DSS Case Study: A knowledge-based

Decision Support System for

enterprise mergers and acquisitions
Faculty of Computer Science and Engineering,
HCMC University of Technology
October 2011

Outline

1. Introduction
2. Mergers and acquisition method and
process
3. The architecture of the knowledge-based
DSS.
4. Conclusions
References

Introduction

The merger and acquisition offers incredible market

opportunities.
The main objectives of M&A are to capitalize on
gaps in the market, increase market share, improve
customer service, and eliminate local and global
competition, not simply to cut operation costs.
M&A have been applied in a wide range of
industries such as banking, communications, airline,
manufacturing, and service industries.
Because of the complexity and importance of M&A,
decision support systems are frequently used as
tools to support decision-making.

Mergers and acquisition method and

process

Merger means acquiring control of a target company through

stock purchases or exchange.
Mergers include the acquisition of the essential assets of a
company by another company or the acquisition of shares in a
company by another company.
Acquisition is the combining of two or more enterprises into
one through the purchasing of a target companys assets or
stocks.
Mergers can be divided into two types: absorptive merge and
creative merge. Absorptive merger means the target company
will be eliminated. Creative merger means that both
companies including the target company and the buying
company will be erased and then a new company will be
established.
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Ten actions by the acquiring firm to assure

success in M&A.

1. Set the companys long-term objectives

2. Select the means to achieve the objectives
3. Make sure that the proposed acquisitions can
achieve the objectives.
4. Establish candidate search procedures
5. Develop strategies and criteria for analyzing
potential acquisitions
6. Prepare negotiations with the target firm.
7. Prepare actual consummation of the acquisitions.
8. Plan the post-acquisition changes and integration.
9. Allocate budgets and responsibilities.
10. Exercise leadership and control.
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Figure 1.The process of mergers and acquisitions6

Five steps of M&A process

In practice, the M&A process can be broken
down into five steps:

1. Perform a pre-acquisition review

2. Search and screen the target company
3. Investigate and value the target
4. Acquire the target through negotiation
5. Perform post-merger integration

Step 1 - Pre-acquisition review

In this step, a pre-acquisition review is performed to

assess the companys own situation and decide whether
a M&A strategy should be adopted.
If the company finds that its difficult in the future to
maintain its core competencies, market share, return on
capital, etc., the a M&A program may be necessary.
If a company fails to protect its valuation, it may find itself
the target of a merger.
The main task in a pre-acquisition review process is to
determine if the desired growth rate of the target
company can be achieved in the future.

If not, an M&A program should establish a set of criteria whereby

the company can grow through acquisition.

Step 2: Search and Screen targets

The second step is to search for possible M&A candidates

Target companies must fulfill a set of criteria so that the
fitness of the target company is good to the acquirers.
The search and screening step process should be
performed in-house by the acquiring company.
This step consists of the following activities:

Develop a growth strategy defining the role of M&A.

Set criteria for candidate screening, evaluation and selection
Identify, collection information about and assess potential
candidates.
Determine which candidate offers the best fit for a deal.
Develop an action plan for executing the deal.

Step 3: Investigate and value the target

The step is to conduct more detailed analysis

of the target company.
This will require review of

Operations
Strategies
Financials
Other aspects

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Step 4 Acquire through negotiation

After the target company is selected, the process of

negotiating an M&A begins.
In this step, several key questions should be
considered:

How much resistance will come from the target company?

What are the M&A benefits for the target company?
What will be the bidding strategy?
How much does the acquirer offer in the first round of
bidding?

The most common M&A method used to acquire a

target company is for both companies to reach
agreement about the M&A.
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Step 5: Post-merger integration

In this step, the integration of two M&A partners is

achieved.
The post-merger integration step is the most difficult
phase.
This step requires extensive planning throughout the
entire organization.
The integration process can take places at three
levels:

Full: all functional departments

Moderate: some key departments
Minimal: some selected personnel

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The architecture of the knowledgebased decision support system (KDSS)

The KDSS for mergers and acquisitions is

composed of 6 components:

A database
A case base
A rule base
A model base
An inference engine
A user interface.

It provides users with a friendly and effective

interface to communicate with the system and find
alternative actions for decision-making.
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Figure 2. The knowledge based DSS for mergers and acquisitions

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The architecture of KDSS

The database provides all the information needed in

the model base and rule base for calculating,
analyzing and reasoning.
The rule base stores all the necessary rules for
supporting reasoning when the inference engine
performs forwarding chaining.
The model base employs critical statistical models to
analyze, forecast, or evaluate business value. In
KDSS, there are two models:

The discounted free cash flow

Economic profit models.
and adopt scenario analysis to perform business valuation.
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The case base helps the user deal with a new

problem while he/she faces a similar case.
The inference engine uses rules in the rule base
and data in the database to select suitable rules that
it can use to infer new knowledge or models to
predict or analyze the problem.

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The database

The database stores a collection of end user data

that consists of raw facts of interest to the end user
and meta data which are the data about data.
The meta data provide a description of the data
characteristics and relationships.
To manage data, answer ad hoc queries, gain better
access, and reduce data inconsistency, a DBMS is
required.
This approach uses Microsoft Access to create a
database and an ODBC driver to access the data in
the database.
The database contains all financial data used in the
models, cases, or rules.
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The database consists of 3 tables: Password,

FinancialData, and ModelParameters
The Password table is to verify user identification.
The FinancialData table provides diverse
information about a companys finance. The
attributes of FinancialData are Current_Liabilities,
Net_Operating_Capital, Current_Assets,
Net_Property_Plant_Equipment,
Other_Operating_Assets, Short_term_Investment,
Goodwill_amortization, Non_Operating_Investment,
market_price, stockholder_equity, debt_ration, etc.
The ModelParameter is used to provide a wide
range of variables for model analysis and
forecasting.

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The knowledge base

The knowledge base contains domain knowledge

useful for problem solving.
In order to use experiences effectively, knowledge
extraction and collection must be continually
performed.
The knowledge stored in the knowledge base is in
the form of rules or cases, which the inference
engine in the KDSS can quickly and accurately infer
and generate suggestions and actions.

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The rule base

There is a rule base in the knowledge base.

The rules in the rule base are represented as a set
of rules.
Each rule specifies a relation, directive, strategy,
and recommendation.
It is in the form of:
if <antecedent clauses> then <consequent
clauses>
If the antecedent clauses are true, then the
consequent clauses are true.

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Some rules:

Rule: 1
If Growth_Rate 30% of a similar industry then Type = Optimistic
Rule: 2
If 5% Growth_Rate 29% of a similar industry then Type =
Normal
Rule: 3
If -5% Growth_Rate 4% of a similar industry then Type =
Conservative
Rule: 4
If After_Merger_Business_Value 130%*
Before_Merger_Business_Value then Strong_Suggestion_to_Buy
Rule: 5
If 110%*Before_Merger_Business_Value
After_Merger_Business_Value <130%*
Before_Merger_Business_Value then Suggestion_to_Buy
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Rule: 6
If 100%*Before_Merger_Business_Value
After_Merger_Business_Value <110%*
Before_Merger_Business_Value then Suggestion_to_Wait
Rule:7
If Merger_Type = Electronic Industry then show Case 1
Rule: 8
If Merger_Type = Chemical Industry then show Case 2
Rule:9
If Choice = Discounted Free Cash Flow then execute Model1
Rule:10
If Choice = Economic Profit then execute Model2

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The case base

Beside a rule base, the KDSS also uses a case base in the
knowledge base.
The case base records all past cases of mergers and
acquisitions. For these cases, the basic financial data,
procedures, policies, legal issues, and other related problems are
evaluated, organized and saved in the case base.
There are four pairs of successful merger and acquisition
company, called X1Y1, X2Y2, X3Y3 and X4Y4, from Taiwans
electronic and chemical industries.
The four main cases in the current case base named CASE01,
CASE02, CASE03 and CASE04.
Each case links basic data, related regulations and taxes,
procedures, expert audits, and agreements, all organized in a
hierarchical format.

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Figure 3. The hierarchical structure of a case

representation

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Case base reasoning

Upon receiving a case, the KDSS first checks the

case base to determine if a similar case exists.
If so, the old case is used as guidance to solve the
case.
If not, the case is regarded as a new case, the
whole process is performed.
When the case is finished, it will be evaluated and
added in the case base if it exhibits good
performance

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The model base

A model base in a DSS provides at least one management

science model for analysis, evaluation, or forecasting.
The result produced by the model will be used by the
inference engine in the DSS to infer and suggest a feasible
solution based on the rules in the rule bases.
There are a number of models can be used in evaluating
business values:

Discounted cash flow (DCF) model

Economic profit model
Adjusted present value (APV) model
Equity DCF model

The first two models are most popular. Here, DCF model and
economic profit model are used.

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The discounted cast flow model

Companys Value
= Present Value of Cash Flow During Explicit Forcast Period + Present
Value of Cash Flow After Explicit Forcast Period

When the business enters the mature stage, we can assume that g = 0
and the Eq. (1) can be simplified as follows:

The definition of various variables in the above formulas are given as

follows:

(1) NOPLAT: Net operating Profit Less Adjusted Tax,

NOPLAT = EBIT(1 Tax Rate)
(2) EBIT: Earnings Before Interest and Taxes
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(3) ROIC: Return of Invested Capital

ROIC = NOPLAT/Invested Capital
(4) IC: Invested Capital
IC = Net Operating Capital (Current Assets Current Liabilities)
+ Net Property, Plant, and Equipment + Other Operating Assets
+ Short-term Investment + Goodwill Amortization+ Non-operating
Investment.
When the value of ROIC is high, it means the creative value on
the investment is high.
(5) g: Growth Rate in NOPLAT,
g = ROIC Net Investment Rate,
where
Net Investment = Net Invested Rate NOPLAT
(6) FCF: Free Cash Flow
FCF = NOPLAT + Depreciation Net Investment

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(7) WACC: Weight Average Capital Cost,

where WACC = WdKd(1-T) + WpKd + WsKs.
Wd: Debt Ratio = Liabilities/(Liabilities + Preferred Stock Equity
+ Common Stock Equity).
Wp: Preferred Stock Ratio = Preferred Stock Equity/(-Liabilities
+ Preferred Stock Equity + Common Stock Equity).
Ws: Common Stock Ratio = Common Stock Equity/(-Liabilities
+ Preferred Stock Equity + Common Stock Equity).
Kd = Cost of Debt = Debt i.
Kp: Cost of Preferred Stock = (if the target company does not
have this item, then ignore this item).
Ks : Cost of Common Stock

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Economic profit model

Companys value = Invested Capital + Present Value of Projected
Economic Profit = Invested Capital

The economic profit equals the spread between the return on invested
capital and the cost of capital times the amount of invested capital. The
model can be defined as follows:
Economic Profit:
= Invested Capital (ROIC WACC)

= NOPLAT Capital Charge

= NOPLAT (Invested Capital WACC)
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The reasoning mechanism

There are two kinds of reasoning. One is forward

chaining, and the other is backward chaining.
Backward chaining is goal-driven reasoning. In
backward chaining, the inference engine first has a
goal (hypothesis) and attempts to find evidence to
prove it. The inference engine starts by searching for
rules that might produce the desired solution and
achieve the goal in the THEN (action) parts.
Forward chaining is data-driven reasoning. Forward
chaining does not start from a hypothesis, but with
some confirmed findings.

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Conclusions

The KDSS system provides not only formal merger and

acquisition procedures, relevant law and regulations, but
also actions and feasible suggestions.
By using the system, managers can easily deal with
M&A decision-making problems via the Internet.
The system consists of a database, case-base, rulebase and model-base.
For assessing a businesss value, a discounted cash
flow model and economic profit model are provided in
the model base.

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References

1. W. Wen, W.K. Wang, T.H. Wang, A hybrid

knowledge based decision support system for
enterprise mergers and acquisitions, Expert
Systems with Applications, 28, 569-582 (2005).
2. K. Pal, O. Palmer, A decision support system for
business acquisitions, Decision Support Systems,
27, 411-429 (2000).

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