Mergers and Acquisitions Overview

M&A market trends Why acquire? Key concepts

Market-extension merger Two companies that sell the same products in different markets. Product-extension merger Two companies selling different but related products in the same market.

Why?
Gain market share Economies of scale Enter new markets Acquire technology Utilization of surplus funds Managerial Effectiveness Strategic Objective Vertical integration

Reasons for Mergers & Acquisitions 1) Increased Market Power:

It is intended to reduce the competitive balance of the industry.

2) Revamping production facilities:

To achieve economies of scale by amalgamating production facilities through more intensive utilization of plant and resources.

3) Financial strength:
To improve liquidity and have direct access to cash resource.

4) General gains:
To improve its own image and to offer better satisfaction to consumers or users of the product.

5) Procurement of supplies:
To obtain economies of purchase in the form of discount, savings in transportation costs, overhead costs in buying department, etc.

Conclusion

What works for the company is announced with much fanfare, but what remains hidden is that what does not work!!!

Why Mergers & Acquisitions Fail? 1) Integration Facilities:

Different Financial & Control Systems can make integration of firms difficult.

2) Large or Extraordinary Debt:

Costly Debt can create onerous burden on cash outflows.

3) Inadequate Evaluation of Target:

Inadequate Evaluation causes acquirer to overpay for the firm.

4) Inability to achieve synergy:

Justifying Acquisitions can increase estimate of expected benefits.

5) Overly Diversified:
Acquirer doesnt have expertise required to manage unrelated businesses

Key Drivers of a Successful Acquisition

What creates value in an acquisition? Why do some acquisitions fail? Academic research Can firms learn to acquire? Synergy

Attractiveness of Target Companies

Structure Asset Purchase Business Purchase Share Purchase A Mixture Apportionment of Risk No Hidden matters Remedy warranty Indemnity

Process of Acquisition
Finding A Target Business Appointing Advisers Negotiating terms Due Diligence Exchange of Contracts Completion

Business Resources Structure Culture Leadership Person M&A Strategy Objective

Taxation and Accountancy Considerations

Tension between Acquisition / sale of shares or assets. Due Diligence Tricky areas Accounting issues Accounting policies of the Target Accounting for Goodwill Fair value accounting Earnings per share Other Matters

Negotiating Terms
The nature of the fit Commonality of client base Financial strength Strategic intent Sharing of resources Applicable Benefits

Appointing Advisers
The Right Chemistry The Right Experience Size is not Everything Talk Your Language

Finding A Target Business

Synergy of Operations Help the Organizations to Achieve Strategic Objectives Enter new markets Vertical Integration

Acquisition Structure
Asset purchase Share purchase Merger Hostile Acquisition accounting fundamentals

Documentation and Agreements

Confidentiality agreement Letter of intent Stock purchase agreement Asset purchase agreement Fairness opinion

Sequence of Events
Initial negotiations to closing

How Does the Integration Process Affect Value Creation?

Pre merger planning Post merger planning

Managing for Value Creation

Key managerial success factors Merger planning - start at the top

Valuation
Appraisal Principles Valuation Methods

Taxation and Accountancy Considerations

Tension between Acquisition / sale of shares or assets. Due Diligence Tricky areas Accounting issues Accounting policies of the Target Accounting for Goodwill Fair value accounting Earnings per share Other Matters

Financing the Acquisition

Financing mix Consideration Methods of payment

VALUATION OF FIRMS IN MERGERS AND ACQUISITIONS

Motives and Determinants of Mergers

Synergy Effect
NAV= Vab (Va+Vb) P E Where Vab = combined value of the 2 firms

Vb = market value of the shares of firm B. Va = As measure of its own value P E = premium paid for B = expenses of the operation

Operating Synergy Financial Synergy

Diversification Economic Motives

Horizontal Integration Vertical Integration Tax Motives

FIRM VALUATION IN MERGERS AND ACQUISITIONS-2

Dividend Discount Models

D3 D1 D2 V0 !    ....... 2 3 1  k (1  k ) (1  k )
Where Vo = value of the firm Di k = dividend in year I = discount rate

FIRM VALUATION IN MERGERS AND ACQUISITIONS-3

The Constant Growth DDM
D0 (1  g ) D0 (1  g )2   ...... V0 ! 2 1 k (1  k )

And this equation can be simplified to:

V0 ! D0 (1  g ) D1 ! kg kg

where g = growth rate of dividends.

FIRM VALUATION IN MERGERS AND ACQUISITIONS-4

Price-Earnings Ratio
P0 1 PVGO ! 1  E1 k E/k

where PVGO = Present Value of Growth Opportunity

P0 E1 (1  b ) ! E1 k  ROExb
Implying P/E ratio

P0 1 b ! E1 k  ROExb
where ROE = Return On Equity

FIRM VALUATION IN MERGERS AND ACQUISITIONS-5

Cash Flow Valuation Models
The Entity DCF Model : The entity DCF model values the value of a company as
the value of a companys operations less the value of debt and other investor claims, such as preferred stock, that are superior to common equity . Value of Operations: The value of operations equals the discounted value of expected future free cash flow.

Continuing Value =
. Value of Debt
. Value of Equity

Net Operating Profit - Adjusted Taxes WACC

FIRM VALUATION IN MERGERS AND ACQUISITIONS-6

What Drives Cash Flow and Value? - Fundamentally to increase its value a company must do one or more of the following: . Increase the level of profits it earns on its existing capital in place (earn a higher return on invested capital). . Increase the return on new capital investment. . Increase its growth rate but only as long as the return on new capital exceeds WACC. . Reduce its cost of capital.

FIRM VALUATION IN MERGERS AND ACQUISITIONS-7

The Economic Profit Model:
The value of a company equals the amount of capital invested plus a premium equal to the present value of the value created each year going forward.
Economic Pr ofit ! Invested Capital x ( ROIC  WACC )
where ROIC = Return on Invested Capital WACC = Weighted Average Cost of Capital

Economic Pr ofit ! NOPLAT  ( Invested Capital x WACC )

where NOPLAT = Net Operating Profit Less Adjusted Taxes

Value=Invested Capital+Present Value of Projected Economic Profit

STEPS IN VALUATION
Analyzing Historical Performance
NOPLAT Invested Capital

Return on Investment Capital =

Economic Profit

NOPLAT (Invested Capital x WACC)

FCF

Gross Cash Flow Gross Investments

STEPS IN VALUATION-2
Forecast Performance
- Evaluate the companys strategic position, companys competitive advantages and disadvantages in the industry. This will help to understand the growth potential and ability to earn returns over WACC. - Develop performance scenarios for the company and the industry and critical events that are likely to impact the performance. - Forecast income statement and balance sheet line items based on the scenarios. - Check the forecast for reasonableness.

STEPS IN VALUATION-3
Estimating The Cost Of Capital S B P WACC ! kb (1- Tc )  k p  k s V V V
where kb Tc B kp P ks S = the pretax market expected yield to maturity on non-callable, non convertible debt = the marginal taxe rate for the entity being valued = the market value of interest-bearing debt = the after-tax cost of capital for preferred stock = market value of the preferred stock = the market determined opportunity cost of equity capital = the market value of equity

Develop Target Market Value Weights Estimate The Cost of Non-equity Financing Estimate The Cost Of Equity Financing

STEPS IN VALUATION-4
Estimating The Cost Of Equity Financing - CAPM

k s ! r f  E ( rm )  r f F
where rf E(rm) E(rm)- rf = the risk-free rate of return = the expected rate of return on the overall market portfolio = market risk premium = the systematic risk of equity

. Determining the Risk-free Rate (10-year bond rate) . Determining The Market Risk premium 5 to 6 percent rate is used for the US companies . Estimating The Beta

STEPS IN VALUATION-5
The Arbitrage Pricing Model (APM)
ks ! rf  E ( F1 )  rf F1  E ( F2 )  rf F 2  ....
where E(Fk ) = the expected rate of return on a portfolio that mimics the kth factor and is independent of all others. Beta k = the sentivity of the stock return to the kth factor.

STEPS IN VALUATION-6
Estimating The Continuing Value
- Selecting an Appropriate Technique . Long explicit forecast approach . Growing free cash flow perpetuity formula . Economic profit technique
CV = where Economic Profit T+1 = the normalized economic profit in the first year after the explicit forecast period. NOPLAT T+1 g ROIC WACC = the normalized NOPLAT in the first year after the explicit forecast period. = the expected growth rate of return in NOPLAT in perpetuity = the expected rate of return on net new investment. = weighted average cost of capital Economic Profit T+1 (NOPLATT+1 )( g / ROIC )( ROIC  WACC ) + WACC WACC (WACC  g )

STEPS IN VALUATION-7
Calculating and Interpreting Results - Calculating And Testing The Results - Interpreting The Results Within The Decision Context

Anti-takeover Mechanisms
Poison pills and other defensive measures Anti-trust Policies

 I believe this will be the first step in showing that Indian industry can step outside the shores of India in an international market place and acquit itself as a global player

- Ratan Tata
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