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MERGERS AND ACQUISITION – 1A

Introduction

Mergers, Amalgamations & Takeovers all through the globe have become universal practices in

the corporate world covering different sectors within the nations and across their borders forsecuring survival, growth, expansion and globalisation of the enterprise and achieving multitudeof objectives.

Meaning of terms

Mergers, consolidation, takeovers, amalgamations, acquisitions, combinations, restructuring andreconstructing are some of the terms which are required to be understood in the sense these areused. In different circumstances some of these terms carry different meanings and might not beconstructed as merger or takeover in application of these sense underlying the term for aparticular situation. In the following paragraphs, the meaning of these terms have been explained

in the light of the definition and explained in the light of the definitions and explanations givenby eminent scholars and practitioners in their works.

1. Merger

Merger is defined as combination of two or more companies into a single company where onesurvives and the others lose their corporate existence. The survivor acquires the assets as well asliabilities of the merged company or companies. Generally, the company which survives is thebuyer which retains its identity and the seller company is extinguished. Merger is also defined asamalgamation. Merger is the fusion of two or more existing companies. All assets, liabilities andstock of one company stand transferred to transferee company in consideration of payment in the

form of equity shares of transferee company or debentures or cash or a mix of the two or threemodes.

2. Amalgamation

Ordinarily amalgamation means merger

Halsbury‟s Laws of England describe amalgamation as a blending of two or more existingundertaking into one undertaking, the shareholders of each blending company becomingsubstantially the shareholders in the company which is to carry on the blended undertaking.

Andhra Pradesh High Court held in S.S. Somayajulu v Hope Prudhomme & Co. the word“amalgamation” has no definite legal meaning. It contemplates a state of things under which twocompanies are so joined as to form a third entity, or one company is absorved into and blendedwith another company. Amalgamation does not involve a formation of a new company to carryon the business of the old company.

Madras High Court held in W.A. Beardsell & Co. (P) Ltd. the world „amalgamation‟ has notbeen defined in the Act. The ordinary dictionary meaning of th e expression is “combination”.



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Judging from the context and from the marginal note of section 394, which appears in Chapter Vrelating to arbitration, compromise, arrangements and reconstructions, the primary object of amalgamation of one company with another is to facilitate reconstruction of the amalgamatingcompanies and this is matter which is entirely left to the body of shareholders of the primarycompany which offers or intends to amalgamate with another. There is indeed an absorption by

the company with which it is amalgamated, the latter being statutorily called the transfereecompany and the former the transferor company. In fact, the company amalgamating and thecompany with which it is amalgamated are so statutorily defined under section 394(1) (b) of theCompanies Act, 1956. On a prima facie examination of the relevant provisions in Chapter V, it isabundantly clear that it is essentially an affair relating to the internal administration of thetransferor company. Of course, there should be consensus ad litem between the transferorcompany and the transferee company. The initiative thus lying on the shoulders of the transferorcompany, it is obligatory that a scheme or arrangement should be proposed by that company andthe shareholders put on notice of such intendment and objects, and they being informed of thebenefits, facilities and privileges attendant upon such an obligation. Thus, amalgamation beingwithin the scope of the decision of the body of the shareholders, such a decision if made by the

body unanimously ought not to be lightly interfered with by Court.The Companies Act, 1956 vide sections 394 and 396A explains amalgamation which will bediscussed separately under Legal Aspects of Merger. However, the term will be usedinterchangeably with “merger” wherever the circumstances would so require.

3. Consolidation

Consolidation is known as the fusion of two existing companies into a new company in whichboth the existing companies extinguish. Thus, consolidation is mixing up of the two companiesto make them into a new one in which both the existing companies lose their identity and ceaseto exist. The mix-up assets of the two companies are known by a new name and the shareholdersof two companies become shareholders of the new company. None of the consolidating firmslegally survives. There is no designation of buyer and seller. An consolidating companies areDOSSOLVED. In other words, all the assets, liabilities and stocks of the consolidatingcompanies stand transferred to new company in consideration of payment in terms of equityshares or bonds or cash or combination of the two or all modes of payments in proper mix.

4. Combination

Combination refers to mergers and consolidations as a common term used interchangeably butcarrying legally distinct interpretation. All mergers, acquisitions, and amalgamations arebusiness combinations. Types of business combination are discussed in the followingparagraphs.

5. Holding company

Mergers and consolidations are distinct business combination which differs from a holdingcompany. The relationship of the two companies when combine their resources are differently



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known as parent company which holds the equity stock of the other company knows assubsidiary and controls its affairs.

Section 4 of the Companies Act, 1956 defines the „holding Company‟ and „subsidiary‟ which isquite relevant in the present context. The main criteria of becoming holding company is the

control in the composition of the Board of Directors in another company and such control shouldemerge from holding of equity shares and thereby more than 50% of the total voting power of such company.

6. Acquisition

Acquisition in general sense is acquiring the ownership in the property.

In the context of business combinations, an acquisition is the purchase by one company of acontrolling interest in the share capital of another existing company. An acquisition may beaffected by (a) agreement with the persons holding majority interest in the company management

like members of the board or major shareholders commanding majority of voting power; (b)purchase of shares in open market; (c) to make takeover offer to the general body of shareholders; (d) purchase of new shares by private treaty; (e) acquisition of share capital or onecompany may be either all or any one of the following form of considerations viz. means of cash,issuance of loan capital, or insurance of share capital.

7. Takeover

A „takeover‟ is acquisition and both the terms are used interchangeably.

Takeover differs from merger in approach to business combinations i.e. the process of takeover,transaction involved in takeover, determination of the share exchange or cash price and thefulfilment of goals of combination all are different in takeovers than in mergers. For example,process of takeover is unilateral and the offeror company decides about the maximum price.Time taken in completion of transaction is les in takeover than in mergers, top management of the offeree company being more co-operative.

8. Reconstruction

The term „reconstruction‟ has been used in section 394 along with the term „amalgamation‟. Theterm has not been defined therein but it has been used in the sense not synonymous withamalgamation.

In the Butterworth publication, the term has been explained as under:

“By a reconstruction, a company transfers its undertaking and assets to a new company inconsideration of the issue of the new company‟s shares to the first company‟s members and, if the first company‟s debentures are not paid off, in further consideration of the new companyissuing shares or debentures to the first company‟s debenture holders in satisfaction of their claims. The result of the transaction is that the new company has the same assets and members



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and, if the new company issues debentures to the first holders as the first company, the firstcompany has no undertaking to operate and is therefore usually wound up or dissolved.”

Reconstructions were far more common at the end of the last century and the beginning of thiscentury than they are now. The purposes to be achieved by them were usually on of the

following: either to extend or alter the objects of a company by incorporating a new companywith the wider or different objects desired; or to alter the rights attached to different classes of acompany‟s shares or debentures by the new company issuing shares or debentures with thosedifferent rights to the original company‟s share or debenture holders; or to compel the membersof a company to contribute further capital by taking shares in the new company on which a largeramount was unpaid than on the shares of the original company.

The first two of these purposes can now be achieved without reconstruction and the third is nowregarded as a species of coercion, which is strongly disapproved of by the courts and is notpursued in practice. Consequently, reconstructions for these reasons do not now occur.

In Indian context, the term would cover various types of arrangements or compromises whichmay include merger as well as demerger.

9. Restructuring

The term “restructuring” is used in the corporate literature for mergers and amalgamations. Theterm should carry the same meaning as reconstruction as explained above.

In American literature the term finds mention in the sense o f “industrial restructuring”. EdwordJ. Blakely a professor at University of California, Berkeley in a jointly written paper along withPhilip Shapira in Annals has discussed the „industrial structuring‟ taking place in Americaneconomy particularly the manufacturing sector being recognised and deindustrialised throughchanging location of capital investments, use of superior technologies and displacement of labour, etc. with objectives to maintain profitability for large corporations.

The above position was observed during 1980s in developed countries but now in 1990s, theabove elements of industrial restructuring are being observed in India‟s industrial economy, inmany industries where computerisation and use of modern technology is being inducted.

10. Demerger or corporate splits or division

Demerger or split or division of a company are the synonymous terms signifying a movement inthe company just opposite to combination in any of the forms defined above.

Such types of demerger or „divisions‟ have been occurring in developed nations particularly inUK and USA.

In UK, the above terms carry the meaning as a division of a company takes place when part of itsundertaking is transferred to a newly-formed company or to an existing company, some of all of



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whose shares are allotted to certain of the first company‟s shareholders. The remainder of thefirst company‟s shareholders. The remainder of the first company‟s undertaking continues to bevested in it and its shareholders are reduced to those who do not take shares in the othercompany; in other words, the company‟s undertaking, and shareholders are divided between thetwo companies.

In USA, too, the corporate splits carry the similar features excepting difference in accountingtreatment in post-demerger practices.

In India, too, demergers and corporate splits have started taking place in old industrialconglomerates and big groups which are discussed in detail under a separate head.

Mergers and takeovers

The terms „merger‟ and „takeover‟ shall be used in this report interchangeably so far as thevaluation techniques and academic orientation are concerned but the other aspects will be

supported with explanations about the different routes the companies follow in embracing thebusiness combinations through takeover or merger.

Purpose of merger and acquisition

The company which proposes to acquire another company is knows differently in differentmodes of acquisition, the familiar ones are; „predator, offeror, corporate raider (for takeover bids), etc. The transferee company is also denoted as victim, offeree, acquire or target etc.

The purpose for an offeror company for acquiring another company shall be reflected in thecorporate objective. It has to decide the specific objectives to be achieved through acquisition.The basic purpose of merger or business combination is to achieve faster growth of the corporatebusiness. Faster growth may be had through product improvement and competitive position i.e.enhanced profitability through enhanced production and efficient distribution of goods andservices or by expanding the scope of the enterprise through “empire building” throughacquisition of other corporate units. Other possible purposes for acquisition are short listedbelow:

1. Procurement of supplies

To safeguard the source of supplies of raw material or intermediary product;

To obtain economies of purchases in the form of discount, savings in transportation costs,overhead costs in buying department, etc. To share the benefits of suppliers economies by standardising the materials.

2. Revamping production facilities

To achieve economies of scale by amalgamating production facilities through moreintensive utilisation of plan and resources;



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To standardise product specifications, improvement of quality of product, expandingmarket and aiming at consumers satisfaction through strengthening after sale services;

To obtain improved production technology and know how from the offeree company toreduce cost, improve quality and produce competitive products to retain and improvemarket share.

3. Market expansion and strategy

To eliminate competition and protect existing market; To obtain new market outlets in possession of the offeree; To obtain new product for diversification or substitution of existing products and to

enhance the product range; Strengthening retail outlets and sale depots to reationalise distribution; To reduce advertising cost and improve public image of the offeree company; Strategic control of patents and copyrights.

4. Financial strength

To improve liquidity and have direct access to cash resources; To dispose of surplus and outdated assets for cash out of combined enterprise; To enhance gearing capacity, borrow on better strength and greater assets backing; To avail of tax benefits; To improve EPS.

5. General gains

To improve its own image and attract superior managerial talents to manage its affairs; To offer better satisfaction to consumers or users of the product.

6. Own developmental plans

The purpose of acquisition is basked by the offeror company‟s own development plans.

A company thinks in terms of acquiring the other company only when it has arrived at its owndevelopment plan to expand its operations having examined its own internal strength where itmight not have any problem of taxation, accounting valuation, etc. but might feel resourcesconstraints with limitation of funds and lack of skilled managerial personnel. It has to aim at asuitable combination where it could have opportunities to supplement its funs by issuance of securities; secure additional financial facilities eliminate competition and strengthen its marketposition.

7. Strategic purpose



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The Acquirer Company views the merger to achieve strategic objectives through alternative typeof combinations which may be horizontal, vertical, product expansional, market extensional orother specified unrelated objectives depending upon the corporate strategy. Thus, various typesof combinations distinct with each other in nature are adopted to pursue this objective likevertical or horizontal combination.

8. Corporate friendliness

Although it is rare but it is true that business houses exhibit degrees of cooperative spirit despitecompetitiveness in providing rescues to each other from hostile takeovers and cultivate situationsof collaborations sharing goodwill of each other to achieve performance heights through businesscombinations. The combining corporate aim at circular combinations by pursuing this objective.

9. Desired level of integration

Mergers and acquisitions are pursued to obtain the desired level of integration between the two

combining business houses. Such integration could be operational or financial. This gives birthto conglomerate combinations.

The purpose and the requirements of the offeror company go a long way in selecting a suitablepartner for merger or acquisition in business combinations.

Types of Mergers

Merger or acquisition depends upon the purpose of the offeror company it wants to achieve.Based on the offerors objectives profile combination could be vertical, horizontal, circular andcongromeratic as precisely described below with reference to the purpose in view of the offerorcompany.

1. Vertical Combination

A company would like to takeover another company or seek its merger with that company toexpand espousing backward integration to assimilate the sources of supply and forwardintegration towards market outlets. The acquiring company through merger of another unitattempts on reduction of inventories of raw material and finished goods, implements itproduction plans as per objectives and economises on working capital investments. In otherwords, in vertical combinations, the merging undertaking would be either a supplier or a buyerusing its product as intermediary material for final production.

The following main benefits accrue from the vertical combination to the acquirer company i.e.(1) it gains a strong position because of imperfect market of the intermediary products, scarcityof resources and purchased products; (2) has control over product specifications.

2. Horizontal combinations



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It is a merger of two competing firms which are at the same stage of industrial process. Theacquiring firm belongs to the same industry as the target company. The main purpose of suchmergers is to obtain economies of scale in production by eliminating duplication of facilities andoperations and broadening the product line, reduction in investment in working capital,

elimination of competition concentration in product, reduction of advertising costs, and increasein market segments and exercise of better control on market.

3. Circular Combination

Companies producing distinct products seek amalgamation to share common distribution andresearch facilities to obtain economies by elimination of cost of duplication and promotingmarket enlargement. The acquiring company obtain benefits in the form of economies of resource sharing and diversification.

4. Conglomerate Combination

It is amalgamations of two companies engaged in unrelated industries like DCM and ModiIndustries. The basic purpose of such amalgamations remains utilisation of financial resourcesand enlarges debt capacity through re-organising their financial structure so as to service theshareholders by increased leveraging and EPS, lowering average cost of capital and therebyraising present worth of the outstanding shares. Merger enhances the overall stability of theacquirer company and creates balance in th e company‟s total portfolio of diverse products andproduction processes.

5. Within Stream Mergers

Such mergers take place when subsidiary company merges with parent company or parentcompany merges with subsidiary company. The former arrangement is call ed “down stream”merger whereas the latter is called „up stream‟ merger. For example, recently, the ICICI Ltd. aparent company has merged with its subsidiary ICICI Bank signifying down stream merger.Such mergers are very common in the corporate world. Another instance of up stream merger isthe merger of Bhadrachalam Paper Board, subsidiary company with the parent ITC Ltd. andlikewise.

6. Objectives of takeover or merger

Takeover or merger, in practice, depends upon the motives of the persons behind such move.They adopt according to their convenience the route which leads to attaining their goal of acquiring the controlling interest in the voting rights or the assets in part or in whole of the targetcompany. Generally, the following types of decisions limit their choice for a particular firm inwhich takeover or merger activity could be organised:

(a) Acquisition of shares in the target company;(b) Acquisition of the assets of the target company‟s undertaking; (c) Acquisition for full or part ownership of the target undertaking;



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(d) Acquisition for cash or for shares or other securities of the Offeror Company orcombination of cash and variety of securities.

(e) Attitude of offeror company towards its own shareholders for availing of the tax relief under the tax-laws for income, capital gains, exemptions in stamp duty, corporationstax, etc.;

(f) Possibilities of friendly acquisition and the percentage of shareholding in TargetCompany available through persons agreeable to merger or takeover;(g) Attitude of the management (board) of the offeror company to have exclusive control

of the affairs of the target company on acquisition or share the management of combined company with the direction of the target company;

(h) Legal formalities to be compiled with under various corporate laws the provisions of which are attracted in effecting takeover or merger of the two or more companies;

(i) Means of finance available with Offeror Company to pay off for the acquisition of shares, loan, stocks or assets of the target company;

(j) The types of securities available with target company for acquisition and theirpossible adjustment in the capital structure of the combined company particularly of

the loan stock convertible securities, warrants, options or subscription rightsoutstanding which require appropriate arrangements to be made by the offeror.(k) Involvement of financial institutions and banks as lenders of long-term finance and

stake in the equity capital of the target company, the chances of obtaining theirapproval and also availing of further finance from them for the combined company.

(l) Valuation of shares of Target Company, valuation of shares of combined company;(m) Favourable features in the Memorandum and Articles of Association of the two

companies with powers of the Board to go for acquisition for offeror company and toget for sale of undertaking for the offeree company through takeover or merger, etc.;

(n) Future plans of the combined company towards its business.Reasons for merger or takeover

There is not one single reason for a merger or takeover but a multitude of reasons cause mergersand acquisitions which are precisely discussed below:

(1) Synergistic operating economies

It is assumed that existing undertakings are operating at a level below optimum. But when twoundertakings combine their resources and efforts they may with combined efforts produce betterresults than two separate undertakings because of savings in operating costs viz. combined salesoffices, staff facilities, plants management, etc. which lower the operating costs. Thus, theresultant economies are known as synergistic operating economies. The worth of the combinedundertaking should be greater than the sum of the worth of the two separate undertakings i.e. 2+2= 5.

Synergy means working together. The gains obtained by working together by amalgamatedundertakings result into synergistic operating gains. These gains are most likely to occur inhorizontal mergers in which there are more chances for eliminating duplicate facilities. Verticaland conglomerate mergers do not offer these economies.



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Among others, synergy is possible in areas viz. production, finance and technology. Merger of Hindustan Computers, Hindustan Reprographics, Hindustan Telecommunications and IndianComputer Software Company into HCL Limited exhibited synergy in transfer of technology andresources to enable the company to cut down imports of components at a fabulous duty of 198%.Similarly, Eicher had the synergy advantage in merging with subsidiaries Eicher Good Earch,

Eicher Farm technology and finance as the company could borrow increased funds from banksand institutions.

(2) Diversification

Mergers and acquisitions are motivated with the objective to diversify the activities so as toavoid putting all the eggs in one basket and obtain advantage of joining the resources forenhanced debt financing and better serviceability to shareholders. Such amalgamations result increating conglomeratic undertakings. But critics hold that diversification caused by merger of companies does not benefit the shareholders as they can get better returns by having diversifiedportfolios by holding individual shares of these companies.

(3) Taxation advantages

Mergers take place to have benefits of tax laws and company having accumulated losses maymerge with a profit earning company that will shield the income from taxation. Section 72A of Income Tax Act, 1961 provides this incentive for reverse mergers for the survival of sick units.

(4) Growth advantage

Mergers and acquisitions are motivated with a view to sustain growth or to acquire growth. Todevelop new areas becomes costly, risky and difficult than to acquire a company in a growthsector even though the acquisition is on premium rather than investing in a new assets or newestablishments.

(5) Production capacity reduction

To reduce capacity of production merger is sometimes used as a tool particularly duringnecessary times as was in early 1980 in USA. The technique is used to nationalise traditionalindustries.

(6) Managerial motivates

Manager‟s benefit i n rank, status and perquisites as the enterprise grows and expands becausetheir salaries, perquisites and status often increase with the size of the enterprise. The acquirermay motivate managerial support by assuring benefits of larger size of the company to themanagerial staff. The resultant large company can offer better security for salary earners.

(7) Acquisition of specific assets



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Surviving company may purchase only the assets of the other company in merger. Sometimesvertical mergers are done with the motive to secure source of raw material but acquirer maypurchase the specific assets of the acquiree rather than acquiring the whole undertaking withassets and liabilities.

The assets may also be acquired at a discount to obtain a going concern cheaply.

There can be many situations to take over the assets of a company at discount viz. (i) theacquiree may be in possession of valuable land and property shown at depreciatedvalue/historical costs in books of account which underestimates the current replacement value.Thus, acquirer shall be benefited by acquiring the assets of the company and selling them off subsequently; (ii) to acquire non-profit making company, close down its loss making activitiesand sell off the profitable sector to make gains; (iii) the existing management is incapable of utilising the assets, the acquirer might take over ungeared company and increase its debt securedon acquiree‟s assets.

(8) Acquisition by management or leveraged buyouts

The acquisition of a company can be had by the management personnel. It is known asmanagement buyout. This practice is common in USA for over 25 years and quite in vogue inUK. Management may raise capital from the market or institutions to acquire the company on thestrength of its assets, known as leveraged buyouts.

(9) Other reasons

There may be many other reasons motivating mergers in addition to the above ones viz. profitenhancement for the company, achieving efficiency, increasing market power, tax andaccounting opportunities, growth as a goal and many speculative goals etc. depending upon thecircumstances and prevailing conditions within the company and the economy of the country.

Advantages of mergers and takeovers

Mergers and takeovers are permanent form of combinations which vest in management completecontrol and provide centralised administration which are not available in combinations of holding company and its partly owned subsidiary. These are in general the advantages whichaccrue to the organisation besides multitude of gains already discussed.

Shareholders in the selling company gain from the merger and takeover as the premium offeredto induce acceptance of the merger or takeover offers much more price than the book value of shares.

Shareholders in the buying company gain in the long run with the growth of the company notonly due to synergy but also due to “books trapping earnings”.

Motivation for mergers and acquisitions



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Mergers and acquisitions are caused with the support of shareholder, managers and promoters of the combining companies. The factors which motivate the shareholders and managers to lendsupport to these combinations and the resultant consequences they have to bear are briefly notedbelow based on the research work done by various scholars globally.

(1) From the standpoint of shareholders

Investments made by shareholders in the companies subject to merger should enhance in value.The sale of shares from one company‟s shareholders to another and holding investmen t in sharesshould give rise to greater values i.e. the opportunity gains in alternative investments.Shareholders may gain from merger in different ways viz. from the gains and achievements of the company i.e. through (a) realisation of monopoly profits; (b) economies of scale; (c)diversification of product line; (d) acquisition of human assets and other resources not availableotherwise; (e) better investment opportunity in combinations.

Realisation of gains from the merger and acquisition to shareholder in the above form might notbe generalised but one or more features would generally be available in each merger whereshareholders may have attraction and favour merger.

(2) From the standpoint of managers

Managers are concerned with improving operations of the company managing the affairs of thecompany effectively for all round gains and growth of the company which will provide thembetter deals in raising their status, perks and fringe benefits. Mergers where all these things arethe guaranteed outcome get support from managers. At the same time, where managers have fearof displacement at the hands of new management in amalgamated company and also resultantdepreciation from the merger then support from them becomes difficult.

(3) Promoters‟ gains

Mergers do offer to company promoters the advantage of increasing the size of their companyand the financial structure and strength. They can convert a closely-held and private limitedcompany into a public company without contributing much wealth and without losing control. Inthe above example of HCL, only Hindustan Reprographics Ltd. was public company whereas theother three merging entities were private limited companies. The promoters of HindustanComputers were allotted shares worth Rs.1.27 crores on merger in a new company called HCLequity of Rs.1.48 crores shares. This gain was against their original investment of meagre Rs.40lakhs in Hindustan Computers and they did not invest any money extra in getting shares worthRs.1.48 crores.

Another recent example is of Jaiprakash Industries which was formed out of merger of Jaiprakash Associates and Jay Pee Rewa Cement. Jaiprakash Associates was a closely-heldcompany. The merger enabled the promoters to have stake at 60% (Rs.39.85 crores) in



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Jaiprakash Industries Ltd. against an investment of Rs.4.5 Crore in Jaiprakash Associates. Thus,merger invariably results into monetary gains for the promoters and their associates in thesurviving company.

Impact of mergers on general public

Impact of mergers on general public could be viewed as aspect of benefits and costs to:

(1) Consumers of the product of services;

(2) Workers of the companies under combination;

(3) General public affected in general having not been user or consumer of the worker inthe companies under merger plan.

(1) Consumers

The economic gains realised from mergers (i.e. enhanced economies and diversification leadingto lower costs and better quality products) are passed on to consumers in the form of lower pricesand better quality of the product which directly raise their standard of living and quality of life.The balance of benefits in favour of consumers will depend upon the fact whether or not themergers increase or decrease competitive economic and productive activity which directly affectthe degree of welfare of the consumers through changes in price levels, quality of products, aftersales service, etc.

(2) Workers community

The benefit or loss from mergers to worker community will depend upon the level of satisfactionof their demands, merger of companies provides in the form of employment, increased wages,environmental improvements, better living conditions and amenities. The merger or acquisitionof a company by a conglomerate or other acquiring company may have the effect on both thesides of increasing the welfare in the form of enhanced quality of life or decrease the welfare bycreating unemployment through retrenchment and resultant lack of purchasing power and othermiseries of life. Two sides of the impact as discussed by the researchers and academicians are:first, merges with cash payment to shareholders provide opportunities for them to invest thismoney in other companies which will generate further employment and growth to the uplift of the economy in general. Secondly, any restrictions placed on such mergers will decrease thegrowth and investment activity with corresponding decrease in employment. Both workers andcommunities will suffer on lessening job opportunities, preventing the distribution of benefitsresulting from diversification of production activity. Diversification fosters and providesopportunities for advancement in career, training in new skills amount may other alike benefits.

(3) General Public

Mergers result into centralised concentration of power in small number of corporate leaderswhich results in the concentration of an enormous aggregation of economic power in their hands.



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Economic power is to be understood in specific limited sense as the ability to control prices andindustries output as monopolists. Such monopolists affect social and political environment to tilteverything in their favour to maintain their power and expand their business empire. Theseadvances result into deceleration of level of welfare and well being of the general public whichare subjected to economic exploitation. But in a free economy a monopolist does not stay for a

longer period as other companies enter into the field to reap the benefits of high prices set in bythe monopolist. This enforces competition in the market as consumers are free to substitute thealternative products. Therefore, it is difficult to generalise that mergers affect the welfare of general public adversely or favourably. Every, merger of two or more companies has to beviewed from different angles in the business practices which protects the interest of theshareholders in the merging company and also serves the national purpose to add to the welfareof the employees, consumers and does not create hindrance in administration of the Governmentpolicies.

Choice for alternative modes of acquisition

The foregoing discussion reveals that the various terms used in business combinations carrygenerally synonymous connotations and can be used interchangeably as has been indicated whileexplaining the meanings of these terms. All the different terms carry one single meaning of “merger” but each term cannot be given equal treatment in the discussion because law hascreated a dividing line between „take -over‟ and acquisitions by way of merger, amalgamation or reconstruction. Particularly the takeover Regulations for substantial acquisition of shares andtakeovers known as SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 1977vide section 3 excludes any attempt of merger done by way of any one more of the followingmodes:

(a) By allotment in pursuance of an application made under a public issue;

(b) Allotment pursuant to an application made by the shareholders for right issue;(c) Preferential allotment made in pursuance of a resolution passed under section 81(1A) of

the Companies Act, 1956;

(d) Allotment of the underwriters pursuant to underwriters agreements;

(e) Inter-se-transfer of shares amongst group companies, relatives (within the meaning of section 6 of the Companies Act, 1956, Indian promoters and foreign collaborators whoare shareholders/promoters;

(f) Acquisition of shares in the ordinary course of business, by registered stock brokers,public financial institutions and banks on own account or as pledges;

(g) Acquisition of shares by way of transmission on succession or inheritance;

(h) Acquisition of shares by government companies and statutory corporations;



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(i) Transfer of shares from state level financial institutions to co-promoters in pursuance toagreements between them;

(j) Acquisition of shares in pursuance to rehabilitation schemes under Sick IndustrialCompanies (Special Provisions) Act, 1985 or schemes of arrangements, mergers,

amalgamation, demerger, etc. under the Companies Act, 1956 or any law or regulations,Indian or foreign;

(k) Acquisition of shares of company whose shares are not listed on any stock exchange.However, this exemption is not available if the said acquisition results into control of alisted company;

(l) Such other cases as may be exempted from the applicability of Chapter III of SEBIregulations by SEBI.

The basic logic behind substantial disclosure of takeover of a company through acquisition of

shares is that the common investors and shareholders should be made aware of the largerf inancial stake in the company of the person who is acquiring such company‟s shares.

The main objective of these Regulations is to provide greater transparency in the acquisition of shares and the takeovers of companies through a system of disclosure of information.

Consideration of Merger and Takeover

Merger and takeovers are two different approaches to business combinations. Mergers arepursued under the Companies Act, 1956 vide sections 391/394 thereof or may be envisagedunder the provisions of Income-tax Act, 1961 or arranged through BIFR under the Sick Industrial Companies (Special Provisions) Act, 1985 whereas takeovers fall solely under theregulatory frame work of the SEBI (Substantial Acquisition of Shares & Takeovers) Regulations,1997.



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Procedure of organising takeover bids

The procedure for organising takeover bids as narrated in the following paragraphs is based oninternational practices in particular the City Code. However, once an understanding is developed,the procedure should be streamlined in terms of the SEBI Takeover Regulations, 1997 which, of course, do not lay down the procedure but prescribe a restrictive drill to safeguard the interests of the investors and shareholder.

Takeover bids are organised in a systematic way by one company offering to acquire shares of another company to gain sufficient shares and voting control of the company. The followingsteps generally take place in a takeover bid.

(1) Collection of relevant information and its analysis

The potential bidder should collect all possible relevant information on the target or offereecompany, analyse the information through experts from financial, accounting, tax and legalangles, and keep the information and appraisal results top secret.

(2) Examine shareholders' profile

Potential bidder should examine the share register of the target company and see the profile of the shareholders i.e. the number and weight of institutional investors and small shareholders. If the directors of the target Company cooperate, it can also trace the dividend register to find outnumber of shareholders not traceable to design the course of its bid.

(3) Investigation of title and searches into indebtedness

Potential bidder should also have the searches carried out in Land Registry Office and Registrarof Companies office to find out the extent of encumbrance on offeree's properties and theindebtedness.

(4) Examining of articles of association

The offeror should also examine the Articles of Association of the offeree company to ascertainthe extent of power of directors with regard to borrowing restrictions, etc.

(5) Representation on board

The potential bidder should ensure first his entry or representation on the board of the offereecompany and should win over some of the directors on the board to the suggested changes and



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explore possibility of offer being successfully discussed on the board for takeover bid onconvenient terms. This will ensure friendly takeover.

(6) Press announcement

Once the board of the offeree company shows a sympathetic view, the joint preliminaryannouncement could be made for awareness of shareholders of the main terms of the offer.

(7) Approval under FEMA

Necessary approvals under the Foreign Exchange Management Act, 1999 are required to be takeby the companies, primarily under Foreign Exchange Management (Transfer or Issue of Securityby a Person Resident Outside India) Regulations, 2000.

(8) Recommendations to shareholders

Once the board of the offeree company agrees to the takeover bid it can bring to the notice of shareholders through circular, the merits of the takeover or merger and the advantages which willaccrue to them from such amalgamation. In case the board does not approve of the move, thedirectors can also bring the fact tot he notice of the shareholders.

(9) Improvement of conditions by offeror

In case a. group of shareholders oppose the proposal for bid, the offeror can circularise itsrejoinder to the criticism of the bid and alternatively can announce improvement of the bidconditions through press.

(10) Information about acceptance

The takeover offer is open for a limited time within which it should be accepted by theshareholders. The offeror should announce information about the acceptance for the knowledgeof shareholders to know the response in its favour and make their own judgement.

(11) Despatch of consideration



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With a view to complete the transaction with the shareholders of the offeree company the biddershould despatch consideration for the shares in the offeree company to the shareholders whohave accepted the offer and submitted valid acceptances with the share certificates or otherdocuments of title. The offeror will take further steps for registration of shares in its own name asper provisions of the Companies Act, 1956 Stock Exchange Rules & Regulations, etc.

10. INFORMATION IN THE OFFER DOCYMENTS

The offer document should contain the following information for the shareholders of the offereecompany about the offer:

(1) General information

Should cover the write up about offeror's intention to continue business, employment of existingemployees, major changes to be intgroduced, justification for the offer.

(2) Identity and financial means of the offeror

Offer document must disclose fullidentity of the person making offer, their business connectionsand means of finance, etc., ability to run the company's business for the good of theshareholders.

(3) Terms of the offer

Should state the acquisition of shares free from all lien, charges and encumbrances, totalconsideration offered for the shares in cash or kind, and the mode of payment, the basis forarriving at the said consideration like net assets value, etc., duration for which the offer to remainopen, conditions attached to the offer like minimum number of shares, share – for-share offerwith condition of approval of shareholder required in general body, share-for-share (new sharebeing admitted on list by stock exchange), etc. etc.

(4) Information on strength of offeror

Information regarding offeror company and its shares ranking of shares for dividend, listingstatus, market price financial information, etc.

(5) Comparative view of offeree



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Information about offeree companyand its shares listing status, market price, financialinformation, etc. in comparison with offeror's own strength be furnished.

(6) Profit forecast and asset valuation about offeror

The projections should be reasonable and supported by the future growth plans of the offeror.

(7) Existing shareholdings in offeree company

The offerer should give details of its existing shareholdings in the offeree company.

(8) Information on management pattern

Information relating to directors of offeeror and offeree company, their shareholdings,emoluments, professional skills, achievements, etc.

(9) Arrangement for acceptance

The offerer should spell out for convenience of the shareholders of offeree the variousarrangements it has made to materialise the acceptance viz. underwriting arrangements,appointment of merchant bankers who on behalf of offeror shall make offer to purchase fromaccepting shareholders for cash at a stated price, the shares and/or loan stock in the offereecompany, etc.

The above information should cover the following particulars required to be made in publicannouncement vide regulation 16 of SEBI Takeover Regulations, 1997:

(i) the paid up share capital of the target company, the number of fully paid up and partlypaid up shares;

(ii) the total number and percentage of shares proposed to be acquired from the public,subject to a minimum as specified in sub-regulation (I) of Regulation 21;

(iii) the minimum offer price for each fully paid up or partly paid up share;

(iv) mode of payment of consideration;

(v) the identity of the acquirer(s) and in case the acquirer is a company or companies, theidentity of the promoters and, or the persons having control over such company(ies)and the group, if any, to which the company(ies) belong;

(vi) the existing holding, if any, of the acquirer in the shares of the target company,including holding of persons acting in concert with him;



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(vii) salient features of the agreement, if any, such as the date, the name of the seller, theprice at which the shares are being acquired, the manner of payment of theconsideration and the number and percentage of shares in respect of which theacquirer has entered into the agreement to acquire the shares or the consideration,monetary or otherwise, for the acquisition of control over the target company, as the

case may be;(viii) the highest and the average price paid by the acquirer or persons acting in concert

with him for acquisition, if any, of shares of the target company made by him duringthe twelve month period prior to the date of public announcement;

(ix) object and purpose of the acquisition of the shares and future plans, if nay, of theacquirer for the target company, including disclosures whether the acquirer proposesto dispose of or otherwise encumber any assets of the target company in thesucceeding two years, except in the ordinary course of business of the targetcompany:

Provided that where the future plans are set out the public announcement shall alsoset out how the acquirers propose to implement such future plans;

(x) the „specified date‟ as mentioned in Regulation 19;

(xi) the date by which individual letters of offer would be posted to each of theshareholders;

(xii) the date of opening and closure of the otter and the manner in which and the date bywhich the acceptance or rejection of the offer would be communicated to theshareholders;

(xiii) the date by which the payment of consideration would be made for the shares inrespect of which .the offer has been accepted;

(xiv) disclosure to the effect that firm management for financial resources required toimplement the offer is already in place, including details regarding the sources of thefunds whether domestic i.e., from banks, financial institutions, or otherwise. orforeign i.e. from Non-resident Indians or otherwise;

(xv) provision for acceptance of the offer by person(s) who own the shares but are not theregistered holders of such shares;

(xvi) statutory approvals, if any, required to be obtained for the purpose of acquiring theshares under the Companies Act, 1956 (1 of 1956), the Monopolies and RestrictiveTrade Practices Act, 1969 (54 of 1969), the Foreign Exchange Regulation Act, 1973(46 of 1973), and/or any other applicable laws;

(xvii) approvals of banks or financial institutions required, if any;

(xviii) whether the offerer is subject to a minimum level of acceptances from theshareholders; and



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(xix) such other information as is essential for the shareholders to make an informeddecision in regard to the offer.

In addition to the above tl1e offer should contain the following information also:

(a) Specified date for the purpose of determining the names of the shareholders to whomthe letter of offer should be sent. Such date shall not be later than 30 th day from thedate of public announcement (see regulation 19).

(b) Minimum offer price should be stated as payable and shall be ascertained in terms of regulation 20.

(c) Minimum number of shares to be acquired as specified in regulation 21 of the SEBITakeover Regulations.

(d) The officer shall observe the general obligations laid down under regulation 22 of theSEBI Takeover Regulations.

It has been prescribed vide regulation 17 of SEBI Regulations, 1997 that public announcement of the offer or any other advertisement, circular, brochure, publicity material or letter of offer issuedin relation to the acquisition of shares shall not contain any misleading information. Within 14days from the date or public announcement, the acquirer shall file through its merchant bankerwith the SEBI the draft of letter of offer containing disclosures as specified by SEBI alongwiththe fee of Rso 50,0000. The letter of offer shall be dispatched to the shareholders not earlier than21 days from its submission to SEBI In case SEBI had suggested some changes, the same shallbe incorporated in letter of offer before dispatch to shareholders.

11. DEFENCE AGAINST TAKEOVER BID

The Directors of the company hold command of the affairs of a company. They owe moralresponsibility to protect the interest of the shareholders and also safeguard the existence of thecompany ensuring continuity of its business activity on profitable footing and warding off theunscrupulous corporate raiders striving to take over possession of its assets and control of itsaffairs. They hold fiduciary position in the company and should place all facts about tilecompany before the shareholders. The power of management delegated to the board must be

exercised bona fide in the interest of the company.

In takeover bids, it is the responsibility of the directors to take defensive measure to check themand thwart away the bids. London „City Code‟ places very stringent obligation upon the directorsof an offeree company faced with an offer. They must accurately, fairly and promptly placebefore their shareholders all the facts necessary for forming an informed judgment as to themerits and demerits of the offer. Directors must secure their position of control against theimminent change attempt.



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Directors have been vested with powers under section 111 of the Companies Act, 1956 to refuseregistration of shares in the circumstances when it is not in the interest of the existence of thecompany in takeover bids, etc.

Besides the above statutory power the company can take the following defensive measures to

thwart away takeover bids;

(1) Advance preventive measures for defence.(2) Defence in face takeover bid.

(1) Advance preventive measures for defence

Offeree company should take precautions when it feels that takeover bid is imminent throughmarket reports and available information so that the attempt of takeover bid by the corporateraider could be avoided successfully. Some of the prominent advance measures as derived fromthe experiences of the advanced nations and the prevalent laws and practices in India arediscussed below.



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A. JOINT HOLDINGS OR JOINT VOTING AGREEMENT

Two or more major shareholders may enter into agreement for block voting or block sale of shares rather than separate voting or separate sale of shares. This agreement is entered into incollaboration with or with the cooperation of offeree company‟s directors who wish to exerciseeffective control of the company.

B. INTERLOCKING SHAREHOLDINGS OR CROSS SHAREHOLDINGS

Two or more group companies acquire shares of each other in large quantity or one companymay distribute shares to the shareholders of its group company to avoid threads of takeover bids.Such companies shall fall within the same management control and attract provisions of section372 of the Companies Act, 1956. If the interlocking of shareholdings is accompanied by jointvoting agreement then the joint system of advance defence could b e termed as „pyramiding‟ asmost safe device of defence.

C. ISSUE OF BLOCK OF SHARES TO FRIENDS AND ASSOCIATES

With a view to forestall a takeover bid, the directors issue block of shares to their friends andassociates to continue maintaining their controlling interest and as a safeguard to the threads of dislodging their control position. This may also be done by issue of rights shares.

D. DEFENSIVE MERGER

The directors of a threadtened company may acquire another company for shares as a defensivemeasure to forestall the unwelcome takeover bid. For this purpose they put large block of sharesof their own company in the hands of shareholders of the friendly company to make their owncompany least attractive for takeover bid.

E. SHARES WITH NON-VOTING RIGHTS LIKE PREFERENCE SHARES

In India, so far, non-voting right shares are only of one variety i.e. preference shares orcumulative convertible preference shares as against a wide variety of restricted or weightedvoting rights equity shares under English Company Law. Management may retain shares withvoting rights so that takeover bid could be thwarted away without voting support. Non-votingshares are a convenient method of providing for any desired adjustment of control on a merger of two companies.

F. CONVERTIBLE SECURITIES

To make the company less attractive to corporate raiders, it is necessary that its capital structureshould contain loan capital by way of debentures either convertible in part or full or non-convertible. This is so because a ny successful bidde can‟t acquire compulsorily convertiblesecurities, options or warrants because liability towards repayments of principal and payment of interest discourages takeover bids.



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G. DISSEMINATION TO SHAREHOLDERS OF FAVORABLE FINANCIALINFORMATION

To make the investors and the shareholders aware, it is necessary that true earning position of thecompany should be told to them through press media or direct communications to ensure

continuity of their interest in the management set up of the company. The dissemination of information about the company‟s favourable features of operations and profitability go a longway in bringing the market price of share nearer to its true assets value. This type of behaviouron the part of the directors of the company elicit confidence of shareholders in their managementand control which will in many ways help prevent any takeover bid to set in or to succeed.

H. DEFERMENT OF SHAREHOLDERS CONTROL OVER THE COMPANY‟SASSETS

Prudent board of directors make the chances of any takeover bid in near future dim by makingthe possession of the company‟s assets less attractive. This is possibly dine by putting the assets

outside the control of the shareholders by entering into various types of financial arrangementslike sale and lease back, mortgage of the assets to financial institutions for long-term loans,keeping the assets in trust for security of debenture, loan, etc. This is done with the specificapproval of shareholders in their general meetings in pursuance of sections 293(1) (a) and (b) of the Companies Act, 1956.

I. LONG-TERM SERVICE AGREEMENTS

Directors having specialised skills in any specific technical field may enter into contract with thecompany with specific approval of shareholders and/or the Central Government under theCompanies Act, 1956 or the rules framed thereunder for rendering service over a period of time.There are two significant aspects of such an agreement viz. the prospective bidder would not beattracted due to the fear of non-cooperation by such directors if the company is acquired withoutpersonal involvement of such directors and secondly, the bidder will have to pay handsomecompensation for terminating the agreement or the technical assistance or services providedunder the said agreement might not be made available by any other outside party. In view of these circumstances the takeover game becomes unattractive to the bidders.

J. OTHER PREVENTIVE MEASURES

The companies take various other preventive and precautionary measures to thwart awayacquisition bids in future viz. (i) maintaining a fraction of share capital uncalled which can becalled up during any emergency like takeover bid or liquidation threat. This strategy is known as“Rainy day call”, (ii) companies may from a g roup or cartel to fight against any future bid of takeover against any of their member companies and maintain a pool of funds to use it to counterthe takeover bids. This technique is known an anti-takeover cartel.

To sum up, the above preventive measures are only illustrative and not exhaustive as in differentcircumstances appropriate measures are adopted which continue adding up to the above list.



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It may be noted that SEBI Takeover Regulations, 1997 facilitate takeover bid ensuring safeguardto the interest of the investors/shareholders. The general obligations prescribed under regulation23 for the board of directors of the target company should be taken into consideration whileusing the above preventive measures as defence against takeover bids. These general obligationsare operative only after the date of public announcement of the offer. As such, the above

measures can be carefully adopted to thwart away the advances of the predators.

(2) Defence in face of takeover bid

A company might be caught by surprise when a takeover bid is made by some outside to acquirecontrol of its management. A company is supposed to take defensive steps when it come tocomes to know that some corporate raider has been making efforts for takeover. In differentcircumstances, different devices for defence device or in multiple of two or more devices suitingthe defence strategy planned and adopted by the board of directors of the offeree company.

For defence against takeover bid two types of strategies could be suggested which are based on

the experience of the developed nations viz. (a) Commercial strategies; and (b) tracticalstrategies.

A. COMMERCIAL STRATEGIES

(i) Dissemination of favourable information

To have defence against the offeror being critical of the company‟s past performance the targetcompany should be ready with profits forecast and performance information to demolish theofferor‟s arguments.

The threatened company should keep their shareholders abreast of all latest developmentsparticularly about the financial strength of the company as evidenced by market coverage,product demand, industry outlook and resultant profit forecast and value appreciation, etc.Disclosure of all these favourable aspects will keep the shareholders in good humour and theywill always side with the existing management dislodging all the takeover bids. After attempt of takeover bid, the disclosure might miss the reliability and significance and invite criticism of directors keeping the shareholders in dark.

(ii) Step up dividend and update share price record

The fall in the market price of shares might occur due to restrictive dividend policy of thecompany. The company should, therefore. This will, automatically, bolster up the price of itsshares and frustrate the takeover bid, for raising expectations for higher dividend, the companyshould in advance declare interim dividend and meet all statutory requirements of stock exchange of giving advance information and deciding date of closure of register of members, etc.In pursuance of the provisions of the Companies Act, 1956 declaration of final dividend is to bedone at the annual general meeting of a company but interim dividend can be declared by theboard to indicate the clear intentions of the company for stepping up the dividend.



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(iii) Revaluation of Assets

Assets shown at depreciated historical costs in financial accounts understate the real value of assets. For defence strategy it is common practice to revalue the assets periodically andincorporate them in the balance sheet. Such valuation should be attested by recognized values.

(iv) Capital structure reorganization

Proper capital structure is essential for enhanced profitability and brightening of the dividendprospects. Capital structure which is under geared or geared with tax inefficient preferencecapital instead of debenture stock or term loans exhibits poor financial performance of thecompany and is required to be reorganized for proper gearing and tax efficiency. Company maytake suitable steps to replace preference capital by loan capital. In those cases where thecompany has excess liquidity there are chances of takeover raids. The company should use liquidresources for financial acquisition of assets, replacements, expansion programme, etc. ordistribute the surplus to shareholders through bonus and rights issues. The company should have

expert advice from financial consultants on the issue of capital restructuring before implementingany conceived plan to thwart away the takeover bid.

(v) Unsuitability of offeror

Research based arguments should be prepared to show and convince the shareholders that theofferor is incapable of managing the business efficiently. The management style, the profit anddividend record of the offeror in existing companies should be focussed particularly, specificlosses, skipping of dividend, lower market experience and other similar denouncing factorsshould be highlighted about the offeror and its associate concerns.

(vi) Other commercial aspects

The target comp any‟s management in its defence strategy should, inter alia, trace out the variousdiscouraging commercial features of the functioning of the offeror company which may convinceits own shareholders to thwart away the take over bid and at the same time should highlight ownfavourable commercial aspects with optimistic and promising futuristic view like new productdevelopment, new business avenues, prospects and future growth, etc.

B. TACTICAL DEFENCE STRATEGIES

(i) Friendly purchase of shares

To stave off the takeover bid the directors of the company may persuade their friends andrelatives to purchase the shares of the offeree company as they themselves cannot indulge intothe game without serious violation of the existing rules and regulations or statutory prescriptiondespite the bona fide defence against the bid. A company under the Indian law cannot purchaseits own shares. Hence directors of the company have to take protective steps to persuade theirfriends to be shareholders in supports of their management and control of the company underthreat of takeover bid.



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(ii) Emotional attachments, loyalty and patriotism

To ward off takeover bids, the board may make attempt to win over the shareholders throughraising their emotions for continued association and attachment with the company as shareholder

and raising fearsin their mind towards changes of the name of the company, independence of business and goodwill, etc. Particularly, institutional shareholders might yield to these reasoning.Similarly, takeover bid from a foreign controlled company could be warded off by invokingnational interest and emotional feelings. Much will depend upon economic circumstances,political climate and the prospects of the trade in which the company is engaged. Argumentscould also be made of the possible consequences which follow on takeover like retrenchment of work force, displacement of managerial, technical and financial executives, shifting work placeand all possible miseries resulting from the successful takeover bid. Many times, such appealworks well to raise sentiments of shareholders to support the board of directors and confide withthe management.

(iii) Recourse to legal actionTo dissuade the corporate raider, the target company can refuse registration of transfer of any of the grounds given under relevant sections of the Companies Act, 1956.

To sum up, it is the responsibility of the directors to accept a takeover bid or thwart it away inthe interest of the company. In averting the takeover bid the directors are not absolved of theirliability under the law for making any wrong statements and painting in words any unrealisticposition into high hopes for the future of the company. For example, profit forecasts made bythem in the context of fighting off the takeover bid should be realistic, based on viableassumptions. In other words, they should not indulge in fraudulent acts against the interest of theshareholders.

(iv) Operation „White Knights‟

„White knight‟ is the term used in UK Financial ma rkets for a bidder in acquisition pursuit.White knight enters the fray when the target company is raided by a hostile suitor. White knightoffers a higher bid to the target company than the present predator who might not remaininterested in acquisition and hence the target company is protected from losing to the corporateraid. While using this defence, the provisions of regulation 25 of SEBI Takeover Regulations

providing a drill for competitive bids should be adhered to by the „white knights‟, the targe tcompany and the predators.

(v) Disposing of “Crown Jewels”

The precious assets in the company are called “Crown Jewels” to depict the greed of the acquirer under the takeover bid. These precious assets attract the raider to bid for the company‟s cont rol.The term “crown jewels” was coined in USA in 1982. The company, as a defence strategy, in itsown interest, sells these valuable assets at its own initiative leaving the rest of the companyintact. Instead of them or mortgage them to creditors so that the attraction of free assets to the



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predator is over. This defence is very much in vogue in UK but subject to regulations of „CityCode‟.

SEBI Takeover Regulations vide regulation 23 thereof prescribes general obligations for theboard of directors of the target company. Under the said regulation, it will be difficult for any

target company to sell, transfer, renumber or otherwise dispose off or enter with an agreementfor sale, transfer, encumbrance or for disposal of assets once the predator has made publicannouncement. Thus, the above defence can be used only before the predator makes publicannouncement of its intentions to takeover the target company.

(vi) „Pac -man' strategy

This term was coined in America in 1982. Under this strategy the target company attempts totakeover the hostile raider. This happens when the target company is quite larget than thepredator.

(vii) Compensation packages viz: “Golden Parachutes” or “First Class Passengers”strategy

The term “Golden Parachute” again was coin ed in USA and is very much in vogue since early1980s. The term is known as “first class passengers‟ in UK. The strategy is common in UK andUSA and envisages a termination package for senior executives and is used as a protection to thedirectors of the company against the takeover bids. This strategy is adopted as a precautionarymeasure by the companies in USA and UK to make the takeover bid very expensive. Thesecompensation packages do exist in the company as both City Code in UK and SecuritiesExchange Commission in USA.

(viii) “Shark repellent” character

The companies change and amend their bye-laws and regulations to be less attractive for thecorporate raider company. Such features in the bye- laws are called “Shark Repellent” character.US companies adopt this tactic as a precautionary measure against prospective bids. Forexample, shareholders approvals for approving combination proposal is fixed at minimum by 80-95% of the shareholders and to call shareholders meeting for this purpose 75% of the board of directors consent is needed.(ix) Swallowing “Poison Pills” strategy

There are many variants in this strategy. For example, as a tactical strategy, the target companymight issue convertible securities which are converted into equity to deter the efforts of theofferor because such conversion dilutes the bidder‟s shares and discourages acquisition. Another example, target company might raise borrowings distorting normal debt: equity ratio.

(x) Green mail

A large block of shares is held by an unfriendly company, which forces the target company torepurchase the stock at a substantial premium to prevent the takeover. In a takeover bid this



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could prove to be an expensive defence mechanism.

(xi) Poison put

A covenant allowing the bond holder to demand repayment in the event of a hostile takeover.

(xii) Grey knight

A friendly party of the target company who seeks to takeover the predator.

To sum up, the target company may adopt a combination of various strategies for successfullyaverting the acquisition bid. All the above strategies are experience based and have beensuccessfully used in developed nations, particularly in USA or UK and some of them have beentested in critical times by the companies in India also. Nevertheless, the above list is notexhaustive but only illustrative. In different circumstances and even, the scope for evolving morerapid strategies always remains for the target companies to defend their existence against

takeover bids.

12. COMBATING TAKEOVER BIDS

Indian corporates do not have adequate defense mechanism to tackle threat of a takeover bid.However, amendments in Companies Act, 1956 to effect the following changes might createfactors for combating hostile takeover and also facilitate restructuring the corporates to increaseglobal; competitiveness, viz.

(1) Introduction of non-voting shares

Companies would be able to raise resources from the capital market without diluting thepromoters stake.

Value Created by Merger

A merger will make economic sense to the acquiring firm if its shareholders benefit.Merger will create an economic advantage (EA) when the combined present value ofthe merged firms is greater than the sum of their individual present values as separateentities. For example, if firm P and firm Q merge, and they are separately worth V P andVQ, respectively, and worth V PQ in combination, then the economic advantage will occurif:

VPQ > (VP + VQ)

And it will equal to:

EA = VPQ - (VP + VQ)



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Suppose that firm P acquires firm Q. After merger P will gain the present value of Q i.e.,VQ, but it will also have to pay a price (say in cash) to Q. Thus, the cost of merging to Pis [Cash paid - V Q]. For P, the net economic advantage of merger (NEA) is positive if theeconomic advantage exceeds the cost of merging. Thus

Net economic advantage = economic advantage – cost of merging

NEA = [VPQ - (VP + VQ) – (cash paid – VQ)

The economic advantage i.e., [V PQ - (VP + VQ)], represents the benefits resulting fromoperating efficiencies and synergy when two firms merge. If the acquiring firm payscash equal to the value of the acquired firm, i.e. cash paid – VQ = 0, then the entireadvantage of merger will accrue to the shareholders of the acquiring firm. In practice,the acquiring and the acquired firm may share the economic advantage betweenthemselves.

Example 1

Firm P has a total market value of Rs.18 Crore (12 lakh shares of Rs.150 market valueper share). Firm Q has a total market value of Rs.3 Crore (5 lakh of Rs.60 market valueper share). Firm P is considering the acquisition of Firm Q. The value of P after merger(that is, the combined value of the merged firms) is expected to be Rs.25 Crore due tothe operating efficiencies. Firm P is required to pay Rs.4.5 Crore to acquire Firm Q.What is the net economic advantage to Firm P if it acquired Firm Q? It is the differencebetween the economic advantage and the cost of merger to P:

NEA = [25 – (18+3)] – (4.5 - 3) = (4 – 1.5) = Rs. 2.5 Crore

The economic advantage of Rs.4 Crore is divided between the acquiring firm Rs.2.5Crore and the target firm, Rs. 1.5 Crore.

The acquiring firm can issue shared to the target firm instead of paying cash. The effectwill be the same if the shares are exchanged in the ratio of cash-to-be-paid to combinedvalue of the merged firms. In example,

X = 12 + 0.18 XX - 0.18 X = 12X = 12/0.82 = 14.63 lakh shares

And the new shares price will be: 25/0.1463 = Rs.170.9. Firm Q will get 2.63 lakhshares of Rs. 170.9 each. Thus, the cost of acquisitions to Firm P remains the same:(2.63 lakh x Rs. 170.9) – Rs. 3 Crore = Rs.1.5 Crore.

In practice, the number of shares to be exchanged may be based on the current marketvalue of the acquiring firm. Thus, in example 1, Firm Q may require 300,000 shares



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(i.e., Rs.4.5 Crore/Rs. 150) of the acquiring Firm P. Now Firm P after merger will have15 lakh shares of total value of Rs.25 Crore. The new share price will be: Rs.25/0.15 =Rs.166.67. The worth of shares given to the shareholders of Firm Q will be Rs.5 Crore(i.e., Rs.166.67 x 3 lakh). The cost of merger of Firm P is Rs.2 Crore (i.e., the value ofshare exchanged, Rs.5 Crore less the value of the acquired firm, Rs. 3 Crore). Thus,

the effective cost of merger may be more when the merger is financed by issuingshares rather than paying cash.

Merger Negotiations: Significance of P/E Ratio and EPS Analysis

In practice, investors attach a lot of importance to the earnings per share (EPS) and theprice-earnings (P/E) ratio. The product to EPS and P/E ratio is the market price pershare. In an efficient capital market, the market price of a share should be equal to thevalue arrived by the DEF technique. In reality, a number of factors may cause a

divergence between these two values. Thus, in addition to the market price and thediscount value of shares, the mergers and acquisitions decisions are also evaluated interms of EPS, P/E ratio, book value etc. We have already discussed the impact ofmerger on these variables in the case of the merger of Sarangi Engineering Companyand XL Company. In this section, we extend the discussion in a more formal manner inthe context of the negotiations in terms of exchange of shares.

Exchange Ratio

The current market values of the acquiring and the acquired firms may be taken as thebasis for exchange of shares. As discussed earlier, the share exchange ratio (SER)

would be as follows: Share price of the acquired firm P b Share exchange ratio = Share price of the acquiring firm = P b

The exchange ratio in terms of the market value of shares will keep the position of theshareholders in value terms unchanged after the merger since their proportionatewealth would remain at the pre-merger level. There is no incentive for the shareholdersof the acquired firm, and they would require a premium to be paid by the acquiringcompany. could the acquiring company pay a premium and be better off in terms of theadditional value of its shareholders? In the absence of net economic gain, theshareholders of the acquiring company would become worse-off unless the price-

earnings ratio of the acquiring company remains the same as before the merger. Forthe shareholders of the acquiring firm to be better-off after the merger without any neteconomic gain either the price-earnings ratio will have to increase sufficiently higher orthe share exchange ratio is low, the price-earnings into remaining the same. Let usconsider the example in Example 3.

Example 3Shyama Enterprise is considering the acquisition of Rama Enterprise. The



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following are the financial data of two companies:

Shyama Enterpriseq RamaEnterprise

Profit after tax (Rs. lakh)

Number of shares (Lakh)EPS (Rs.)Market value per share (Rs.)Price-earnings ratio (times)Total market capitalization (Rs. lakh)

40,000

10,00046015

6,00,000

8,000

4,000215

7.560,000

Shyama Enterprise is thinking of acquiring Rama Enterprises through exchange ofshares in proportion of the market value per share. If the price-earnings ratio isexpected to be (a) pre-merger P/E ratio of Rama i.e. 7.5 (b) pre-merger P/E ratio ofShyama i.e. 15, (c) weighted average of pre-merger P/E ratio of Shyama and Ramai.e. 13.75, what would be the impact on the wealth of share-holders after merger?

Since the basis of the exchange of shares is the market value per share of the acquiring(Shyama Enterprise) and the acquired (Rama Enterprise) firms, then Shyama wouldoffer 0.25 of its shares to the shareholders of Rama:

P b 15P a = 60 = 0.25

In terms of the market value per share of the combined firm after the merger, theposition of Rama’s shareholders would remain the same; that is, their per share valuewould be: Rs. 60 x 0.25 = Rs.15. The total number of shares offered by Shyama (the

acquiring firm) to Rama’s (the acquired firm) shareholders would be:No. of shares exchanged = SER x Pre-merger number of

Shares of the acquired firm

= (P b /P a) Nb = 0.25 x 4,000 = 1,000

And the total number of shares after the merger would be: N a + (SER) N b = 10,000 +1,000 = 11,000. The combined earnings (PAT) after the merger would be: Rs. 40,00 +Rs.8,000 = Rs. 48,000 and EPS after the merger would be:

Post-merger combined PAT PAT a + PAT b Post-merger combined EPS = Post-merger combined shares = N a + (SER)N b

40,000 + 8,000 48,00010,000 + (0.25) 4,00 = 11,000 = Rs. 4.36

The earnings per share of Shyama (the acquiring firm) increase from Rs.4 to Rs.4.36,but for Rama’s (the acquired firm) shareholders, it declined from Rs.2 to Rs.1.09; that is,



33

Rs.4.36 x 0.25 = Rs.1.09.

Given the earnings per share after the merger, the post-merger value per share woulddepend on the price-earnings ratio of the combined firm. How would P/E ratio affect thewealth of shareholders of the individual companies after the merger? Table 12 shows

the impact.Table 12

Rama and Shyama Enterprise: P/E Ratio Effect on value

Market Value ofShyama

Market Value ofRama

P/ERatio

EPSAfter

Merger

CombinedFirm’s MarketValue Merger

Beforemerger

Aftermerger

Beforemerger

Aftermerger

7.5015.0013.75

4.364.364.36

32.7065.4060.00

606060

32.7065.4060.00

151515

8.1816.3515.00

Note that Rama’s shareholder’s value in terms of their shareholding in Shyama is: MVafter merger x 0.25.

We can observe from Table 11 that the shareholders of both the acquiring and theacquired firms neither gain nor lose in value in terms if post-merger P/E ratio is merely aweighted average of pre-merger P/E ratios of the individual firms. The post-mergerweighted P/E ratio is calculated as follows:

Post-merger weighted P/E ratio:

(Pre- merger P/E ratio of the acquiring firm) x (Acquiring firm’s pre -merger earnings / Post-merger combined earnings) + (Pre-merger P/E ratio of the acquired firm) x(Acquired f irm’s pre -merger earnings + Post-merger combined earnings)

P/E w = (P/E a) (PAT a / PAT c) + (P/E b) x (PAT b /PAT c) (5)

Using Equation (5) in our example, we obtain:

= (15) (40,000/48,000) + (7.5) (8,000/48,000) = 12.5 + 1.25 = 13.75.The acquiring company would lose in value if post-merger P/E ratio is less than theweighted P/E ratio. Any P/E ratio above the weighted P/E ratio would benefit both theacquiring as well as the acquired firms in value terms. An acquiring firm would alwaysbe able to improve its earnings per share after the merger whenever it acquires acompany with a P/E ratio lower than its own P/E ratio. The higher EPS need notnecessarily increase the share price. It is the quality of EPS rather than the quality



34

which would influence the price.

An acquiring firm would lose in value if its post-merger P/E ratio is less than theweighted P/E ratio. Shyama Enterprise would lose Rs.27.30 value per share if P/E ratioafter merger was 7.5. Any P/E ratio above the weighted P/E ratio would benefit both the

acquiring as well as the acquired firm in value terms. When the post-merger P/E ratio is15, Shyama gains Rs.5.40 value per share and Rama Rs.1.35.

Why does Shyama Enterprise’s EPS increase after merger? Because it has a currentP/E ratio of 15, and it is required to exchange a lower P/E ratio, i.e.

SER x P a 0.25 x 60P/E exchanged = EPS b = 2 = 7.5

Shyama Enterprise’s EPS after merger would be exactly equal to its pre -merger EPS ifP/E ratio paid is equal to its pre- merger P/E ratio of 15. In that case, given Rama’s EPS

of Rs.2, the price paid would be Rs.30 or a share exchange ratio of 0.5. Thus, ShyamaEnterprise would issue 0.5 x 4,000 = 2,000 shares to Rama Enterprise. The acquiringfirm’s EPS after merger would be: Rs. 48,000/12,000 = Rs.4. It may be noticed that atthis P/E ratio, Shyama’s shareholders would have the same EPS as before the merger:0.5 x Rs.4 = Rs.2. It can be shown that if the acquiring firm takes over another firm byexchanging a P/E ratio higher than its P/E ratio, its EPS will fall and that of the acquiredfirm would increase after the merger.

Let us assume in our illustration that Shyama exchange a P/E ratio of 22.5 to acquireRama. This implies a price of Rs.45 per share and a share exchange ratio of 0.75. Theearnings per share after acquisition would be as follows:

40,000 + 8,000 48,000Post merger EPS = 10,000 + 0.75 x 4,000 = 13,000

= Rs. 3.69

Thus, the acquiring firm’s EPS falls (from Rs. 4 to Rs. 3.69) and the acquired firm’s EPSincreases (from Rs.2 to Rs.3.69 x 0.75 = Rs.2.77).

Leveraged Buy-outs

A leveraged buy-out (LBO) is an acquisition of a company in which the acquisition issubstantially financed through debt. Debt typically forms 70-90 per cent of the purchaseprice and it may have a low credit rating. In the USA, the LBO shares are not boughtand sold in the stock market, and the equity is concentrated in the hands of a fewinvestors. Debt is obtained on the basis of the company’s future earnings potential.LBOs generally involve payment by cash to the seller.

When the managers buy their company from its owners employing debt, the leveraged



35

buy-out is called management buy-out (MBO). LBOs are very popular in the USA. It hasbeen found there that in LBOs, the sellers require very high premium, ranging from 50to 100 per cent. The main motivation in LBOs is to increase wealth rapidly in a shortspan of time. A buyer would typically go public after four or five years, and makesubstantial capital gains.

Which companies are targets for the leveraged buy-out? In LBOs, a buyer generallylooks for a company which is operating in a high growth market with a high marketshare. It should have a high potential to grow fast, and be capable to earning superiorprofits. The demand for the company’s product should be known so that its earningscan be easily forecasted. A typical company for a leveraged buyout would be one whichhas high profit potential, high liquidity and low or no debt. Low operating risk or suchcompanies allows the acquiring firm or the management team to assume a high degreeof financial leverage and risk.

Why is a lender prepared to assume high risk in a leveraged buy-out? A lender provides

high leverage in a leveraged buy-out because he may have full confidence in theabilities of the managers-buyers to fully utilize the potential of the business and convertit into enormous value. His perceived risk is low because of the soundness of thecompany and its assumed, predictable performance. He would also guard himselfagainst loss by taking ownership position in the future and retaining the right to changethe ownership of the buyers if they fail to manage the company. The lender also expectsa high return on his investment in a leveraged buy-out since the risk is high. He may,therefore, stipulate that the acquired company will go public after four or five years. Amajor portion of his return comes from capital gains.

MBOs/LBOs can create a conflict between the (acquiring) managers and shareholdersof the firm. The shareholders ’ benefits will reduce if the deal is very attractive for themanagers. This gives rise to agency costs. It is the responsibility of the board to protectthe interests of the shareholders, and ensure that deal offers a fair value of their shares.

Another problem of LBOs could be the fall in the price of the LBO target company’s debtinstruments (bonds/debentures). This implies a transfer of wealth from debentureholders to shareholders since their claim gets diluted. Debenture holders may, thus,demand a protection in the event of a LBO/MBO. They may insist for the redemption oftheir claims at par if ownership/control of the firm changes.

Example 4 provides an example of a leverage buy-out and also explains themethodology for estimating the return and the share of ownership of the lender in suchdeals.

Example 4

Hindustan Chemicals is a small size private limited company. The companymanufactures as specialized industrial chemical. The large and medium size industrialcompanies are its buyers, and it commands about three-fourths of the market due to its



36

excellent quality, prompt delivery and reasonable price. The company is owned by SurajBhan Gupta and Mahesh Chand Goyal; both are chemical engineers and are college-days friends. The current sales of the company are Rs.99.8 lakh, and the annual salesgrowth rate in the past years has been 12-13 per cent. The company has been showinggood profits. It was been retaining profits and financing its activities internally without

resorting to any external funding. Its earnings before interest and tax (EBIT) areRs.18.41 lakh for the current year, giving a profit margin of 18.5 per cent and a 25 percent return on assets. Tables 14 and 15 give summary of the company’s profit and lossstatements and balance sheet.

Legal Measures against Takeovers

The Companies Act restricts and individual or a company or a group of individuals fromacquiring shares, together with the shares held earlier, in a public company to 25 percent of the total paid-up capital. Also, the Central Government needs to be intimatedwhenever such holding exceeds 10 per cent of the subscribed capital. The Companies

Act also provides for the approval of shareholders and the Central Government when acompany, by itself or in association of an individual or individuals purchases shares ofanother company in excess of its specified limit. The approval of the CentralGovernment is necessary if such investment exceeds 10 per cent of the subscribedcapital of another company. These are precautionary measures against the takeover ofpubic limited companies.

Refusal to Register the Transfer of Shares

In order to defuse situation of hostile takeover attempts, companies have been givenpower to refuse to register the transfer of shares. If this is done, a company must informthe transferee and the transferor within 60 days. A refusal to register transfer ispermitted if:

A legal requirement relating to the transfer of shares have not be compiled with;orThe transfer is in contravention of the law; orThe transfer is prohibited by a court order; orThe transfer is not in the interest of the company and the public.

Protection of Minority Shareholders’ Interests

In a takeover bid, the interests of all shareholders should be protected without aprejudice to genuine takeovers. It would be unfair if the same high price is not offered toall the shareholders of prospective acquired company. The larger shareholders(including financial institutions, banks and individuals) may get most of the benefitsbecause of their accessibility to the brokers and the takeover deal makers. Before thesmall shareholders know about the proposal, it may be too late for them. TheCompanies Act provides that a purchaser can force the minority shareholder to sell theirshares it:



37

The offer has been made to the shareholders of the company;The offer has been approved by at least 90 per cent of the shareholders of thecompany whose transfer is involved, within 4 months of making the offer, andThe minority shareholders have been intimated within 2 months from the expiry

of 4 months referred above.

If the purchaser is already in possession of more than 90 per cent of the aggregatevalue of all the shares of the company, the transfer of the shares of minorityshareholders is possible if:

The purchaser offers the same terms of all shareholders andThe tenders who approve the transfer, besides holding at least 90 per cent of thevalue of shares should also form at least 75 per cent of the total holders ofshares.

Guidelines for Takeovers

SEBI has provided guidelines for takeovers. The guidelines have been strengthenedrecently to protect the interests of the shareholders from takeovers. The salient featuresof the guidelines are:

Notification of takeover: If an individual or a company acquires 5 per cent ormore of the voting capital of a company, the target company and the stockexchange shall be notified immediately.

Limit to share acquisition: An individual or a company can continue acquiring

the shares of another company without making any offer to other shareholdersuntil the individual or the company acquires 10 per cent of the voting capital.

Public Offer: If the holding of the acquiring company exceeds 10 per cent, apublic offer to purchase a minimum of 20 per cent of the shares shall be made tothe remaining shareholders through a public announcement.

Offer price: Once the offer is made to the remaining shareholders, the minimumoffer price shall not be less than the average of the weekly high and low of theclosing prices during the last six months preceding the date of announcement.

Disclosure: The offer should disclose the detailed terms of the offer, identity ofthe offerer, details of the offerer’s existing holdings in the offeree company etc.and the information should be make available to all the shareholders at the sametime and in the same manner.

Offer document: The offer document should contain, the offer’s financialinformation, its intention to continue the offeree company’s business and to makemajor change and long-term commercial justification for the offer.



38

The objectives of the Companies Act and the guidelines for takeover are to ensure fulldisclosure about the mergers and takeovers and to protect the interests of theshareholders, particularly the small shareholders. The main thrust is that publicauthorities should be notified within two days.

In a nutshell, an individual or company can continue to purchase the share withoutmaking and offer to other shareholders until the shareholding exceeds 10 per cent.Once the offer is make to other shareholders, the offer price should not be less than theweekly average price in the past 6 months or the negotiated price.

Legal Procedures

The following is the summary of legal procedures for merger or acquisition laid down inthe Companies Act, 1956:

Permission for merger: Two or more companies can amalgamate only whenamalgamation is permitted under their memorandum of association. Also, the acquiringcompany should have the permission in its object clause to carry on the business of theacquired company. in the absence of these provisions in the memorandum ofassociation, it is necessary to seek the permission of the shareholders, board ordirectors and the Company Law Board before affecting the merger.

Information to the stock exchange: The acquiring and the acquired companiesshould inform the stock exchanges where they are listed about the merger.

Approval of board of directors: The boards of the directors of the individualcompanies should approve the draft proposal for amalgamation and authorize themanagement of companies to further pursue the proposal.

Application in the High Court: An application for approving the draft amalgamationproposal duly approved by the boards of directors of the individual companies should bemade to the High Court. The High Court would convene a meeting of the shareholdersand creditors to approve the amalgamation proposal. The notice of meeting should besent to them at least 21 days in advance.

Shareholders ’ and creditors’ meetings: The individual companies should holdseparate meetings of their shareholders and creditors for approving the amalgamationscheme. At least, 75 per cent of shareholders and creditors in separate meeting, votingin person or by proxy, must accord their approval to the scheme.

Sanction by the High Court: After the approval of shareholders and creditors, on thepetitions of the companies, the High Court will pass order sanctioning the amalgamationscheme after it is satisfied that the scheme is fair and reasonable. If it deems so, it canmodify the scheme. The date of the court ’s hearing will be published in two newspapersand also, the Regional Director of the Company Law Board will be intimated.



39

Filling of the Court Order: After the Court order, its certified true copies will be filedwith the Registrar of Companies.

Transfer of assets and liabilities: The assets and liabilities of the acquired company

will be transferred to the acquiring company in accordance with the approved scheme,with effect from the specified date.

Payment by cash or securities: As per the proposal, the acquiring company willexchange shares and debentures and/or pay cash for the shares and debentures of theacquired company. These securities will be listed on the stock exchange.

Accounting for Mergers and Acquisitions

Mergers and acquisitions involve complex accounting treatment. A merger, defined asamalgamation in India, involves the absorption of the target company by the acquiring

company, which results in the uniting of the interests of the two companies. The mergershould be structured as pooling of interest. In the case of acquisition, where theacquiring company purchases the shares of the target company, the acquisition shouldbe structured as a purchase.

Pooling of Interests Method

In the pooling of interests method of accounting, the balance sheet items and the profitand loss items of the merged firms are combined without recording the effects ofmerger. This implies that asset, liabilities and other items of the acquiring and theacquired firms are simply added at the book values without making any adjustments.Thus, there is no revaluation of assets or creation of goodwill. Let us consider anexample as given in example 5.

Example – 5

Firm T merges with Firm S. Firm S issues shares worth Rs. 15 crore t o Firm T’sshareholders. The balance sheets of both companies at the time of merger are shown inTable 18. The balance sheet of Firm S after merger is constructed as the addition of thebook values of the assets and liabilities of the merged firms. It may be noticed that theshareholders funds are recorded at the book value, although T’s shareholders receivedshares worth Rs.15 Crore in Firm S. They now own Firm S along with its existingshareholders.

Table – 18



40

Pooling of Interest: Merger of Firms S and T

(Rs. crore)Firm T Firm S Combined Firm

Assets

Net Fixed AssetsCurrent assetsTotalShareholdersFundBorrowingsCurrent Liabilities

2483210166

371350182012

612182283618

Total 32 50 82

Purchase Method

Under the purchase method, the assets and liabilities of the acquiring firm after theacquisitions of the target firm are adjusted for the purchase price paid to the targetcompany. Thus, the assets and liabilities after merger are re-valued. If the acquirer paysa price greater than the fair market value of assets and liabilities, the excess amount isshown as goodwill in the acquiring company’s books. On the contrary, if the fair value of assets and liabilities is less than the purchase price paid, then this difference isrecorded as capital reserve. Let us consider an example as given in Example-6.

Example - 6

Firm S acquired Firm T by assuming all its assts and liabilities . The fair value of firm T’s

fixed assets and current assets is Rs.26 crore. Current liabilities are valued at bookvalue while the fair value of debt is estimated to be Rs.15 crore. Firm S raises cash ofRs.15 crore to pay to T’s shareholders by issuing shares worth Rs. 15 crore to its ownshareholders. The balance sheets of the firms before acquisition and the effect ofacquisition are shown in Table 19. The balance sheet of Firm S (the acquirer) afteracquisition is constructed after adjusting assets, liabilities and equity.

Table 19Pooling of Interests: Merger of Firms S and T

(Rs. crore)Firm T Firm S Combined Firm

AssetsNet Fixed AssetsCurrent assetsGoodwillTotalShareholdersFundBorrowings

248--3210166

3713--50182012

63203

86333518



41

Current LiabilitiesTotal 32 50 86

The goodwill is calculated as follows:

Payment to T’s shareholders Rs. 15Fair value of fixed assets 26Fair value of current assets 7Less: Fair value of borrowings 15Less: Fair value of current liabilities 6

Fair value of net assetsGoodwill

12 ____ Rs.3

Financing Techniques in MergersAfter the value of firm has been determined on the basis of the preceding analysis, thenext step is the choice of the method of payment of the acquired firm. The choice offinancial instruments and techniques of acquiring a firm usually have an effect on thepurchasing agreement. The payment may take the form of either cash or securities, thatis, ordinary shares, convertible securities, deferred payment plans and 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 twofirms are an important consideration. For instance, for a firm having a high P/E ratio,

ordinary shares represent an ideal method for financing mergers an acquisition.Similarly, ordinary shares are more advantageous for both companies when the firm tobe acquired has a low P/E ratio. This fact is illustrated in Table A.

Table – AEffect 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 50,000EPS (EAT/N) (Rs.) 5 5Price-earnings (P/E) ratio (times) 10 4Market price per share, MPS (EPS x P/E ratio) (Rs.) 50 20Total Market value of the firm (N x MPS) or (EAT x P/Eratio) (Rs.) 50,00,000 10,00,000



42

(b) Post-merger Situation

Assuming share exchange ratio as

1:2.5* 1:1EATc of combined firm (Rs.) 7, 50,000 7, 50,000Number of shares outstandingafter additional shares issues 1,20,000 1,50,000EPS (EATc/N) (Rs.) 6.25 5P/Ec ratio (times) 10 10MPSc (Rs.) 62.50 50Total Market value (Rs.) 75, 00,000 75,00,000* Based on current market price per share

From a perusal of Table A certain fact stand out. The exchange ratio of 1:2.5 is based

on the exchange of shares between the acquiring and acquired firm on their relativecurrent market prices. This ratio implies that Firm A will issue 1 share for every 2.5shares of Firm B. The EPS has increased from Rs.5 (pre-merger) to Rs.6.25 (post-merger). The post-merger market price of the share would be higher at Rs.6.25x10 (P/Eratio) = Rs.62.50.

When the exchange ratio is 1:1 it implies that the shareholders of the Firm B earned aheavy premium per share Rs.30 in this case i.e. (Rs. 50 worth of shares against thepost-merger situation – Rs.20 worth of equity share in pre-merger situation).

As shown in Table B, at such an exchange ratio, the entire merger gain (of Rs.15 lakh)

accrues to the shareholders of Firm B. Evidently, this is the most favorable exchangeratio for shareholders of Firm B; the management of Firm A, in general, is not likely toagree to a more favorable exchange ratio (as it will decrease in shareholders ’ wealth of Firm A). This is the tolerable exchange ratio from the perspective of Firm A. Likewise;the management of Firm B is not likely to agree to a share exchange ratio that isdetrimental to the wealth of its shareholders. Such an exchange ratio is 1:3.25 (TableC). At this ratio the total gains accruing from the merger rests with the shareholders ofFirm A. This is another set of tolerate exchange ratio from the viewpoint of Firm B.Thus, it may be generalized that the maximum and the minimum exchange ratio shouldbe between these two sets of tolerable exchange ratio.

The exchange ratio eventually negotiated/agreed upon would determine the extent ofmerger gains to be shared between the shareholders of the two firms. This ratio woulddepend on the relative bargaining position of the two firms and the market reaction ofthe merger move.

Table – BApportionment of Merger Gains between the Shareholders of Firms A and B



43

(1) Total market value of the merged firm Rs.75, 00,000Less: Market value of the pre-merged

Firms:Firm A Rs. 50, 00,000Firm B Rs. 10, 00,000 Rs. 60,

00,000Total merger gains Rs. 15, 00,000

(2) (a) Appointment of gains (assumingShare exchange ratio of 2.5:1)Firm A:Post-merger market value (1, 00,000 shares x Rs.62.50)

62, 50,000Less: Pre-merger market value 50, 00,000Gains for shareholders of Firm A

12, 50,000

Firm B:Post-merger market value (20,000 shares x Rs.62.50) 12, 50,000Less: Pre-merger market value 10, 00,000Gains for shareholders of Firm B 2, 50,000

(b) Assuming share exchange ratio of 1:1

Firm A:Post-merger market value (1,00,000 shares x Rs.50)

Less: Pre-merger market valueGains for shareholders of Firm A

Firm B:Post-merger market value (50,000 shares x Rs.50) 25, 00,000

Less: Pre-merger market value 10, 00,000

Gains for shareholders of Firm B 15, 00,000

Table C

Determination of Tolerable Share Exchange Ratio for shareholders of Firms. Based onTotal Gains Accruing to Shareholders of Firm A

(a) Total market value of the merged firm(Combined earnings, Rs.7,50,000 x P/E ratio,10 times)

Rs.75,00,000

(b) Less: Pre-merger or minimum post-mergervalue acceptable to shareholders of Firm B 10,00,000



44

(c) Post-merger market value of Firm A (a – b) 65,00,000(d) Dividend by the Number of equity shares

outstanding in Firm A1,00,000

(e) Desired post-merger MPS (Rs.65 lakh/1 lakhshares)

Rs.65

(f) Number of equity issues required to be issuedin Firm A to have MPS of Rs.65 and to havepost-merger value of Rs.10 lakh of Firm B, thatis, (Rs. 10 lakh/Rs.65)

15,385

(g) Existing number of equity shares outstanding ofFirm B

50,000

(h) Share exchange ratio (g)/(h) i.e. 50,000/15,385for every 3.25 shares of firm B, 1 share in FirmA will be issued

1:3.25

Debt and Preference Shares Financing: From the foregoing discussion its is clear

that financing of mergers and acquisitions with equity shares is advantageous both tothe acquiring firm and the acquired firm when the P/E ratio is high. However, sincesome firms may have a relatively lower P/E ratio as also the requirements of someinvestors might be different, other types of securities, in conjunction with/in lieu of equityshares may be used for the purpose.

In an attempt to tailor a security to the requirements of investors who seek dividendinterest income in contrast to capital appreciation/growth, convertible debentures andpreference shares might be used to finance mergers. The use of such sources offinancing has certain advantages: (i) Potential earning dilution may be partiallyminimized by issuing convertible security. For example, assumed that the current

market price of a share in the acquiring company is Rs.50 and the value of the acquiredfirm is Rs.50, 00,000. If the merger proposal is to be financed with equity, 1, 00,000additional shares will be required to be issued. Alternatively, convertible debentures ofthe face value of Rs.100 with conversion ratio of 1.8, which imply a conversion value ofRs.90 (Rs.50 x 1.8), may be issued. To raise the required Rs.50, 00,000, 50,000debentures convertible into 90,000 equity share would be issued. Thus, the number ofshares to be issued would be reduced by 10,000, thereby reducing the dilution in EPS,which could ultimately result, if convertible security was not resorted to in place of equityshares. (ii) A convertible issue might serve the income objectives of the shareholders ofthe target firm without changing the dividend policy of the acquiring firm. (iii) Convertiblesecurity represents a possible way of lowering the voting power of the target company.

(iv) Convertible security may appear more attractive to the acquired firm as it combinedthe protection of fixed security with the growth potential of ordinary shares.

In brief, fixed income securities are compatible with the needs and purposes of mergersand acquisitions. The need for changing the financing leverage and the need for avariety of securities is partly resolved by the use of senior securities.

Deferred Payment Plan: Under this method, the acquiring firm, besides making an



45

initial payment, also undertakes to make additional payments in future years to thetarget firm in the event of the former being able to increase earnings consequent to themerger. Since the future p ayment is linked to the firm’s earnings, this plan is also knownas earn-out plan. Adopting such a plan ensures several advantages to the acquiringfirm: (i) It emerges to be an appropriate outlet for adjusting the differences between the

amount of shares the acquiring firm is willing to issue and the amount the target firm isagreeable to accept for the business; (ii) in view of the fact that fewer number of shareswill be issued at the time of acquisition, the acquiring firm will be able to report higherEPS immediately; (iii) There is a build-in cushion/protection to the acquiring firm as thetotal payment is not made at the time of acquisition; it is contingent on the realization ofthe projected earnings after merger.

There could be various types of deferred payments plans. The arrangement eventuallyagreed upon would depend on the imagination of the management of the two firmsinvolved. One of the often used plans, for this purpose is the base-period earnout.Under this plan, the shareholders of the target firm are to receive additional shares for a

specified number of future years, if the firm is able to improve its earnings vis-à-vis theearnings of the base period (the earnings in the previous year before the acquisition).The amount becoming due for payment, in shares, in the future years will primarily be afunction of excess earnings, price-earnings ratio and the market price of the shares ofthe acquiring firm. The basis for determining the required number of shares to be issuedas per the following Equation.

(Excess earnings x P/E ratio) / Share price of Acquiring firm

Example

Company A has purchased Company B in the current year. Company B had its pre-merger earnings of Rs.3, 00,000. At the time of merger, its shareholders received aninitial payment of 75,000 shares of Company A. The market value of Company A sharesis Rs. 30 per share and the P/E ratio is 8. The projected post mergers earnings ofCompany B for the three years are Rs.3, 30,000 and Rs.4, 14,000. Assuming nochanges in share prices and P/E ratio of Company A, determine the number of sharesrequired to be issues to the shareholders of Company B during these three years. Asper the agreement with Company B, they will receive shares for 3 years only.

Thus, the shareholders of Company B will receive a total of 1, 37,400 shares (75,000initially + 62,400 in the subsequent three years). In financial terms, they have receivedCompany A, shares worth Rs.41.22 lakh (1, 37,400 shares x Rs.30). This sum is higherthan the shareholders would have received initially. Assuming the P/E ratio of CompanyB is times (the assumption is reasonable in that the P/E ratio of Company A is 8 times:the P/E multiple of the acquiring firm is normally higher than that of the acquired firm),its valuation/purchase consideration would have been Rs.21 lakh only (Rs.3 lakh x 7times). Clearly, there is a substantial gain to the shareholders of Company B and thisgain is not at the cost of the wealth of the shareholders of Company A. evidently, themethod is fair and equitable.



46

To conclude, the deferred plan technique provides a useful means by which theacquiring firm can eliminate part of the guesswork involved in purchasing a firm. Inessence, it allows the merging management the privilege of hindsight.

Rs. 30,000 x 8Year 1: Rs.30 = 8,000 shares

Rs. 90,000 x 8Year 1: Rs.30 = 24,000 shares

Rs. 1,14,000 x 8Year 1: Rs.30 = 30,400 shares

Tender Offer: An alternative approach to acquire another firm is the tender offer. Atender offer, as a method of acquiring a firm, involves a bid by the acquiring firm for

controlling interest in the acquired firm. The essence of this approach is that thepurchase approaches the shareholders of the firm rather than the management toencourage them to sell their shares generally at a premium over the current marketprice.

Since the tender offer is a direct appeal to the shareholders, prior approval of themanagement of the target firm is not required.

As a form of acquiring firm, the tender offer has certain advantage and disadvantages.The disadvantages are: (i) If the target firm’s management attempts to block it, the costit, the cost of executing the offer may increase substantially and (ii) the purchasingcompany fail to acquire a sufficient number of shares to meet the objectives ofcontrolling the firm.

The major advantages of acquisition through tender offer include: (i) if the offer is notblocked, say in ‘friendly’ takeover, it may be less expensive than the normal mode of acquiring a company. This is so because it permits control by purchasing a smallerproportion of the Firm shares and (ii) the fairness of the purchase price isunquestionable as each shareholder individually agrees to part with the shares at thatprice.



47

CONCEPTUAL FRAMEWORK OF VALUATION

The term 'valuation' implies the task of estimatingthe worth/value of an asset, a security or a business.

The price an investor or a firm (buyer) is willing to

pay to purchase a specific asset/ security would be

related to this value. Obviously, two different buyers

may not have the same valuation for an

asset/business as their perception regarding its

worth/value may vary; one may perceive the

asset/business to be of higher worth (for whatever

reason) and hence may be willing to pay a higherprice than the other. A seller would consider the

negotiated selling price of the asset/business to be

greater than the value of the asset/business he is

selling.

Evidently, there are unavoidable subjective

considerations involved in the task and process of



48

valuation. Inter-se, the task of business valuation is

more awesome than that of an asset or an individual

security. In the case of business valuation, thevaluation is required not only of tangible assets

(such as plant and machinery, land and buildings,

office equipments, and so on) but also of intangible

assets (like, goodwill, brands, patents, trademark

and so on) as well as human resources that

run/manage the business. Likewise, there is an

imperative need to take into consideration recorded

liabilities as well as unrecorded/contingent liabilities

so that the buyer is aware of the total sums payable,subsequent to the purchase of business. Thus, the

valuation process is affected by, subjective

considerations. In order to reduce the element of

subjectivity, to a marked extent, and help the financemanager to carry out a more credible valuation

exercise in an objective manner, the following

concepts of value are explained in this Section: (i)



49

book value, (ii) market value, (iii) intrinsic value, (iv)

liquidation value, (v) replacement value, (vi) salvage

value, (vii) value of goodwill and (viii) fair value.

Book Value

The book value of an asset refers to the amount at

which an asset is shown in the balance sheet of a

firm. Generally, the sum is equal to the initial

acquisition cost of an asset less accumulated

depreciation. Accordingly, this mode of valuation ofassets is as per the going concern principle of

accounting. In other words, book value of an asset

shown in balance does not reflect its current sale

value.

Book value of a business refers to total book value

of all valuable assets (excluding fictitious assets,



50

such as accumulated losses and deferred revenue

expenditures, like advertisement, preliminary

expenses, cost of issue of securities not written off)less all external liabilities (including preference share

capital). It is also referred to as net worth.

Market Value

In contrast to book value, market value refers to the

price at which an asset can be sold in the market.

The market value can be applied with respect totangible assets only; intangible assets (in isolation),

more often than not, do not have any sale value.

Market value of a business refers to the aggregate

market value (as per stock market quotation) of allequity shares "outstanding. The market value is

relevant to listed companies only.



51

Intrinsic/Economic Value

The intrinsic value of an asset is equal to the presentvalue of incremental future cash inflows likely to

accrue due to the acquisition of the asset,

discounted at the appropriate required rate of return

(applicable to the specific asset intended to be

purchased). It represents the maximum price the

buyer would be willing to pay for such an asset. The

principle of valuation based on the dis-counted cash

flow approach (economic value) is used in capital

budgeting decisions.

In the case of business intended to be purchased, its

valuation is equivalent to the present value of

incremental future cash inflows after taxes, likely to.accrue to the acquiring firm, discounted at the

relevant risk adjusted discount rate, as applicable to

the acquired business. The economic value



52

indicates the maximum price at which the business

can be acquired.

Liquidation Value

As the name suggests, liquidation value represents

the price at which each individual asset can be sold

if business operations are discontinued in the wake

of liquidation of the firm. In operational terms, the

liquidation value of a business is equal to the sum of

(i) realisable value of assets and (ii) cash and bank

balances minus the payments required to dischargeall external liabilities. In general, among all

measures of value, the liquidation value of an

asset/or business is likely to be the least.

Replacement Value

The replacement value is the cost of acquiring a new



53

asset of equal utility and usefulness. It is normally

useful in valuing tangible assets such as office

equipment and furniture and fixtures, which do notcontribute towards the revenue of the business firm.

Salvage Value

Salvage value represents realisable/scrap value on

the disposal of assets after the expiry of their

economic useful life. It may be employed to value

assets such as plant and machinery. Salvage value

should be considered net of removal costs.Value of Goodwill

The valuation of goodwill is conceptually the most

difficult. A business firm can be said to have 'real'goodwill in case it earns a rate of return (ROR) on

invested funds higher than the ROR earned by

similar firms (with the same level of risk). In



54

operational terms, goodwill results when the firm

earns excess ('super') profits. Defined in this way,

the value of goodwill is equivalent to the presentvalue of super profits (likely to accrue, say for 'n'

number of years in future), the discount rate being

the required rate of return applicable to such

business firms.

The value of goodwill in terms of the present value

of super profits method can serve as a useful

benchmark in terms of the amount of .goodwill the

firm would be willing to pay for the acquired

business. In the case of mergers and acquisitiondecisions, the value of goodwill paid is equal to the

net difference between the purchase price paid for

the acquired business and the value of assets

acquired net of liabilities the acquiring firm hasundertaken to pay for.

Fair Value



55

The concept of 'fair' value draws heavily on the value

concepts discussed above, in particular, book value,intrinsic value and market value. The fair value is

hybrid in nature and often is the average of these

three values. In India, the concept of fair value has

evolved from case laws (and hence is more statutory

in nature) and is applicable to certain specific

transactions, like payment to minority shareholders.

It may be noted that most of the concepts related to

value are 'stock' based in that they are guided by theworth of assets at a point of time and not the likely

contribution they can make towards earnings/cash

flows of the business in the future. Ideally, business

valuation should be related to the cash flowgenerating ability of acquired business. The intrinsic

value reflects the firm's capacity to generate cash

flows over the long-run and, hence, seems to be



56

more aptly suited for business valuation.

In fact, in general, business firms are not acquiredwith the intent to sell their assets in the post-

acquisition period. They are to be deployed primarily

for generating more earnings. However, from the

conservative point of view, it will be useful to know

the realisable value, market value, liquidation value

and other values, if the acquiring firm has to resort to

liquidation. In brief, the finance manager will find it

useful to know business valuation from different

perspectives. For instance, the book value may bevery relevant form accounting/tax purposes; the

market value may be useful in determining share

exchange ratio and liquidation value may provide an

insight into the maximum loss, if the business is tobe wound up.



57

APPROACHES/METHODS OF VALUATION

The various approaches to valuation of businesswith focus on equity share valuation are examined in

this Section. These approaches should not be

considered as competing alternatives to the dividend

valuation model. Instead, they should be viewed as

providing a range of values, catering to varied

needs, depending on the circumstances. The major

approaches, namely, the (i) asset based approach to

valuation, (ii) earnings based approach to valuation,

(iii) market value based approach to valuation and(iv) the fair value method to valuation are described

below.

Asset-Based Approach to Valuation

Asset-based approach focuses on determining the

value of net assets from the perspective of equity



58

share valuation. What should the basis of assets

valuation be, is the central issue of this approach. It

should be determined whether the assets should bevalued at book, market, replacement or liquidation

value. More often than not, they are (and should be)

valued at book value that is, original acquisition cost

minus accumulated depreciation, as assets are

normally acquired with the intent to be used in

business and not for resale. Thus, the valuation of

assets is based on the going concern concept.

Some other value measure may be used depending

on circumstances of the case. For instance, if theplant and machinery has outlived its economic

useful life (earlier than its initial estimated period),

and is not in use for production, it will be in order to

value the machinery at liquidation value.

Apart from tangible assets, intangible assets, such

as goodwill, patents, trademark, brands, know how,



59

and so on, also need to be valued satisfactorily. It

may be useful to adopt the super profit method to

value some of these assets.

To arrive at the net assets value, total external

liabilities (including preference share capital)

payable are deducted from total assets (excluding

fictitious assets). The company's net assets are

computed as per Equation

Net assets = Total assets - Total external liabilities

The value of net assets is also known as net worth

or equity/ordinary shareholders funds. Assuming thefigure of net assets to be positive, it implies the

value available to equity shareholders after the

payment of all external liabilities. Net assets per

share can be obtained, dividing net assets by thenumber of equity shares issued and outstanding.

Thus,



60

Net assets per share = Net assets/Number of equity

shares issued and outstanding

The value of net assets is contingent upon the

measure of value adopted for the purpose of

valuation of assets and liabilities. In the case of book

value, assets and liabilities are taken at their

balance sheet values. In the market value measure,

assets shown in the balance sheet are revalued at

the current market prices. For the purpose of valuing

assets, and liabilities, it will be useful for a finance

manager/valuer to accord special attention to thefollowing points:

(i) While valuing tangible assets, such as plant and

machinery, he should consider aspects related totechnological obsolescence and capital

improvements made in the recent years.

Depreciation adjustment may also be needed in



61

case the company is following unsound depreciation

policy in this regard.

(ii) Is the valuation of goodwill satisfactory, given

the amount of profits, capital employed and average

rate of return available on such businesses?

(iii) With respect to current assets, are additional

provisions required for "unrealisability" of debtors?

Likewise, are adjustments required for "unsaleable"

stores and stock?

(iv) With respect to liabilities, there is a need for

careful examination of 'contingent liabilities', inparticular when there is mention of them in the

auditor's report, with a view to assess what portion

of such liabilities may fructify. Similarly, adjustments

may be required on account of guarantees invoked,income tax, sales tax and other tax liabilities that

may arise.



62

The net assets valuation based on book value is

in tune with the going concern principle of.

accounting. In contrast, liquidation value measure isguided by the realisable value available on the

winding up/liquidation of a corporate firm.

Liquidation value is the final net asset value (if

any) per share available to the equity shareholder.

The value is given as per Equation.

Net assets per share = (Liquidation value of assets -

Liquidation expenses - Total external

liabilities)/Number of equity shares issued andoutstanding.

In the case of liquidation, assets are likely to be sold

through an auction. In general, they are likely torealise much less than their market values. This

apart, sale proceeds from assets are further

dependent on whether the company has been



63

forced to go into liquidation or has voluntarily

liquidated. In the case of the 'former' type of

liquidation, the realisable value is likely to be stilllower.

The net asset value (NAV) per share will be the

lowest under the liquidation value measure

(Example).

(Example Following is the balance sheet of

Hypothetical Company Limited as on March 31,

current year:

Liabilities Amount Assets Am

ount

Share capital Fixed

assets

Rs

15040,000 11%

Preference shares

40 Less:

Deprecia

30 120



64

of Rs 100 each, fully

paid-up

tion

1,20,000 Equity

shares of Rs 100

each, fully paid-up

120 Current

assets:

Profit and loss

account

23 Stocks 100

10% Debentures 20 Debtors 50

Trade creditors 71 Cash

and bank

10 160

Provision for incometax

8 Preliminary

expense

s

2

282 282

Additional Information:

(i) A firm of professional valuers has provided the



65

following market estimates of its various assets:

fixed assets Rs 130 lakh, stocks Rs 102 lakh,

debtors Rs 45 lakh. All other assets are to be takenat their balance sheet values.

(ii) The company is yet to declare and pay dividend

on preference shares.

(iii) The valuers also estimate the current sale

proceeds of the firm's assets, in the event of its

liquidation: fixed assets Rs 105 lakh, stock Rs 90

lakh, debtors Rs 40 lakh. Besides, the firm is to incur

Rs 15 lakh as liquidation costs.

You are required to compute the net asset value per

share as per book value, market value and

liquidation value bases.

Solution



66

Determination of Net Asset Value per Share

(Rs. Lakh)

(i) Book value basis Rs.

120

Fixed assets (net)

Current assets:

Stock 100

Debtors 50

Cash and Bank 10 160

Total assets 280

Less : External liabilities:

10% Debentures 20

Trade Creditors 71

Provision for taxation 8

11% Preference Share capital 40

Dividend on preference shares (0.11 x 4.4 143.4



67

Rs. 40 Lakh)

Net assets available for equityholders 136.6

Divided by the number of equity

shares (in lakh)

1.2

Net assets value per share (Rs.) 113.83

(ii) Market value basis

Fixed assets (net) 130

Current assets:

Stock 102

Debtors 45


Total assets 287

Less: External liabilities (as per

details given above)

143.4


Divided by the number of equity 1.2



68

shares (in lakh)

Net assets value per equity share (Rs.) 119.67

(iii) Liquidation value basis

Fixed assets (net) 105

Current Assets:

Stock 90

Debtors 40


Total assets 245

Less : external liabilities (listed

above);

143.4

Less : Liquidation costs 15.0


Divided by the number of equityshares (in lakh)

1.2

Net assets value per equity share (in 72.17



69

Rs.)

The asset based approach is intuitively appealing in

that it indicates the net assets backing per equity

share. However, the approach ignores the future

earnings/cash flow generating ability of the

company's assets. In fact, the assets acquisition by

business firms are not an end in themselves; they

are means to an end. The end is value maximization

and firms acquire assets for the purpose of creating

value. The earning based approach reckons thisperspective.

Earnings Based Approach to Valuation

The earnings approach is essentially guided by theeconomic proposition that business valuation should

be related to the firm's potential of future earnings or



70

cash flow generating capacity. This approach

overcomes the limitation of assets-based approach,

which ignores the firm's prospects of future earningsand ability to generate cash in business valuation.

Earnings can be expressed in the sense of

accounting as well as financial management.

Accordingly, there are two major variants of this

approach: (i) earnings measure on accounting basis

and (ii) earnings measure on cash flow (financial

management) basis.

Earnings Measure Based on Accounting —

Capitalisation Method As per this method, theearnings approach of business valuation is based on

two major parameters, that is, the earnings of the

firm and the capatilisation rate applicable to such

earnings (given the level of risk) in the market.Earnings, in the context of this method, are the

normal expected annual profits. Normally to

smoothen out the fluctuations in earnings, the



71

average of past earnings (say, of the last three to

five years) is computed.

Apart from averaging, there is an explicit need for

making adjustments, to the profits of the past years,

in extraordinary items (which are not likely to occur

in the future), with a view to arriving at credible

future maintainable profits. The notable examples of

extraordinary/non-recurring items - include profits

from the sale of land, losses due to sale of plant and

machinery, abnormal loss due to major fire, theft or

natural calamities, substantial expenditure incurredon the voluntury retirement scheme (not to be

repeated) and abnormal results due to strikes and

lock-outs of major competing firm(s). Obviously, their

non-exclusion will cause distortion in determiningsustainable future earnings.

Above all, it will be useful to understand the profile of



72

the business, focussing on identifying the major

growth and income drivers. Are such drivers likely to

continue in future years? If not, projected profitsneed to be discounted. Finally, additional income

expected in the coming years — say, due to launch

of a new product —should also be considered. In

brief, the valuer should try to familiarise himself or

herself with all major factors/events that had affected

the profits of the business in the past year(s) and are

likely to affect them in the future years too.

Determination of appropriate capitalisation rate isanother major requirement of this approach.

Capitalisation rate, normally expressed in

percentages, refers to the investment sum, that an

investor is willing to make to earn a specifiedincome. For instance, 12.5 per cent capitalisation

rate implies that an investor is prepared to invest Rs

100 to earn an income of Rs 12.5 or an acquiring



73

firm is prepared to invest Rs 100 to buy the

expected profits of Rs 12.5 of another business.

Given the risk return framework of financial decision

making, businesses that exhibit (or are exposed to)

higher business and financial risks obviously warrant

a higher capitalisation factor. Conversely,

businesses carrying a low degree of risk are subject

to lower capitalisation factor. There are a host of

factors that affect the risk complexion including

fluctuation in sales/earnings, degree of operating

leverage, degree of financial leverage, nature ofcompetition, availability of substitute products and

their prices, pace of change in technology and the

level of governmental regulations. Thus, there are a

number of internal and external factors associatedwith a business that can influence the risk and,

hence, the capitalisation factor.



74

The determination of the capitalisation factor is not

an easy task in practice. A few guidelines/ principles

may, however, be helpful to the valuer in itsquantification. First, the capitalisation factor for a

business firm should be higher than that of a

government security (normally considered riskless).

Secondly, the capitalisation factor should

match/hover around the one that is used for other

firms operating in similar type of businesses. In case

the valuer wants to apply different capitalisation rate,

there should be weighty and convincing reasons to

do so. For instance, firms having the potential andprospects of achieving abnormal growth rates (for

reasons that are firm specific), vis-a-vis other firms

in the industry, managed by a well known

management team (having a good track record),may have low capitalisation factor and vice versa.

Having determined the two major inputs, Equation,



75

can be used to compute the value of business ,VB,

(from the perspective of share owners).

VB = Future maintainable profits / Relevantcapitalisation factor

Example. In the current year, a firm has reported a

profit of Rs 65 lakh, after paying taxes @ 35 per

cent. On close examination, the analyst ascertains

that the current year's income includes: (i)

extraordinary income of Rs 10 lakh and (ii)

extraordinary loss of Rs 3 lakh. Apart from existing

operations, which arc-normal in nature and are likelyto continue in the future, the company expects to

launch a new product in the coming year.

Revenue and cost estimates in respect of the newproduct are as follows: (Rs lakh)

Sales 60



76

Material Cost 15

Labour Cost (additional) 10

Allocated fixed costs 5

Additional fixed costs 8

From the given information, compute the value of

the business, given that capitalisation rate applicable

to such business in the market is 15 per cent.



77

SolutionTABLE 1 Valuation of Business

(Rs lakh)

Profit before tax (Rs. 65 lakh / (1-

0.35)

Rs.

100

Less : Extraordinary income (not

likely to accrue in future)

(10)

Add: extraordinary loss (non-

recurring in nature)

3

Sales Rs. 60

Less: Incremental costs

Material Costs Rs. 15

Labour Costs 10

Fixed costs (additional) 8 33 27

Expected profits before taxes 120Less: Taxes (0.35) 42

Future maintainable profits after 78



78

taxes

Relevant capitalization factor 0.15

Value of business (Rs 78 lakh /

0.15)

520

Some useful insights into estimate of capitalisation

rate can be made by referring to the Price earnings(P/E) ratio. The reciprocal of the P/E ratio is

indicative of the capitalisation factor employed for

the business by the market. In Example 32.2, the

P/E ratio is approximately 6.67 (1/0.15). The product

of future maintainable profits, after taxes, Rs 78 lakh

and the P/E multiple of 6.67 times, yield Rs 520

lakh. Given the fact that P/E ratio is a widely used

measure, it is elaborated below.

Price Earnings (P/E) Ratio The P/E ratio (also known

as the P/E multiple) is the method most widely used



79

by finance managers, investment analysts and

equity shareholders to arrive at the market price of

an equity share. The application of this methodprimarily requires the determination of earnings per

equity share (EPS). The EPS is computed as per

Equation.

EPS = Net earnings available to equity shareholders

during the period

Number of equity shares outstanding during the

period.

The net earnings/profits are after deducting taxes,preference dividend, and after adjusting for

exceptional and extraordinary items (related to both

incomes and expenses/losses) and minority interest.

Likewise, appropriate adjustments should be madefor new equity issues or buybacks of equity shares

made during the period to determine the number of

equity shares.



80

The EPS is to be multiplied by the P/E ratio to arrive

at the market price of equity share (MPS).MPS = EPS x P/E ratio ($2.6)

A high P/E multiple is suggested when the investors

are confident about the company's future

performance/prospects and have high expectations

of future returns; high P/E ratios reflect optimism. On

the contrary, a low P/E multiple is suggested for

shares of firms in which investors have low

confidence as well as expectations of low returns infuture years; low P/E ratios reflect pessimism.

The P/E ratio may be derived given the MPS and

EPS.P/E ratio = MPS/EPS

The future maintainable earnings/projected future

earnings should also be used to determine UPS. It



81

makes economic sense in that investors have

access to future earnings only. There is a financial

and economic justification to compute forward orprojected P/E ratios with reference to projected

future earnings, apart from historic P/E ratios. This is

all the more true of present businesses-that operate

in a highly turbulent business environment. Witness

in this context, the following: "In a dynamic business

world, a firm's past earnings record may not be an

appropriate guide to its future earnings. For

example, past earnings may have been exceptional

due to a period of rapid growth. This may not besustainable in the future.

The P/E ratios should, however, be used with

caution as the published P/E multiples are normallybased on the published financial statements of

corporate enterprises. Obviously, earnings are not

adjusted for extraordinary items and, therefore, to



82

that extent, may be distorted. Besides, all financial

fundamentals are often ignored in published data.

Finally, they reflect market sentiments, moods andperceptions. For instance, if investors are upbeat

about retail stocks, the P/E ratios of these stocks will

be higher to reflect this optimism. This can be

viewed as a weakness as well, in particular when

markets make systematic errors in valuing entire

sector. Assuming retail stocks have been

overvalued, this error has to be built into die

valuation also.

In spite of these limitations attributed to the P/E

ratio, it is the most widely used measure of

valuation.- The major plausible reasons are: (i) It is

intuitively appealing in that it relates price toearnings, (ii) It is simple to compute and is

conveniently available in terms of published data.

(iii) It can be a proxy for a number of other



83

characteristics of the. firm, including risk and growth.

Example For facts in Example, determine themarket price per equity share (based on future

earnings). Assuming:

(i) The company has 1,00,000 11% Preference

shares of Rs 100 each, fully paid-up.

(ii) The company has 4,00,000 Equity shares of

Rs 100 each, fully paid-up.

(iii) P/EE ratio is 8 times.

Solution



84

Determination of Market Price of Equity ShareFuture maintainable profits after taxes

Less: Preference dividends (1,00,000 xRs 11)

Earnings available to equity-holders

Divided by number of equity shares

Earnings per share (Rs 67 lakh/4 lakh)

Multiplied by P/E ratio (times)

Market price per share (Rs 16.75 x 8)

Rs.

78,00,00011,00,000

67,00,000

4,00,000

16.75

8

134

To conclude, the P/E ratios should be

used/interpreted with caution and care. In particular,die investors should focus on prospective/future P/E

ratios, risk and growth attributes of business and

comprehensive company analysis with a view to

have more authentic and credible valuation.

OTHER APPROACHES TO VALUE

MEASUREMENT



85

In recent years, a number of new

approaches/techniques/methods to measure value(with focus on shareholders) have been developed

and practised. The two major approaches are

market value added (MVA) and economic value

added (EVA). They are explanied in this Section.

Market Value Added Approach (MVA)

The MVA approach measures the change in the

market value of the firm's equity vis-a-vis equity

investment (consisting of equity share capital andretained profits). Accordingly,

MVA = Market value of firm's equity - Equity capital

investment/funds (14)Though the concept of MVA is normally used in the

context of equity investment (and, hence, is of

greater relevance for equity shareholders), it can



86

also be adapted (like other previous approaches) to

measure value from the perspective of providers of

all invested funds (i.e., including preference sharecapital and debt).

MVA = [Total market value of firm's securities -

(Equity shareholders funds

+ Preference share capital + Debentures)] (15)

The MVA approach cannot be used for all types of

firms. It is applicable to only firms whose

market prices are available. In that sense, themethod has limited application. Besides, the value

provided by this approach may exhibit wide

fluctuations, depending on the state of the capital

market/stock market in the country.

Example 7 Suppose, Supreme Industries has an



87

equity market capitalisation of Rs 3,400 crore. in

current year. Assume further that its equity share

capital is Rs 2;000 crore and its retained earningsare Rs 600 crore. Determine the MVA and interpret

it.

Solution

MVA = (Rs 3,400 core - Rs 2,600 crore) = Rs 800

crore.

The value of Rs 800 crore implies that the

management of Supreme Industries has created

wealth/value to the extent of Rs 800 crore for itsequity shareholders. Well managed companies

(engaged in sunrise businesses),"having good

growth prospects, and perceived so by the investors,

have positive MVA. Investors may be willing to paymore than the net worth. In contrast, companies

relatively less known or engaged in businesses that

do not hold future growth; potentials may have



88

negative MVA.

Example 8

Suppose, Hypothetical Limited has equity market

capitalisation of Rs 900 crore in the current year. Its

equity share capital and accumulated losses are of

Rs 1,200 crore and Rs 200 crore respectively.

Determine the MVA of the film.

Solution

MVA = (Rs 900 crore - Rs 1,000 crore) = (-Rs 100

crore).The firm has negative MVA of Rs 100 crore. The

investors discount its value/worth, as it is loss

incurring firm.

The market value added approach reflects market

expectations and is essentially a future-oriented and

forward looking approach. The investors, willing to



89

pay a different price (other than one suggested by

book value), are guided by the individual company's

future prospects, future growth rates, riskcomplexion of the firm, industry to which the firm

belongs, required rate of return and so on.

Economic Value Added (EVA)

The EVA method is based on the past performance

of the corporate enterprise. The underlying

economic principle in this method is to determine

whether the firm is earning a higher rate of return on

the entire invested funds than the cost of such funds(measured in terms of the weighted average cost of

capital, WACC). If the answer is positive, the firm's

management is adding to the shareholders value by

earning extra for them. On the contrary, if the WACGis higher than the corporate earning rate, the firm's

operations have eroded the existing wealth of its

equity shareholders. In operational terms, the



90

method attempts to measure economic value added

(or destroyed) for equity shareholders, by the firm's

operations, in a given year.

Since WACC takes care of the financial costs of all

sources of providers of invested funds in a corporate

enterprise, it is imperative that operating profits after

taxes (and not net profits after taxes) should be

considered to measure EVA. The accounting profits

after taxes, as reported by the income statement,

need adjustments for interest costs. The profits

should be the net operating profits after taxes andthe cost of funds will be product of the total capital

supplied (including retained earnings) and WACC.

EVA .= [Net Operating profits after taxes - (Totalcapital x WACC)] (16)

The computation of EVA is illustrated in Example 9

Example 9 Following is the condensed income



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statement of a firm for the current year: (Rs

lakh)

Sales revenueLess: Operating costs

Less: Interest costs

Earnings before taxes

Less: Taxes (0.40)

Earnings after taxes

Rs 500300

12

188

75.2

112.8

The firm's existing capital consists of Rs 150 lakh

equity funds, having 15 per cent cost and of Rs 100

lakh 12 per cent debt. Determine the economic

value added during the year.

Solution

(i) Determination of Net Operating Profit After Taxes

(Rslakh)

Sales revenue Rs. 500



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Less : Operating Costs

Operating profit (EBIT)

Less: Taxes (0.40)Net operating profit after taxes (NOPAT)*

300

200

80120

* Alternatively, [EAT, Rs 112.8 lakh + Interest Rs 12

lakh - (Tax savings on interest, Rs 12 lakh x 0.4 =

Rs 4.8 lakh)]



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(ii) Determination of WACGEquity (Rs 150 lakh x 15%)

12% Debt (Rs:100 lakh x 7.2%)*Total cost

WACC (29.7 lakh/Rs 250 lakh)

= Rs 22.5

lakh= 7.2

29.7

11.88%

*Cost of debt = 12% (1 - 0.4 tax rate) = 7.2 per cent

(iii) Determination of EVA

EVA = NOPAT* - (Total capital x WACC)

Rs 120 lakh-(Rs 250 lakh x 11.88%)

Rs 120 lakh - Rs 29.7 lakh = Rs 90.3 lakhDuring the current year, the firm has added an

economic value of Rs 90.3 lakh to the existing

wealth of the equity shareholders. Essentially, the

EVA approach is a modified accounting approach to

determine profits earned after meeting all financial

costs of all the providers of capital. Its major

advantage is that this approach reflects the true



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profit position of the firm. What may happen is that

the firm may exhibit positive profits after taxes (as

per the conventional income statement) ignoringcosts of shareholders funds, giving an impression to

the owners as well as outsiders that the firm's

operations are profitable. The profit picture, in fact,

may be illusory. Consider Example 10.

Example 10

For Example 53.8, assuming sales revenues are Rs

330 lakh, compute the earnings after taxes.

SolutionIncome Statement (Conventional)

(Rs lakh)

Sales revenue

Less: Operating costsLess: Interest costs

Earnings before taxes

Rs 330

30012

18



95

Less: Taxes (0.40)

Earnings after taxes

7.2

10.8

The firm has registered profits of Rs 10.8 lakh during

the current year on the equity funds of Rs 150 lakh,

which has financial costs of Rs 22.5 lakh. Therefore,the firm has, suffered a loss, (of Rsll.7 lakh) as the

opportunity costs of equity funds invested by equity

holders is more than what has been earned by the

firm for them. This point is brought to the fore by the

EVA approach. It is for this reason that the EVA

approach is getting more attention. It is superior to

the conventional approach of determining profits.

Determination of EVA

(Rs. lakh)(a) Sales revenue

Less : Operating Costs

Rs. 330

300



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Operating Profits

Less : taxes (0.4)

Net operating profits after taxes(b) EVA = Rs. 18 Lakh – (Rs. 29.7

lakh, already computed above) = -

Rs. 11.7 lakh

30

12

18

Example 10 demonstrates that there may be asubstantial difference between profits determined as

per accounting approach and the EVA approach.

Profits shown ass per the EVA approach are

conceptually realistic than shown by traditional

accounting approach. In no way, the firm can be

said to have earned profits without meeting financial

costs of all sources of finance. The EVA approach is

in tune with the basic financial tenet of cost-benefit

analysis; financial benefits have to be more thanfinancial costs to have true profits.



97

Though the MVA and EVA are two different

approaches, the MVA of the firm (in a technical

sense) can be conceived in terms of the presentvalue of all the EVA profits that the firm is expected

to generate in the future.



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Solved ProblemsThe following particulars are available in respect of a

corporate:

(i) Capital employed, Rs 500 million.

(ii) Operating profits, after taxes, for last three years

are: Rs 80 million, Rs 100 million, Rs 90 million;

current year's operating profit, after taxes, is Rs 105

million.

(iii) Riskless rate of return, 10 per cent.

(iv) Risk premium relevant to the-business of

corporate firm, 5 per cent.

You are required to compute the value of

goodwill, based on the present value of. the super

profits method. Super profits are to be computed on

the basis of the average profits of 4 years. It is

expected that the firm is likely to earn super profits

for the next 5 years only.



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SolutionDetermination of goodwill, using super profit method

(Rs million)

Average profits (Rs 80 million + Rs

100 million + Rs 90 million + Rs 105

million = Rs 375 million)/ 4 years

Rs. 93.75

Less: Normal profits (Rs 500 million x

0.15)

75.00

Super profits 18.75

Multiplied by the PV of .annuity for 5

years at 15 percent

(x) 3.352

PV of super profits/Value of goodwill 62.85

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