Download ppt - M&a Practicals

M&AM&A

PracticalsPracticals

Financial FrameworkFinancial Framework

The financial framework of merger covers three

inter-related aspects:

1) Determining the firm’s value,

2) Financing techniques in merger and

3) Analysis of the merger as a capital

budgeting decision.

Impact of the merger

on the earnings per share (EPS).

Example 1

Company 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 A’s 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.

Solution

TABLE 1 Merger Effect on EPS (Exchange Ratio in Proportion to Relative Earnings Per Share, 0.8 that is Rs 2.5/Rs 3.125)

Company Original number of shares

EPS Total earnings after taxes

Col. 2 × Col. 3

1 2 3 4

A 2,00,000 Rs 3.125 Rs 6,25,000

B 1,00,000 2.50 2,50,000

Total post-merger earnings 8,75,000

Number of shares after the merger: 2,00,000 + 80,000 i.e. (1,00,000 × 0.8)

2,80,000

Earnings per share for Company A:

1. Equivalent before the merger 3.125

2. After the merger (Rs 8,75,000/2,80,000) 3.125

Earnings per share for Company B:

1. Before the merger 2.50

2. Equivalent EPS after the merger: (EPS after the merger × Share exchange ratio) i.e Rs 3.125 × 0.8 2.50

TABLE 2 Merger 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 A’s shareholders

EPS before the merger 3.125

EPS after the merger 3.017

Dilution in EPS (0.108)

(5) Company B’s 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 EPS 0.215

TABLE 3 Projections of Earnings Per Share

Y

e

a

r

Post-merger earnings Post-merger EPS Accretion

(Dilution)

in EPS

Company

A

(8% growth)

Company

B

(14% growth)

Total

earnings

(A + B)

Combined

EPS Col. 4

÷

2,90,000a

Company

A

Col.2 ÷

2,00,000

Company

B

Col.3 ÷

90,000b

Company

A

Company

B

1 2 3 4 5 6 7 8 9

1 Rs 6,25,000 Rs 2,50,000 Rs 8,75,000 Rs 3.02 Rs 3.13 Rs 2.78 Rs (0.11) Rs 0.24

2 6,75,000 2,85,000 9,60,000 3.31 3.38 3.17 (0.01) 0.20

3 7,29,000 3,24,900 10,53,900 3.63 3.65 3.61 (0.02) 0.02

4 7,87,320 3,70,386 11,57,706 3.99 3.94 4.11 0.05 (0.12)

5 8,50,306 4,22,240 12,72,546 4.39 4.25 4.69 0.14 (0.30)

6 9,18,330 4,81,354 13,99,684 4.83 4.59 5.34 0.24 (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 firm’s 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 concern’s 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 Mergers

The alternative methods of financing mergers/payment to the acquired company are:

1) Ordinary share financing,

2) Debt and preference share financing,

3) Convertible securities,

4) Deferred payment plan and

5) Tender offers.

Ordinary Share Financing When 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 4 Effect of Merger on Firm A’s EPS and MPS

(a) Pre-merger Situation:

Firm A Firm B

Earnings after taxes (EAT) (Rs) 5,00,000 2,50,000

Number of shares outstanding (N) 1,00,000 50,000

EPS (EAT ÷ N) (Rs) 5 5

Price-earnings (P/E) ratio (times) 10 4

Market price per share, MPS (EPS × P/E ratio) (Rs) 50 20

Total market value of the firm (N × MPS) or (EAT × P/E ratio) (Rs) 50,00,000 10,00,000

(b) Post-merger Situation:

Assuming share exchange ratio as

1: 2.5* 1:1

EATc of combined firm (Rs) 7,50,000 7,50,000

Number of shares outstanding after additional shares issued 1,20,000 1,50,000

EPSc (EATc ÷ N) (Rs) 6.25 5

P/Ec ratio (times) 10 10

MPSc (Rs) 62.50 50

Total market value (Rs) 75,00,000 75,00,000

* 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 5 Apportionment 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 50,00,00010,00,000

Rs 75,00,000

60,00,00015,00,000

62,50,00050,00,00012,50,000

12,50,00010,00,000

2,50,000

50,00,00050,00,000 NIL

25,00,00010,00,00015,00,000

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 A 1,00,000

(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 B 50,000

(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 issued 1 : 3.25

Note: 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 firm’s business.

The cost of acquisition is deducted from the present value of FCFF.

The merger proposal is financially viable in case the NPV is positive. The finance manager can use sensitivity 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 1 Determination of FCFF

After-tax operating earnings

Plus: Non-cash expenses, such as depreciation and amortisation

Less: Investment in long-term assets

Less: Investment in net working capital

Note: 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 Capital In 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 virtually identical debt-equity ratio), the acquiring firm can use its own weighted average cost of capital (k0) as discount rate. In case the risk complexion of the acquired firm is different, the appropriate discount rate is to be computed reflecting the riskiness of the projected FCFF of the target firm.

(iv) Determination of Present Value of FCFF The present value of FCFF during the explicit forecast period [as per step (i)] and of terminal value [as per step (ii)] is determined by using appropriate discount rate [as per step (iii)].

(v) Determination of Cost of Acquisition The cost of acquisition is determined

as per Format 2.

FORMAT 2 Cost of Acquisition

Payment to equity shareholders (Number of equity shares issued in acquiring

company × Market price of equity share)

Plus:Payment to preference shareholders

Plus:Payment to debenture-holders

Plus:Payment of other external liabilities (say creditors)

Plus:Obligations assumed to be paid in future

Plus:Dissolution expenses (to be paid by acquiring firm)

Plus:Unrecorded/contingent liability

Less: Cash proceeds from sale of assets of target firm (not to be used in

business after acquisition)

Example 2 The Hypothetical Limited wants to acquire Target Ltd. The balance sheet of Target Ltd. as on March 31 (current year) has the following assets and liabilities:

(Rs lakh)

Liabilities Amount Assets Amount

Equity share capital

(4 lakh shares of Rs. 100 each) Rs 400 Cash Rs 10

Retained earnings 100 Debtors 65

10.50% Debentures 200 Inventories 135

Creditors and other liabilities 160 Plant and Equipment

650

860 860

Additional information: (i) The shareholders of Target Ltd. will get 1.5 share in Hypothetical Ltd. for every

2 shares; the shares of the Hypothetical Ltd. would be issued at its current market price of Rs 180 per share. The debenture-holders will get 11% debentures of the same amount. The external liabilities are expected to be settled at Rs 150 lakh. Dissolution expenses of Rs 15 lakh are to be met by the acquiring company.

(ii) The following are projected incremental free cash flows (FCFF) expected from acquisition for 6 years (Rs lakh):

Year-end 123456

Rs 150200260300220120

(iii) The free cash-flow of Target limited is expected to grow at 3 per cent per annum, after 6 years.

(iv) Given the risk complexion of Target limited, cost of capital relevant for Target limited cash flows has been decided at 13 per cent.

(v) There is unrecorded liability of Rs 20 lakh.

Advise the company regarding financial feasibility of the acquisition

Solution

TABLE 7 Financial Evaluation of Merger Decision

(i) Cost of Acquisition (t = 0) (Rs lakh)

Share capital (3,00,000 shares × Rs 180)11% DebenturesSettlement of external liabilitiesUnrecorded liabilityDissolution expenses of Target firm

Rs 540200150 20

15925

(ii) PV of Free Cash Inflows (years = 1 – 6) (Rs lakh)

Year-end FCFF PV factor (0.13)

Total PV

1 Rs 150 0.885 Rs 132.75

2 200 0.783 156.60

3 260 0.693 180.18

4 300 0.613 183.90

5 220 0.543 119.46

6 120 0.480 57.60

830.49

(iii) PV of FCFF After the Forecast Period (Referred to as Terminal Value, TV)

TV6 = FCFF6 (1 + g)/(k0 – g)

= Rs 120 lakh (1.03)/(0.13 – 0.03) = Rs 123.6/0.1 = Rs 1,236 lakh

PV of TV = Rs 1,236 lakh × 0.480 = Rs 593.28 lakh

(iv) Determination of Net Present Value

PV of Free cash flows (years 1 – 6) Rs 830.49 lakh

PV of Free cash flows subsequent to year 6 593.28

Total PV of benefits/FCFF 1,423.77

Less: Cost of acquisition 925.00

Net present value 498.77

Recommendation As the NPV is positive, acquisition of Target limited is

financially viable.

Example 3 Would your decision for acquiring Target limited (in Example 2)

change, if FCFF after the forecast period are assumed to be (a) constant and (b)

decline by 10 per cent per annum after 6 years.

Solution

TABLE 8 Determination of NPV, When FCFF are Constant after year-6 (Rs lakh)

PV of FCFF (years 1 – 6) Rs 830.49

PV of FCFF (subsequent to year 6) 443.08*

Total PV of benefits 1,273.57



* Determination of PV related to TV:

TV = FCFF6/k0 = Rs 120 lakh/0.13 = Rs 923.08 lakh

PV = Rs 923.08 lakh × 0.480 = 443.08 lakh

TABLE 9 Determination of NPV when FCFF are Expected to Decline at 10 per

cent after year 6 (Rs lakh)

PV of FCFF (years 1 – 6) Rs 830.49

PV of FCFF (subsequent to year 6) 225.39*

Total PV of benefits 1,055.88



* Determination of PV related to TV:

TV = FCFF6(1 – g)/(k0 + g) = Rs 108 lakh/(0.13 + 0.10) = Rs 469.57 lakh

PV = Rs 469.57 lakh × 0.480 = Rs 225.39

Recommendation Since the NPV is positive in both the situations, the merger

proposal continues to be financially viable.

Adjusted Present Value (APV) Approach

Adjusted Present Value a variant of DCF, is value of the target

company if it were entirely financed by equity plus the value of the

impact of debt financing in terms of the tax benefits as well as

bankruptcy cost.

The APV based valuation has its genesis in the Modigliani-Miller (MM)

propositions on capital structure, according to which in a world of no

taxes, the valuation of the firm (the sum of equity and debt) is

independent of capital structure (change in debt/equity proportion).

In other words, the capital structure can affect the valuation only

through taxes and other market imperfections and distortions.

Example 4 For the facts in Example 2, compute the value of Target Limited based on the APV approach, given the cost of unlevered equity as 16 per cent, perpetual debentures and a corporate tax rate of 35 per cent. Ignore bankruptcy costs. Also estimate the NPV.

Solution

TABLE 10 (i) PV of FCFF, Discounted at Unlevered Cost of Equity (ku)

Year-end FCFF PV factor (0.16) Total PV

1 Rs 150 0.862 Rs 129.30

2 200 0.743 148.60

3 260 0.641 166.66

4 300 0.552 165.60

5 220 0.476 104.72

6 120 0.410 49.20

764.08

(ii) PV of FCFF After the Forecast Period/Terminal Value (Rs lakh)

TV6 = FCFF6 (1 + g)/(ku – g)

= Rs 120 lakh (1.03)/(0.16 – 0.03) = Rs 950.77 lakh

PV of TV = Rs 950.77 lakh × 0.410 = Rs 389.82 lakh

(iii) PV of Tax Savings Due to Interest (Rs lakh)

Amount of Debt (11% Debentures) Rs 200

Amount of interest (Rs 200 lakh × 0.11) 22

Tax savings (Rs 22 lakh per year × 0.35 tax rate) 7.7

Present value of tax shield (Rs 7.7 lakh/0.11) 70.0

TABLE 11 (iv) Adjusted Present Value and NPV of Target Limited (Rs lakh)

(i) PV of FCFF (years 1 – 6) Rs 764.08

(ii) PV of terminal value 389.82

(iii) PV of tax shield 70.00

Total adjusted present value 1223.90



Annexure 1 below contains the gist of the scheme of merger of Reliance Pertrochemicals Ltd with Reliance Industries Ltd. The demerger scheme of DCM Ltd is outlined in Annexure 2 below.

Annexure 1 Merger of Reliance Pertrochemicals Ltd (RPL) with Reliance Industries Ltd (RIL)

The merger of RPL with RIL in March 1992 was the biggest ever merger till date and resulted in the creation of the largest Indian corporate. RIL was engaged in the manufacture and sale of textiles, fibre and fibre intermediates and petrochemicals. In particular, it was engaged in the manufacture of polyester staple fibre (PSF), polyester filament yearn (PFY), purified teraphtalic acid (PTA), linear alkyl benzene (LAB) and other products. Its paid-up capital (Rs 157.94 crore) consisted of (i) equity capital, Rs 152.14 crore (15.21 crore shares of Rs 10 each) (ii) 11 per cent cumulative redeemable preference shares of Rs 100 each, Rs 30 lakh; and 15 per cent cumulative redeemable preference shares of Rs 100 each, Rs 5.5 crore.

The RPL was incorporated in November 1988 with the main objective of manufacturing poly vinyl chloride (PVC), mono ethylene glycol (MEG) and high density poly ethylene (HDPE). Its paid-up equity capital stood at Rs 749.30 crore consisting of 74.93 crore shares of Rs 10 each.

In terms of a scheme of amalgamation approved by the shareholders of the two companies and Mumbai and Gujarat High Courts in July/August 1992, the RPL was merged with the RIL with effect from March 2, 1992. The merger was aimed to enhance shareholders’ value by realising significant synergies of both the companies. Liberalization of government policy and the accompanying economic reforms created this opportunity for the RIL’s shareholders.

As per the scheme of amalgamation, the expected benefits of merger to the amalgamated entity, inter-alia, were:

Benefit from diversification as the risks involved in the operation of different units would be minimised

Business synergy due to economies of scale and integrated operations Higher retailed earning leading to enhanced intrinsic values of shareholding to investors. The

capital requirement would also be at manageable levels Strong fundamentals which would enhance its credit rating and resource raising ability in

financial markets, both national and international

The exchange ratio was one equity share of Rs 10 each in RIL for every 10 equity shares of RPL with a par value of Rs 10 each. The exchange ratio was based on the expert valuation made by three reputed firms of chartered accountants, namely, S.B. Billimoria & Co, Choksi & Co and Heribhakthi & Co. Pursuant to the above, 7,49,26,428 equity shares of Rs 10 each were issued as fully paid-up to the shareholders of RIL without payment being received in cash.

All the assets, liabilities and obligations of RPL were taken over by the merged entity—RIL. The excess of assets over liabilities takenover by RIL consequent on the amalgamation less the face value of the equity shares issued to the shareholders of the RPL represented amalgamation reserve. All the employees of RPL on the date immediately preceding the effective date became the employees of the RIL.

The post-merger scenario of the RIL is reflected in the increase in its capital, turnover, net profit and equity dividend. Compared to the pre-merger capital of Rs 157.94 crore, the post-merger capital rose to Rs 358.74 crore. The turnover increased from Rs 2,298 crore in 1991–92 to Rs 7,019 crore in 1994–95. Net profit of RIL stood at Rs 10,651 crore in 1994–95 compared to Rs 163 crore in 1991–92. The equity dividend rose phenomenally to 55 per cent (1994–95) from 30 per cent (1991–92). The RIL emerged post-merger as a mega corporation and became a global player. Its foreign exchange earnings in 1994–95 aggregated Rs 174 crore.

CONTD.

Annexure 2 Demerger of DCM Ltd

DCM Ltd, promoted by Late Shri Ram in 1889, has become a conglomerate of 13 units with multifarious manufacturing activities in sugar, textile, chemicals, ryon tyre cord, fertilisers and so on. These units on their own being of the size of independent companies, the directors felt that greater focus on the operation of the various units of the company would result in substantial improvement in the results of their operations. The post-reorganisation slogan would be: “The Trimmer We Are, The Faster We Are”.

On the basis of the various discussions, meetings, consultations between the members of the Board of Directors, financial institutions and consultants, it was decided to take appropriate steps to carry on the business of various units more effectively and efficiently in the larger interest of shareholders, debentureholders, creditors, employees and in the general public interest. To achieve the objective of carrying the business of DCM Ltd more smoothly and profitably, DCM Ltd was reorganised by dividing its business among four companies having shareholders with the same interest inter-se in DCM but to be managed and operated independently (Exhibit 1).

EXHIBIT 1 Division of DCM Ltd.

1. DCM Ltd comprising DCM Mills (DCM Estate) DCM Engineering Products, DCM Data Products, Hissar Textiles Mills, Shri Ram Fibres Ltd, and DCM Toyota Ltd.

2. DCM Shri Ram Industries Ltd comprising Shri Ram Rayons, Daurala Sugar Works, and Hindon River Mills.

3. DCM Shri Ram Consolidated Ltd comprising Shri Ram Fertilises and Chemicals Industries Ltd, Shri Ram Cement Works Ltd, Swatantra Bharat Mills Ltd, and DCM Silk Mils Ltd.

4. Shri Ram Industrial Enterprises Ltd comprising Shri Ram Food and Fertilisers Ltd, and Mawana Sugar Works Ltd.

The division of DCM Ltd took place through the scheme of arrangement approved by the Delhi High Court on April 16, 1990 according to which three new companies were formed. The scheme of arrangement became effective from April 1, 1990. The four companies thereafter started operating independently, each with their respective Boards of Directors.

Some of the notable features of the scheme of reorganisation of the erstwhile DCM Ltd into four companies were:

The total paid-up capital of Rs 23 crore was divided equally.The allocation of various assets and liabilities among them was done as

under:

DCM ShriRam

IndustriesLtd

DCM ShriRam

ConsolidatedLtd

Shri RamIndustrial

EnterprisesLtd

DCM Ltd

Fixed deposits 16% 33% 36% 15%

Debentures 16% 12% 36% 36%

Common assets/liabilities/

income/benefit 16.66% 16.66% 33.33% 33.33%

Expenses and cost of arrangement

16.66% 16.66% 33.33% 33.33%

Specific assets (All at book value as on 1.4.1990 unit-wise)

Though the liability for debentures was divided, the debentures were physically retained in DCM Ltd. The mortgage of assets of various units already created with the trustees for debentureholders were modified to the effect that each group’s assets would stand charged only for the liability allocated to it.

For payment of interest and principal amount to debentureholders, Indian Bank, which was the debenture trustees was appointed a Registrar by all the four companies and they remitted their share of liabilities to the Registrar on due dates for onward payment to debentureholders. The cost of Registrar would be shared by all the companies.

The fixed deposit receipts were split into four new receipts in the proportion in which the fixed deposits appeared in the books of account as on the effective date.

Upon transfer of the undertakings to them, the new companies allotted one equity share each to the holders of four equity shares in DCM Ltd. The paid-up value of DCM equity share was thereupon reduced for Rs 10 each to Rs 2.5 each. Thereafter, the DCM equity shares were consolidated into equity shares of the face value of Rs 10 each. Any fraction arising on allotment/consolidation of shares was disposed of and sales proceed distributed pro rata to the eligible shareholders.

The equity shares of the four companies were subsequently listed in the stock exchange(s).

Disputes with respect to the provisions of the scheme of arrangement were to be settled by two arbitrators and an umpire appointed by the arbitrators.

Thus, the demerger of DCM Ltd was completed with lots of innovation and practical solutions to the complex problem of reorganising a century-old company. After reorganisation, all the DCM Group companies have grown tremendously. From a non-dividend position prior to the demerger, all the companies have grown manifold adding value both to the shares as well as to the new entities.

Other Forms Of Corporate Other Forms Of Corporate RestructuringRestructuring

Financial restructuring is carried out internally in the firm with the consent of its various stakeholders. It is suitable mode of restructuring for corporate firms that have accumulated sizable losses over a number of years but hold prospects for better financial performance in future. An appropriate financial restructuring scheme is formulated which enables the corporate to write-off past accumulated losses and fictitious assets and restart with a fresh balance sheet which shows its share capital as well as its assets at their real/true worth.

Example 5 Following is the balance sheet of Weak Limited as on March 31, current year

(Rs lakh)


Equity capital (5,00,000 shares) 500 Land and building 180

13% Preference shares (Rs 100 each)

100 Plant and machinery 220

12.5% Debentures 200 Furniture 30

Debenture interest payable 25 Stock 120

Bank loan 75 Sundry debtors 50

Trade creditors 300 Cash at bank 5

Preliminary expenses 10

Cost of issue of debentures

5

__________ Profit and loss account 580

1,200 1,200

The company suffered heavy losses and was not getting on well. Now, it feels that the worst is over and that it holds the potential of earning profits in the future. To ensure better future functioning, the company adopts the following scheme of reconstruction:

1) Equity shares are to be reduced to Rs 25 per share, fully paid up.

2) Preference shares are to be reduced (with coupon rate of 11%) to equal number of shares of Rs 50 each, fully paid up.

3) Debentureholders agree to forgo outstanding interest. They have also agreed to accept new debentures carrying 10 per cent interest.

4) Trade creditors have agreed to forgo 25 per cent of their existing claims.

5) To make payment of the bank loan and augment the working capital, the company issues 5 lakh equity shares at Rs 25 each; payable on application. The existing shareholders have agreed to subscribe to the new issue.

6) While land and building is to be revalued at Rs 300 lakh, plant and machinery is to be written down to Rs 175 lakh. A provision amounting to Rs 5 lakh is to be made for bad and doubtful debts.

You are required to show the impact of financial restructuring/reconstruction. Also draw the new balance sheet assuming the scheme of reconstruction is executed.

Solution

Impact of Financial Restructuring (Rs lakh)

(I) Benefits to Weak Limited

(a) Reduction of liabilities payable

Reduction in equity share capital (5 lakh shares × Rs 75 per share) Rs 375

Reduction in preference share capital (1 lakh shares × Rs 50 per share) 50

Waiver of outstanding debenture interest 25

Waiver from trade creditors (Rs 300 lakh × 0.25) 75

525

(b) Revaluation of assets

Appreciation of land and building ( Rs 300 lakh – Rs 180 lakh) 120

(c) Total sum available to write off fictitious assets and over-valued assets 645

(II) Amount (Rs 645 lakh) Utilised to Write off Losses, Fictitious Assets and Over- valued Assets

Writing off profit and loss account Rs 580

Cost of issue of debentures 5

Preliminary expenses 10

Provision for bad and doubtful debts 5

Revaluation of plant and machinery (Rs 220 lakh-Rs 175 lakh) 45

645

Balance Sheet of Weak Limited as at … (After Reconstruction) (Rs lakh)


Equity capital (Rs 25 each) 250 Land and building 300

11% Preference shares (Rs 50 each)

50 Plant and machinery

175

10% Debentures 200 Furniture 30

Trade creditors 225 Stock 120

Sundry debtors Rs 50

Less: Provision 5 45

________ Cash at bank 55*

725 725

*Opening balance, Rs 5 lakh + Sale proceeds from issue of new equity shares, Rs 125 lakh – Payment of bank loan, Rs 75 lakh.

Annexure 4 below contains the salient features of the scheme of reverse merger of ICICI Ltd with ICICI Bank Ltd.

Annexure 4 Reverse Merger of ICICI Ltd with ICICI Bank Ltd

The ICICI Ltd was one of the leading development/public financial institutions [D/P FIs]. It had sponsored a large number of subsidiaries including the ICICI Bank Ltd. The RBI permitted D/P FIs to transform themselves into banks in 2002. As a bank, ICICI Ltd would have access to low-cost (demand) deposits and could offer a wide range of products and services and greater opportunities for earning non-fund-based income in the form of fee/commission. The ICICI Bank Ltd also considered various strategic alternatives in the context of the emerging competitive scenario in Indian banking. It identified a large capital base and size and scale of operations as key success factors. The ICICI Ltd and its two other subsidiaries, namely, ICICI Capital Services Ltd (ICICI Capital) and ICICI Personnel Financial Services Ltd (ICICI PFs) amalgamated in reserve merger with the ICICI Bank in view of its significant shareholding and the strong business synergies between them. As a financial institution, ICICI Ltd was offering a wide range of products and services to corporate and retail customers in India through a number of business operations, subsidiaries and affiliates. The ICICI PFs, a subsidiary of ICICI, was acting as a focal point for marketing, distribution and servicing the retail product portfolio of ICICI including auto/commercial vehicle loans, credit cards, consumer loans and so on. The ICICI Capital was engaged in sale and distribution of various financial and investment products like bonds, fixed deposits, Demat services, mutual funds and so on. The appointed date for the merger was March 30, 2002. The effective date of merger was May 3, 2002.

The (reverse) merger of ICICI Ltd and two of its subsidiaries with ICICI Bank has combined two organisations with complementary strengths and products and similar processes and operating structure. The merger has combined the large capital base of ICICI Ltd with strong deposit raising capacity of ICICI Bank, giving ICICI Bank improved ability to increase its market share in banking fee and commission while lowering the overall cost of funding through access to lower-cost retail deposits. The ICICI Bank would now be able to fully leverage the strong corporate relationship that ICICI has built seamlessly, providing the whole range of financial products and services to corporate clients. The merger has also resulted in the integration of the retail financial operations of the ICICI and its two merging subsidiaries and ICICI Banks into one entity, creating an optimum structure for the retail business and allowing the full range of assets and liability products to be offered to retail customers.

As per the scheme of amalgamation (reverse merger) approved by the High Court of Gujarat and the High Court of Mumbai in March/April 2002, the (consideration) exchange ratio for the merger was one fully paid-up equity share of Rs 10 of ICICI Bank for two fully paid-up equity shares of the ICICI Ltd of the face value of Rs 10 each. No shares were issued pursuant to the amalgamation of ICICI PFS and ICICI Capital. The exchange ratio was determined on the basis of a comprehensive valuation process incorporating international best practices, carried out by two separate financial advisors (JM Morgan Stanley and DSP Merril Lynch) and an independent accounting firm (Deloitte, Haskins and Sells).

The equity shares of the ICICI Bank held by ICICI Ltd were transferred to a trust, to be divested by appropriate placement. The proceeds of such divestment would accrue to the merged entity.

The ICICI Bank has issued to the holders of preference shares of Rs 1 crore each of ICICI, one preference share of Rs 1 crore fully-paid up on the same terms and conditions.

CONTD.

With respect to stock options issued by the ICICI to its Directors/employees, which have not been exercised/are outstanding, the options in ICICI Bank in the ratio of one equity share of Rs 10 each for every two equity shares of Rs 10 each granted in ICICI Ltd would be issued. The exercise price would be twice the price paid by the directors/employees for the exercise of ICICI stock options.

As both ICICI Ltd and ICICI Bank were listed in India and U.S. markets, effective communication to a wide range of investors was a critical part of the merger process. It was equally important to communicate the rationale for the merger to domestic and international institutional lenders and to rating agencies. The merger process was required to satisfy legal and regulatory procedures in India, as well as to comply with the U.S. Securities and Exchange Commission requirements under U.S. securities laws.

The merger also involved significant accounting complexities. In accordance with the best practices in accounting, the merger has been accounted for under the purchase method of accounting under the Indian GAAPs. Consequently, ICICI’s assets have been fair-valued for their incorporation in the books of accounts. The fair value of ICICI’s loan portfolio was determined by an independent valuer while its equity and related investment portfolio was fair-valued by determining its mark-to-market value. The total additional provisions and write-offs required to reflect the fair value of the ICICI’s assets have de-risked the loan and investment portfolios and created a significant cushion in the balance sheet while maintaining healthy levels of capital adequacy.

The merger was approved by the shareholders of both companies in January 2002, by the Gujarat and Mumbai High Courts in March/April 2002.

CONTD.

Motives For Corporate Mergers Motives For Corporate Mergers in Indiain India

•The primary motivation for merges is to take advantage of synergies. Operating economies, increased market share and financial economies have been indicated in order of importance as the desired synergies to be gained through merger. Tax advantage and diversification were the least important factors for mergers. •The other two major motives for mergers have been to consolidate and restructured organization, the primary reason being to have composite scheme of arrangement for consolidation. Another important reason has been a response to the changes in regulatory framework. The other reasons stated are to: (i) Avoid duplication of compliance cost (for corporate governance), (ii) Reduce complexity of organizational structures and (iii) Avoid dividend distribution tax. •The Consolidation has taken place primarily by merger of subsidiaries with their parent companies. SOURCE: Rani, Neelam, S.S. Yadav and P.K. Jain, “Corporate Merger Practices in India” An Empirical Study”, paper presented at 10th Global Conference on Flexible Systems Management hosted by Global Centre for Education Research, New Delhi and Graduate School of Systems Design and Management, Keio University, Tokyo, Japan, July 26-27, 2010.

SOLVED PROBLEMSSOLVED PROBLEMS

SOLVED PROBLEM 1

Sound Industries Limited (SI) is planning to purchase Not so sound Industries

Ltd. (NSS). SI has 5 lakh shares outstanding of Rs 100 each, having the current

market price per share (MPS) of Rs 250. NSS has 2 lakh shares of Rs 100 each,

currently selling in the market at Rs 170 per share. EPS are Rs 32 and Rs 24 for

SI and NSS, respectively.

Required

(a) Illustrate the impact of a merger on the EPS, assuming that the share

exchange ratio is to be in the relative proportion of EPS of the two firms.

Also determine the equivalent EPS after the merger with Firm NSS.

(b)The management of NSS has quoted a share exchange ratio of 1 : 1 for

the merger to take place. Should SI accept this ratio, even through the price-

earning ratio of SI Ltd. will remain unchanged after merger and no synergy

accrues due to the merger. If not, what is the maximum ratio it should

accept.

Solution

(a) Impact of merger on EPS (based on exchange ratio of Rs 24/Rs 32 = 0.75)

Company Number of shares

EPS Total EAT

SI NSSTotal post-merger earnings Divided by the number of shares after the merger (5,00,000 + 1,50,000 i.e., 2,00,000 × 0.75)Combined earnings per shareShareholders of SI: EPS before the merger EPS after the mergerShareholders of NSS: EPS before the merger Equivalent EPS after the merger (EPS after the merger × share exchange ratio) i.e., (Rs. 32 × 0.75)

5,00,0002,00,000

Rs 32 24

Rs 1,60,00,000 48,00,000

2,08,00,000

6,50,000Rs 32

3232

24

24

Thus, there is no change in effective EPS for shareholders of either of the firms.

(b) Effect of share exchange ratio of 1:1 on valuation of the firms (in lakh)

Pre-merger situation:

Firm SI Firm NSS

EAT (Rs) Number of shares outstanding (N) EPS (Rs) Market price per share (Rs) P/E ratio implicit (MPS/EPS) (times)Total market value (N × MPS) (Rs)Post-merger situation: Combined EAT (Rs) Number of shares outstanding after additional shares of 2 lakhissued as shares exchange ratio is 1:1 (N) EPSc (combined EAT/N) (Rs) P/E ratio (times) MPS (Rs)Total market value, MPS × Number of shares of merged firmGain from merger (Rs 1,625 lakh – Rs 1,250 lakh – Rs 340 lakh)Gain to shareholders of firms Firm SI Pre-merger market value Less: Post-merger market value (5 lakh shares × Rs 232.143) Loss to the shareholders

160 5 32

250 7.8125 1,250

48 2

24 170

7.0833 340

208

7 208/7

7.8125 232.143

1,625 35

1,250 1,160.715

89.285

Evidently, the management of SI will not accept a share exchange ratio of 1: 1 as it reduces the wealth of its shareholders by Rs 89.285 lakh. The maximum ratio likely to be acceptable to its management is (0.75 : 1) as calculated on the next page.

Determination of acceptable share exchange ratio to Firm SI (based on total gains of Rs 35 lakh accruing to Firm NSS)

(Rs lakh)

Total market value of the merged firm Less: Minimum post-merger value acceptable to SIPost-merger market value of Firm NSSSince post-merger value of Firm SI remains unchanged, it implies MPS of Rs 250 is to remain intact. Therefore, the number of equity shares required to be issued in Firm SI to have a MPS of Rs 250 and to have a post-merger value of Rs 375 lakh for Firm NSS will be (Rs 375 lakh/Rs 250)Existing number of equity shares outstanding in Firm NSSShare exchange ratio (1,50,000/2,00,000)

1,6251,250 375

1,50,000 2,00,000

0.75:1

For every 1 share in Firm NSS, 0.75 share will be issued in Firm SI. This is the maximum exchange ratio that may be acceptable to management of SI

Firm NSS Post-merger market value (2 lakh shares × Rs 232.143) Less: Pre-merger market value Gain to the shareholders

464.286 340.000 124.286

CONTD.

SOLVED PROBLEM 2

The summarised balance sheet of Target Limited as at March 31 (current year is

given below: (Rs lakh)


Equity share capital (20 lakh

shares @ Rs 100 each) Rs 2,000Fixed assets Rs 1,900

Investments 100

11.5% Preference share capital 100 Current assets:

Retained earnings 400 Inventories Rs 500

10.5% Debentures 300 Debtors 400

Current liabilities 200 Bank 100 1,000

3,000 3,000

Negotiations for takeover of T Limited result in its acquisition by A Limited. The purchase consideration consists of: (i) Rs 300 lakh 11% debentures of A Limited for redeeming the 10.5% debentures of T Limited, (ii) Rs 100 lakh 12% preference shares in A Ltd for the payment of the 11.5% preference shares capital of T Ltd, (iii) 20 lakh equity shares in A Limited to be issued at its current market price 150 and (iv) A Limited would meet dissolution expenses (estimated to cost Rs 30 lakh).

(v) The following are projected incremental free cash flows (FCFF) expected from acquisition for 6 years

(Rs lakh)

Year-end 1 Rs 450

2 600

3 780

4 900

5 650

6 350

Solution

(i) Cost of acquisition (t = 0) (Rs lakh)

Share capital (20 lakh shares × Rs 150 per share) Rs 3,000

12% Preference share capital 100

11% Debentures 300

Settlement of current liabilities 190

Dissolution expenses of target firm 30

Less: Cash proceeds from sale of investments (120)

3,500

(vi) The free cash flow of the target firm are expected to decline at 10 per cent per annum after 6 years.

(vii) After acquisition, investments are to be disposed off; they are expected to realise Rs 120 lakh.

(viii) Current liabilities are expected to be settled at Rs 190 lakh.

(ix) Given the risk complexion of target firm, cost of capital has been decided at 14 per cent.

Advise the company regarding financial feasibility of the acquisition.

(ii) Present value of FCFF (years 1 = 6) (Rs lakh)

Year-end FCFF PV factor (0.14) Total PV

1 Rs 450 0.877 Rs 394.65

2 600 0.769 461.40

3 780 0.675 526.50

4 900 0.592 532.80

5 650 0.519 337.35

6 350 0.456 159.60

2,412.30

(iii) PV of Terminal Value, that is, FCFF after the forecast period

TV6= FCFF6 (1 – g)/ (k0 + g)

= Rs 350 lakh (1 – 0.10)/ (0.14 + 0.10) = Rs 315 lakh/ 0.24 = Rs 1,312.5 lakh

PV of TV = Rs 1312.5 lakh × 0.456 = Rs 598.5 lakh

(iv) Determination of net present value (Rs lakh)

Present value of FCFF (years 1 – 6) Rs 2,412.30

Present value of FCFF subsequent to year 6 598.50

Total PV of FCFF 3010.80


Net present value (489.20)

Recommendation As the NPV is negative, acquisition of Target Limited is not

financially viable.

MINI CASEMINI CASE

Following are the financial statements for A Ltd and T Ltd for the current financial year. Both firms operate in the same industry.

Balance sheets

A Ltd T Ltd

Total current assets Rs 14,00,000 Rs 10,00,000

Total fixed assets (net) 10,00,000 5,00,000

Total assets 24,00,000 15,00,000

Equity capital (of Rs 10 each) 10,00,000 8,00,000

Retained earnings 2,00,000 —

14% Long-term debt 5,00,000 3,00,000

Total current liabilities 7,00,000 4,00,000

24,00,000 15,00,000

Income statements

Net sales Rs 34,50,000 Rs 17,00,000

Cost of goods sold 27,60,000 13,60,000

Gross profit 6,90,000 3,40,000

Operating expenses 2,96,923 1,45,692

Interest 70,000 42,000

Earnings before taxes (EBT) 3,23,077 1,52,308

Taxes (0.35) 1,13,077 53,308

Earnings after taxes (EAT) 2,10,000 99,000

Additional information:

Number of equity shares 1,00,000 80,000

Dividend payment (D/P) ratio 0.40 0.60

Market price per share (MPS) Rs 40 Rs 15

Assume that the two firms are in the process of negotiating a merger through an exchange of equity shares. You have been asked to assist in establishing equitable exchange terms, and are required to:

1) Decompose the share prices of both the companies into EPS and P/E components, and also segregate their EPS figures into return on equity (ROE) and book value or intrinsic value per share (BVPS) components.

2) Estimate future EPS growth rates for each firm.3) Based on expected operating synergies, A Ltd estimates that the intrinsic

value of T’s equity share would be Rs 20 per share on its acquisition. You are required to develop a range of justifiable equity share exchange ratios that can be offered by A Ltd to T Ltd’s shareholders. Based on your analysis in parts (i) and (ii), would you expect the negotiated terms to be closer to the upper, or the lower exchange ratio limits? Why?

4) Calculate the post-merger EPS based on an exchange ratio of 0.4 : 1 being offered by A Ltd. Indicate the immediate EPS accretion or dilution, if any, that will occur for each group of shareholders.

5) Based on a 0.4:1 exchange ratio, and assuming that A’s pre-merger P/E ratio will continue after the merger, estimate the post-merger market price. Show the resulting accretion or dilution in pre-merger market prices.

Solution

(i) Determination of EPS, P/E ratio, ROE and BVPS of A Ltd and T Ltd

Particulars A Ltd T Ltd

EAT (Rs) 2,10,000 99,000

N 1,00,000 80,000

EPS (EAT ÷ N) (Rs) 2.10 1.24

Market price per share (MPS) (Rs) 40 15

P/E ratio (MPS/EPS) 19.05 12.12

Equity funds (EF) (Rs) 12,00,000 8,00,000

BVPS (EF ÷ N) (Rs) 12 10

ROE (EAT ÷ EF) 0.175 0.1237

(iii) Justifiable equity share exchange ratio

(a)Market price based = MPST /MPSA = Rs 15/Rs 40 = 0.375 : 1 (lower limit)

(b)Intrinsic value based = Rs 20/40 = 0.5 : 1 (upper limit)

Since A Ltd has a higher EPS, ROE, P/E ratio, and higher EPS growth

expectations, the negotiated terms would be expected to be closer to the lower

limit, based on the existing share prices.

(ii) Growth rates in EPS

Retention ratio (1 – D/P ratio) 0.6 0.4

Growth rate (ROE × Retention ratio) 0.105 0.0495

(v) Post-merger market price and other effects

A Ltd T Ltd Combined

EPS Rs 2.10 Rs 1.24 Rs 2.34

P/E ratio (×) 19.05 (×) 12.12 (×) 19.05

40 15 44.60

MPS accretion 4.60 2.84***

* 1,00,000 shares + (0.40 × 80,000) = 1,32,000 shares** EPS claim per old share = Rs 2.34 × 0.4 = Re 0.936EPS dilution (Rs 1.24 – Re.0.936) = Re 0.304

***MPS claim per old share = Rs 44.60 × 0.4 Less: MPS per old share

= Rs 17.8415.00

2.84

(iv) Post-merger EPS and other effects

A Ltd T Ltd Combined

EAT (Rs) 2,10,000 99,000 3,09,000

Shares outstanding 1,00,000 80,000 1,32,000*

EPS (Rs ) 2.10 1.24 2.34

EPS accretion or (dilution) (Rs) 0.24 (0.30**) —