Where in a deal between two or more companies in the exchange of securities where just one survives it is a merger. M&As finish off with many benefits to both the acquiring and the target company. There are three types of merger. Mergers take place mainly to lessen the competition, economies of scale, tax advantage, etc.
Any business has a crucial objective of profitable growth. This can be achieved internally or externally. Internally it can be achieved either by introducing or developing new products or services or by capacity expansion. Externally it can be done by acquisition of existing business of the following kinds.
1. Absorption
2. Amalgamation
3. Combinations
4. Merger
5. Takeover
6. Demergers.
Though legally they are totally different but for financial considerations these terms are used interchangeably.
Merger happens when two or more companies combine into one. That is, only one company survives. Acquisition is a purchase of a company or a part of it so that the acquired company is completely absorbed by the acquiring company and thereby no longer exists as a business entity.
With the increase in liberalisation, privatization and globalization (LPG) over the last two decades in India and market becoming more vibrant and competitive, companies enter or exit at their prerogative. Consequently, companies must go all-out to consolidate their positions and improve upon the market share. They use M&As keeping these end objectives in mind.
There are three types of mergers:
1. Horizontal Merger
2. Vertical Merger
3. Conglomerate Merger
Horizontal Merger
When two or more corporate firms dealing in similar lines of business combine thena horizontal merger takes place. Its purpose is removal or decrease in competition, putting an end to price cutting, economies of sale in production, research and development, marketing and management, etc.
Vertical Merger
When a company acquires its upstream and/or down-stream then vertical merger happens. In the former, it extends to the suppliers of raw materials and in the case of the latter, to those companies that sell eventually to the consumer. The purpose is lower buying cost of materials, lower distribution costs, assured supplies and market, increasing or creating barriers to entry for potential competitors.
Conglomerate Merger
In marked contrast, conglomerate merger is a type of combination where a company established in one industry combines with another in an unrelated industry. Such merger moves for diversification of risk constitutes the rationale.
The following are important reasons for M&As.
Economies of Scale
The combined business can have larger volume than the individual firm and enjoy economies of scale. M&As help the company to produce the goods more economically through full capacity utilisation.
Synergy
The value of the company formed through merger will be more than the sum of the value of the individual companies just merged.
Diversification of risk
When a company produces a single product or service then its profits and cash flows fluctuate widely. This increases its risk. But diversification reduces it. So for a company whose earnings are of a different nature it would be helpful. The merger of companies whose earnings are negatively correlated will bring stability in the earnings of the combined firm. So diversification reduces the risk of the firm.
Growth
This is possible in two ways— external and internal. M&As help the company to grow quickly without any gestation period.
Reduction in income tax liability
Under Income-tax act there is a provision for set off and carry for-ward of losses. A sick company may not be in a position to earn sufficient profits in future to take advantage of the carry forward position. So with its accumulated losses it may like some profitable company to merger with it to take advantage of tax benefits. Even the sick company with accumulated losses may be merged with a profitable company and take advantage of income tax benefits with the approval of Government.
Increase market share and reduce competition
Mergers help companies to reduce competition and increase their market share.
Financial synergy
The following are the financial synergy available in the case of mergers.
Better credit worthiness: This helps the company to obtain credit from suppliers, bank finance and easily raise capital.
Reduces the cost of capital: The prospective investors consider big companies as safe and hence they would expect a lower rate of return for their capital. So the cost of capital reduces post-merger.
Increases the debt capacity: After the merger the earnings and cash flows become more stable than before. This increases the capacity of the company to borrow more funds.
Increases the P/E ratio and value per share: The liquidity and marketability of the security increases after the merger. The growth rate as well as earnings of the firm will also increase due to various economies post-merger. All these help the company to enjoy higher P/E in the market.
Low floatation cost: Small companies have to spend higher percentage of the issued capital as floatation cost when compared to a big firm.
Raising of capital: After the merger due to increase in the size of the company and better credit worthiness and reputation, the company can easily raise the capital at any time.
Corporate restructuring
Corporate restructuring can occur in a numerous ways. Companies resort to many activities that lead to expansion, sell off and change in ownership and control. Though the classification is some what arbitrary, it helps in clarifying the emphasis of the
various restructuring practices. The objective of corporate restructuring is to fight competition and conduct business in an efficient and effective manner, so as to consolidate the position of the business.
Financial considerations in merger and acquisitions
A merger can finance by cash or exchange of shares or combinations of cash, shares and debentures.
Cash offer
Here the shareholder of the largest company is paid cash in exchange of their shares in the target company.
Share exchange
Here the acquiring company issues shares to the shareholders of the target company in exchange.
Exchange ratio
The determination of the exchange ratio is based on the value of shares of the companies involved in the merger. The basic objective of financial management is to maximise the shareholder's wealth even the merger decision is to be taken in the light of wealth maximisation.
Summary and Conclusion
M&As are an alternative route to profitable growth. The major financial advantages of mergers are: economies of scale, synergy, tax benefits, diversification, etc. The focus of the analysis of M&As is on the financial framework covering three major as-pects: (1) determining the firm's value, (2) financing technique in merger and (3) merger as a capital budgeting decision. Determining the worth of a firm is the first step. It is a difficult task also. In estimating the value of a firm, several factors are considered in conjunction with one another. The book value although not an effective measure by itself, is useful in specific situations. The appraisal value may or may not be a good indicator to be paid for a company. Its merit depends upon the approach taken and nature of business. The market value is a key element in valuing the firm particularly in the cases of large listed corporate firms. The EPS is an important criterion for merger decisions. However, the worth of a firm should not be determined on the basis of a single approach and a single figure, but within a range on the basis of a consideration of all the alternative approaches. The second aspect of merger is the mode of financing. In the case of a firm having a high P/E ratio, issue of equity shares is advantageous both to the acquiring and acquired firms. To meet the investment needs of different types of investors, convertible securities can also be issued. Yet another form of financing merger is the deferred-payment plan. The tender offer is another alternative to acquire firms. The purchasing firm directly approaches the shareholders of the target firm. This approach may be cheaper provided that the management of the target firm does not attempt to block it. The capital budgeting framework can also be applied to evaluate merger decisions.
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