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FN312: ADVANCED FINANCIAL
MANAGEMENT TOPICS
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LECTURE SERIES VI
7 Mergers, acquisitions and corporatereorganization
j Approaches to attain profitable growth (internal vs.external growth)
jDifferent types of Mergers/acquisitions
jMotives for mergers and acquisitions
jEvaluation of mergers
jCorporate reorganization
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Approaches to attain profitable growth
A firm can achieve profitable growth throughexternal, internal or both.
Internal growth: growth attained within a firm by
Introducing/developing a new line of business (introducea new product).
Expanding the existing lines of business (expand themarket, increase the production capacity).
External growth: acquisition of existing businessentity. This is known as merger, acquisition,amalgamation, takeovers, absorption, consolidationetc.
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Approaches to attain profitable growth
(cont.)
Advantages of Internal growth:
A firm is able to retain control
It offers flexibility: types of technology required
etc. Disadvantages:
The process may take a long time
It may be highly uncertain, particularly whenintroducing a new product/line of business
Inability to raise enough funds
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Mergers/acquisitions
Different types of mergers: Horizontal mergers: firms involved in the same lines
business activity combine together. (e.g. TBL and KIBO).
Vertical mergers: firms in the same value chain, whereby
one (processor) acquires (combines) anupstream/downstream firm. (e.g. textile value chain)
Supplier Producer(Urafiki)
Marketing/ retailer(C&A)
customer
producer
producer Mark & Spenser
P&C
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Mergers/acquisitions
Different types of mergers: Conglomerate merger: firms from different lines
of business (different industries/sectors)
combine together. E.g. One firm in textile industry and another in
pharmaceutical industry.
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Motives for mergers/acquisitions
Defensive motives
Economies of scale
Increase utilisation of idle capacity in all aspects
(finance, production, management, staff, etc) Reduce transaction costs, distribution costs
Reduction of competition
Horizontal: increase mkt power and monopoly (TBL
and KIBO) Vertical: limit mkt entry as it results in the control of
outlets and suppliers (TBL and distributors; Largefishing coys in Mwanza)
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Mot ves or mergers/acqu s t ons(cont.)
Defensive motives
Tax benefits
Fast growth
Synergy: combine strength and opportunitiesto overcome threats and weaknesses
A firm has favourable sources of funds but it has noinvestment opportunities, while another has
investment opportunity but it has no funds. Firms might have different strength in research and
development, management competencies, andproduction. Combining their activities may result in
an increase in their strength.
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Motives for mergers/acquisitions(cont.)
Offensive motives (take-overs) Fast growth
Asset stripping: take advantage of undervalued shares,after buying then selling the assets at profit.
Financial opportunities: take advantage of inefficient (non-optimal) capital structure.
Diversification, particularly for conglomeratemergers
Reduce business risk Reduce fluctuation of an investors income. For this to be
achieved, incomes from merged investments need to beindependent, or inversely correlated.
the reduction should be higher that what the investor canachieve by diversifying his investment portfolio).
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Evaluation of mergers
Analysis of mergers involves 3 steps Planning
Review a firms (acquiring) objectives of acquisition: itsstrength, corporate goals (planned expansion in terms of target markets, interested products, growth rate, etc).
This helps to identify the potential firm for target. Search and screening
Search: looking for suitable candidates for acquisition Screening: process of short-listing a few candidates from the
available ones. Then, gather detailed information for short-listed ones
Financial evaluation Central question: What is the benefit of merger to the
acquiring firm? A merger will make sense to the acquiring firm if its shareholders
benefit. Shareholders will benefit if merger leads to the maximisation of
their wealth.
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Evaluation of mergers (cont)
Financial evaluation A merger will create an economic advantage
(EA) if the combined present value of themerged firms is greater than the sum of their
individual present values when treated asseparate firms. e.g.: Firm P has present value (value of a firm) = VP
Firm Q has present value (value of a firm) = VQ
When P and Q merge, the present value of themerger = VPQ
A merger will have EA if VPQ > VP + VQ
The economic advantage created, EA = V
PQ- (V
P+ V
Q)
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Evaluation of mergers (cont)
Financial evaluation If firm P acquires firm Q, it will gain the value
of firm Q(i.e. VQ).
The cost of merging incurred by firm P is
Cost = Cash paid - VQ
The net economic advantage (NEA) realised byP is positive if
EA > Cost of mergingNEA = EA (Cash paid - VQ)
Note: EA = VPQ - (VP + VQ)
NEA = [VPQ - (VP + VQ)] (Cash paid - VQ)
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Evaluation of mergers (cont)
Financial evaluation
Note: Note: economic advantage [i.e. EA = VPQ - (VP + VQ)] results from synergy and an increase in economiesof scale which leads to increased efficiency.
Distribution of EA
When Cost = Cash paid - VQ = 0; the whole EA willaccrue to the shareholders of the acquiring firm (from
e.g. firm P) The EA is distributed to shareholders of both
companies (P and Q) if the cost is greater than zero.i.e. Cost = Cash paid - VQ > 0
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Evaluation of mergers (cont) Financial evaluation
Example:
Firm P Firm Q
Market value Tshs. 18,000,000 3,000,000
Number of outstanding shares 120,000 50000
Market value per share Tshs. 150 60
Firm P considers acquiring firm Q. Value of P after merger = Tshs
25,000,000. Firm P requires to pay Tshs 4,500,000 to acquire firm Q.
What is the economic advantage of merger? Estimate the new market
value per share of acquiring company (i.e. P) after merger),
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Evaluation of mergers (cont) Financial evaluation
Example: Estimation of EA and the new market value of shares of acquiring company (i.e. P) after merger
P after
merger Firm P Firm Q
Value of firm in Tshs. 25,000,000 18,000,000 3,000,000
EA [Value of Merger -(Value of
P + Value of Q) = Tshs. 4,000,000
Cash paid 4,500,000
Cost (cash - value of Firm Q) 1,500,000
NEA [EA - Cost] 2,500,000
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Evaluation of mergers (cont)
Financial evaluation Example: Estimation of the market value per share of
acquiring company (i.e. P) after merger
P after
merger Firm P Firm QPresent Value of firms = Tshs 25,000,000 18,000,000 3,000,000
NEA [EA - Cost] (accrued to
shareholders of acquiring Firm) Tshs. 2,500,000
Total value of shares Tshs. 20,500,000
Total number of shares 120,000
Market value per share Tshs 170.83
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Evaluation of mergers (cont)
Financial evaluation
Example: In case Firm P decides to issue shares to firm Q insteadof paying cash.
Thus, shares are exchanged in the ratio of cash to be paid tocombine value of the merged firm.
Value of P after
merger
Value accrued
to Firm P
Value accrued to
Firm Q
Value tshs 25,000,000 20,500,000 4,500,000
Distribution in %_ 100 82 18
Number of shares X 120,000
NOTE: If 82% is 120,000 shares, what is the number of share for 100%.
Number of shares 146,341.463 120,000 26,341
Market value per share
Tshs 170.83
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Evaluation of mergers (cont)
Financial evaluation
In practice, the number of shares exchanged may bebased on the current market price of the acquiring firm.
EG. Market price per share of Firm P = Tshs. 150
Cash to be paid to Q = 4,500,000.Instead of cash, number of shares to be issued to Q is
Number of shares = 4,500,000 /150
= 30,000
Value of P after merger
Value tshs 25,000,000
Total number of shares 150,000
Market value per share Tshs 166.67
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Evaluation of mergers (cont)
Discounted cash flow (DCF) evaluation of Merger
Merger is a special type of capital budgeting decision.
Thus, the acquiring firm needs to appraise merger as acapital budgeting decision following the DCF approach
The acquiring firm incur cost (buying the business of thetarget firm) in expectation of a stream of benefits in thefuture: Benefits will result from
Increased efficiency in specified inputs
Synergy Etc.
Merger will be advantageous to acquiring firm if thepresent value of expected benefits (cash flows) is higherthan the cost of acquisition.
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Evaluation of mergers (cont)
Discounted cash flow (DCF) evaluation ofMerger
Information required:
Estimation of cash-flows (NCF)
NCF = EBIT (1-t) + Dep - NWK - CAPEX Dep = Depreciation
NWK = Change in Net working capital
CAPEX = Change in capital expenditure
Timing of cash flows
Discount rate: Mostly used one is the cost of capital of the target firm.
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Evaluation of mergers (cont)
Discounted cash flow (DCF) evaluation ofMerger
Steps to follow:
Identify growth and profitability assumptions under
specified scenarios Estimate cash flows and their timing
Estimate the cost of capital
Compute the NPV for each scenario
Decide if the acquisition is attractive based on the NPV Decide on how the acquisition should be financed
Evaluate the impact of merger on EPS and P/E ratio.
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Evaluation of mergers (cont) Discounted cash flow (DCF) evaluation
of Merger EG:Firm P Firm Q
Sales Tshs 20,000,000 4,000,000
Operating expense (exclude depreciation) 10,000,000 3,000,000
EBIT 10,000,000 1,000,000Other info.
Outstanding shares 50,000 5,000
Cost of equity 0.10 0.13
Firms are financed by equity onlyEarnings will continue to be the same indefinitely (thus the cash flow are
perpetual)
Merger will results to an increase of sales (combined sales of P and Q) by Tshs 2
M, and a decrease of operating costs (combined) by Tshs 1 M.
If P's shareholders would require a return of 12% per annum if take-over of Q issuccessful answer the following questions
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Evaluation of mergers (cont) Discounted cash flow (DCF) evaluation of
Merger EG:
a) What is the maximum price which P will be willing to pay
for Q?
b) what is the minimum price shareholders of Q would be
willing to accept?
c) if the agreed price is Tshs 10 M, estimate the % of total
number of shares which P will issue to Q.
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Evaluation of mergers (cont) Discounted cash flow (DCF) evaluation of
Merger EG:
Firm P
after
merger Firm P Firm Q
Sales Tshs 26,000,000 20,000,000 4,000,000
Operating expense (exclude
depreciation) 12,000,000 10,000,000 3,000,000
EBIT 14,000,000 10,000,000 1,000,000
Cost of equity 0.12 0.10 0.13
Market value 116666667 100000000 7692307.69
a) Maximum price P will be willing to pay 16666666.7
b) Minimum price Q will be willing to
accept 7692307.69
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Evaluation of mergers (cont)
EG. of financing options:
Cash
Exchange of shares Cash and shares
Shares and debt.
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Evaluation of mergers (cont)
Cash as an option:
It does not cause any dilution of EPS andownership (which means control) of acquiringcompanys shareholders,
Not likely to cause wide a fluctuation of shareprice of a merger
Exchange of shares as an option:
It cause dilution of EPS and ownership (whichmeans control)
Likely to cause a wide fluctuation of share price
of a merger
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Merger tactics
In the process of acquisition, the acquirer and target firm may agree on the on
the decision to merge,
the acquirer and management of the target firmmay sometimes disagree on the decision. In thisrespect, the acquirer may use the followingapproaches:
A proxy fight: The acquirer decides to seek the support of
the target firms shareholders at their annual meeting A tender offer: The acquirer makes an offer directly to the
target firms shareholders. The offer is made at valueshigher than the current market price per share.
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Defensive tactics
How the management can defend their firmfrom being taken over,
Persuade the management that acquisition is not fortheir best interests,
increase dividend immediately,
Delay action deliberately
Seek a rival bid from a friendly company
Spread information about the negative performanceof the acquirer
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Corporate reorganization
Causes of financial distress Technical insolvency: The firm is unable to
meet its obligations as they fall due.
Bankruptcy: The market value of the firmsassets is less than its liabilities, and thusowners equity is negative.