Conceptual Overview Of Mergers & Acquisitions And Investment Appraisal For Capital Rationing

Corporate Restructuring and Financial Management

The main purpose of this report is to research and discuss the two core concepts in the field of financial management as per the requirements presented in the assignment brief. This report will be divided into two main sections. Part A of this report will discuss about the conceptual overview of mergers & acquisitions, its value creation and role of confidentiality agreements by citing relevant real life examples of successful acquisitions. Part B of this report discusses about a specific area of investment appraisal which is related to capital rationing where an organization has to evaluate alternatives in a situation of limited resources available for investment.

Corporate restructuring is integral for modern businesses. The era of liberalisation and globalization has resulted in new waves of competition and free trade. This requires businesses to restructure and reorganize for creating new synergies to mitigate the competitive risk and proactively react to changing market conditions. The process of restructuring can range from subtle organizational changes to a dramatic shift in the overall organization strategy. Further, any initiative taken to restructure may be internal or external in nature. An organization may internally restructure themselves by undertaking new capital investments in advanced equipments & technologies, by undertaking research & development or also be focusing more upon their non-core businesses (Brigham and Daves 2018).

However, an organization may also externally engage in corporate restructuring activities by undertaking joint ventures, by forming strategic alliances with other organizations or with the help of mergers & acquisitions. Hence, mergers & acquisitions can be classified as an external means of undertaking corporate restructuring and is quite common among large scale organizations. The term ‘merger’ and ‘acquisition’ are often interchangeably used in common parlance (Martin, Keown and Titman 2020). However, these are both different forms of external corporate restructuring owing to the differences in between the two.

There are three main forms of an acquisition which involves mergers or consolidation, acquisition by stock and acquisition by assets. Mergers can be best interpreted as the process of unifying two or more different firms into one firm and is often termed in other nations as amalgamation. A merger results in the absorption of one entity by the other whereby the acquiring organization retains their identity and name acquiring the assets and liabilities of the target organization. Post merger, the target organization (acquired firm) ceases to exist as a separate legal entity. On the contrary, consolidation works similarly as a merger with the only difference being that both organizations give up on their existing legal existence forming a new organization with a separate legal entity (Brigham and Ehrhardt 2019).

Acquisition by stock is another form of acquisition wherein the acquiring organization acquires the voting stocks of the acquired organization in exchange of a purchase consideration that may be paid in cash, stocks and other different securities. This process mostly initiates as a private offer made from the management of the acquiring organization to the management of the target organization which gradually transitions into a tender offer which is a public offer made to buy the stocks of the target organization. Such forms of communication may be done with the help of public announcements, newspaper advertisements or even by general mailing (Madura 2020).

Mergers and Acquisitions: Overview and Classification

Acquiring of assets is another form of acquisition wherein the acquiring company can acquire another company by acquiring all of their assets. This although requires a formal vote of the stockholders of the target company. This method may be beneficial in comparison to acquisition by stock which leaves the acquiring organization left with minority shareholders which may present problems of holdouts. On the contrary, the acquisition of assets results in transferring the ownership title of assets which may prove to be a costly affair (Block, Hirt and Danielsen 2018).

Financial analysts tend to classify acquisitions into three distinct categories that have been outlined as follows:

1. Horizontal Acquisition: This classification is undertaken keeping in mind the industrial backgrounds of the organizations involved in the acquisition process. If the acquiring organization and the target organization belong to the same industry, the acquisition classified as a horizontal acquisition.
2. Vertical Acquisition: The vertical classification of the acquisition process involves both the organizations operating in different stages of the production process.
3. Conglomerate acquisition: Lastly, the conglomerate acquisition classification involves both organizations that are not all related to one another (Apte and Kapshe 2020).

Mergers and Acquisition if successful is capable of adding and creating value. If there is one word to explain the value creation of m&a, it is termed as ‘synergy’. Synergy from an acquisition can be best interpreted as the difference in between the value of the combined firm and the sum total of the value of the individual organizations. In simpler terms, a synergy exists only if the value of the combined firm exceeds the value of the acquiring and target firms before the merger. This is how value is created from an m&a transaction. It is the increase in cash flows post the merger which helps create synergy and value. Such incremental cash flows are because of four major reasons that are enhancement of revenue, reduction in costs, lowering of taxes and lowering of capital requirements.

Any improvement in one or all four of these classifications will help create synergy which in turn creates value. These gains from synergy are shared on the ground that the acquiring entity pays premium for the target firm. Hypothetically, if the stocks of the target company are trading for $50, the acquiring firm may pay a $10 premium amount which sums up to be $60. If the synergy resulting for the merger is estimated at $30, then the gain which the acquiring firm earns is $20 ($30-$20). The acquiring organization will actually lose if the synergy created from the merger is less than the premium amount of consideration paid to acquire the target organization (Vernimmen, Quiry and Fur 2022).

To summarise, merger and acquisitions can help create or enhance value in the following ways:

1. When such transactions are engaged with the intent of maximising market share, these deals can enhance value as it can help the merged organisation in increasing the organisation’s pricing power, an increase in the bargaining power relative to customers or suppliers and creating barriers to entry.
2. When organisations merge for selling multiple offerings across common distribution networks, the merged entity can take advantage of the operational synergy as this results in diversity of distribution channels resulting in greater success.
3. There are several other synergies which can be created from the merger which can add value. Some of these include revenue synergies created from cross selling of products, added tax benefits resulting in a financial synergy, sharing of key personnel and resources all of which create and enhance value.

The Exxon and Mobil deal is one of the perfect examples that illustrate value creation with the help of mergers. It was in the year 1998 that both companies announced their intention to merge. At the time, both of the companies were largest and second largest oil producers in USA. The deal was worth $80 billion and is regarded as one of the top five successful value creating mergers all around the world. The size of the newly formed Exxon Mobil was staggering posting record breaking profits worth $11.8 billion generating a total revenue of $203.1 billion with a total combined employment of 122,700 employees. Since the announcement of the deal, the share price of Exxon has risen by 85% against a 1.4% rise in S&P 500 and 21% rise in DJIA component. By the year 2008, the combined Exxon Mobil generated a revenue of $459.58 billion and a total net income of $45.22 billion which turned out to be the largest annual reported net profits by a US based corporate (Corcoran, 2022).

Creating Value through Mergers and Acquisitions

The phased acquisition of United Spirits Limited (USL) of Shaw Wallace & Company (SWC) in 2008 is an apt example of how the acquisition helps create value. This acquisition is explained as a ‘runaway success’ wherein an effective consolidation resulted in competitive advantage which was realized from promotional, operational and financial synergies (Nicholson, Salaber and Cao 2016). The merger resulted in gaining a 55% market share for USL and as an industry leader, the company was able to leverage their bargaining power into greater pricing. These organizations were fierce competitors representing a vertical acquisition wherein the company was also able to increase its margins by undertaking cost reductions owing to a decline in promotional spends and consolidation of distribution channels (Christofi, Leonidou and Vrontis 2017).

An increase in cash flows creates synergy. This can be credited to four different elements which have been discussed above that sums up the overall motives for entering into an M&A transactions. These are elaborated in details as follows:

1. Revenue Enhancement: A combined entity can generate more revenue when compared to separate organizations. Such an increase in revenue is because of three main reasons which are market gains, market power and strategic benefits. Marketing gains can help increase operating revenue by appropriate marketing and improvement in distribution network, product mix and media advertisements. Further, the new formed organization will be better positioned to take advantage of technological advancements which will result in strategic benefits (Ross et al. 2019). Lastly, the acquiring firm may acquire to gain monopoly and reduce competition which helps in increasing the market share. This allows an increase in negotiating power, charging higher prices and an increase in monopolistic profits.
2. Cost Reduction: Often, lowering of costs have been cited as the primary motive for m&a. This is because a combined organization will be able to operate much more efficiently which in turn will translate to better cost management. There are several reasons why the combined firm will be able to increase their efficiency in operations. Horizontal mergers can allow for economies of scale which decreases the average production cost. Vertical integrations can also result in operating economies by coordinating together closely related operating activities. Transfer of technology and complementary resources for increasing the utilization of existing resources can also help in cutting down on costs. Lastly, a change in management can also help in creating value. This is further supported by eliminating of inefficient management which further drives cost numbers down.
3. Tax Gains: Tax reductions and savings can also offer a great incentive to merge or acquire. An organization with a profitable division and a non profitable division will have a lower tax liability because of offsets. However, if this were two different companies, it would be difficult for the non profitable company to offset. Hence, in such appropriate circumstances, a merger can prove beneficial. Further, if the target organization has little financial leverage, the acquiring organization may infuse debt to generate a higher tax shield. Also, if both organizations have optimal debt levels, a merger will increase the total debt and thus the tax shield. Lastly, a firm can pay dividend or buy back its shares from their available free cash flows. The shareholders of the firm can avoid taxes by acquisitions which avoid the taxes to be paid on dividend (Graham, Adam and Gunasingham 2020).
4. Reduction in Capital Requirements: It has already been discussed that because of mergers, an economy of scale can help reduce operating costs. It turns out that m&a can also help reduce the requirements of capital. This is because on merging, management is more than likely to find duplicate facilities. For instance, individual firms may have different headquarters and on merging one of the headquarters can be sold. This also extends for redundancy concerning plant & equipment. In the case of firms merging within the same industry, the research and development facility can be consolidated as well. This also pertains to working capital wherein the economies of scale can result in lowering of working capital requirements.

The role and importance of confidentiality in the case of buying and selling a business is paramount. If such bits of information are leaked, such discussions have the potential of derailing the transaction and adversely affect the ongoing operations of the business, value and future prospects. Hence, the need for confidentiality agreements also termed as non disclosure agreements arise. These are best explained as legal documents which binds on or more parties to a non-disclosure of proprietary or confidential information. In other words, such a contract enforces a confidential relationship among two or more parties which provides for an arrangement that any sensitive information shared will not be disclosed to any other third party. There are two major benefits of a confidentiality agreement. Firstly, it serves protection from any potential disclosure of intellectual property which includes trade secrets, proprietary data and other confidential information. Lastly, such agreements also tend to offer additional legal options and protection if someone infringes a patent or illegally makes use of protected information. This document can be referred to for conflict resolution and settlement of disputes by damage related compensations. It is worth mentioning that for a confidentiality agreement to be effective, it must be detailed and specific when it comes to its contents (Booth, Cleary and Rakita 2020).

Diaz Plc is at present considering three different investment proposals. These investments (Project A, B & C) have an effective useful life of 3 years each and require different initial capital investments. The cash flow particulars of each of the three proposals have been provided for in the case study. The cost of capital is assumed to be 12% while the company has a limited investment capacity of only €2 million available. Hence, it can be said that Diaz Plc is exposed to the situation of Capital Rationing.

According to the general thumb rule, if any particular investment has a positive net present value, it should be accepted bearing in mind that the investment will be able to maximize the wealth of the shareholders and therefore create value. However, in reality, it is not always possible for an organization to accept all the alternatives with positive npv for wealth maximization (De Matos 2018). This is most often because of limited capital resources. Hence in a situation because of resource (capital) constraints (rationing), the organization will have to select some projects among a set of multiple projects having a positive npv bearing in mind its available capital to maximize shareholder’s wealth. In such a situation of capital rationing, there are two broad circumstances that can influence the evaluation method to be adopted. These are outlined and discussed as follows:

1. Divisible Projects: Divisible projects are situations where each projects are independent of each other and are divisible in nature which means that it is possible to invest in a selected proportion of the project as per capital availability. In these situations, projects are ranked on the basis of the profitability index of each project. Investments are then recommended on the basis of capital available.
2. Non-divisible Projects: As the name suggests, these projects are not divisible in nature which means that it is not possible to undertake a proportion of the project. In these situations, projects are ranked on the basis of absolute npv figures and are mixed to the point available resources are exhausted (Brealey et al. 2018).

• Discount Factor assuming 12% cost of capital has been calculated using a spreadsheet by the formula 1/1(1+12%)ⁿ
• Present value is calculated by multiplying cash flow column and discount factor column.
• The npv is calculated as the sum total of discounted cash flows.

• The total present value of inflows is calculated as the sum of investment column and the npv column.
• Profitability index is calculated by dividing the present value of inflows by the investment column.
• Proposals are ranked on the basis of the calculated profitability index.
• Proportionate NPV earned by investing €1,000,000 available balance is calculated by (1000000*174952/1600000) equalling €109,345.

Recommendation: Assuming investments to be divisible, the optimal investment combination of projects which can maximise the npv are projects A, B and €1,000,000 worth of investment in project C.

Recommendation: If these proposals are assumed to be non divisible in nature, then there are two combinations possible, given the capital constraints of €2 million. It can be observed that the optimal investment combination of projects A and C can be recommended as this combination will help generate the maximum npv worth €271,795 by incurring a total investment of €1,800,000.

Conclusion

Based on the discussions in this report, it can be concluded upon that mergers and acquisition are one of the most popular and effective ways by which an organization can externally restructure themselves to gain value. Further, while undertaking such restructuring activities, it is in best interests to prepare a non disclosure agreement. Lastly, investment appraisal is very effective for gauging the financial viability of any capital investment keeping in mind shareholder’s wealth maximization objective and situations of capital rationing with limited resources available.

References

Apte, P.G. and Kapshe, S., 2020. International Financial Management|. McGraw-Hill Education.

Block, S.B., Hirt, G.A. and Danielsen, B.R., 2018. Foundations of financial management. McGraw-Hill Education.

Booth, L., Cleary, W.S. and Rakita, I., 2020. Introduction to corporate finance. John Wiley & Sons.

Brealey, R.A., Myers, S.C., Allen, F. and Mohanty, P., 2018. Principles of corporate finance, 12/e (Vol. 12). McGraw-Hill Education.

Brigham, E.F. and Daves, P.R., 2018. Intermediate financial management. Cengage Learning.

Brigham, E.F. and Ehrhardt, M.C., 2019. Financial management: Theory & practice. Cengage Learning.

Christofi, M., Leonidou, E. and Vrontis, D., 2017. Marketing research on mergers and acquisitions: a systematic review and future directions. International Marketing Review.

Corcoran, G., 2022. Exxon-Mobil 12 Years Later: Archetype of a Successful Deal. [online] WSJ. Available at: <https://www.wsj.com/articles/BL-DLB-29342> [Accessed 7 April 2022].

De Matos, J.A., 2018. Theoretical foundations of corporate finance. Princeton University Press.

Graham, J., Adam, C. and Gunasingham, B., 2020. Corporate finance. Cengage AU.

Madura, J., 2020. International financial management. Cengage Learning.

Martin, J.D., Keown, A.J. and Titman, S., 2020. Financial management: principles and applications. Prentice Hall.

Rao-Nicholson, R., Salaber, J. and Cao, T.H., 2016. Long-term performance of mergers and acquisitions in ASEAN countries. Research in International Business and Finance, 36, pp.373-387.

Ross, S.A., Westerfield, R., Jaffe, J.F., Jordan, B.D., Jaffe, J. and Jordan, B., 2019. Corporate finance (pp. 880-86). McGraw-Hill Education.

Vernimmen, P., Quiry, P. and Le Fur, Y., 2022. Corporate finance: theory and practice. John Wiley & Sons.

Order an Essay Now & Get These Features For Free:

Turnitin Report

Formatting

Title Page

Citation

Outline

Place an Order