Unit-1

Mergers and acquisitions are two of the most misunderstood words in the business world. Both
terms are used in reference to the joining of two companies, but there are key differences
involved in when to use them.

A merger occurs when two separate entities combine forces to create a new, joint organization.
Meanwhile, an acquisition refers to the takeover of one entity by another. Mergers and
acquisitions may be completed to expand a company’s reach or gain market share in an attempt
to create shareholder value.

Mergers Vs. Acquisitions

In an acquisition, a new company does not emerge. Instead, the smaller company is often
consumed and ceases to exist with its assets becoming part of the larger company. Acquisitions –
sometimes called takeovers – generally carry a more negative connotation than mergers. Due to
this reason, many acquiring companies refer to an acquisition as a merger even when it is clearly
not. 

Legally speaking, a merger requires two companies to consolidate into a new entity with a new
ownership and management structure (ostensibly with members of each firm). An acquisition
takes place when one company takes over all of the operational management decisions of
another. The more common distinction to differentiating a deal is whether the purchase is
friendly (merger) or hostile (acquisition).

In practice, friendly mergers of equals do not take place very frequently. It's uncommon that two
companies would benefit from combining forces with two different CEOs agreeing to give up
some authority to realize those benefits. When this does happen, the stocks of both companies
are surrendered and new stocks are issued under the name of the new business identity.

Both mergers and acquisitions have pros and cons. Mergers require no cash to complete but
dilute each company's individual power. Acquisitions require large amounts of cash, but the
buyer's power is absolute.

Definition of Merger

Merger refers to the mutual consolidation of two or more entities to form a new enterprise with a
new name. In a merger, multiple companies of similar size agree to integrate their operations into
a single entity, in which there is shared ownership, control, and profit. It is a type of
amalgamation. For example M Ltd. and N Ltd. joined together to form a new company P Ltd.

The reasons for adopting the merger by many companies is that to unite the resources, strength &
weakness of the merging companies along with removing trade barriers, lessening competition
and to gain synergy. The shareholders of the old companies become shareholders of the new
company. The types of Merger are as under:
  Horizontal
 Vertical
 Reverse
 Conglomerate
 Demerger

Definition of Acquisition

The purchase of the business of an enterprise by another enterprise is known as Acquisition. This
can be done either by the purchase of the assets of the company or by the acquiring ownership
over 51% of its paid-up share capital.

In acquisition, the firm which acquires another firm is known as Acquiring company while the
company which is being acquired is known as Target company. The acquiring company is more
powerful in terms of size, structure, and operations, which overpower or takes over the weaker
company i.e. the target company.

Most of the firm uses the acquisition strategy for gaining instant growth, competitiveness in a
short notice and expanding their area of operation, market share, profitability, etc. The types of
Acquisition are as under:

 Hostile
 Friendly
 Buyout

Key Differences Between Merger and Acquisition

The points presented below explain the substantial differences between merger and acquisition in
a detailed manner:

1. A type of corporate strategy in which two companies amalgamate to form a new

company is known as Merger. A corporate strategy, in which one company purchases
another company and gain control over it, is known as Acquisition.
2. In the merger, the two companies dissolve to form a new enterprise whereas, in the
acquisition, the two companies do not lose their existence.
3. Two companies of the same nature and size go for the merger. Unlike acquisition, in
which the larger company overpowers the smaller company.
4. In a merger, the minimum number of companies involved are three, but in the
acquisition, the minimum number of companies involved is 2.
5. The merger is done voluntarily by the companies while the acquisition is done either
voluntarily or involuntarily.
 6. In a merger, there are more legal formalities as compared to the acquisition
7. Mergers require no cash to complete but dilute each company's individual power.
Acquisitions require large amounts of cash, but the buyer's power is absolute.
Motives of Mergers and Acquisition

1. Synergies through Consolidation

Synergy implies a situation where the combined firm is more valuable than the sum of the
individual combining firms. It is defined as ‘two plus two equal to five’ (2+2=5) phenomenon.
Synergy refers to benefits other than those related to economies of scale. Operating economies
are one form of synergy benefits. But apart from operating economies, synergy may also arise
from enhanced managerial capabilities, creativity, innovativeness, R&D and market coverage
capacity due to the complementarily of resources and skills and a widened horizon of
opportunities.

An under valued firm will be a target for acquisition by other firms. However, the fundamental
motive for the acquiring firm to takeover a target firm may be the desire to increase the wealth of
the shareholders of the acquiring firm.  This is possible only if the value of the new firm is
expected to be more than the sum of individual value of the target firm and the acquiring firm.
For example, if A Ltd. and Ltd. decide to merge into AB Ltd. then the merger is beneficial if

V (AB)> V (A) +V (B)

2. Diversification

A commonly stated motive for mergers and acquisitions is to achieve risk reduction through
diversification. The extent, to which risk is reduced, depends upon on the correlation between the
earnings of the merging entities. While negative correlation brings greater reduction in risk,
positive correlation brings lesser reduction in risk. If investors can diversify on their own by
buying stocks of companies which propose to merge, they do not derive any benefits from the
proposed merger. Any investor who wants to reduce risk by diversifying between two
companies, say, ABC Company and PQR Company, may simply buy the stocks of these two
companies and merge them into a portfolio. The merger of these companies is not necessary for
him to enjoy the benefits of diversification. As a matter of fact, his ‘home-made diversification
give him far greater flexibility. He can contribute the stocks of ABC Company and PQR
Company in any proportion he likes as he is not confronted with a ‘fixed’ proportion that result
from the merger.

3. Accelerated Growth

Growth is essential for sustaining the viability, dynamism and value-enhancing capability of
company. A growth- oriented company is not only able to attract the most talented executives but
it would also be able to retain them. Growing operations provide challenges and excitement to
the executives as well as opportunities for their job enrichment and rapid career development.
This helps to increase managerial efficiency. Other things being the same, growth leads to higher
profits and increase in the shareholders value. A company can achieve its growth objective by:
 Expanding its existing markets
 Entering in new markets.

A company may expand and/or diversify its markets internally or externally. If the company
cannot grow internally due to lack of physical and managerial resources, it can grow externally
by combining its operations with other companies through mergers and acquisitions. Mergers
and acquisitions may help to accelerate the pace of a company’s growth in a convenient and
inexpensive manner.

4. Increased Market Power

A merger can increase the market share of the merged firm. The increased concentration or
market share improves the profitability of the firm due to economies of scale. The bargaining
power of the firm with labour, suppliers and buyers is also enhanced. The merged firm can also
exploit technological breakthroughs against obsolescence and price wars. Thus, by limiting
competition, the merged firm can earn super normal profit and strategically employ the surplus
funds to further consolidate its position and improve its market power.

The acquisition of Universal Luggage by Blow Plast is an example of limiting competition to

increase market power. Before the merger, the two companies were competing fiercely with each
other leading to a severe price war and increased marketing costs. As a result of the merger,
Blow Plast has obtained a strong hold on the market and now operates under near monopoly
situation. Yet another example is the acquisition of Tomco by Hindustan Lever. Hindustan Lever
at the time of merger was expected to control one-third of three million tonne soaps and
detergents markets and thus, substantially reduce the threat of competition.

5. Purchase of Assets at Bargain Price

Mergers may be explained by the opportunity to acquire assets, particularly land, mined rights,
plant and equipment at lower cost than would be incurred if they were purchased or constructed
at current market prices. If market prices of many stocks have been considerably below the
replacement cost of the assets they represent, expanding firm considering constructing plants
developing mines, or buying equipment. Often it has found that the desired asset could be
obtained cheaper by acquiring a firm that already owned and operated the asset. Risk could be
reduced because the assets were already in place and an organization of people knew how to
operate them and market their products.

Many of mergers can be financed by cash tender offers to the acquired firm’s shareholders at
price substantially above the current market. Even, so, the assets can be acquired for less than
their current cost of construction. The basic factor underlying this is that inflation in construction
costs not fully reflected in stock prices because of high interest rates and limited optimism (or
downright pessimism) by stock investors regarding future economic conditions.

6. Increased External Financial Capability

Many mergers, particularly those of relatively small firms into large ones, occur when the
acquired firm simply cannot finance its operations. This situation is typical in a small growing
firm with expanding financial requirements. The firm has exhausted its bank credit and has
virtually no access to long term debt or equity markets. Sometimes the small firms have
encountered operating difficulty and the bank has served notice that its loans will not be
renewed. In this type of situation, a large firm with sufficient cash and credit to finance the
requirements of the smaller one probably can obtain a good situation by making a merger
proposal to the small firm. The only alternative the small firm may have is to try to interest two
or more larger firms in proposing merger to introduce completion into their bidding for the
acquisition.

The smaller firm’s situation might not be so bleak. It may not be threatened by nonrenewable of
a maturing loan. But its management may recognize that continued growth to capitalize on its
markets will require financing beyond its means. Although its bargaining position will be better,
the financial synergy of the acquiring firm’s strong financial capability may provide the impetus
for the merger.

Sometimes the financing capability is possessed by the acquired firm. The acquisition of a cash
rich firm whose operations have matured may provide additional financing to facilitate growth of
the acquiring firm. In some cases, the acquiring firm may be able to recover all or part of the cost
of acquiring the cash-rich firm when the merger is consummated and the cash then belongs to it.

A merger also may be based upon the simple fact that the combination will make two small firms
with limited access to capital markets large enough to achieve that access on a reasonable basis.
The improved financing capability provides the financial synergy.

THEORIES OF M&A

Many theories have been advanced to explain why mergers and other forms of restructuring take
place. Efficiency theories imply social gains from M&A activity in addition to the gains for
participants.

1. Differential efficiency Theory: The differential efficiency theory says that more efficient firms
will acquire less efficient firms and realize gains by improving their efficiency; this implies
excess managerial capabilities in the acquiring firm. Differential efficiency would be most likely
to be a factor in mergers between firms related industries where the need for improvement could
be more easily identified. For eg Facebook acquired Little Eye Labs (2014) To take its mobile
development to the next level by leveraging Facebook’s world-class infrastructure and different
application.

2. Inefficient Management Theory: The related inefficient management theory suggest that target
management is so inept that virtually any management could do better, and thus could be an
explanation for mergers between firms in unrelated industries. The theory's main limitation is its
implication that agency costs are so high that shareholders have no way to discipline managers
short of costly merger. Holcim Ltd. acquired ACC Ltd. (2007) To organise talent exchange
programmes at the management levels in Holcim and ACC, to employ innovative technologies in
manufacturing and information technology that would result in higher energy efficiency and
product development
3. Operating Synergy Theory: The operating synergy theories postulates economies of scale or
of scope and those mergers help achieve levels of activities at which they can be obtained. It
includes the concept of complementary of capabilities. For example, one firm might be strong in
R&D but weak in marketing while another has a strong marketing department without the R&D
capability. Merging the two firms would result in operating synergy. Mahindra and Mahindra
Ltd. acquired Ssangyong Motor Co. (2010) .To leverage the combined synergies (Mahindra’
sourcing and marketing strategy Ssangyong’s strong capabilities in technology) by investing in a
new Ssangyong product portfolio to gain momentum in global markets

4. Financial Synergy Theory: The financial synergy theory hypothesis complementarities

between merging firms, not in management capabilities, but in the availability of investment
opportunities an internal cash flow. A firm in a declining industry will produce large cash flows
since there are few attractive investment opportunities. A growth industry has more investment
opportunities than cash with which to finance the. The merged firm will have a lower cost of
capital due to the lower cost of internal funds as well as possible risk reduction, savings in
flotation costs, and improvements in capital allocation. Hindalco Industries Ltd. merges Indo Gulf
Corpn. Ltd. (2002), To increase revenues around Rs. 6,000 crore. Merger of BoB, Dena Bank and
Vijaya Bank is also a case of financial theory

5. Pure diversification Theory: Pure diversification as a theory of mergers differs from

shareholder portfolio diversification. Shareholders can efficiently spread their investment and
risk among industries, so there is no need for firms to diversify for the sake of their shareholders.
Managers and other employees, however, are at greater risk if the single industry in which their
firm operates should fail their firm specific human capital is not transferable. Therefore, firms
may diversify to encourage firm specific human capital investments which make their employees
more valuable and productive, and to increase the probability that the organization and reputation
capital of the firm will be preserved by transfer to another line of business owned by the firm in
the event its initial industry declines. Dabur India Ltd. with Fem Care Pharma Ltd. (2009) To
have a strong foothold in the high-growth skin care market with an established brand name
FEM(Fem Care Pharma Limited brand). Ola and foodpanda

6. Theory of Strategic Alignment: The theory of strategic alignment to changing environments

says that mergers take place in response to environmental changes. External acquisitions of
needed capabilities allow firms to adapt more quickly and with less risk than developing
capabilities internally. Merger of Tata Motors Ltd. with Tata Finance Ltd. (2005) To grow its
auto financing business and offer complete solutions in line with the global best practices in the
auto industry to enable the company to provide a hedge against the cyclicality of the automotive
business. For eg. Snapdeal acquisition of Freecharge.
7.Undervaluation Theory: The under valuation theory states that mergers occur when the market
value of target firm stock for some reason does not reflect it true of potential value or its value in
the hands of an alternative management. The q-ratio is also related to the under valuation theory.
Firms can acquire assets for expansion more cheaply by buying the stock of existing firms than
by buying or building the assets when the target's stock price is below the replacement cost of its
assets. CiplaMedpro Shareholders Back Buyout By India’s Cipla (2013) The shareholders of
South Africa’s CiplaMedpro made a $488 million takeover offer from India’s Cipla Ltd. and the
price was undervalued

8.Signaling Theory: Theories other than efficiency include information and signaling agency
problems and managerialism, free cash flow, market power, taxes, and redistribution. The
information or signaling theory attempts to explain why target shares seem to be permanently
revalued upward in a tender offer whether or not it is successful. The information hypothesis
says that the tender offer sends a signal to the market that the target shares are undervalued, or
alternatively, the offer signals information to target management, which inspires them to
implement a more efficient strategy on their own. Another school holds that the revaluation is
not really permanent, but only reflects the likelihood that another acquirer will materialize for a
synergistic combination. Other aspects of takeovers may also be interpreted as signals value,
including the means of payment and target management's response to the offer. Kotak
Mahindra-ING Vyasa (2015) The deal signals that leverage ING’s digital banking strengths,
evident from the fact that ING was among top two or three consumer banks in Germany with
zero branch presence. ING group was very comfortable with deal. It is a way of signalling
contrary to what you may have felt that this is not a distress deal at all. The combined synergies a
big signal that ING group is committed to make the merger work, to have a 1 year lock in post
merger as a sign of commitment

9. Agency Theory: Agency problems may result from a conflict of interest between managers
and shareholders or between shareholders and debt holders. A number of organization and
market mechanisms serve to discipline self serving managers, and takeovers are viewed as the
discipline of last resort. Managerialism, on the other hand, views takeovers as a manifestation of
the agency problem rather than its solution. It suggests that self-serving managers make ill-
conceived combinations solely to increase firm size and their own compensation. Sun-Taro
merger deal The deal was done, but later it was making Taro as virtually a negative cash
company which indicates that deal was done by managers without properly investigating its
strategic fitness

10. Hubris Theory: The hubris theory is another variant on the agency cost theory; it implies
acquiring firm managers commit errors of over optimism (winner's curse) in bidding for targets.
L&T and Grasim (2003) Grasim is taking every possible step to enhance the value for its
(Grasim’s) shareholders, L&T’s management (read majority shareholders) seem to be pursuing a
course of value destruction. A course that is neither in their own interest, nor in that of the
minority shareholders. It can be considered as a deal done because of hubris

11.Jensen's Free Cash Flow Theory: Jensen's free cash flow hypothesis says that takeovers take
place because of the conflicts between managers and shareholders over the payout of free cash
flows. The hypothesis posits that free cash flows (that is, in excess of investment needs) should
be paid out to shareholders, reducing the power of management and subjecting managers to the
scrutiny of the public capital markets more frequently. Debts for stock exchange offers are
viewed as a means of bonding the managers. Promise to pay out future cash flows to
shareholders. Wipro acquired US-based mortgage services company Opus Capital Market
Consultants for $75 million (around Rs. 465 crore) in December 2013 To utilise their large and
increasing cash piles, M&A is considered better for capital allocation rather than a greater return of
capital to shareholders through dividends and buyback

12. Market Power Theory: Market power advocates claim that merger gains are the result of
increased concentration leading to collusion and monopoly effects. Empirical evidence on
whether industry concentration causes reduced competition is not conclusive. There is much
evidence that concentration is the result of vigorous and continuing competition which causes the
composition of the leading the leading firms to change over time. Merger of Ultratech Cement
Ltd. with Samruddhi Cement Ltd. (2009) To have 20 per cent of market share in India. The 3 rd
and 4th telecom giants in India IDEA Cellular and Vodafone merged to gain the market share.

13. Tax Effects Theory: Tax effects can be important in mergers, although they do not play a
major role in explaining M&A activity overall. Carry over of net operating losses and tax credits,
stepped up asset basis, and the substation of capital gains for ordinary income (less important
after the Tax Reform Act of 1986) are among the tax motivations for mergers. Looming
inheritance taxes may also motivate the sale of privately held firms with aging owners. Merger of
Indo Rama Synthetics (India) Ltd. with Indo Rama Petrochemicals Ltd. (IRPL) (2006)
To bypass some taxes while purchasing raw materials from IRPL

TYPES OF SYNERGIES
There have been a lot of categorizations for synergies but, in an effort to simplify matters, they
have been broken into two forms, as mentioned earlier, which are the Revenue Synergies and
Cost Synergies. However, to provide more details, we can further break them down into 4 types:
Cost, Revenue, Financial, and Market.
 Cost synergies
When we speak of synergies that involve the reduction or decrease in costs, we are referring to
cost synergies. More often than not, these costs include administrative and overhead costs, which
can be reduced, or even completely eliminated in some cases, by combining activities,
technologies or resources after the business combination. Resources that are not used to their full
capacities may also be used up to 100%, and even have extended usage, instead of having to
purchase new resources or technology altogether.

Revenue synergies
These refer to synergies that increase the revenues of the company. This means that the business
combination has enabled the company has greater ability to sell more of its products or services,
or even increase its selling prices to generate more revenue. It may include activities such as
cross-selling and bundling. It may also involve having an expanded product line and being able
to reach more customers or buyers.

The most common revenue synergies are:

 Cross-selling, or being able to sell products to new markets, niches, or customer bases;

 Marketing, selling and distribution of similar or complementary products, which is

applicable when the businesses that have combined belong to the same industry (as is
often the case);

 Gaining access to new markets, made possible by the existing foothold of one of the
companies to a market that was not previously accessible to the other company;

 Sharing of distribution channels, where the combination results to having more

channels for the distribution of products and services; and

 Reduction or elimination of competition, spurred by the larger and more dominant

presence of the two business joining forces.

Financial synergies

Financial synergies
Companies that undergo business combination are likely to find themselves enjoying lower costs
of capital and improved cash flows. Profitability is also a potential synergy that can be enjoyed
by the resulting company, due to these lowered risks, improved performance, and reduced costs.

The most common examples of financial synergies are:

 Higher revenues and cash inflow from sale of products and services of the combined
companies;
 Reduced costs, thanks to the streamlining of operations of the resulting business;

 Higher profits, by virtue of the improved revenue generation and cost efficiency
measures implemented after the combination;

 Improved capacity of the combined business to handle its debts or liabilities;

 Lower cost of capital and business risk, made possible by the combination of two
business, making for a more solid entity; and

 Possible tax benefits arising from the combination of the businesses and their operations.

Market synergies

Market synergies
These synergies are often seen in the enhanced negotiation capabilities of the company,
particularly when dealing with suppliers and partners, as well as its customers.

Some of these synergies are:

 Greater bargaining and negotiating power, where the company is likely to elicit more
trust from suppliers, customers and other business partners, when it is trying to enter into
transactions with them;

 Increased recognition of the combined business in the industry, where two businesses
with separate standings are now seen as one entity, with their combination increasing their power
in the industry they are in; and

 Stronger standing, where the resulting business is bigger, and is less vulnerable to
hostile takeovers by other businesses.