Tata McGraw-Hill Publishing Company Limited, Financial Management
The financial framework of merger covers three inter-related aspects:Determining the firms value, Financing techniques in merger and Analysis of the merger as a capital budgeting decision.
Impact of the merger on the earnings per share (EPS).
Example 1Company A is contemplating the purchase of Company B. Company A has 2,00,000 shares outstanding with Rs 25 market value per share while Company B has 1,00,000 shares selling at Rs 18.75.The EPS are Rs 3.125 for Company A and Rs 2.5 for Company B.Assuming that the two managements have agreed that the shareholders of Company B are to receive Company As shares in exchange for their shares (i) in proportion to the relative earnings per share of the two firms or (ii) 0.9 share of Company A for one share of Company B (share exchange ratio of 0.9: 1), illustrate the impact of merger on the EPSc (earnings per share of the combined firm). Also, compute the EPS after merger on the assumption that the anticipated growth rate in earnings is 8 per cent for Company A and 14 per cent for Company B.
SolutionTABLE 1 Merger Effect on EPS (Exchange Ratio in Proportion to Relative Earnings Per Share, 0.8 that is Rs 2.5/Rs 3.125)CompanyOriginal number of sharesEPSTotal earnings after taxesCol. 2 Col. 31234A2,00,000Rs 3.125 Rs 6,25,000B1,00,000 2.50 2,50,000Total post-merger earnings 8,75,000Number of shares after the merger: 2,00,000 + 80,000 i.e. (1,00,000 0.8) 2,80,000Earnings per share for Company A:1. Equivalent before the merger3.1252. After the merger (Rs 8,75,000/2,80,000)3.125Earnings per share for Company B:1. Before the merger 2.502. Equivalent EPS after the merger: (EPS after the merger Share exchange ratio) i.e Rs 3.125 0.82.50
TABLE 2Merger Effect on EPS (Exchange ratio, 0.9 : 1)(1) Total post-merger earnings (EPSc)Rs 8,75,000(2) Number of shares after the merger: (2,00,000 + 90,000 i.e (0.9 1,00,000)2,90,000(3) Earnings per share: (Rs 8,75,000 Rs 2,90,000) 3.017(4) Company As shareholders EPS before the merger3.125 EPS after the merger3.017 Dilution in EPS(0.108)(5) Company Bs shareholders EPS before the merger 2.50 Equivalent EPS after the merger (EPS after the merger share exchange ratio),i.e (Rs 3.017 0.9) 2.715 Accretion in EPS0.215
TABLE 3Projections of Earnings Per ShareYearPost-merger earningsPost-merger EPSAccretion (Dilution) in EPSCompany A (8% growth)Company B (14% growth)Total earnings(A + B)CombinedEPS Col. 4 2,90,000aCompany A Col.2 2,00,000Company B Col.3 90,000bCompanyACompanyB1234567891Rs 6,25,000Rs 2,50,000Rs 8,75,000Rs 3.02Rs 3.13Rs 2.78Rs (0.11)Rs 0.2426,75,0002,85,0009,60,0003.313.383.17(0.01)0.2037,29,0003,24,90010,53,9003.633.653.61(0.02)0.0247,87,3203,70,38611,57,7063.993.944.110.05(0.12)58,50,3064,22,24012,72,5464.394.254.690.14(0.30)69,18,3304,81,35413,99,6844.834.595.340.24(0.51)a. 2,00,000 shares of Company A + 90,000 of Company B i.e. (1,00,000 0.9, exchange ratio).b. 0.9 1,00,000 shares of Company B = 90,000 equivalent shares in Company A.
To summarise the discussion relating to earnings per share approach to determine the value of a firm, when the share exchange ratio is in proportion to the EPS, there is no affect on the EPS of the acquiring/surviving firm as well as on the acquired firm (Table 1). When, however, the share exchange ratio is different, it may result in dilution in the EPS of the acquiring firm and accretion in the EPS of the acquired firm (Table 2). For management of a firm considering acquiring another firm, a merger that results in dilution in EPS should be avoided. However, the fact that the merger immediately dilutes a firms current EPS need not necessarily make the transaction undesirable. Such a criterion places undue emphasis upon the immediate effect of the prospective merger on the EPS. In examining the consequences of the merger upon the surviving concerns EPS, the analysis should be extended into future periods and the effect of the expected future growth rate in earnings should also be included in the analysis (Table 3) The dilution in the EPS of company A is more than offset by accretion in the EPS, with effect from year 4.
Financing Techniques in MergersThe alternative methods of financing mergers/payment to the acquired company are:Ordinary share financing, Debt and preference share financing, Convertible securities, Deferred payment plan and Tender offers.Ordinary Share FinancingWhen a company is considering the use of common (ordinary) shares to finance a merger, the relative price-earnings (P/E) ratios of two firms are an important consideration. For instance, for a firm having a high P/E ratio, ordinary shares represent an ideal method for financing mergers and acquisitions. Similarly, ordinary shares are more advantageous for both companies when the firm to be acquired has a low P/E ratio. This fact is illustrated in Table 4
TABLE 4Effect of Merger on Firm As EPS and MPS(a) Pre-merger Situation:Firm AFirm BEarnings after taxes (EAT) (Rs)5,00,0002,50,000Number of shares outstanding (N)1,00,00050,000EPS (EAT N) (Rs)55Price-earnings (P/E) ratio (times)104Market price per share, MPS (EPS P/E ratio) (Rs) 5020Total market value of the firm (N MPS) or (EAT P/E ratio) (Rs)50,00,00010,00,000(b) Post-merger Situation: Assuming share exchange ratio as 1: 2.5*1:1EATc of combined firm (Rs) 7,50,0007,50,000Number of shares outstanding after additional shares issued 1,20,0001,50,000EPSc (EATc N) (Rs) 6.255P/Ec ratio (times) 1010MPSc (Rs) 62.5050Total market value (Rs)75,00,00075,00,000* Based on current market price per share
The exchange ratio eventually negotiated/agreed upon would determine the extent of merger gains to be shared between the shareholders of the two firms. This ratio would depend on the relative bargaining position of the two firms and the market reaction of the merger move.
TABLE 5Apportionment of Merger Gains Between the Shareholders of Firms A and B(1)Total market value of the merged firm Less: Market value of the pre-merged firms: Firm A Firm B Total merger gains(2)(a)Apportionment of gains (assuming share exchange ratio of 2.5:1) Firm A: Post-merger market value (1,00,000 shares Rs 62.50) Less: Pre-merger market value Gains for shareholders of Firm A Firm B: Post-merger market value (20,000 shares Rs 62.50) Less: Pre-merger market value Gains for shareholders of Firm B(b) Assuming share exchange ratio of 1:1 Firm A: Post-merger market value (1,00,000 shares Rs 50) Less: Pre-merger market value Gains for shareholders of Firm A Firm B: Post-merger market value (50,000 shares Rs 50) Less: Pre-merger market value Gains for shareholders of Firm B
Rs 50,00,00010,00,000Rs 75,00,000
TABLE 6 Determination of Tolerable Share Exchange Ratio for shareholders of Firms, Based on Total Gain Accruing to Shareholders of Firm A(a) Total market value of the merged firm (Combined earnings, Rs 7,50,000 P/E ratio, 10 times) Rs 75,00,000
(b) Less: Pre-merger or minimum post-merger value acceptable to shareholders of Firm B 10,00,000(c) Post-merger market value of Firm A (a b)65,00,000(d) Divided by the Number of equity shares outstanding in Firm A1,00,000(e) Desired post-merger MPS (Rs 65 lakh/1 lakh shares)Rs 65(f) Number of equity issues required to be issued in Firm A to have MPS of Rs 65 and to have post-merger value of Rs 10 lakh of Firm B, that is, (Rs 10 lakh/Rs 65)
15,385(g) Existing number of equity shares outstanding of Firm B50,000(h) Share exchange ratio (g)/(h) i.e. 50,000/15,385 For every 3.25 shares of Firm B, 1 share in Firm A will be issued1 : 3.25Note: Share exchange ratio of 1:1 (shown in Table 5) can also be determined on the basis of procedure shown in Table 6.
Merger as a Capital Budgeting DecisionMerger as a capital budgeting decision involves the valuation of the target firm in terms of its potentials to generate incremental future free cash flows (FCFF) to the acquiring firm.These cash flows are then to be discounted at an appropriate rate that reflects the riskiness of the target firms business. The cost of acquisition is deducted from the present value of FCFF. Themerger proposal is financially viable in case the NPV is positive. The finance manager can usesensitivity analysis to have a range of NPV values within which the acquisition price may vary.
(i) Determination of Incremental Projected Free Cash Flows to The Firm (FCFF)These FCFF should be attributable to the acquisition of the business of the target firm. Format 1 contains constituent items of such cash flows.FORMAT 1Determination of FCFFAfter-tax operating earningsPlus: Non-cash expenses, such as depreciation and amortisationLess: Investment in long-term assetsLess: Investment in net working capitalNote: All the financial inputs should be on incremental basis.
(ii) Determination of Terminal Value(a) When FCFF are likely to be constant till infinity:TV = FCFFT + 1/K0(4)Where FCFFT + 1 refers to the expected FCFF in the first year after the explicit forecast period.(b) When FCFF are likely to grow (g) at a constant rate:TV = FCFFT (1 + g)/ (K0 g)(5)(c) When FCFF are likely to decline at a constant rate:TV = FCFFT (1 g)/ (K0 + g)(6)
(iii) Determination of Appropriate Discount Rate/Cost of CapitalIn the event of the risk complexion of the target firm matching with the acquired firm (say in the case of horizontal merger and firms having virtual