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Q.3) What are the important reasons for mergers and acquisitions?
Ans.)
Merger : A merger is said to occur when two or more companies combine into one company.
Acquisition : Acquisition means acquiring the ownership in the company.
REASON FOR MERGER AND ACQUISITION
The following are important reasons for mergers and acquisition of firms.
Economies of scale : The combined firm can have larger volume of operations than the individual firms. Thus the combined firm can enjoy econimics of scale. The optimum utilization of plant capacity is possible to combined entity resulting in fall in the average cost of the output. The firm, which produces its output at the minimum average cost, is known as optimum firm. To cut the long story short we can say that, the mergers and acquisitions help the company to produce the goods more economically through the full utilization of plant capacities.
Synergy : Synergy is simply defined as 2+2=5 phenomenon. The value of the company formed through merger will be more than the sum of the value of the individual companies just merged.
Symbolically :
V(A)+V(B)
V(A)=value of A Ltd.
V(B)=value of B Ltd.
V(AB)=Value of merged company.
Diversification of risk : Company’s profits and cash flows fluctuate widely when it produces a single product. This increases the risk of a firm. So a company experiencing wide fluctuations in the earnings may merge with another company whose earnings are of different nature. The merger of companies whose earnings are negatively correlated will bring stability in the earnings of the combined firm. So diversification reduces the risk of the firm.
Growth : Growth is possible in 2 ways i.e. internal expansion of
Reduction in tax liability : In some cases tax shields may be the motivating factor for mergers. Under Income Tax Act, there is a provision for set off and carry forward of losses. A Sick company may not be in a position to earn sufficient profits in future to take advantage of the carry forward provision. So a sick company with accumulated losses may like some profitable company to merge with it to take advantage of tax benefits. Even the sick company with accumulated losses may be merged with a profitable company and take advantage of income tax benefits with the approval of government.
To increase market power and to kill competition : The merger can increase the market share of merged firm. This increases the market power and makes the demand for the product of the firm less elastic. Mergers also help the company to reduce competition in the marketplace. Many mergers have been intended to kill the competition and to increase the market power.
Financial Synergy : The following are the financial synergy available in the case of mergers.
a) Better Credit worthiness : This helps the company to purchase the goods on credit, obtain bank loan and raise capital in the market easily.
b) Reduces the cost of capital : The investors consider big firms as safe and hence they expect lower rate of return for the capital supplied by them. So the cost of capital reduces after the merger.
c) Increases the debt capacity : After the merger the earnings and cash flows become more stable than before. This increases the capacity of the company to borrow more funds.
d) Increases the P/E ratio and value per share : The liquidity and marketability of the security increases after the merger. The growth rate as well as earnings of the firm will also increase due to various economies after the merger. So the investors are willing to pay higher price for the shares of the merged company. All these factors help the company to enjoy higher P/E in the market.
e) Low floatation cost : Small companies have to spend higher percentage of the issued capital as floatation cost when compared to a big firm.
f) Raising of capital : After the merger due to increase in the size of the company and better credit worthiness and reputation, the company can easily raise the capital at any time.
Managerial motives : After the merger manager’s benefit in rank, status and perquisites. This is another motivation for mergers.
Q.4) What is an EBIT-EPS analysis ? Illustrate your answer.
Ans.)
EBIT-EPS analysis is a method to study the effect of financial leverage under variour levels of EBIT under alternative method of financing.
Using the following example we can explain the EBIT-EPS analysis.
A firm has a capital structure exclusively comprising of ordinary shares amounting to Rs. 1,00,000. The firm now wishes to raise additional
Rs. 1,00,000 for investment purposes. The company has 4 alternatives.
a) It can raise the entire amount in the form of equity shares.
b) It can raise 50% as equity and 50% as 5% debentures.
c) It can raise entire amount by 5% debentures.
d) It can raise 50% equity and 50% as 5% preference capital.
Further assume that existing EBIT is Rs. 12000/-, the tax rate is 50% outstanding number of equity shares are 1000.
The financial plan, which gives highest EPS, would be naturally better from the company’s point of view.
Calculation of EPS at an EBIT level of Rs. 12,000 ( ROI = 6% )
| | A | B | C | D |
| EBIT ( Rs. ) | 12,000 | 12,000 | 12,000 | 12,000 |
| Less : Interest ( Rs. ) | - | 2,500 | 5,000 | - |
| EBIT ( Rs. ) | 12,000 | 9,500 | 7,000 | 12,000 |
| Less : Tax@50% | 6,000 | 4,750 | 3,500 | 6,000 |
| EAT ( Rs. ) | 6,000 | 4,750 | 3,500 | 6,000 |
| Less : Preference dividend (Rs.) | - | - | - | 2,500 |
| Earnings available to equity Shareholders ( EAESH ) ( Rs.) | 6,000 | 4,750 | 3,500 | 3,500 |
| No. of shares ( N ) | 2000 | 1500 | 1000 | 1500 |
| EPS ( EAESH/N ) (Rs. ) | 3 | 3.16 | 3.5 | 2.33 |
Calculation fo EPS at an EBIT level of Rs. 8000 ( ROI = 4% )
Financing plans.
| | A | B | C | D |
| EBIT ( Rs. ) | 8,000 | 8,000 | 8,000 | 8,000 |
| Less : Interest ( Rs. ) | - | 2,500 | 5,000 | - |
| EBIT ( Rs. ) | 8,000 | 5,500 | 3,000 | 8,000 |
| Less : Tax @ 50% ( Rs. ) | 4,000 | 2,750 | 1,500 | 4,000 |
| EAT ( Rs. ) | 4,000 | 2,750 | 1,500 | 4,000 |
| Less : Preference Dividend (Rs) | - | - | - | 2,500 |
| Earnings available to equity Shareholder ( Rs. ) | 4,000 | 2,750 | 1,500 | 1,500 |
| No. of shares | 2000 | 1500 | 1000 | 1500 |
| EPS ( Rs. ) | 2 | 1.83 | 1.5 | 1 |
Calculation of EPS at an EBIT level of Rs. 10,000 ( ROI = 5% )
Financial Plans
| | A | B | C | D |
| EBIT ( Rs. ) | 10,000 | 10,000 | 10,000 | 10,000 |
| Less : Interest ( Rs. ) | - | 2,500 | 5,000 | |
| EBIT ( Rs. ) | 10,000 | 7,500 | 5,000 | 10,000 |
| Less : Tax @ 50% ( Rs. ) | 5,000 | 3,750 | 2,500 | 5,000 |
| EAT ( Rs. ) | 5,000 | 3,750 | 2,500 | 5,000 |
| Less : Preference Dividend ( Rs.) | – | - | - | 2,500 |
| Earnings available to equity Shareholders ( Rs. ) | 5,000 | 3,750 | 2,500 | 2,500 |
| No. of shareholders | 2000 | 1500 | 1000 | 1500 |
| EPS ( Rs. ) | 2.5 | 2.5 | 2.5 | 1.66 |
Calculation of EPS at an EBIT level of Rs. 20,000 ( ROI = 10% )
| | A | B | C | D |
| EBIT ( Rs. ) | 20,000 | 20,000 | 20,000 | 20,000 |
| Less : Interest ( Rs. ) | - | 2,500 | 5,000 | - |
| EBT ( Rs. ) | 20,000 | 17,500 | 15,000 | 20,000 |
| Less : Tax @ 50% ( Rs. ) | 10,000 | 8,750 | 7,500 | 10,000 |
| EAT ( Rs. ) | 10,000 | 8,750 | 7,500 | 10,000 |
| Less : Preference dividend (Rs) | - | - | - | 2,500 |
| Earnings available ESH ( Rs. ) | 10,000 | 8,750 | 7,500 | 7,500 |
| No of shares | 2000 | 1500 | 1000 | 1500 |
| EPS (Rs. ) | 5 | 5.83 | 7.5 | 5 |
Calculation of EPS at an EBIT level of Rs. 30,000 ( ROI = 15% )
| | A | B | C | D |
| EBIT ( Rs. ) | 30,000 | 30,000 | 30,000 | 30,000 |
| Less : Interest ( Rs. ) | - | 2,500 | 5,000 | - |
| EBT ( Rs. ) | 30,000 | 27,500 | 25,000 | 30,000 |
| Less : Tax @ 50% ( Rs. ) | 15,000 | 13,750 | 12,500 | 15,000 |
| EAT ( Rs. ) | 15,000 | 13,750 | 12,500 | 15,000 |
| Less : Preference Dividend (Rs.) | - | - | - | 2,500 |
| Earnings available to ESH ( Rs. ) | 15,000 | 13,750 | 12,500 | 12,500 |
| No. of shares | 2000 | 1500 | 1000 | 1500 |
| EPS ( Rs. ) | 7.5 | 9.16 | 12.5 | 8.33 |
Analysis of results :
1) EPS increases along with the increases in EBIT under all financial plans.
2) When the financial leverage in absent ( When only equity share are issued), EPS increases proportionately along with the increase in EBIT. That is 1% change in EBIT will be followed by only 1% change in EPS as in the case of financial plan A.
3) If the ROI is less than the cost of debt ( e.g.:EBIT of Rs. 8,000 ROI=4%), there is unfavourable financial leverage. So EPS falls as and when more and more debt is issued.
4) If ROI is more than the cost of debt ( e.g.: EBIT of Rs. 30,000 ROI=15%) there is favourable financial leverage. So issue of more and more of low cost debt increases the EPS. So EPS will be maximum when the debt is maximum.
5) If ROI is just equal to the cost of debt, issue if debt neither makes any sense nor objectionable. So there is neither favourable nor unfavourable financial leverage. So EPS remains same at an EBIT level of Rs. 10,000 ( ROI=5% ) under plans A,B and C.
6) If the company considers the issue of 5% preference shares, the Roi must be atleast 10%. If the ROI is less than 10% issue of 5% preference shares does not make sense. If the ROI is more than 10% issue of 5% preference shares will increase the EPS.
7) Whenever the leverage is present the change in EPS for a given change in EBIT is more than proportionate. For example under the financial plan C, EPS is Rs. 2.5. When EBIT is Rs. 10,000 and it increases to Rs. 7.5 on EBIT level of Rs. 20,000.
8) The level of EBIT at which EPS is same under two or ,more alternatives is called indifference level of EBIT. For example : For alternatives A and B, indifference level of EBIT is Rs. 10,000. For alternatives A and D indifference level of EBIT is Rs. 20,000. If the EBIT is below the indifference level, equity financing will give higher EPS and of the EBIT is above the indifference level debt or preference capital will give higher EPS.
Q. 5) What do you understand by ‘ Exchange Ratio ‘? What are the significance?
Ans.)
Exchange Ratio is the number of the acquirer’s shares to be offered to the shareholders of the Target company for each share held by them in the target company. Both the Acquire and the target company conduct valuation of the target company and then the Acquire determines the maximum price it is willing to pay to the target and the target determines the minimum price it is willing to accept. Within these limits the actual agreement price will be fixed based on the relative bargaining power and investment opportunities.
The determination of the exchange ratio is based on the value of shares of the companies involved in the merger. As the basic objective of financial management is to maximize the shareholders wealth, even the Merger decision is to be taken in the light of wealth maximisation. Hence, a successful merger would be one that maximizes the EPS and market price of the shares of the acquiring company.
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