What Are Mergers and Acquisitions (M&A)?

The term mergers and acquisitions (M&A) refers to the consolidation of companies or their
major business assets through financial transactions between companies. A company may
purchase and absorb another company outright, merge with it to create a new company, acquire
some or all of its major assets, make a tender offer for its stock, or stage a hostile takeover. All
are M&A activities.

The term M&A also is used to describe the divisions of financial institutions that deal in such
activity.

What is a Merger?

A merger is a corporate strategy to combine with another company and operate as a single legal
entity. The companies agreeing to mergers are typically equal in terms of size and scale of
operations.

Companies seek mergers to gain access to a larger market and customer base, reduce
competition, and achieve economies of scale.

There are different types of mergers that the companies can follow, depending on their objectives
and strategies.

A merger is different from an acquisition. Mergers happen when two or more companies
combine to form a new entity, whereas an acquisition is the takeover of a company by another
company.

Why do Mergers Happen?

 After the merger, companies will secure more resources and the scale of operations will
increase.

 Companies may undergo a merger to benefit their shareholders. The existing shareholders
of the original organizations receive shares in the new company after the merger.

 Companies may agree to a merger to enter new markets or diversify their offering
of products and services, consequently increasing profits.

 Mergers also take place when companies want to acquire assets that would take time to
develop internally.

 To lower the tax liability, a company generating substantial taxable income may look to
merge with a company with significant tax loss carry forward.
  A merger between companies will eliminate competition among them, thus reducing the
advertising price of the products. In addition, the reduction in prices will benefit
customers and eventually increase sales.

 Mergers may result in better planning and utilization of financial resources.

Types of Merger

1. Congeneric/Product extension merger

Such mergers happen between companies operating in the same market. The merger results in
the addition of a new product to the existing product line of one company. As a result of the
union, companies can access a larger customer base and increase their market share.

2. Conglomerate merger

Conglomerate merger is a union of companies operating in unrelated activities. The union will
take place only if it increases the wealth of the shareholders.

3. Market extension merger

Companies operating in different markets, but selling the same products, combine in order to
access a larger market and larger customer base.

4. Horizontal merger

Companies operating in markets with fewer such businesses merge to gain a larger market. A
horizontal merger is a type of consolidation of companies selling similar products or services. It
results in the elimination of competition; hence, economies of scale can be achieved.

5. Vertical merger

A vertical merger occurs when companies operating in the same industry, but at different levels
in the supply chain, merge. Such mergers happen to increase synergies, supply chain control, and
efficiency.

Advantages of a Merger

1. Increases market share When companies merge, the new company gains a larger market
share and gets ahead in the competition.

2. Reduces the cost of operations Companies can achieve economies of scale, such as bulk
buying of raw materials, which can result in cost reductions. The investments on assets are now
spread out over a larger output, which leads to technical economies.
3. Avoids replication Some companies producing similar products may merge to avoid
duplication and eliminate competition. It also results in reduced prices for the customers.

4. Expands business into new geographic areas A company seeking to expand its business in a
certain geographical area may merge with another similar company operating in the same area to
get the business started.

5. Prevents closure of an unprofitable business Mergers can save a company from going
bankrupt and also save many jobs.

Disadvantages of a Merger

1. Raises prices of products or services A merger results in reduced competition and a larger
market share. Thus, the new company can gain a monopoly and increase the prices of its
products or services.

2. Creates gaps in communication The companies that have agreed to merge may have
different cultures. It may result in a gap in communication and affect the performance of the
employees.

3. Creates unemployment In an aggressive merger, a company may opt to eliminate the

underperforming assets of the other company. It may result in employees losing their jobs.

4. Prevents economies of scale In cases where there is little in common between the companies,
it may be difficult to gain synergies. Also, a bigger company may be unable to motivate
employees and achieve the same degree of control. Thus, the new company may not be able to
achieve economies of scale.

What Is an Acquisition?

An acquisition is a transaction in which one company purchases most or all of another

company’s shares to gain control of that company.

Acquisitions are common in business and may occur with or without the target company’s
approval. There’s often a no-shop clause during the process of approval.

Most people commonly hear about the acquisitions of large well-known companies, but mergers
and acquisitions (M&A) occur more regularly between small- to medium-sized firms than
between large companies.

 An acquisition is a business combination that occurs when one company buys most or all
of another company’s shares.
 A firm effectively gains control of that company if it buys more than 50% of a target
company’s shares.
 An acquisition is often friendly, but a takeover can be hostile. A merger creates a brand-
new entity from two separate companies.
  Acquisitions are often carried out with the help of an investment bank because they’re
complex arrangements with legal and tax ramifications.
 Acquisitions are closely related to mergers and takeovers.

What are Proforma Earnings per Share (EPS)?

Proforma earnings per share (EPS) is the calculation of EPS assuming a merger and
acquisition (M&A) takes place and all financial metrics, as well as the number of shares
outstanding, are updated to reflect the transaction. “Pro forma” in Latin means “for the sake of
form.” In this case, it refers to calculating EPS “for the sake of form” in the event of the
acquisition.

Basic EPS is calculated by dividing a firm’s net income by its weighted shares outstanding. The
pro forma EPS, on the other hand, adds the target firm’s net income and any
additional synergies or incremental adjustments to the numerator, while adding
new shares issued due to the acquisition to the denominator.

Proforma Earnings per Share EPS Formula:

Here is the formula for proforma earnings per share:

Pro Forma EPS = (Acquirer’s Net Income + Target’s Net Income +/- “Incremental
Adjustments” ) / (Acquirer’s shares outstanding + New Shares Issued)

What Proforma Earnings per Share Mean in M&A

Proforma EPS is used by the acquiring company to determine the financial outcome they will
have by acquiring the target or merging with the target. This also allows the acquirer to
determine whether this transaction will be accretive or dilutive and cause a positive effect on
their EPS. Note that simply analyzing an acquisition or merger on the basis of EPS is not
recommended, as there are situations where EPS can increase, but the value of the merged firm is
lower than the sum of the acquirer and target.

What Is Synergy?
Synergy is the concept that the combined value and performance of two companies will be
greater than the sum of the separate individual parts. Synergy is a term that is most commonly
used in the context of mergers and acquisitions (M&A). Synergy, or the potential financial
benefit achieved through the combining of companies, is often a driving force behind a merger .

Mergers and acquisitions (M&A) are made with the goal of improving the company's financial
performance for the shareholders. Two businesses can merge to form one company that is
capable of producing more revenue than either could have been able to independently, or to
create one company that is able to eliminate or streamline redundant processes, resulting in
significant cost reduction.
Because of this principle, the potential synergy is examined during the M&A process. If two
companies can merge to create greater efficiency or scale, the result is what is sometimes
referred to as a synergy merge.

Shareholders will benefit if a company's post-merger share price increases due to the synergistic
effect of the deal. The expected synergy achieved through the merger can be attributed to
various factors, such as increased revenues, combined talent and technology, and cost reduction.

What Is the Exchange Ratio?

The exchange ratio is the relative number of new shares that will be given to
existing shareholders of a company that has been acquired or that has merged with another. After
the old company shares have been delivered, the exchange ratio is used to give shareholders the
same relative value in new shares of the merged entity.

Calculating the Exchange Ratio

The exchange ratio only exists in deals that are paid for in stock or a mix of stock and cash as
opposed to just cash. The calculation for the exchange ratio is:

Exchange Ratio= Target Share Price/ Acquirer Share Price

KEY POINTS

 The exchange ratio calculates how many shares an acquiring company needs to issue for
each share an investor owns in a target company to provide the same relative value to the
investor.
 The target company purchase price often includes a price premium paid by the acquirer
due to buying 100% control of the target company.
 The intrinsic value of the shares and the underlying value of the company are considered
when coming up with an exchange ratio.
 There are two types of exchange ratios: a fixed exchange ratio and a floating exchange
ratio.

A fixed exchange ratio is fixed until the deal closes. The number of issued shares is known but
the value of the deal is unknown. The acquiring company prefers this method as the number of
shares is known therefore the percentage of control is known.

A floating exchange ratio is where the ratio floats so that the target company receives a fixed
value no matter the changes in price shares. In a floating exchange ratio, the shares are unknown
but the value of the deal is known. The target company, or seller, prefers this method as they
know the exact value they will be receiving.

Post Merger Price of Share

 Accounting for Amalgamations

  The provisions of Accounting Standard (AS-14) on Accounting for Amalgamations
issued by the Institute of Chartered accountants of India need to be referred to in this
context.

 The two main methods of financing an acquisition are cash and share exchange:

Cash: This method is generally considered suitable for relatively small acquisitions. It
has two advantages:

(i) The buyer retains total control as the shareholders in the selling company are
completely bought out.

(ii) The value of the bid is known and the process is simple

Required rate of return of merged company

 Return on investment

 Return on investment (ROI) is similar to ROE, except it accounts for the acquisition
price and the sale price of a business. You calculate it by subtracting the sale price from
the acquisition price and dividing that difference by the acquisition price; the result is a
percentage. If you acquire a company for $10 million and sell it for $15 million, the ROI
is 50 percent.

What Is a De-Merger?

A de-merger is a form of corporate restructuring in which a business is broken into components.

These units operate on their own or may be sold or liquidated as a divestiture. A de-merger
allows a large company to split off its various brands or business units to invite or prevent an
acquisition, to raise capital by selling off components that are no longer part of the business's
core product line, or to create separate legal entities to handle different operations.

De-mergers allow companies to:

 Refocus on their most profitable units

 Reduce risk

 Create greater shareholder value

 Have specialists manage specific business units or brands rather than generalists

De-merging also allows companies to separate underperforming business units that create a drag
on their overall performance. Although they can create some complicated accounting issues, de-
mergers can create tax benefits or other efficiencies. Government intervention, such as to break
up a monopoly, can spur a de-merger.
Types of De-Mergers

There are several types of de-mergers that companies can execute. The following are the most
common types:

Spinoff

One of the most common ways for a de-merger to be executed is a spinoff. This step occurs
when a parent company receives an equity stake in a new company equal to their loss of equity
in the original company.

At that point, shares are bought and sold independently, and investors have the option of buying
shares of the unit they believe will be the most profitable. A partial de-merger is when
the parent company retains a partial stake in a de-merged company.

Split

A split is like a spinoff but with multiple components. It occurs when multiple businesses are
split from the parent company into different entities. If the company is public, shareholders of
the parent company are given the option of trading in their shares of the parent company to
those of the newly created entity(s).

Equity Carve Out

When company sells some or full equity in a business unit to an external party then we call it an
equity carve-out. In this the parent company exists, but the parent company has no sake or
control over the new entity. It is owned or controlled by an outsider.