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MERGERS AND ACQUISITIONS With increasing globalization and dispersion of technology, product life-cycles are shortening and competition is becoming intense, where there is little room for organizations to meet their growth aspirations through internal development or organic growth. In order to achieve speedy growth with limited market access, technology, finance and time, corporates worldwide have preferred to grow inorganically through the route of mergers and acquisitions (M&A) From the beginning of the 21st century, India has witnessed a tremendous growth in M&A activities, both inbound & outbound. However, the recent economic downturn has eclipsed the M&A landscape almost halving the deals in both number and value. Cross border M&A deal values have fallen from USD 42 billion in H1 2007 and USD 12 billion in H1 2008 to just USD 1.4 billion in H1 2009. This marks an 85% decrease from last year highlighting the lack of overseas deals. Domestic deals have registered USD 3.5 billion in H1 2009 compared to USD 4.3 billion in H1 2008 . The buoyancy in the domestic market could be attributed in part to Indian companies looking for group consolidation, cash repatriation strategies and avenues for balance sheet restructuring all in an attempt to tide over the current crisis. With reports of green shoots showing in some European economies there is some optimism that the economic crisis may pass by the third or fourth quarter of 2009. However the M&A space is still being treaded upon cautiously and there is not enough clarity on when volumes would get back to the highs of 2008. However, there remains a huge potential for M&A as in spite of the economic crisis, the advantages of inorganic growth still fit in the modern corporate rationale.
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Page 1: 2 Mergers and Acquisitions

MERGERS AND ACQUISITIONS

With increasing globalization and dispersion of technology, product life-cycles are shortening and competition is becoming intense, where there is little room for organizations to meet their growth aspirations through internal development or organic growth. In order to achieve speedy growth with limited market access, technology, finance and time, corporates worldwide have preferred to grow inorganically through the route of mergers and acquisitions (M&A)

From the beginning of the 21st century, India has witnessed a tremendous growth in M&A activities, both inbound & outbound. However, the recent economic downturn has eclipsed the M&A landscape almost halving the deals in both number and value.

Cross border M&A deal values have fallen from USD 42 billion in H1 2007 and USD 12 billion in H1 2008 to just USD 1.4 billion in H1 2009. This marks an 85% decrease from last year highlighting the lack of overseas deals.

Domestic deals have registered USD 3.5 billion in H1 2009 compared to USD 4.3 billion in H1 2008 . The buoyancy in the domestic market could be attributed in part to Indian companies looking for group consolidation, cash repatriation strategies and avenues for balance sheet restructuring all in an attempt to tide over the current crisis.

With reports of green shoots showing in some European economies there is some optimism that the economic crisis may pass by the third or fourth quarter of 2009. However the M&A space is still being treaded upon cautiously and there is not enough clarity on when volumes would get back to the highs of 2008.

However, there remains a huge potential for M&A as in spite of the economic crisis, the advantages of inorganic growth still fit in the modern corporate rationale.

This article attempts to provide a broad overview of various aspects of M&A activities.

CERTAIN IMPORTANT CONCEPTS IN M&A

Merger and Amalgamation

A merger may be regarded as the fusion or absorption of one thing or right into another. A merger has been defined as an arrangement whereby the assets, liabilities and businesses of two (or more) companies become vested in, or under the control of one company (which may or may not be the original two companies), which has as its shareholders, all or substantially all the shareholders of the two companies. In merger, one of the two existing companies merges its identity into another existing company or one or more existing companies may form a new company and merge their identities into the new company by transferring their business and undertakings including all other assets and liabilities to the new company (herein after known as the merged company).

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The process of merger is also alternatively referred to as “amalgamation”. The amalgamating companies loose their identity and the shareholders of the amalgamating companies become shareholders of the amalgamated company.

The term amalgamation has not been defined in the Companies Act, 1956. However, the Income-tax Act, 1961 (‘Act’) defines amalgamation as follows:

“Amalgamation”, in relation to companies, means the merger of one or more companies with another company or the merger of two or more companies to form one company (the company or companies which so merge being referred to as the amalgamating company or companies and the company with which they merge or which is formed as a result of the merger, as the amalgamated company) in such a manner that—

all the property of the amalgamating company or companies immediately before the amalgamation becomes the property of the amalgamated company by virtue of the amalgamation;

all the liabilities of the amalgamating company or companies immediately before the amalgamation become the liabilities of the amalgamated company by virtue of the amalgamation;

shareholders holding not less than three-fourths in value of the shares in the amalgamating company or companies (other than shares already held therein immediately before the amalgamation by, or by a nominee for, the amalgamated company or its subsidiary) become shareholders of the amalgamated company by virtue of the amalgamation,

and not as a result of the acquisition of the property of one company by another company pursuant to the purchase of such property by the other company or as a result of the distribution of such property to the other company after the winding up of the first-mentioned company;

Thus, the above three conditions should be satisfied for a merger to qualify as an amalgamation within the meaning of the Income-tax Act 1961.

Mergers are generally classified as follows:

1. Cogeneric mergers or mergers within same industries

2. Conglomerate mergers or mergers within different industries

Cogeneric mergers

These mergers take place between companies within the same industries. On the basis of merger motives, cogeneric mergers may further classified as:

i. Horizontal Mergers

ii. Vertical Mergers

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Horizontal mergers takes place between companies engaged in the same business activities for profit; i.e., manufacturing or distribution of same types of products or rendition of similar services. A classic instance of horizontal merger is the acquisition of Mobil by Exxon. Typically, horizontal mergers take place between business competitors within an industry, thereby leading to reduction in competition and increase in the scope for economies of scale and elimination of duplicate facilities. The main rationale behind horizontal mergers is achievement of economies of scale. However, horizontal mergers promote monopolistic trend in an industry by inhibiting competition.

Vertical mergers take place between two or more companies which are functionally complementary to each other. For instance if one company specializes in manufacturing a particular product, and another company specializes in marketing or distribution of this product, a merger of these two companies will be regarded as a vertical merger. The acquiring company may expand through backward integration in the direction of production processes or forward integration in the direction of the ultimate consumer. The merger of Tea Estate Ltd. with Brooke Bond India Ltd. was a case of vertical merger. Vertical mergers too discourage competition in the industry.

Conglomerate mergers

Conglomerate mergers take place between companies from different industries. The businesses of the merging companies obviously lack commonality in their end products or services and functional economic relationships. A company may achieve inorganic growth through diversification by acquiring companies from different industries. A conglomerate merger is a complex process that requires adequate understanding of industry dynamics across diverse businesses vis-à-vis the merger motives of the merging entities.Besides the above, mergers may be classified as:

Up stream merger, in which a subsidiary company is merged with its parent company.

Down stream merger, in which a parent company is merged with its subsidiary company.

Reverse merger, in which a company with a sound financial track record amalgamates with a loss making or less profitable company.

Takeover

Takeover is a strategy of acquiring control over the management of another company – either directly by acquiring shares carrying voting rights or by participating in the management. Where the shares of the company are closely held by a small number of persons a takeover may be effected by agreement within the shareholders. However, where the shares of a company are widely held by the general public, relevant regulatory aspects, including provisions of SEBI (Substantial Acquisition of Shares and Takeovers) Regulations 1997 need to be borne in minds.

Takeovers may be broadly classified as follows:

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Friendly takeover: It is a takeover effected with the consent of the taken over company. In this case there is an agreement between the managements of the two companies through negotiations and the takeover bid may be with the consent of majority shareholders of the target company. It is also known as negotiated takeover.

Hostile takeover: When an acquirer company does not offer the target company the proposal to acquire its undertaking but silently and unilaterally pursues efforts to gain control against the wishes of the existing management, such acts are considered hostile on the management and thus called hostile takeovers. The recently consummated Arcelor Mittal deal is an example of hostile takeover, where the LN Mittal group acquired management control of Arcelor against the wishes of the Arcelor management.

Bail out takeover: Takeover of a financially weak or a sick company by a profit earning company to bail out the former is known as bail out takeover. Such takeovers normally take place in pursuance to a scheme of rehabilitation approved by the financial institution or the scheduled bank, who have lent money to the sick company. In bail out takeovers, the financial institution appraises the financially weak company, which is a sick industrial company, taking into account its financial viability, the requirement of funds for revival and draws up a rehabilitation package on the principle of protection of interests of minority shareholders, good management, effective revival and transparency. The rehabilitation scheme should provide the details of any change in the management and may provide for the acquisition of shares in the financially weak company as follows:

1. An outright purchase of shares or

2. An exchange of shares or

3. A combination of both

Joint Venture

Joint venture is a strategic business policy whereby a business enterprise for profit is formed in which two or more parties share responsibilities in an agreed manner, by providing risk capital, technology, patent/trademark/ brand names and access to the market. Joint ventures with multinational companies contribute to the expansion of production capacity, transfer of technology and penetration into the global market. In joint ventures the assets are managed jointly. Skills and knowledge flow from both the parties.

Leveraged/Management Buyout

Leveraged buyout (LBO) is defined as the acquisition of stock or assets by a small group of investors, financed largely by borrowing. The acquisition may be either of all stock or assets of a hitherto public company. The buying group forms a shell company to act as a legal entity for making the acquisition.

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The LBOs differ from the ordinary acquisitions in two main ways: firstly a large fraction of the purchase price is debt financed and secondly the shares are not traded on open markets. In a typical LBO programme, the acquiring group consists of number of persons or organizations sponsored by buyout specialists.

The buyout group may not include the current management of the target company. If the group does so, the buyout may be regarded as Management Buyout (MBO). A MBO is a transaction in which the management buys out all or most of the other shareholders. The management may tie up with financial partners and organizes the entire restructuring on its own.

An MBO begins with an arrangement of finance. Thereafter an offer to purchase all or nearly all of the shares of a company (not presently held by the management) has to be made which necessitates a public offer and even delisting. Consequent upon this restructuring of the company may be affected and once targets have been achieved, the company can list its share on stock exchange again.

Demerger

Demerger is a common form of corporate restructuring. In the past we have seen a number of companies following a demerger route to unlock value in their businesses. Demerger has several advantages including the following:

Creating a better value for shareholders by both improving profitability of businesses and changing perception of the investors as to what are the businesses of the Company and what is the future direction;

Improving the resource raising ability of the businesses;

Providing better focus to businesses and thereby improve overall profitability;

Hedging risk by inviting participation from investors.

Demerger is a court approved process and requires compliance with the provisions of sections 391-394 of the Companies Act, 1956. It requires approval from the High Courts of the States in which the registered offices of the demerged and resulting companies are located. Under the Income-tax Act, 1961, “demerger”, in relation to companies, means the transfer, pursuant to a scheme of arrangement, by a demerged company of its one or more undertakings to any resulting company in such a manner that:

all the property of the undertaking, being transferred by the demerged company, immediately before the demerger, becomes the property of the resulting company by virtue of the demerger;

all the liabilities relatable to the undertaking, being transferred by the demerged company, immediately before the demerger, become the liabilities of the resulting company by virtue of the demerger;

the property and the liabilities of the undertaking or undertakings being transferred by the demerged company are transferred at values appearing in its books of account immediately before the demerger;

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the resulting company issues, in consideration of the demerger, its shares to the shareholders of the demerged company on a proportionate basis;

the shareholders holding not less than three-fourths in value of the shares in the demerged company (other than shares already held therein immediately before the demerger, or by a nominee for, the resulting company or, its subsidiary) become shareholders of the resulting company or companies by virtue of the demerger, otherwise than as a result of the acquisition of the property or assets of the demerged company or any undertaking thereof by the resulting company;

the transfer of the undertaking is on a going concern basis;

the demerger is in accordance with the conditions, if any, notified under sub-section (5) of section 72A by the Central Government in this behalf.

As evident from the above definition, demerger entails transfer of one or more undertakings of the demerged company to the resulting company and the resultant issue of shares by the resulting company to the shareholders of the demerged company. The satisfaction of the above conditions is necessary to ensure tax neutrality of the demerger.

In case of demerger of a listed company of its undertaking, the shares of the resulting company are listed on the stock exchange where the demerged company’s shares are traded. For instance, the largest demerger in India was in the case of Reliance Industries wherein its 4 businesses where demerged into separate companies and the resulting companies were listed on the stock exchanges.

The shareholders of Reliance Industries were allotted shares in the resulting companies based on a predetermined share swap ratio.

Advantages and disadvantages of M&A

The advantages of mergers and acquisitions are:

Economies of scale, which reduces unit costs. Greater market share for horizontal integration, which means the

business can often charge higher prices. Spreads risks if products different. Reduces competition if a rival is taken over. Other businesses can bring new skills and specialist departments to

the business. It is easier to raise money if a larger business.

The disadvantages of mergers and acquisitions are:

Diseconomies of scale if business becomes too large, which leads to higher unit costs.

Clashes of culture between different types of businesses can occur, reducing the effectiveness of the integration.

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May need to make some workers redundant, especially at management levels – this may have an effect on motivation.

May be a conflict of objectives between different businesses, meaning decisions are more difficult to make and causing disruption in the running of the business.

Economic aspects of M&A

Some of the key economic considerations in an M&A process are as follows

Shareholder wealth

An M&A transaction may enhance shareholders value in two ways — value creation and value capture.

Value creation is a long term phenomenon which results from the synergy generated from a transaction. Value creation may be achieved by way of functional skill or management skill transfers. Value capture is a one time phenomenon, wherein the shareholders of the acquiring company gain the value of the existing shareholders of the acquired company.

Synergy

Synergy from mergers and acquisitions has been characteristically connoted by 2+2=5. It signifies improvement of the performance of the acquired company by the strength of the acquiring company or vice versa. There may be operational synergies through improved economies of scale or financial synergies through reduction in cost of capital.

Realisation of synergies through consolidation — domestic and global have been one of the main aims of the worldwide M&A activities today

Market share

The co-relation between increased market share and improved profitability underlies the motive of constant increase of market share by companies. The focus on new markets and increase in product offerings, leads to higher level of production and lower unit costs. Thus this motive is closely aligned with the motive to achieve economies of scale.

Core competence

Cogeneric mergers often augment a firm’s competitiveness in an existing business domain. This urge for core competence is closely aligned with the motive of defending or fortifying a company’s business domain and warding off competition.

Diversification

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The M&A route serves as an effective tool to diversify into new businesses. Increasing returns with set customer base and lower risks of operation form the rationale of such conglomerate mergers.

Increased debt capacity

Typically a merged entity would enjoy higher debt capacity because benefits of combination of two or more firms provide greater stability to the earnings level. This is an important consideration for the lenders. Moreover, a higher debt capacity if utilized, would mean greater tax advantage for the merged firm leading to higher value of the firm.

Customer pull

Increased customer consciousness about established brands have made it imperative for companies to exploit their customer pull to negotiate better deals fulfilling the twin needs of customer satisfaction and enhancement of shareholder value

Valuation aspects of M&A

Valuation is the central focus in fundamental analysis, wherein the underlying theme is that the true value of the firm can be related to its financial characteristics, viz. its growth prospects, risk profile and cash flows. In a business valuation exercise, the worth of an enterprise, which is subject to merger or acquisition or demerger (the target), is assessed for quantification of the purchase consideration or the transaction price.

Generally, the value of the target from the bidder’s point of view is the pre-bid standalone value of the target. On the other hand, the target companies may be unduly optimistic in estimating value, especially in case of hostile takeovers, as their objective is to convince the shareholders that the offer price is too low. Since valuation of the target depends on expectations of the timing of realization as well as the magnitude of anticipated benefits, the bidder is exposed to valuation risk. The degree of risk depends upon whether the target is a private or public company, whether the bid is hostile or friendly and the due-diligence performed on the target.The main value concepts viz.

• Owner value• Market value and• Fair value

The owner value determines the price in negotiated deals and is often led by a promoter’s view of the value if he was deprived from the property. The basis of market value is the assumption that if comparable property has fetched a certain price, then the subject property will realize a price something near to it. The fair value concept in essence, ensures that the value is equitable to both parties to the transaction.

METHODS OF VALUATION OF TARGET

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Valuation based on assets

The valuation method is based on the simple assumption that adding the value of all the assets of the company and sub-contracting the liabilities leaving a net asset valuation, can best determine the value of a business. Although the balance sheet of a company usually gives an accurate indication of the short-term assets and liabilities, this is not the case of long term ones as they may be hidden by techniques such as “off balance sheet financing”. Moreover, valuation being a forward looking exercise may not bear much relationship with the historical records of assets and liabilities in the published balance sheet.

Valuations of listed companies have to be done on a different footing as compared to an unlisted company. In case of listed companies, the real value of the assets may or may not be reflected by the market price of the shares. However, in case of unlisted companies, only the information relating to the profitability of the company as reflected in the accounts is available and there is no indication of market price.

Valuation based on earnings

The normal purpose of the contemplated purchase is to provide for the buyer the annuity for his investment outlay. The buyer would certainly expect yearly income, returns stable or fluctuating but nevertheless some return which commensurate with the price paid therefore. Valuation based on earnings, based on the rate of return on the capital employed, is a more modern method being adopted.

An alternate to this method is the use of the price earning (P/E) ratio instead of the rate of return. The P/E ratio of a listed company can be calculated by dividing the current price of the share by the earning per share (EPS). Therefore the reciprocal of the P/E ratio is called earnings-price ratio or earning yield.

Thus P/E = P/ EPS, where P is the current price of the shares. The share price can therefore be determined as P=EPS × P/E ratio. Similarly, several other valuation methodologies (including valuation based on sales, profit after tax, earning before interest, tax, depreciation and amortization etc.) are commonly used.

Need of merger and acquisition

Two companies that are recognized as among the best at making successful acquisitions are General Electric and Cisco Systems. These companies have been star performers in growing shareholder value. The core principal that runs through almost every acquisition is integration. Over the past 10 years Cisco Systems has acquired 81 companies. Their stock price is up a remarkable 1300%. GE outperformed the S&P 500 index over the same period by 300%. There are several categories of strategic acquisition that can produce some outstanding results:

1. ACQUIRE CUSTOMERS - this is almost always a factor in strategic acquisitions. Some companies buy another that is in the same business in a different geography. They get to integrate market presence, brand awareness, and market momentum.

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2. OPERATING LEVERAGE - the major focus in this type of acquisition is to improve profit margins through higher utilization rates for plant and equipment. A manufacturer of cardboard containers that is operating at 65% of capacity buys a smaller similar manufacturer. The acquired company's plant is sold, all but two machines are sold, the G&A staff are let go and the new customers are served more cost effectively.

3. CAPITALIZE ON A COMPANY STRENGTH - this is why Cisco and GE have been so successful with their acquisitions. They are so strong in so many areas, that the acquired company gets the benefit of many of those strengths. A very powerful business accelerator is to acquire a company that has a complementary product that is used by your installed customer base. Management depth and skill, production efficiency/ capacity, large base of installed accounts, developed sales and distribution channels, and brand recognition are examples of strengths that can power post acquisition performance.

4. COVER A WEAKNESS - This requires a good deal of objectivity from the acquiring company in recognizing and chinks in the corporate armor. Let me help you with some suggestions - 1. Customer concentration; 2. Product concentration; 3. Weak product pipeline; 4. Lack of management depth or technical expertise and 5. Great technology and products - poor sales and marketing.

5. BUY A LOW COST SUPPLIER - this integration strategy is typically aimed at improving profit margins rather than growing revenues. If your product is comprised of several manufactured components, one way to improve corporate profitability is to acquire one of those suppliers. You achieve greater control of overall costs, availability of supply, and greater value-add to your end product

6. IMPROVING OR COMPLETING A PRODUCT LINE - this approach has several elements from other acquisition strategies. Successfully adding new products to a line improves profitability and revenue growth. Giving a sales force more "arrows in their quiver" is a powerful growth strategy. You take advantage of your existing sales and distribution channel (strength). You may be able to improve your competitive position by simplifying the buying process - providing your customers one stop shopping.

7. TECHNOLOGY - BUILD OR BUY? This is a quandary for most companies, but is especially acute for technology companies. Acquiring technology through acquisition can be an excellent growth strategy. The R&D costs are generally lower for these smaller, agile, more narrowly focused companies than their larger, higher overhead acquirers. Time to market, window of opportunity, first mover advantage can have a huge impact on the ultimate success of a product. First one to establish their product as the "standard" is the big winner

8. ACQUISITION TO PROVIDE SCALE AND ACCESS TO CAPITAL MARKETS - In this area, bigger is better. Larger companies are considered safer investments. Larger companies command larger valuation multiples. Some companies make acquisitions in order to get big enough to attract public capital in the form of an IPO or investments from Private Equity Groups.

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9. PROTECT AND EXPAND MATURE PRODUCT LINES - This has been very effectively done in the pharmaceutical sector where a new technology is acquired to repurpose and re patent drugs.

10. PROTECT CUSTOMER BASE FROM COMPETITION - The telephone companies have done studies that show that with each additional product or service that a customer uses, the likelihood of the customer defecting to a competitor drops exponentially. Get your customers to use local, long distance, cellular, cable, broadband, etc and you will not lose them. Multiple products and services provided to the same customer dramatically improve retention rates.

11. ACQUISITION TO REMOVE BARRIERS TO ENTRY - For example, a large commercial IT consulting firm acquires a technology consulting firm that specializes in the Federal Government. The larger IT consulting firm has valuable expertise that is easily transferable to government business if they could only break the code of the vendor approval process. After many fits and starts, they simply acquired a firm that had an established presence. They were able to then bring their full capabilities from the commercial side to effectively increase their newly acquired government business.

Many larger firms have established business development offices to execute corporate growth strategies through acquisition. These experienced buyers search for companies that fit their well-defined acquisition criteria. In most cases they are attempting to buy companies that are not actively for sale. The win for the successful corporate acquirer is to target several candidates, buy them at financial valuation multiples, integrate to strength and achieve strategic performance.

Process of M&A

The Merger & Acquisition Process can be broken down into five phases:

Phase 1 - Pre Acquisition Review: The first step is to assess your own situation and determine if a merger and acquisition strategy should be implemented. If a company expects difficulty in the future when it comes to maintaining core competencies, market share, return on capital, or other key performance drivers, then a merger and acquisition (M & A) program may be necessary.It is also useful to ascertain if the company is undervalued. If a company fails to protect its valuation, it may find itself the target of a merger. Therefore, the pre-acquisition phase will often include a valuation of the company - Are we undervalued? Would an M & A Program improve our valuations?The primary focus within the Pre Acquisition Review is to determine if growth targets (such as 10% market growth over the next 3 years) can be achieved internally. If not, an M & A Team should be formed to establish a set of criteria whereby the company can grow through 4 Acquisition. A complete rough plan should be developed on how growth will occur through M&A, including responsibilities within the company, how information will be gathered, etc.

Phase 2 - Search & Screen Targets: The second phase within the M & A Process is to search for possible takeover candidates. Target companies must fulfill a set of criteria so that the Target Company is a good strategic fit with the acquiring company. For example, the target's drivers of

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performance should compliment the acquiring company. Compatibility and fit should be assessed across a range of criteria - relative size, type of business, capital structure, organizational strengths, core competencies, market channels, etc. It is worth noting that the search and screening process is performed in-house by the Acquiring Company. Reliance on outside investment firms is kept to a minimum since the preliminary stages of M & A must be highly guarded and independent.

Phase 3 - Investigate & Value the Target: The third phase of M & A is to perform a more detail analysis of the target company. You want to confirm that the Target Company is truly a good fit with the acquiring company. This will require a more thorough review of operations, strategies, financials, and other aspects of the Target Company. This detail review is called "due diligence." Specifically, Phase I Due Diligence is initiated once a target company has been selected. The main objective is to identify various synergy values that can be realized through an M & A of the Target Company. Investment Bankers now enter into the M & A process to assist with this evaluation. A key part of due diligence is the valuation of the target company. In the preliminary phases of M & A, we will calculate a total value for the combined company. We have already calculated a value for our company (acquiring company). We now want to calculate a value for the target as well as all other costs associated with the M & A. The calculation can besummarized as follows:Value of Our Company (Acquiring Company) Rs. 560Value of Target Company 176Value of Synergies per Phase I Due Diligence 38Less M & A Costs (Legal, Investment Bank, etc.) ( 9)Total Value of Combined Company Rs. 765

Phase 4 - Acquire through Negotiation: Now that we have selected our target company, it's time to start the process of negotiating a M & A. We need to develop a negotiation plan based on several key questions:! How much resistance will we encounter from the Target Company?! What are the benefits of the M & A for the Target Company?! What will be our bidding strategy?! How much do we offer in the first round of bidding?The most common approach to acquiring another company is for both companies to reach agreement concerning the M & A; i.e. a negotiated merger will take place. This negotiated arrangement is sometimes called a "bear hug." The negotiated merger or bear hug is the preferred approach to a M & A since having both sides agree to the deal will go a long way to 5 making the M & A work. In cases where resistance is expected from the target, the acquiring firm will acquire a partial interest in the target; sometimes referred to as a "toehold position." This toehold position puts pressure on the target to negotiate without sending the target into panic mode. In cases where the target is expected to strongly fight a takeover attempt, the acquiring company will make a tender offer directly to the shareholders of the target, bypassing the target's management. Tender offers are characterized by the following:! The price offered is above the target's prevailing market price.! The offer applies to a substantial, if not all, outstanding shares of stock.! The offer is open for a limited period of time.! The offer is made to the public shareholders of the target.A few important points worth noting:

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! Generally, tender offers are more expensive than negotiated M & A's due to the resistance of target management and the fact that the target is now "in play" and may attract other bidders.! Partial offers as well as toehold positions are not as effective as a 100% acquisition of "any and all" outstanding shares. When an acquiring firm makes a 100% offer for the outstanding stock of the target, it is very difficult to turn this type of offer down.Another important element when two companies merge is Phase II Due Diligence. As you may recall, Phase I Due Diligence started when we selected our target company. Once we start the negotiation process with the target company, a much more intense level of due diligence (Phase II) will begin. Both companies, assuming we have a negotiated merger, will launch a very detail review to determine if the proposed merger will work. This requires a very detail review of the target company - financials, operations, corporate culture, strategic issues, etc.

Phase 5 - Post Merger Integration: If all goes well, the two companies will announce an agreement to merge the two companies. The deal is finalized in a formal merger and acquisition agreement. This leads us to the fifth and final phase within the M & A Process, the integration of the two companies. Every company is different - differences in culture, differences in information systems, differences in strategies, etc. As a result, the Post Merger Integration Phase is the most difficult phase within the M & A Process. Now all of a sudden we have to bring these two companies together and make the whole thing work. This requires extensive planning and design throughout the entire organization. The integration process can take place at three levels:1. Full: All functional areas (operations, marketing, finance, human resources, etc.) will be merged into one new company. The new company will use the "best practices" between the two companies.2. Moderate: Certain key functions or processes (such as production) will be merged together. Strategic decisions will be centralized within one company, but day to day operating decisions will remain autonomous.3. Minimal: Only selected personnel will be merged together in order to reduce redundancies. Both strategic and operating decisions will remain decentralized and autonomous. If post merger integration is successful, then we should generate synergy values. However, before we embark on a formal merger and acquisition program, perhaps we need to understand the realities of mergers and acquisitions.

Impact of merger and acquisition

Mergers and acquisitions are aimed at improving profits and productivity of a company. Simultaneously, the objective is also to reduce expenses of the firm. However, mergers and acquisitions are not always successful. At times, the main goal for which the process has taken place loses focus. The success of mergers, acquisitions or takeovers is determined by a number of factors. Those mergers and acquisitions, which are resisted not only affects the entire work force in that organization but also harm the credibility of the company. In the process, in addition to deviating from the actual aim, psychological impacts are also many. Studies have suggested that mergers and acquisitions affect the senior executives, labor force and the shareholders.

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Impact Of Mergers And Acquisitions on workers or employees:

Aftermath of mergers and acquisitions impact the employees or the workers the most. It is a well

known fact that whenever there is a merger or an acquisition, there are bound to be layoffs.

In the event when a new resulting company is efficient business wise, it would require less number of people to perform the same task. Under such circumstances, the company would attempt to downsize the labor force. If the employees who have been laid off possess sufficient skills, they may in fact benefit from the lay off and move on for greener pastures. But it is usually seen that the employees those who are laid off would not have played a significant role under the new organizational set up. This accounts for their removal from the new organization set up. These workers in turn would look for re employment and may have to be satisfied with a much lesser pay package than the previous one. Even though this may not lead to drastic unemployment levels, nevertheless, the workers will have to compromise for the same. If not drastically, the mild undulations created in the local economy cannot be ignored fully.

Impact of mergers and acquisitions on top level management:Impact of mergers and acquisitions on top level management may actually involve a "clash of the egos". There might be variations in the cultures of the two organizations. Under the new set up the manager may be asked to implement such policies or strategies, which may not be quite approved by him. When such a situation arises, the main focus of the organization gets diverted and executives become busy either settling matters among themselves or moving on. If however, the manager is well equipped with a degree or has sufficient qualification, the migration to another company may not be troublesome at all.

Impact of mergers and acquisitions on shareholders:

We can further categorize the shareholders into two parts:

The Shareholders of the acquiring firm The shareholders of the target firm.

Shareholders of the acquired firm:

The shareholders of the acquired company benefit the most. The reason being, it is seen in majority of the cases that the acquiring company usually pays a little excess than it what should. Unless a man lives in a house he has recently bought, he will not be able to know its drawbacks. So that the shareholders forgo their shares, the company has to offer an amount more then the actual price, which is prevailing in the market. Buying a company at a higher price can actually prove to be beneficial for the local economy.

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Shareholders of the acquiring firm:

They are most affected. If we measure the benefits enjoyed by the shareholders of the acquired company in degrees, the degree to which they were benefited, by the same degree, these shareholders are harmed. This can be attributed to debt load, which accompanies an acquisition

TAXATION ASPECTS OF M&A

Carry forward and set off of accumulated loss and unabsorbed depreciation

Under the Income-tax Act 1961, a special provision is made which governs the provisions relating to carry forward and set off of accumulated business loss and unabsorbed depreciation allowance in certain cases of amalgamations and demergers.

It is to be noted that as unabsorbed losses of the amalgamating company are deemed to be the losses for the previous year in which the amalgamation was effected, the amalgamated company (subject to fulfillment of certain conditions) will have the right to carry forward the loss for a period of eight assessment years immediately succeeding the assessment year relevant to the previous year in which the amalgamation was effected.

If any of the conditions for allowability of right to carry forward of loss, is violated in any year, the set off of loss or allowance of depreciation made in any previous year in the hands of the amalgamated company shall be deemed to be the income of the amalgamated company chargeable to tax for the year in which the conditions are violated.

Capital gains

Capital gains tax is levied if capital gain arises due to transfer of capital assets. The term “transfer” is defined in the Income-tax Act in an inclusive manner.

Under the Income-tax Act, “transfer” does not include any transfer in a scheme of amalgamation of a capital asset by the amalgamating company to the amalgamated company, if the later is an Indian company.

From assessment year 1993-94, any transfer of shares of an Indian company held by a foreign company to another foreign company in a scheme of amalgamation between the two foreign companies will not be regarded as “transfer” for the purpose of levying capital gains tax, subject to fulfilment of certain conditions.

Further, the term transfer also does not include any transfer by a shareholder in a scheme of amalgamation of a capital asset being a share or the shares held by him in the amalgamating company if the transfer is made in consideration of the allotment to him of any share or the shares in the amalgamated company and the amalgamated company is an Indian company.

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Similar exemptions have been provided to a ‘demerger’ under the Income-tax Act, 1961.

Expenditure of amalgamation or demerger

The Income-tax Act, 1961 provides that where an assessee being an Indian company incurs any expenditure on or after the 1st day of April, 1999, wholly and exclusively for the purposes of amalgamation or demerger of an undertaking, the assessee shall be allowed a deduction u/s of an amount equal to of one-fifth of such expenditure for each of the successive previous years beginning with the previous year in which the amalgamation or demerger takes place.

Deductibility of certain expenditure incurred by amalgamating or demerged companies

The Income-tax Act, 1961 provides for continuance of deduction of certain expenditure incurred by the amalgamating company or demerged company as the case may be in the hands of the amalgamated company or resulting company, post amalgamation or demerger viz. capital expenditure on scientific research (only in case of amalgamation), expenditure on acquisition of patents or copyrights, expenditure on know how, expenditure for obtaining Slump — Sale/Hive off

The Income-tax Act, 1961 defines “slump sale” as follows:

“Slump sale” means the transfer of one or more undertakings as a result of the sale for a lump sum consideration without values being assigned to the individual assets and liabilities in such sales.

In a slump sale, a company sells or disposes of the whole or substantially the whole of its undertaking for a lump sum predetermined consideration. In a slump sale, an acquiring company may not be interested in buying the whole company, but only one of its divisions or a running undertaking on a going concern basis. The sale is made for a lump sum price without values being assigned to individual assets and liabilities transferred. The business to be hived off is transferred from the transferor company to an exiting or a new company. A Business Transfer Agreement is drafted containing the terms and conditions of business transfer.

Legal aspects of M&A

Merger/Demerger is a court approved process which requires compliance of provisions under sections 391-394 of the Companies Act, 1956. Accordingly, a merger/demerger scheme is presented to the courts in which, the registered office of the transferor and transferee companies are situated for their approval. However in the case of listed companies such scheme before filing with the State High Court, need to the submitted to Stock Exchange where its shares are listed.

The Courts then require the transferor and transferee companies to comply with the provisions of the Companies Act relating to calling for shareholders and creditors meeting for passing a resolution of merger/ demerger and the resultant issue of shares by the transferee company. The

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Courts accord their approval to the scheme provided the scheme is not prejudicial to public interest and the interests of the creditors and stakeholders are not jeopardized.

The Companies Bill 2008, was introduced in the Parliament on 23rd October, 2008 based on J.J. Irani Committee's recommendation and on detailed consultations with various Ministries, Departments and Government Regulators. The Bill proposes certain changes to existing provisions with respect to M&A.

The key features of the bill as regards M&A are as follows:

Cross border mergers (both ways) seem to be possible under the proposed Bill, with countries as may be notified by Central Government form time to time. (Clause 205 of Companies Bill, 2008) unlike prohibition in case of a “foreign transferee company” under existing provisions.

Currently merger of a listed transferor company into an unlisted transferee company typically results in listing of shares of the unlisted company. The Bill proposes to give an option to the transferee company to continue as an unlisted company with payment of cash to shareholders of listed transferor company who decide to opt out of the unlisted company.

The Bill proposes a valuation report to be given alongwith notice of meeting and also at the time of filing of application with the National Company Law Tribunal (“NCLT”) to the shareholders and the creditors which is not required as per the current provisions.

The Bill proposes that in case of merger or hive off, in addition to the notice requirements for shareholders and creditors meetings, confirmation of filing of the scheme with Registrar and supplementary accounting statement where the last audited accounting statement is more than six months old before the first meeting of the Company will be required.

In order to enable fast track and cost efficient merger of small companies, the Bill proposes a separate process for a merger and amalgamation of holding and wholly owned subsidiary companies or between two or more small companies.

The Bill provides that fees paid by the transferor company on authorized share capital shall be available for setoff against the fees payable by the transferee company on its authorized share capital subsequent to the merger. This may enable clubbing of authorized share capital.

license to operate telecommunication services.

Tax characterisation of sale of business/slump sale

For a sale of business to be considered as a ‘slump sale’ the following conditions need to fulfilled:

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• There is a sale of an undertaking; • The sale is for a lump sum consideration; and • No separate values being assigned to individual assets and liabilities.

If separate values are assigned to assets, the sale will be regarded as an ‘itemised sale’.

Indian tax laws have specifically clarified that the determination of the value of an asset or liability for the sole purpose of payment of stamp duty, registration fees or other similar taxes or fees shall not be regarded as assignment of values to individual assets or liabilities

In a slump sale, the profits arising from a sale of an undertaking would be treated as a capital gain arising from a single transaction. Where the undertaking being transferred was held for at least 36 months prior to the date of the slump sale, the income from such a sale would qualify as long-term capital gains at rate of 20% (plus surcharge and cess). If the undertaking has been held for less than 36 months prior to the date of slump sale, then the income would be taxable as short-term capital gains at the rate of 30% (plus surcharge and cess).

Whereas an itemized sale of individual assets takes place, profit arising from the sale of each asset is taxed separately. Accordingly, income from the sale of assets in the form of “stock-in-trade” will be taxed as business income, and the sale of capital assets is taxable as capital gains. Significantly, the tax rates on such capital gains would depend on the period that each asset (and not the business as a whole) has been held by the seller entity prior to such sale.

Stamp duty aspects of M&A

Stamp duty is payable on the value of immovable property transferred by the demerged/ amalgamating/ transferor company or value of shares issued/consideration paid by the resulting/ amalgamated/ transferee company. In certain States there are specific provisions for levy of stamp duty on amalgamation/ demerger order viz. Maharashtra, Gujarat, Rajasthan etc. However in other States these provisions are still to be introduced.

Thus in respect of States where there is no specific provision, there exists an ambiguity as to whether the stamp duty is payable as per the conveyance entry or the market value of immovable property. The High Court order is regarded as a conveyance deed for mutation of ownership of the transferred property. Stamp duty is payable in the States where the registered office of the transferor and transferred companies is situated. In addition to the same, stamp duty may also be payable in the States in which the immovable properties of the transferred business are situated. Normally, set off for stamp duty paid in a particular State is available against stamp duty payable in the other State. However, the same depends upon the stamp laws under the various States.In addition to the stamp duty on transfer of business, additional stamp duty on issue of shares is also payable based on the rates prevailing in the State in which shares are issued.

COMPETITION ACT, 2002

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Competition Act, 2002 has been enacted to prevent practices having adverse effect on competition, to promote and sustain competition in markets, to protect the interests of consumers and to ensure freedom of trade carried on by other markets participants in India.

Competition Act, 2002 regulates the specified combination of acquisition or merger or amalgamation based on the turnover or gross turnover. The amended provision is applicable to entities

a. in India, if the acquiring and the acquired entities jointly have assets more than Rs 1,000 crore or turnover more than Rs. 3,000 crore or the group has assets more than Rs. 4,000 crore or the turnover more than Rs. 12,000 crore, or

b. in India or outside India if the acquiring and the acquired entities jointly have assets more than Rs.500 million assets (including > Rs. 500 crore in India) or turn over more than Rs. 1500 million turnover (including >1,500 crore in India) or the group has assets more than Rs. 2000 million (including > Rs. 500 crore in India) or turnover more than Rs. 6000 million (including > Rs. 1,500 crore in India).

The above-mentioned entities is required to give notice to Competition Commission of India (CCI), within 30 days of the approval of the proposal relating to the merger by board of directors of the companies or execution of any agreement/document for acquisition and no combination shall come in effect unless 210 days have passed from serving such notice to the CCI or grant of approval by CCI, whichever is earlier.

LIMITED LIABILITY PARTNERSHIPS

With a view to provide an alternative to the traditional partnership, with an unlimited liability and a statute based governance structure of limited liability company, a new corporate form namely a Limited Liability Partnership (LLP) has been established under LLP Act, 2008. (“LLP Act”)

It is felt that the new business form will not only enable professional expertise and entrepreneurial initiative to combine, organize and operate in flexible, innovative and efficient manner but will also provide a further impetus to India’s economic growth.

LLP allows its members the flexibility of organizing their internal structure as a partnership based on a mutually arrived agreement with a limited liability of its members. Accordingly enterprises are now free to form commercially efficient vehicles suited to their requirements.

An LLP can either be incorporated as such or a partnership firm, private company or an unlisted public company can be converted into a LLP. Further the LLP Act provides for compromise, arrangement or reconstruction of LLPs amongst LLPs.

On the taxation front, the income tax Act considers LLP at par with a partnership firm.

Also currently there is no clarity on the stamp duty implications or the position of FDI in case of LLP.

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The recently released Code also treats a LLP as firm for taxation purposes. Further, the Code proposes to allow amalgamation of LLP with company subject to satisfaction of certain conditions.

HUMAN ASPECTS OF M&A

The period of merger is a period of great uncertainty for the employees at all levels of the merging organizations. The uncertainty relates to job security and status within the company leading to fear and hence low morale among the employees and quite naturally so. The influx of new employees into an organization also creates a sense of invasion at times and ultimately leads to resentment. Moreover, the general chaos which follows any merger results in disorientation due to ill defined roles and responsibilities. This leads to frustrations resulting into poor performance and low productivity since strategic and financial advantage is generally a motive for any merger.

The top executives involved in implementation of merger often overlook the human aspect of mergers by neglecting the culture shocks facing the merger. Understanding different cultures and where and how to integrate them properly is vital to the success of an acquisition or a merger.

Important factors to be taken note of would include the mechanism of corporate control particularly encompassing delegation of power and power of control, responsibility towards management information system, interdivisional and intra-divisional harmony and achieving optimum results through changes and motivation.

The key to a successful M&A transaction is an effective integration that is capable of achieving the benefits intended. It is at the integration stage immediately following the closing of the transaction that many well-conceived transactions fail. Although often overlooked in the rush of events that typically precede the closing of the transaction, it is at the integration stage with careful planning and execution that plays an important role which, in the end, is essential to a successful transaction.

Integration issues, to the extent possible, should be identified during the due diligence phase, which should comprise both financial and HR exercises, to help to mitigate transaction risk and increase likelihood of integration success.

In conclusion, to achieve a flawless M&A transaction lies in being able to start right, well before the combination, plan with precision, and ensure a relentless clarity of purpose and concerted action in the actual integration and post-integration stage.

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Income Tax Act , 1961 as Amended by Finance Act 2005

Provisions relating to carry forward and set off of accumulated loss and unabsorbed depreciation allowance in amalgamation or demerger, etc.

Section 72A. (1) Where there has been an amalgamation of a company owning an industrial undertaking or a ship or a hotel with another company or an amalgamation of a banking company referred to in clause (c) of section 5 of the Banking Regulation Act, 1949 (10 of 1949) with a specified bank, then, notwithstanding anything contained in any other provision of this Act, the accumulated loss and the unabsorbed depreciation of the amalgamating company shall be deemed to be the loss or, as the case may be, allowance for depreciation of the amalgamated company for the previous year in which the amalgamation was effected, and other provisions of this Act relating to set off and carry forward of loss and allowance for depreciation shall apply accordingly.(2) Notwithstanding anything contained in sub-section (1), the accumulated loss shall not be set off or carried forward and the unabsorbed depreciation shall not be allowed in the assessment of the amalgamated company unless

(a) the amalgamating company (i) has been engaged in the business, in which the accumulated loss occurred or depreciation remains unabsorbed, for three or more years; (ii) has held continuously as on the date of the amalgamation at least three-fourths of the book value of fixed assets held by it two years prior to the date of amalgamation; (b) the amalgamated company (i) holds continuously for a minimum period of five years from the date of amalgamation at least three-fourths of the book value of fixed assets of the amalgamating company acquired in a scheme of amalgamation; (ii) continues the business of the amalgamating company for a minimum period of five years from the date of amalgamation; (iii) fulfils such other conditions as may be prescribed to ensure the revival of the business of the amalgamating company or to ensure that the amalgamation is for genuine business purpose.

(3) In a case where any of the conditions laid down in sub-section (2) are not complied with, the set off of loss or allowance of depreciation made in any previous year in the hands of the amalgamated company shall be deemed to be the income of the amalgamated company chargeable to tax for the year in which such conditions are not complied with.

(4) Notwithstanding anything contained in any other provisions of this Act, in the case of a demerger, the accumulated loss and the allowance for unabsorbed depreciation of the demerged company shall (a) where such loss or unabsorbed depreciation is directly relatable to the undertakings transferred to the resulting company, be allowed to be carried forward and set off in the hands of the resulting company; (b) where such loss or unabsorbed depreciation is not directly relatable to the undertakings transferred to the resulting company, be apportioned between the demerged company and the resulting company in the same proportion in which the assets of the undertakings have been retained by the demerged company and transferred to the resulting company, and be allowed to be carried forward and set off in the hands of the demerged

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company or the resulting company, as the case may be.

(5) The Central Government may, for the purposes of this Act, by notification in the Official Gazette, specify such conditions as it considers necessary to ensure that the demerger is for genuine business purposes.(6) Where there has been reorganisation of business, whereby, a firm is succeeded by a company fulfilling the conditions laid down in clause (xiii) of section 47 or a proprietary concern is succeeded by a company fulfilling the conditions laid down in clause (xiv) of section 47, then, notwithstanding anything contained in any other provision of this Act, the accumulated loss and the unabsorbed depreciation of the predecessor firm or the proprietary concern, as the case may be, shall be deemed to be the loss or allowance for depreciation of the successor company for the purpose of previous year in which business reorganisation was effected and other provisions of this Act relating to set off and carry forward of loss and allowance for depreciation shall apply accordingly :

Provided that if any of the conditions laid down in the proviso to clause (xiii) or the proviso to clause (xiv) to section 47 are not complied with, the set off of loss or allowance of depreciation made in any previous year in the hands of the successor company, shall be deemed to be the income of the company chargeable to tax in the year in which such conditions are not complied with.

(7) For the purposes of this section, (a) accumulated loss means so much of the loss of the predecessor firm or the proprietary concern or the amalgamating company or the demerged company, as the case may be, under the head Profits and gains of business or profession (not being a loss sustained in a speculation business) which such predecessor firm or the proprietary concern or amalgamating company or demerged company, would have been entitled to carry forward and set off under the provisions of section 72 if the reorganisation of business or amalgamation or demerger had not taken place;

Explanation 97[(aa) industrial undertaking means any undertaking which is engaged in (i) the manufacture or processing of goods; or (ii) the manufacture of computer software; or (iii) the business of generation or distribution of electricity or any other form of power; or 98[(iiia) the business of providing telecommunication services, whether basic or cellular, including radio paging, domestic satellite service, broadband network and internet services; or (iv) mining; or (v) the construction of ships, aircrafts or rail systems;(b) unabsorbed depreciation means so much of the allowance for depreciation of the predecessor firm or the proprietary concern or the amalgamating company or the demerged company, as the case may be, which remains to be allowed and which would have been allowed to the predecessor firm or the proprietary concern or amalgamating company or demerged company, as the case may be, under the provisions of this Act, if the reorganisation of business or amalgamation or demerger had not taken place;99[(c) specified bank means the State Bank of India constituted under the State Bank of India Act, 1955 (23 of 1955) or a subsidiary bank as defined in the State Bank of India (Subsidiary Banks) Act, 1959 (38 of 1959) or a corresponding new bank constituted under section 3 of the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970 (5 of 1970) or under

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section 3 of the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1980 (40 of 1980).]

Provisions relating to carry forward and set-off of accumulated loss and unabsorbed depreciation allowance in scheme of amalgamation of banking company in certain cases.

72AA. Notwithstanding anything contained in sub-clauses (i) to (iii) of clause (1B) of section 2 or section 72A, where there has been an amalgamation of a banking company with any other banking institution under a scheme sanctioned and brought into force by the Central Government under sub-section (7) of section 45 of the Banking Regulation Act, 1949 (10 of 1949)1a, the accumulated loss and the unabsorbed depreciation of such banking company shall be deemed to be the loss or, as the case may be, allowance for depreciation of such banking institution for the previous year in which the scheme of amalgamation was brought into force and other provisions of this Act relating to set-off and carry forward of loss and allowance for depreciation shall apply accordingly.

Explanation.For the purposes of this section, (i) accumulated loss means so much of the loss of the amalgamating banking company under the head Profits and gains of business or profession (not being a loss sustained in a speculation business) which such amalgamating banking company, would have been entitled to carry forward and set-off under the provisions of section 72 if the amalgamation had not taken place;(ii) banking company shall have the same meaning assigned to it in clause (c) of section 5 of the Banking Regulation Act, 1949 (10 of 1949) 1a;(iii) banking institution shall have the same meaning assigned to it in sub-section (15) of section 45 of the Banking Regulation Act, 1949 (10 of 1949) 1a;(iv) unabsorbed depreciation means so much of the allowance for depreciation of the amalgamating banking company which remains to be allowed and which would have been allowed to such banking company if amalgamation had not taken place

Cross-border mergers and acquisitions: Tax and regulatory issues

Indian companies are increasingly becoming involved in cross border mergers and acquisitions with an Intention to enhance shareholder value. Several tax and regulatory issues need to be considered when such Deals are contemplated.

Swap transactionWhen Indian residents holding the entire share capital of an Indian Company intends to transfer their Shareholding in the Indian Company to the Foreign say unlisted Company in exchange for shares of the Foreign Company thereby making the Indian Company a 100 % subsidiary of the Foreign Company. This Exchange is generally termed as share swap transaction.

What are the Tax implications

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The transfer of shares in the Indian Company in exchange of shares of the Foreign Company would imply Capital gains for the shareholders of the Indian Company. For the purpose of computing the capital gains, The consideration received by the shareholders of the Indian Company would have to be reduced from the cost of acquisition of the shares in the Indian Company.

The consideration received computed based on the value of shares in the Foreign Company and not on the Value of the shares in the Indian Company given up.

Then the question is, what is the value of shares of an unlisted Foreign Company. The Income Tax Act 1961 does not provide for any valuation norms for shares of unlisted companies and the capital gains arising as a result of such a swap. In case the Foreign Company was a listed company, the market value of Foreign Company shares Received could be taken as the consideration for the transfer and used to compute capital gains.

In the past, legislations like the Gift Tax and Wealth Tax provided for valuation of shares in unlisted companies on the basis of Net Asset Value (NAV).It is a debatable issue whether NAV method is the appropriate method or not in computing the sale consideration for capital gains purposes.

One aspect that needs to be considered when the Indian Company has unabsorbed business losses is, Section 79 of the Act. Section 79 of the Act restricts an Indian company from carrying forward and setting off its business losses against future profits in case of change of more than 51% shareholding of such an Indian company. Since more than 51% shareholding of the Indian Company would change, it will not be allowed to carry forward its prior year's business losses for set off against profits of future years.

Business valuation

The five most common ways to value a business are

asset valuation, historical earnings valuation, future maintainable earnings valuation, relative valuation (comparable company & comparable transactions), discounted cash flow (DCF) valuation

Professionals who valuate businesses generally do not use just one of these methods but a combination of some of them, as well as possibly others that are not mentioned above, in order to obtain a more accurate value. The information in the balance sheet or income statement is obtained by one of three accounting measures: a Notice to Reader, a Review Engagement or an Audit.

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Accurate business valuation is one of the most important aspects of M&A as valuations like these will have a major impact on the price that a business will be sold for. Most often this information is expressed in a Letter of Opinion of Value (LOV) when the business is being valuated for interest's sake. There are other, more detailed ways of expressing the value of a business. While these reports generally get more detailed and expensive as the size of a company increases, this is not always the case as there are many complicated industries which require more attention to detail, regardless of size.

Financing M&A

Mergers are generally differentiated from acquisitions partly by the way in which they are financed and partly by the relative size of the companies. Various methods of financing an M&A deal exist:

Cash

Payment by cash. Such transactions are usually termed acquisitions rather than mergers because the shareholders of the target company are removed from the picture and the target comes under the (indirect) control of the bidder's shareholders.

Stock

Payment in the acquiring company's stock, issued to the shareholders of the acquired company at a given ratio proportional to the valuation of the latter.

Which method of financing to choose?

There are some elements to think about when choosing the form of payment. When submitting an offer, the acquiring firm should consider other potential bidders and think strategically. The form of payment might be decisive for the seller. With pure cash deals, there is no doubt on the real value of the bid (without considering an eventual earnout). The contingency of the share payment is indeed removed. Thus, a cash offer preempts competitors better than securities. Taxes are a second element to consider and should be evaluated with the counsel of competent tax and accounting advisers. Third, with a share deal the buyer’s capital structure might be affected and the control of the New co modified. If the issuance of shares is necessary, shareholders of the acquiring company might prevent such capital increase at the general meeting of shareholders. The risk is removed with a cash transaction. Then, the balance sheet of the buyer will be modified and the decision maker should take into account the effects on the reported financial results. For example, in a pure cash deal (financed from the company’s current account), liquidity ratios might decrease. On the other hand, in a pure stock for stock transaction (financed from the issuance of new shares), the company might show lower profitability ratios (e.g. ROA). However, economic dilution must prevail towards accounting dilution when making the choice. The form of payment and financing options are tightly linked. If the buyer pays cash, there are three main

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financing options:

- Cash on hand: it consumes financial slack (excess cash or unused debt capacity) and may decrease debt rating. There are no major transaction costs.

- Issue of debt: it consumes financial slack, may decrease debt rating and increase cost of debt. Transaction costs include underwriting or closing costs of 1% to 3% of the face value.

- Issue of stock: it increases financial slack, may improve debt rating and reduce cost of debt. Transaction costs include fees for preparation of a proxy statement, an extraordinary shareholder meeting and registration.

If the buyer pays with stock, the financing possibilities are:

- Issue of stock (same effects and transaction costs as described above).

- Shares in treasury: it increases financial slack (if they don’t have to be repurchased on the market), may improve debt rating and reduce cost of debt. Transaction costs include brokerage fees if shares are repurchased in the market otherwise there are no major costs.

In general, stock will create financial flexibility. Transaction costs must also be considered but tend to have a greater impact on the payment decision for larger transactions. Finally, paying cash or with shares is a way to signal value to the other party, e.g.: buyers tend to offer stock when they believe their shares are overvalued and cash when undervalued.

Discounted cash flow methods

The valuation computation includes the following steps:1. Discounting the future expected cash flows over a forecast period.2. Adding a terminal value to cover the period beyond the forecast period.3. Adding investment income, excess cash, and other non-operating assets at their presentvalues.4. Subtracting out the fair market values of debt so that we can arrive at the value of equity.Before we get into the valuation computation, we need to ask: What are we trying to value?Do we want to assign value to the equity of the target? Do we value the Target Company on a long-term basis or a short-term basis? For example, the valuation of a company expected to be liquidated is different from the valuation of a going concern.Most mergers and acquisitions are directed at acquiring the equity of the Target Company.However, when you acquire ownership (equity) of the Target Company, you will assume theoutstanding liabilities of the target. This will increase the purchase price of the Target company.Chapter Example 1 - Determine Purchase Price of Target CompanyEttco has agreed to acquire 100% ownership (equity) of Fulton for Rs. 100 million. Fulton has Rs. 35 million of liabilities outstanding. Amount Paid to Acquire Fulton Rs. 100 million Outstanding Liabilities Assumed 35 million

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Total Purchase Price Rs. 135 million Key Point →Ettco has acquired Fulton based on the assumption that Fulton's business will generate a Net Present Value of Rs. 135 million.For publicly traded companies, we can get some idea of the economic value of a company by looking at the stock market price. The value of the equity plus the value of the debt is the total market value of the Target Company.

Example 2 - Total Market Value of Target Company Referring back to Example 1, assume Fulton has 2,500,000 shares of stock outstanding. Fulton's stock is selling for Rs. 60.00 per share and the fair market value of Fulton's debt is Rs. 40 million.Market Value of Stock (2,500,000 x Rs. 60.00) Rs. 150 millionMarket Value of Debt 40 millionTotal Market Value of Fulton Rs. 190 millionA word of caution about relying on market values within the stock market; stocks rarely trade in large blocks similar to merger and acquisition transactions. Consequently, if the publicly traded target has low trading volumes, then prevailing market prices are not a reliable indicator of value. Calculation of Free Cash Flow come StreamsOne of the dilemmas within the merger and acquisition process is selection of income streams for discounting. Income streams include Earnings, Earnings Before Interest & Taxes (EBIT), Earnings Before Interest Taxes Depreciation & Amortization (EBITDA), Operating Cash Flow, Free Cash Flow, Economic Value Added (EVA), etc.In financial management, we recognize that value occurs when there is a positive gap between return on invested capital less cost of capital. Additionally, we recognize that earnings can be judgmental, subject to accounting rules and distortions. Valuations need to be rooted in "hard numbers." Therefore, valuations tend to focus on cash flows, such as operating cash flows and free cash flows over a projected forecast period.

Free Cash FlowOne of the more reliable cash flows for valuations is Free Cash Flow (FCF). FCF accounts for future investments that must be made to sustain cash flow. Compare this to EBITDA, which ignores any and all future required investments. Consequently, FCF is considerably more reliable than EBITDA and other earnings-based income streams. The basic formula for calculating Free Cash Flow (FCF) is:

FCF = EBIT (1 - t ) + Depreciation - Capital Expenditures + or - Net Working Capital( 1 - t ) is the after tax percent, used to convert EBIT to after taxes.Depreciation is added back since this is a non-cash flow item within EBITCapital Expenditures represent investments that must be made to replenish assets and generate future revenues and cash flows. Net Working Capital requirements may be involved when we make capital investments. At the end of a capital project, the change to working capital may get reversed.

Example 3 - Calculation of Free Cash FlowEBIT Rs. 400Less Cash Taxes (130)Operating Profits after taxes 270Add Back Depreciation 75

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Gross Cash Flow 345Change in Working Capital 42Capital Expenditures (270)Operating Free Cash Flow 117Cash from Non Operating Assets * 10Free Cash Flow Rs. 127* Investments in Marketable SecuritiesIn addition to paying out cash for capital investments, we may find that we have some fixed obligations. A different approach to calculating Free Cash Flow when we have affixed obligation is:FCF = After Tax Operating Tax Cash Flow - Interest ( 1 - t ) - PD - RP - RD - EPD: Preferred Stock DividendsRP: Expected Redemption of Preferred StockRD: Expected Redemption of DebtE: Expenditures required to sustain cash flowsExample 4 - Calculation of Free Cash FlowThe following projections have been made for the year 2005:Operating Cash Flow after taxes are estimated as Rs. 190,000Interest payments on debt are expected to be Rs. 10,000Redemption payments on debt are expected to be Rs. 40,000New investments are expected to be Rs. 20,000The marginal tax rate is expected to be 30%After Tax Operating Cash Flow Rs. 190,000Less After Tax interest =(Rs.10,000 x (1 - .30))= ( 7,000)Debt Redemption Payment (40,000)New Investments (20,000)Free Cash Flow Rs. 123,000Discount Rate

Now that we have some idea of our income stream for valuing the Target Company, we need to determine the discount rate for calculating present values. The discount rate used should match the risk associated with the free cash flows. If the expected free cash flows are highly uncertain, this increases risk and increases the discount rate. The riskier the investment, the higher the discount rate and vice versa. Another way of looking at this is to ask yourself -What rate of return do investors require for a similar type of investment?Since valuation of the target's equity is often the objective within the valuation process, it is useful to focus our attention on the "targeted" capital structure of the Target Company. A review of comparable firms in the marketplace can help ascertain targeted capital structures.Based on this capital structure, we can calculate an overall weighted average cost of capital(WACC). The WACC will serve as our base for discounting the free cash flows of the TargetCompany.Basic ApplicationsValuing a target company is more or less an extension of what we know from capital budgeting. If the Net Present Value of the investment is positive, we add value through a merger and acquisition. Example 5 - Calculate Net Present Value Shannon Corporation is considering

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acquiring Dalton Company for Rs. 100,000 in cash. Dalton's cost of capital is 16%. Based on market analysis, a targeted cost of capital for Dalton is 12%. Shannon has estimated that Dalton can generate Rs. 9,000 of free cash flows over the next 12 years. Using Net present Value, should Shannon acquire Dalton?Initial Cash Outlay Rs. (100,000)FCF of Rs. 9,000 x 6.1944* = 55,750Net Present Value Rs. ( 44,250)* present value factor of annuity at 12%, 12 years.

Based on NPV, Shannon should not acquire Dalton since there is a negative NPV for this investment. We also need to remember that some acquisitions are related to physical assets and some assets may be sold after the merger.

Example 6 - Calculate Net Present ValueBishop Company has decided to sell its business for a sales price of Rs. 50,000. Bishop's Balance Sheet discloses the following:Cash Rs. 3,000Accounts Receivable 7,000Inventory 12,000Equipment - Dye 115,000Equipment - Cutting 35,000Equipment - Packing 30,000Total Assets Rs. 202,000Liabilities 80,000Equity 122,000Total Liab & Equity Rs. 202,000Allman Company is interested in acquiring two assets - Dye and Cutting Equipment. Allman intends to sell all remaining assets for Rs. 35,000. Allman estimates that total future free cash flows from the dye and cutting equipment will be Rs. 26,000 per year over the next 8 years. The cost of capital is 10% for the associated free cash flows. Ignoring taxes, shouldAllman acquire Bishop for Rs. 50,000?Amount Paid to Bishop Rs. (50,000)Amount Due Creditors (80,000)Less Cash on Hand 3,000Less Cash from Sale of Assets 35,000Total Initial Cash Outlay Rs. (92,000)Present Value of FCF's for 8 yearsat 10% - Rs. 26,000 x 5.3349 138,707Net Present Value (NPV) Rs. 46,707Based on NPV, Allman should acquire Bishop for Rs. 50,000 since there is a positive NPV of Rs. 46,707.

A solid estimation of incremental changes to cash flow is critical to the valuation process.Because of the variability of what can happen in the future, it is useful to run cash flowestimates through sensitivity analysis, using different variables to assess "what if" type analysis. Probability distributions are used to assign values to various variables. Simulation analysis can be

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used to evaluate estimates that are more complicated.Valuation StandardsBefore we get into the valuation calculation, we should recognize valuation standards. Mostof us are reasonably aware that Generally Accepted Accounting Principles (GAAP) are used as standards to guide the preparation of financial statements. When we calculate the value (appraisal) of a company, there is a set of standards known as "Uniform Standards ofProfessional Appraisal Practice" or USAAP. USAAP's are issued by the Appraisals Standards Board. Here are some examples:To avoid misuse or misunderstanding when Discounted Cash Flow (DCF) analysis is used in an appraisal assignment to estimate market value, it is the responsibility of the appraiser to ensure that the controlling input is consistent with market evidence and prevailing attitudes. Market value DCF analysis should be supported by market derived data, and the assumptions should be both market and property specific. Market value DCF analysis is intended to reflect the expectations and perceptions of market participants along with available factual data.In developing a real property appraisal, an appraiser must: (a) be aware of, understand, and correctly employ those recognized methods and techniques that are necessary to produce a creditable appraisal; (b) not commit a substantial error of omission or co-omission that significantly affects an appraisal; (c) not render appraisal services in a careless or negligent manner, such as a series of errors that considered individually may not significantly affect the result of an appraisal, but which when considered in aggregate would be misleading.Another area that can create some confusion is the definition of market value. This is particularly important where the Target Company is private (no market exists). We defines market value as:The price at which the property could change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.The Valuation ProcessFive steps for valuing a company:1. Historical Analysis: A detail analysis of past performance, including a determination of what drives performance. Several financial calculations need to be made, such as free cash flows, return on capital, etc. Ratio analysis and benchmarking are also used to identify trends that will carry forward into the future.2. Performance Forecast: It will be necessary to estimate the future financial performanceof the target company. This requires a clear understanding of what drives performanceand what synergies are expected from the merger.3. Estimate Cost of Capital: We need to determine a weighed average cost of capital for discounting the free cash flows.4. Estimate Terminal Value: We will add a terminal value to our forecast period to account for the time beyond the forecast period.5. Test & Interpret Results: Finally, once the valuation is calculated, the results should betested against independent sources, revised, finalized, and presented to senior management.Financial AnalysisWe start the valuation process with a complete analysis of historical performance. The valuation process must be rooted in factual evidence. This historical evidence includes atleast the last five years (preferably the last ten years) of financial statements for the TargetCompany. By analyzing past performance, we can develop a synopsis or conclusion about the

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Target Company's future expected performance. It is also important to gain an understanding of how the Target Company generates and invests its cash flows.One obvious place to start is to assess how the merger will affect earnings. P / E Ratios(price to earnings per share) can be used as a rough indicator for assessing the impact on earnings. The higher the P / E Ratio of the acquiring firm compared to the target company,the greater the increase in Earnings per Share (EPS) to the acquiring firm. Dilution of EPSoccurs when the P / E Ratio Paid for the target exceeds the P / E Ratio of the acquiring company. The size of the target's earnings is also important; the larger the target's earnings are relative to the acquirer, the greater the increase to EPS for the combined company. The following examples will illustrate these points.Chapter Example 7 - Calculate Combined EPSGreer Company has plans to acquire Holt Company by exchanging stock.Greer will issue 1.5 shares of its stock for each share of Holt. Financialinformation for the two companies is as follows:Greer HoltNet Income Rs. 400,000 Rs. 100,000Shares Outstanding 200,000 25,000Earnings per Share Rs. 2.00 Rs. 4.00Market Price of Stock Rs. 40.00 Rs. 48.00Greer expects the P / E Ratio for the combined company to be 15.Combined EPS = (Rs. 400,000 + Rs. 100,000) / (200,000 shares + (25,000 x1.5)) = Rs. 500,000 / 237,500 = Rs. 2.11Expected P / E Ratio x 15Expected Price of Stock Rs. 31.65Before we move to our next example, we should explain exchange ratios. The exchange ratio is the number of shares offered by the acquiring company in relation to each share of the Target Company. We can calculate the exchange ratio as:Price Offered by Acquiring Firm / Market Price of Acquiring FirmExample 8 - Determine Dilution of EPSRomer Company will acquire all of the outstanding stock of Dayton Company through an exchange of stock. Romer is offering Rs. 65.00 per share for Dayton. Financial information for the two companies is as follows:Romer Dayton Net Income Rs. 50,000 Rs. 10,000Shares Outstanding 5,000 2,000Earnings per Share Rs. 10.00 Rs. 5.00Market Price of Stock Rs. 150.00P / E Ratio 15(1) Calculate shares to be issued by Romer: Rs. 65 / Rs. 150 x 2,000 shares = 867 shares to be issued.(2) Calculate Combined EPS: (Rs. 50,000 + Rs. 10,000) / (5,000 + 867) = Rs. 10.23(3) Calculate P / E Ratio Paid: Price Offered / EPS of Target or Rs. 65.00 / Rs. 5.00 = 13(4) Compare P / E Ratio Paid to current P / E Ratio: Since 13 is less than the current ratio of 15, there should be no dilution of EPS for the combined company.(5) Calculate maximum price before dilution of EPS: 15 = price / Rs. 5.00 or Rs. 75.00 per share. Rs. 75.00 is the maximum price that Romer should pay before EPS are diluted.

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Value Drivers.

Example 11 - Forecasted Income Statement for Scenario 2 - Moderate(Rs. million)2001 2002 2003 2004 2005 2006 2007Revenues Rs. 6.50 Rs. 6.70 Rs. 6.85 Rs.6.95 Rs.7.05 Rs.7.09 Rs.7.12Less Operating 3.20 3.30 3.41 3.53 3.65 3.72 3.78Less Depreciation .56 .54 .52 .85 .80 .77 .72EBIT 2.74 2.86 2.92 2.57 2.60 2.60 2.62Less Interest .405 .380 .365 .450 .440 .410 .390Earnings Before Tax 2.335 2.480 2.555 2.12 2.16 2.19 2.23Less Taxes .780 .810 .870 .650 .660 .71 .73Net Income 1.555 1.670 1.685 1.470 1.500 1.48 1.50Terminal ValuesIt is quite possible that free cash flows will be generated well beyond our forecast period.Therefore, many valuations will add a terminal value to the valuation forecast. The terminal value represents the total present value that we will receive after the forecast period.

Example 12 - Adding Terminal Value to Valuation ForecastNet Present Value for forecast period (Example 9) Rs. 423,500Terminal Value for beyond forecast period 183,600Total NPV of Target Company Rs. 607,100There are several approaches to calculating the terminal value:Dividend Growth: Simply take the free cash flow in the final year of the forecast, add anominal growth rate to this flow and discount the free cash flow as a perpetuity. Terminalvalue is calculated as:Terminal Value = FCF ( t + 1 ) / wacc - g( t + 1 ) refers to the first year beyond the forecast periodwacc: weighted average cost of capitalg: growth rate, usually a very nominal rate similar to the overall economy It should be noted that FCF used for calculating terminal values is a normalized free cashflow (FCF) representative of the forecast period.

Example 13 - Calculate Terminal Value Using Dividend GrowthYou have prepared a forecast for ten years and the normalized free cashflow is Rs. 45,000. The growth rate expected after the forecast period is 3%.The wacc for the Target Company is 12%.(Rs. 45,000 x 1.03) / (.12 - .03) = Rs. 46,350 / .09 = Rs. 515,000If we wanted to exclude the growth rate in Example 13, we would calculate terminal value asRs. 46,350 / .12 = Rs. 386,250. This gives us a much more conservative estimate.Adjusted Growth: Growth is included to the extent that we can generate returns higher thanour cost of capital. As a company grows, you must reinvest back into the business and thusfree cash flows will fall. Therefore, the Adjusted Growth approach is one of the more

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appropriate models for calculating terminal values.Terminal Value = EBIT ( 1 - tr) ( 1 - g / r ) / wacc - gtr: tax rate g: growth rate r: rate of return on new investments

Example 14 - Calculate Terminal Value Using Adjusted GrowthNormalized EBIT is Rs. 60,000 and the expected normal tax rate is 30%. Theoverall long-term growth rate is 3% and the weighted average cost of capitalis 12%. We expect to obtain a rate of return on new investments of 15%.Rs. 61,800 ( 1 - .30 ) ( 1 - .03 / .15 ) / (.12 - .03) =Rs. 43,260 ( .80 ) / .09 = Rs. 384,533If we use Free Cash Flows, we would have the following type of calculation:Earnings Before Interest Taxes (EBIT) Rs. 60,000Remove taxes (1 - tr ) x .70Operating Income After Taxes 42,000Depreciation (non cash item) 12,000Less Capital Expenditures ( 9,000)Less Changes to Working Capital ( 1,000)Free Cash Flow 44,000Growth Rate @ 3% x 1.03Free Cash Flow ( t + 1 ) 45,320Adjust Growth > Return on Capital x .80Adjusted FCF ( t + 1 ) 36,256Divided by wacc - g or .12 - .03 .09Terminal Value Rs. 402,844EVA Approach: If your valuation is based on economic value added (EVA), then you shouldextend this concept to your terminal value calculation:Terminal Value = NOPAT ( t + 1 ) x ( 1 - g / rc ) / wacc - gNOPAT: Net Operating Profits After Taxes rc: return on invested capitalTerminal values should be calculated using the same basic model you used within the forecast period. You should not use P / E multiples to calculate terminal values since the price paid for a target company is not derived from earnings, but from free cash flows or EVA.Finally, terminal values are appropriate when two conditions exist:1. The Target Company has consistent profitability and turnover of capital for generating a constant return on capital.2. The Target Company is able to reinvest a constant level of cash flow because of consistency in growth.If these two criteria do not exist, you may need to consider a more conservative approach to calculating terminal value or simply exclude the terminal value altogether.Example 15 - Summarize Valuation Calculation Based on Expected Values under Three ScenariosPresent Value of FCF's for 10 year forecast period Rs. 62,500Terminal Value based on Perpetuity 87,200Present Value of Non Operating Assets 8,600Total Value of Target Company 158,300Less Outstanding Debt at Fair Market Value:Short-Term Notes Payable ( 6,850)

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Long-Term Bonds (25 year Grade BB) ( 26,450)Long-Term Bonds (10 year Grade AAA) ( 31,900)Long-Term Bonds ( 5 year Grade BBB) ( 22,700)Present Value of Lease Obligations ( 17,880)Total Value Assigned to Equity 52,520Outstanding Shares of Stock 7,000Value per Share (Rs. 52,520 / 7,000) Rs. 7.50Example 16 - Calculate Value per ShareYou have completed the following forecast of free cash flows for an eightyear period, capturing the normal business cycle of Arbor Company:Year FCF2001 Rs. 1,5502002 1,5732003 1,5982004 1,6262005 1,6562006 1,6802007 1,7032008 1,725Arbor has non-operating assets of Rs. 150. These assets have an estimated present value of Rs. 500. Based on the present value of future payments, the present value of debt is Rs. 2,800. Terminal value is calculated using the dividend growth model. A nominal growth rate of 2% will be used. Arbor's targeted cost of capital is 14%. Arbor has 3,000 shares of stockoutstanding. What is Arbor's Value per Share?Year FCF x P.V. @ 14% Present Value2001 Rs. 1,550 .8772 Rs. 1,3602002 1,573 .7695 1,2102003 1,598 .6750 1,0792004 1,626 .5921 9632005 1,656 .5194 8602006 1,680 .4556 7652007 1,703 .3996 6812008 1,725 .3506 605Total Present Value for Forecast Period Rs. 7,523Terminal Value = (Rs. 1,725 x 1.02) / (.14 - .02) = 14,663Value of Non Operating Assets 500Total Value of Arbor 22,686Less Value of Debt ( 2,800)Value of Equity 19,886Shares Outstanding 3,000Value per Share Rs. 6.63Special ProblemsBefore we leave valuations, we should note some special problems that can influence the valuation calculation.Private Companies: When valuing a private company, there is no marketplace for the private company. This can make comparisons and other analysis very difficult. Additionally, complete

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historical information may not be available. Consequently, it is common practice to add to the discount rate when valuing a private company since there is much more uncertainty and risk.Foreign Companies: If the target company is a foreign company, you will need to considerseveral additional variables, including translation of foreign currencies, differences in regulations and taxes, lack of good information, and political risk. Your forecast should be consistent with the inflation rates in the foreign country. Also, look for hidden assets since foreign assets can have significant differences between book values and market values.Complete Control: If the target company agrees to relinquish complete and total control over to the acquiring firm, this can increase the value of the target. The value assigned to control isexpressed as:CV = C + MCV: Controlling ValueC: Maximum price the buyer is willing to pay for control of the target companyM: Minority Value or the present value of cash flows to minority shareholders.If the merger is not expected to result in enhanced values (synergies), then the acquiring firm cannot justify paying a price above the minority value. Minority value is sometimes referred to as stand-alone value.

Valuation of intangible assets

The identified intangible asset is either separable i.e. capable of being divided from the entity and sold, transferred, licensed, rented or exchanged (either individually or together with a related asset or liability), or arises from contractual or other legal rights. Difference between business value and values of identified tangible and intangible assets is goodwill, which would include value attributable to growth opportunities and synergies.

The 3 most common approaches in valuing intangible assets are comparison approach, income approach and cost approach. In the comparison approach, on determines the value of an intangible asset by reference to market activity like transaction prices, bids or offers involving identical or similar assets. Since all relevant information is seldom available in public domain, this method becomes less relevant. Also, given that intangible assets by their very nature are unique, market data for comparison approach, if available at all, is generally for similar but not identical assets and thereby requires certain adjustments. 

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Valuation methods under the income approach determine the value of an intangible asset, by reference to the present value of income, cash flows or cost savings that could actually or hypothetically be achieved by a market participant owning the asset. The methods generally used under the Income approach are royalty relief, premium profit and excess earnings. The royalty relief method considers a hypothetical royalty payment saved through ownership as compared to licensing the asset from third party. Royalty rates are generally based on observed data in the same industry and typically applied as a percentage of revenues expected to be generated from the use of assets. The premium profit method involves comparison of future profit streams/cash flows that would be earned by a business using the intangible asset with those that would be earned by a business that does not use the asset. The excess earnings method determines cash flows attributable to the subject intangible asset after excluding the proportion of the cash flows that are attributable to other assets (say working capital, fixed assets) and is generally used in practice for those intangibles which have the biggest impact on the cash flows (i.e. where other assets are effectively only secondary assets in the business). The contribution to cash flows made by assets other than the subject intangible asset is known as the ‘contributory asset charge’ or ‘economic rent’ and requires determining value of those assets first. Broadly speaking, royalty relief method is popular for valuation of brands/technical know-how while excess earnings method is generally used to value customer related assets.   In the cost approach, the value of an intangible asset is arrived at by calculating the cost of replacing it with an asset with similar or identical service capacity. It is generally used for valuation of workforce, computer software, websites, etc.  While importance of intangible assets may differ between industries and also amongst companies within a particular industry, one can make some broad conclusions. For example, consumer products or retail businesses have higher level of marketing related intangible assets like brand as against industrial products where technology may play a more important role. Telecom deal prices would get impacted by availability of license and spectrum, which is a key intangible asset for this industry, while content library could be key intangible for transactions involving media companies. Intangible asset valuation is relevant not only in M&As but also for financial and tax reporting. Whether entity specific factors are considered in valuation depends upon the purpose of valuation. For purchase price allocations, scenario based on a typical market participant is considered.  

Brand Valuation

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To capture the complex value creation of a brand, take the following five steps:

1. Market segmentation. Brands influence customer choice, but the influence varies depending on

the market in which the brand operates. Split the brand’s markets into non-overlapping and

homogeneous groups of consumers according to applicable criteria such as product or service,

distribution channels, consumption patterns, purchase sophistication, geography, existing and

new customers, and so on. The brand is valued in each segment and the sum of the segment

valuations constitutes the total value of the brand.

2. Financial analysis. Identify and forecast revenues and earnings from intangibles generated by

the brand for each of the distinct segments determined in Step 1. Intangible earnings are defined

as brand revenue less operating costs, applicable taxes and a charge for the capital employed. The

concept is similar to the notion of economic profit.

3. Demand analysis. Assess the role that the brand plays in driving demand for products and

services in the markets in which it operates, and determine what proportion of intangible earnings

is attributable to the brand measured by an indicator referred to as the “role of branding index.”

This is done by first identifying the various drivers of demand for the branded business, then

determining the degree to which each driver is directly influenced by the brand. The role of

branding index represents the percentage of intangible earnings that are generated by the brand.

Brand earnings are calculated by multiplying the role of branding index by intangible earnings.

4. Competitive benchmarking. Determine the competitive strengths and weaknesses of the brand

to derive the specific brand discount rate that reflects the risk profile of its expected future

earnings (this is measured by an indicator referred to as the “brand strength score”). This

comprises extensive competitive benchmarking and a structured evaluation of the brand’s market,

stability, leadership position, growth trend, support, geographic footprint and legal protectability.

5. Brand value calculation. Brand value is the net present value (NPV) of the forecast brand

earnings, discounted by the brand discount rate. The NPV calculation comprises both the forecast

period and the period beyond, reflecting the ability of brands to continue generating future

earnings. An example of a hypothetical valuation of a brand in one market segment is shown in

Table 2.2. This calculation is useful for brand value modeling in a wide range of situations, such

as:

• predicting the effect of marketing and investment strategies;

• determining and assessing communication budgets;

• calculating the return on brand investment;

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• assessing opportunities in new or underexploited markets; and

• tracking brand value management.

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Applications

The range of applications for brand valuation has widened considerably since its creation in 1988, and it is

now used in most strategic marketing and financial decisions. There are two main categories of

applications:

Strategic brand management, where brand valuation focuses mainly on internal audiences by

providing tools and processes to manage and increase the economic value of brands.

Financial transactions, where brand valuation helps in a variety of brand-related transactions with

external parties.

Strategic brand management

Recognition of the economic value of brands has increased the demand for effective management of the

brand asset. In the pursuit of increasing shareholder value, companies are keen to establish procedures

for the management of brands that are aligned with those for other business assets, as well as for the

company as a whole. As traditional purely research-based measurements proved insufficient for

understanding and managing the economic value of brands, companies have adopted brand valuation as

a brand management tool. Brand valuation helps them establish valuebased systems for brand

management. Economic value creation becomes the focus of brand management and all brand-related

investment decisions. Companies as diverse as American Express, IBM, Samsung Electronics, Accenture,

United Way of America, BP, Fujitsu and Duke Energy have used brand valuation to help them refocus

their businesses on their brands and to create an economic rationale for branding decisions and

investments. Many companies have made brand value creation part of the remuneration criteria for senior

marketing executives.

These companies find brand valuation helpful for the following:

Making decisions on business investments. By making the brand asset comparable to other intangible

and tangible company assets, resource allocation between the different asset types can follow the same

economic criteria and rationale, for example, capital allocation and return requirements.

Measuring the return on brand investments based on brand value to arrive at an ROI that can be

directly compared with other investments. Brand management and marketing service providers can be

measured against clearly identified performance targets related to the value of the brand asset.

Making decisions on brand investments. By prioritizing them by brand, customer segment, geographic

market, product or service, distribution channel, and so on, brand investments can be assessed for cost

and impact and judged on which will produce the highest returns.

Making decisions on licensing the brand to subsidiary companies. Under a license the subsidiaries will

be accountable for the brand’s management and use, and an asset that has to be paid for will be

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managed more rigorously than one that is free.

Turning the marketing department from a cost center into a profit center by connecting brand

investments and brand returns (royalties from the use of the brand by subsidiaries). The relationship

between investments in and returns from the brand becomes transparent and manageable. Remuneration

and career development of marketing staff can be linked to and measured by brand value development.

Allocating marketing expenditures according to the benefit each business unit derives from the brand

asset.

Organizing and optimizing the use of different brands in the business (for example, corporate, product

and subsidiary brands) according to their respective economic value contribution.

Assessing co-branding initiatives according to their economic benefits and risks to the value of the

company’s brand.

Deciding the appropriate branding after a merger according to a clear economic rationale.

Managing brand migration more successfully as a result of a better understanding of the value of

different brands, and therefore of what can be lost or gained if brand migration occurs.

Establishing brand value scorecards based on the understanding of the drivers of brand value that

provide focused and actionable measures for optimal brand performance.

Managing a portfolio of brands across a variety of markets. Brand performance and brand investments

can be assessed on an equally comparable basis to enhance the overall return from the brand portfolio.

Communicating where appropriate the economic value creation of the brand to the capital markets in

order to support share prices and obtain funding.

Financial transactions

The financial uses of brand valuation include the following:

• Assessing fair transfer prices for the use of brands in subsidiary companies. Brand royalties can be

repatriated as income to corporate headquarters in a tax-effective way. Brands can be licensed to

international subsidiaries and, in the United States, to subsidiaries in different states.

• Determining brand royalty rates for optimal exploitation of the brand asset through licensing the brand to

third parties.

• Capitalizing brand assets on the balance sheet according to US GAAP, IAS and many countryspecific

accounting standards. Brand valuation is used for both the initial valuation and the periodical impairment

tests for the derived values.

• Determining a price for brand assets in mergers and acquisitions as well as clearly identifying the value

that brands add to a transaction.

• Determining the contribution of brands to joint ventures to establish profit sharing, investment

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requirements and shareholding in the venture.

• Using brands for securitization of debt facilities in which the rights for the economic exploitations of brands are used as collateral.

What is due diligence

Due diligence means "making sure you get what you think you are paying for."Mergers and

acquisitions (M&A) due diligence is the process of investigating the financial, legal, regulatory,

and operational viability of a company prior to buying it. Owners of the company are asked to

produce documents and provide written answers to questionnaires to satisfy the buyer’s need to

exercise an appropriate amount of care when executing a major transaction. The M&A due

diligence label is typically reserved for complex corporate transactions on a large scale and the

investigation is handled by law firms, but the rationale behind the process is applicable to the

purchase of any business, regardless of size.

Practically speaking, for any company acquisition, due diligence would include fully understanding all of the obligations of the company: debts, pending and potential lawsuits, leases, warranties, long-term customer agreements, employment contracts, distribution agreements, compensation arrangements, and so forth. Furthermore, for software company investments and acquisitions, due diligence also includes

In the corporate context, an acquisition happens when one company buys another. The acquired

company either continues to operate under new ownership or is absorbed into the purchaser and

ceases to exist. In a merger, two companies agree to combine operations to form an entirely new

enterprise. The individual companies cease to exist and a new company is formed to move

forward with the combined assets. M&A due diligence can require the production of information

from one party in the case of an acquisition or from both parties in the case of a merger.

Due diligence is a legal standard that requires buyers to exercise care when entering into

transactions. This duty of care puts the onus on the buyer to make sure the transaction is

legitimate, financially feasible, of sufficient value, and legally binding. Corporate buyers, in

particular, have to meet this standard because the officers and directors are acting on behalf of

diverse shareholders to whom they have the added duty of maximizing the value of their

investment. If the buyer needs to invalidate the transaction because of fraud or any other type of

material misrepresentation, the court will look to whether or not it conducted a reasonable

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investigation into the viability of the transaction before it will allow the buyer a legal remedy.

M&A due diligence is conducted by lawyers in the time period between the deal announcement

and the date the deal is scheduled to close, which can be as long as 18 months. The deal won’t

close unless due diligence is completed to the satisfaction of all parties. Acquisitions require a

complete financial investigation. The seller will have to produce documents, such as financial

records, major contracts, and corporate filings, and answer questions about a wide range of

matters, including outstanding legal issues, government and regulatory affairs, and stockholder

information.

Mergers typically require the added step of conducting organizational due diligence to determine

if the cultures of the two companies are compatible. This type of investigation evaluates the

company in terms of leadership, strategy, competencies, structure, process, and work philosophy.

M&A due diligence concerning organizational matters attempts to prevent a later realization that

two companies have such divergent cultures that merging them would detract from the value of

one or the other.

Leveraged buyout What is a leveraged buyout?

A leveraged buyout or LBO is a type of aggressive business practice whereby investors or a larger corporation utilizes borrowed funds (junk bonds, traditional bank loans, etc.) or debt to finance its acquisition. Both the assets of the acquiring corporation and acquired company function as a form of secured collateral in this type of business deal. Often times, a leveraged buyout does not involve much committed capital, as reflected by the high debt-to-equity ratio of the total purchase price (an average of 70% debt with 30% equity). In addition, any interest that accrues during the buyout will be compensated by the future cash flow of the acquired company. Other terms used synonymously with an LBO are “hostile takeover,” “highly-leveraged transaction,” and “bootstrap transaction.”

Going private

Once the control of a company is acquired, the firm is then made private for some time with the intent of going public again. During this “private period,” new owners (the buyout investors) are able to reorganize a company’s corporate structure with the objective of making a substantial profitable return. Some comprehensive changes include downsizing departments through layoffs or completely ridding unnecessary company divisions and sectors. Buyout investors can also sell

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the company as a whole or in different parts in order to achieve a high rate on returns.

The 1980’s buyout boom

Historically, leveraged buyouts soared in the 1980s due to various U.S. economic and regulatory factors. First, the Reagan administration of the 1980s employed very liberal federal anti-trust and securities legislation, which greatly endorsed the merger and acquisition (M&A) of corporations. Second, in 1982, the Supreme Court declared any state law against takeovers as unconstitutional, further promoting corporate M&A. Third, deregulation (relaxation, reduction, or complete removal) of many industry-related legislation restrictions incited further proceedings of corporate reorganization and acquisition. In addition, the use of risky high-interest bonds (also known as junk bonds) made it possible for multi-million dollar companies to buyout enterprises with very little capital.

Management buyouts or MBO

The most common buyout agreement is the management buyout or MBO. In this corporate arrangement, the company’s management teams and/or executives agree to “buyout” or acquire a large part of the company, subsidiary, or divisions from the existing shareholders. Due to the fact that this financial compromise requires a considerable amount of capital, the management team often employs the assistance of venture capitalists to finance this endeavor. As with traditional leveraged buyouts, the company is made private and corporate restructuring occurs. Many financial analysts will agree that MBOs will greatly increase management commitment since they are involved in the high stake of a company.

Advantages and disadvantages of leveraged buyouts

Financial analysts strongly believe there are many pros and cons in the leveraged buyout of a company.

Corporate restructuring

Pros- One positive aspect of leveraged buyouts is the fact that poorly managed firms prior to their acquisition can undergo valuable corporate reformation when they become private. By changing their corporate structure (including modifying and replacing executive and management staff, unnecessary company sectors, and excessive expenditures), a company can revitalize itself and earn substantial returns.

Cons- Corporate restructuring from leveraged buyouts can greatly impact employees. At times, this means companies may have to downsize their operations and reduce the number of paid staff,

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which results in unemployment for those who will be laid off. In addition, unemployment after leveraged acquisition of a company can result in negative effects of the overall community, hindering its economic prosperity and development. Some leveraged buyouts may not be friendly and can lead to rather hostile takeovers, which goes against the wishes of the acquired firms’ managers.

An example of a hostile takeover occurred when the PepsiCo acquired the Quaker Oats Company, an American food company well-known for its breakfast cereals and oatmeal products. In 2001, PepsiCo, in an attempt to diversify its portfolio in non-carbonated drinks, primarily acquired Quaker Oats because QO owned the Gatorade brand. Even though this merger created the fourth-largest consumer goods company in the world, many of Quaker Oats’ managers were against the acquisition, claiming that such a merger was unlawful and contrary to the public interest.

Small amount of capital requirements

Pros- Since this type of acquisition involves a high debt-to-equity ratio, large corporations can easily acquire smaller companies with very little capital. If the acquired company’s returns are greater than the cost of the debt financing, then all stockholders can benefit from the financial returns, further increasing the value of a firm.

Cons- However, if the company’s returns are less than the cost of the debt financing, then corporate bankruptcy can result. In addition, the high-interest rates imposed by leveraged buyouts may be a challenge for companies whose cash-flow and sale of assets are insufficient. The result cannot only lead to a company’s bankruptcy but can also result in a poor line of credit for the buyout investors.

An example of an unsuccessful leveraged buyout is the Federated Department Stores. The Federated Department Stores had many stores nationwide and tailored primarily to high-end retailers. However, they lacked an effective marketing strategy. In 1989, Robert Campeau, a Canadian financier, bought out Federated with the hope to make considerable changes. Only one year later, and only after some reforms, Federated could not keep up with the financial burdens of high interest payments and had to file bankruptcy for 258 stores.

Management buyout

Pros- As mentioned earlier, management buyout of a company is a common business practice. Often times, MBOs occur as a last resort to save an enterprise from permanent closure or replacement of existing management teams by an outside company. Many analysts strongly believe management buyouts greatly promote executive and shareholder interests as well as management loyalty and efficiency.

Cons- Not every MBO turns out to be successful as planned. Management buyouts can generate substantial conflicts of interest among employees and managers alike. Management and executive teams can easily be lured to propose a short-term buyout for personal profit. In addition, they can

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also corruptly mismanage a company, leading to an enterprise’s depreciated stock.

An example of a successful management buyout is Springfield Remanufacturing Corporation, or SRC, an engine remanufacturing plant located in Springfield, Missouri. In 1983, SRC was at risk for permanent closure and was being bought by an outside company until their employees decided to buyout the company. The management buyout of SRC resulted in extreme success. Since 1983, it has grown exponentially from one company within Rs.10,000 of being shut down to a proud assembly of 23 small businesses with a combined profit of over Rs.120 million today.

Economy

Pros- Every leveraged buyout can be considered risky, especially in reference to the existing economy. If the existing economy is strong and remains solid, then the leveraged buyout can greatly improve its chances for success.

Cons- On the other hand, a weak economy is highly indicative of a problematic LBO. During an economic crisis, money may be difficult to come by and dollar weakness could make acquiring companies result in poor financial returns. In addition, acquisition can affect employee morale, increase animosity against the acquiring corporation, and can hinder the overall growth of a company.

Conclusion

There are many advantages and disadvantages concerning leveraged buyouts. First, this type of agreement can allow many large companies to acquire smaller-sized enterprises with very little personal capital. Second, since corporate restructuring can take place, the acquired company can benefit from necessary reorganization and reform. In addition, management buyout can prevent a company from being acquired by external sources or from being shut down completely. However, there are many disadvantages imposed by LBOs as well. Often times, the restructuring can lead a company to downsize and can even result in hostile takeovers. The high interest rates from the high debt-to-equity amounts can result in a corporation’s bankruptcy, especially if the company is not generating substantial returns after acquisition. Lastly, management buyouts can produce conflicts of interest among employees, executives, and management teams as well as possible mismanagement by the buyout owners. With the potential for enormous profit, it is no wonder that leveraged buyout strategies expanded throughout the 1980s and have recently made a comeback in modern corporate America.

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