Capital asset pricing model valuation: it can be used to value the shares of the company. This method is suitable when we need to estimate the initial listing of the shares and the market price of the unlevered firm 5. Cash flow model : in this method the valuation is based on the present value of the cash flows that arises due to the firm. It is the method which estimates the maxcimum pricxe that can be apid for the firm.
Financing M&A
Mergers are generally differentiated from acquisitions partly by the way in which they are financed and partly by the relative size of the companies. Various methods of financing an M&A deal exist:
Cash
Payment by cash. Such transactions are usually termed acquisitions rather than mergers because the shareholders of the target company are removed from the picture and the target comes under the (indirect) control of the bidder's shareholders alone. A cash deal would make more sense during a downward trend in the interest rates. Another advantage of using cash for an acquisition is that there tends to lesser chances of EPS dilution for the acquiring company. But a caveat in using cash is that it places constraints on the cash flow of the company.
Financing
Financing capital may be borrowed from a bank, or raised by an issue of bonds. Alternatively, the acquirer's stock may be offered as consideration. Acquisitions financed through debt are known as leveraged buyouts if they take the target private, and the debt will often be moved down onto the balance sheet of the acquired company.
Hybrids
An acquisition can involve a combination of cash and debt or of cash and stock of the purchasing entity.
2. If the amount is paid in the form of shares : in this case the cost of the merger is the difference between the post merger market value of the shares allotted to the shareholders of the tarhget company less the value of the target company
2. Revalue fixed assets: with the revaluation of the fixed assets the book value of the assets goes up thus increasing the value of the firm making the takeover more costly. 3. Super majority clause : make a claise in the memorandum or the articles that for Approving the amalgamation a very high majority is required 4. Poison pills : issue rights to shareholders to buy additional equity shares that may materialize in the event of the takeover resulting in the dilution of the stake of the predator 5. Composition of the boared : to protect the interest of the shareholders the company may realign the board so that they effectively present the shareholders and preserve their interests 6. Golden parachute : the incumbent management is entitled to receive faboulous compensation in the evnt of the takeover
Sell-offs
The sale of assets can consist of the entire company or of some business unit, such as a subsidiary, a smaller business unit, or a product line.
Spin offs
Similar to a sell off, a spin off involves a decision to divest a business unit such as a stand alone subsidiary or division. In a spin off, the business unit is not sold for cash or securities. Rather, common stock in the unit is distributed to the stock holders of the company on a pro rata basis, after which the operation becomes a completely separate company with its own traded stock. There is no tax to the stock holder at the time of the spin off, taxation occurs only when the stock is sold.
Leveraged Buyouts
Going private can be a straight transaction, where the investor group simply buys out the public stock holders, or it can be a leveraged buyout, where there are third-and sometimes fourth-party investors. As the name implies, a leveraged buyout represents an ownership transfer consummated primarily with debt. Sometimes called asset based financing, the debt is secured y the assets of the enterprise involved. While some leveraged buyouts involve the acquisition of an entire company, many involve the purchase of a division of a company or some other sub unit. Frequently, the sale is to the management of the division being sold, the company having decided that the division no longer fits its strategic objectives. Another distinctive feature is that leveraged buyouts are cash purchases, as opposed to stock purchases. Finally, the business unit involved invariably becomes a privately held as opposed to a publically held company.
Questions
Q.1 vehicles ltd. is the acquire and transporters ltd. is a target company. Basic information is as follows: Particulars vehicles transporters Earning per share (Rs.) 3.00 1.20 Next year DPS (Rs.) 1.00 0.75 Market price (Rs.) 40 15 Number of share 3000 1500 Present growth rate -5% Growth rate because of improvement to be brought about by vehicles ltd. -8% Proposals for merger are (a) either cash of 20 per share or (b) 1 share of vehicles for every 3 shares of transporters. Show the costs and gains for the two alternatives. Q.2 Company X is contemplating the purchase of company. Company X has 300000 shares having a market price of Rs.30 per share, which company Y has 200000 shares selling at Rs.20 per share. The EPS are Rs.4.00 and Rs.2.25 for company X and Y respectively. Managements of both companies are discussing two alternative proposals for exchange of shares as indicated below: (a) in proportion to the relative earning per share of two companies. (b) 0.5 share of company X for one share of company Y (0.50 : 1) You are required; (a) To calculate the earnings per share after merger under two alternatives and (b) To show the impact on EPS for the share holders of two companies under both the alternatives. Q.3 XYZ ltd. is considering merger with ABC ltd XYZ ltd. shares are currently traded at Rs.20. it has 250000 shares outstanding and its earnings after taxes amount to Rs.500000. ABC ltd has 125000 shares outstanding: its current market price is Rs.10 and its EAT are Rs.125000. 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. shares:
(a) What is the pre-merger earning per share and P/E ratio of both the companies? (b) If ABC ltd.s P/E ratio is 6.4, what is current market price? What will XYZ ltds post merger EPS be? (c) What should be the exchange ratio, if XYZ ltds pre merger and post merger EPS are to be the same?