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Calculation of Exchange Ratio from the perspective of the acquired and the acquiring firm Whenever a firm A acquires

another firm B, the compensation to the shareholders of the acquired firm is usually paid in the form of shares of the acquiring firm. In other words, shares of firm A will be given in exchange for shares of firm B. Thus, the exchange ratio is a very important factor in any kind of merger. Firm A will want to keep this ratio as low as possible, while firm B will want it to be as high as possible. In any case, both firms would ensure that post merger, their equivalent price per share will at least equal their pre-merger price per share. Given below is the model developed by Conn and Nielson for determining the exchange ratio. The symbols used in this model are: ER = Exchange ratio P = Price per share EPS = Earning per share PE = Price earning multiple E = Earnings S = Number of outstanding equity shares AER = Actual exchange ratio In addition, the acquiring, acquired and combined firms will be referred to by subscripts A, B and AB respectively. Firm A would ensure that the wealth of its shareholders is preserved. This implies that the price per share of the combined firm is at least equal to the price per share of firm A before merger: PAB >= PA For the sake of simplicity consider that P AB =P A Price earnings ratio of the combined firm x Earnings per share of the combined firm gives the Market Price per share. P AB =PE AB x EPS AB = P A ------- (1) Earnings per share of the combined firm can be expressed as: EPS AB = (E A + EB ) / [S A + S B (ER A )] ------- (2) ER A = number of shares of firm A given in lieu of one share of firm B. Substituting formula of EPS AB in equation 1 we get

P A = PE AB (E A +EB)/[S A +S B (ER)] From the above equation, we may solve for the value of ER A as follows ER A = -(S A /S B ) + [(E A +E B) PE AB] / P A S B After discussing the maximum exchange ratio acceptable to the shareholders of firm A above, we will now calculate the minimum exchange ratio acceptable to the firm B(ER B) The basic condition is P AB (ER B) >= P B ---------- (3) Using the equality form of above equation and substituting P AB from equation 1 in equation 3 we get PE AB x EPS AB x ER B = P B Substituting the value of EPS AB from equation 2 in the above equation, and solving the equation for ER B we get ER B = P B S A / [(PE AB)(E A + E B) P B S B]

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What is Corporate Governance? Although there is no single acceptable definition of corporate governance, it is a means to maximise the long-term shareholder value in a legal and ethical manner, ensuring fairness, courtesy and dignity in all transactions of the company. The Securities and Exchange Board of India (SEBI) under the Chairmanship of Shri Kumaramangalam Birla set up a committee on corporate governance on 7th May 1999, to promote and raise the standards of corporate governance. The committee recently tabled its recommendations, and the highlights are given below:

Have an appropriate mix in the Board

The Confederation of Indian Industry recommends that at least 30% of the board should consist of outsiders if the chairman is one of them. If the chairman is an insider then 50% of the board should consist of non-executive directors. However, the major emphasis is to have directors who have a thorough understanding of the business, the market and the needs of the company.

Ensure that the Board is aware of its functions

As per law, the board is responsible for decisions related to borrowing, lending, investing and maintenance, dividends and accounts, though good governance goes beyond that. The boards contributions are needed to ensure customer satisfaction, employee satisfaction, succession, planning, financial prudence, a culture of performance and the protection of society and the environment.

Make use of a Sub Committee

Conformance to both the letter and the spirit of the law, transparency, honesty and fair play in financial practices and disclosures are essential. This can be done by setting up an audit committee with at least 3 members.

Provide Transparency

Transparency is the basis for corporate governance. A good corporate governance model ensures fairness, courtesy and dignity in all transactions within and outside the company. Indian disclosure norms presently being inadequate, directors should benchmark international standards such as US Generally Accepted Accounting Practices. Corporate governance also addresses issues of insider trading. It is very important that directors who have inside information of the company should not use it to unfair disadvantage of the uninformed stockholders. This calls for companies to devise an internal procedure for adequate and timely disclosures, reporting requirements, confidentiality norms and code of conduct for their directors and employees with regard to their dealings in securities.

Corporate Governance Corporate governance carries great depth of meaning. To most people, it means the way a company manages its business, in a manner that is accountable and responsible to someoneusually the shareholders. In a broad sense, responsibility and accountability are seen to be to broader audiences that also include the companys other stakeholders such as employees, suppliers,

customers, and the local community. It suggests ethics and morals, as well as the best practices. Corporate governance is usually expressed in the form of a codesuch as the Cadbury code in the UK. The CII has established its committee on corporate governance. The challenge for corporate India will be to establish a set of principles or a code that is acceptable in international best practice terms. This set of codes will lead to change in the Companies Act and auditing and reporting requirements eventually. Corporate governance practices in India are likely to be changed for the better in the coming years. Promoters are becoming more answerable and responsive to shareholders. Financial institutions are appreciating the interventionist role they need to play in ensuring sound corporate governance. Corporate governance refers to the relationship among the owners, directors and managers. The Cadbury Committee Recommendations (Highlights) In Britain, the Cadbury Committee was set up to go into the details of Corporate Governance prevailing there. After detailed studies, the committee made the following recommendations:

Boards should have separate audit and remuneration committees made up entirely of independent directors. Audit committees should meet with the external auditors at least once a year and without executive directors. The full remuneration package of all directorsincluding performancerelated elements-should be disclosed in annual reports. Directors terms of office should run for no more than three years without shareholder approval. Companies must make funds available to non-executive directors who wish to get independent professional advice. The board must meet regularly. It ought to have a formal schedule of matters for decision. Independent directors should be appointed for specified terms. Independent directors should be appointed through a formal process. Independent directors should have a standing outside the company which ensures that their views carry weights. Independent directors should be fully independent and free from links with the company other than the fees and shareholdings.

Fees for independent directors should reflect the time they spend on company business. There should be an accepted division at the head of the company, which will ensure a balance of power and authority such that no one individual has unfettered powers of decision. Where the chairman is also chief executive, there should be a strong independent element on the board with an independent leader.

Mergers & Acquisitions When two or more companies agree to combine their operations, where one company survives and the other loses its corporate existence, a merger is affected. The surviving company acquires all the assets and liabilities of the merged company. The company that survives is generally the buyer and it either retains its identity or the merged company is provided with a new name. Types of Mergers 1. Horizontal Mergers 2. Vertical Mergers 3. Conglomerate Mergers Horizontal Mergers This type of merger involves two firms that operate and compete in a similar kind of business. The merger is based on the assumption that it will provide economies of scale from the larger combined unit. Example: Glaxo Wellcome Plc. and SmithKline Beecham Plc. megamerger The two British pharmaceutical heavyweights Glaxo Wellcome PLC and SmithKline Beecham PLC early this year announced plans to merge resulting in the largest drug manufacturing company globally. The merger created a company valued at $182.4 billion and with a 7.3 per cent share of the global pharmaceutical market. The merged company expected $1.6 billion in pretax cost savings after three years. The two companies have complementary drug portfolios, and a merger would let them pool their research and development funds and would give the merged company a bigger sales and marketing force. Vertical Mergers

Vertical mergers take place between firms in different stages of production/operation, either as forward or backward integration. The basic reason is to eliminate costs of searching for prices, contracting, payment collection and advertising and may also reduce the cost of communicating and coordinating production. Both production and inventory can be improved on account of efficient information flow within the organisation. Unlike horizontal mergers, which have no specific timing, vertical mergers take place when both firms plan to integrate the production process and capitalise on the demand for the product. Forward integration take place when a raw material supplier finds a regular procurer of its products while backward integration takes place when a manufacturer finds a cheap source of raw material supplier. Example: Merger of Usha Martin and Usha Beltron Usha Martin and Usha Beltron merged their businesses to enhance shareholder value, through business synergies. The merger will also enable both the companies to pool resources and streamline business and finance with operational efficiencies and cost reduction and also help in development of new products that require synergies. Conglomerate Mergers Conglomerate mergers are affected among firms that are in different or unrelated business activity. Firms that plan to increase their product lines carry out these types of mergers. Firms opting for conglomerate merger control a range of activities in various industries that require different skills in the specific managerial functions of research, applied engineering, production, marketing and so on. This type of diversification can be achieved mainly by external acquisition and mergers and is not generally possible through internal development. These types of mergers are also called concentric mergers. Firms operating in different geographic locations also proceed with these types of mergers. Conglomerate mergers have been sub-divided into:

Financial Conglomerates Managerial Conglomerates Concentric Companies

Financial Conglomerates These conglomerates provide a flow of funds to every segment of their operations, exercise control and are the ultimate financial risk takers. They not

only assume financial responsibility and control but also play a chief role in operating decisions. They also:

Improve risk-return ratio Reduce risk Improve the quality of general and functional managerial performance Provide effective competitive process Provide distinction between performance based on underlying potentials in the product market area and results related to managerial performance.

Managerial Conglomerates Managerial conglomerates provide managerial counsel and interaction on decisions thereby, increasing potential for improving performance. When two firms of unequal managerial competence combine, the performance of the combined firm will be greater than the sum of equal parts that provide large economic benefits. Concentric Companies The primary difference between managerial conglomerate and concentric company is its distinction between respective general and specific management functions. The merger is termed as concentric when there is a carry-over of specific management functions or any complementarities in relative strengths between management functions. ACQUISITIONS The term acquisition means an attempt by one firm, called the acquiring firm, to gain a majority interest in another firm, called target firm. The effort to control may be a prelude

To a subsequent merger or To establish a parent-subsidiary relationship or To break-up the target firm, and dispose off its assets or To take the target firm private by a small group of investors.

There are broadly two kinds of strategies that can be employed in corporate acquisitions. These include: Friendly Takeover

The acquiring firm makes a financial proposal to the target firms management and board. This proposal might involve the merger of the two firms, the consolidation of two firms, or the creation of parent/subsidiary relationship. Hostile Takeover A hostile takeover may not follow a preliminary attempt at a friendly takeover. For example, it is not uncommon for an acquiring firm to embrace the target firms management in what is colloquially called a bear hug.

Value based management

McKINSEY APPROACH Mckinsey and Company, a leading international consultancy firm developed this model to help companies implement Value-Based Management. This approach is based on the discounted cash flow principle, which is a direct measure of value creation. The important steps in the Mckinsey approach to value maximisation are as follows:

Emphasis on value maximisation Finding value drivers Establishing appropriate managerial processes Implementing value based management properly

Ensure the supremacy of value maximisation Value maximisation involves endorsing the principle that value maximisation is the ultimate financial objective and that the top management should adopt the discounted cash flow method to assess value-creating activities. The organisations activities can be classified into financial and non-financial types. The former helps the senior management sustain focus, while the latter motivates the entire workforce. Non-financial activities include product development, customer satisfaction and quality improvement efforts, which are normally consistent with the financial goal of value maximisation.

In case of conflict between financial and non-financial goals, financial goals are given precedence. Finding Value Drivers Key value drivers are those performance variables that influence the value of the business. These can be classified into: 1. Generic level value drivers, which include ROI and operating margins 2. Business unit level, which includes variables like product-mix, customer-mix, operating leverage etc. 3. Grass roots level, which includes capacity utilisation, revenue per visit, cost per delivery etc. Establish Appropriate Managerial Processes The process of adopting appropriate managerial processes for value maximisation include the following 1. Strategy development to address issues regarding businesses which benefit the company, resource allocation, choosing the best options, etc 2. Target setting to reflect what the management wants to achieve in short, medium and long term for the purpose of value maximisation 3. Action plans show how to implement what the plan, taking into account the various steps and factors involved 4. Performance Measurement and linking incentive system to success of plans Implementing value based management Value based management is a complex process. The complete involvement of decision-makers and executors is essential to synchronise the activities of the management in line with the principle of value-based management, to ensure value maximisation. The organisations commitment towards VBM can be ascertained through comparative analysis on the following fronts through a spider diagram: Measurement and managing the value of Companies

Marakon Approach for Value Based Management Marakon Associates is an international management-consultancy firm that has done pioneer research in area of value-based management. James M McTaggert, Peter W Kontes, and Michel C Mankins have dealt with this approach extensively in the book titled, The Value Imperative. The key steps in this approach are: 1. Specify determinants of value 2. Understand the strategic drivers of value 3. Formulate higher value strategies 4. Develop superior organisational capabilities. Specify the Financial Determinants of Value This approach is based on the market to book ratio model, which stipulates that shareholders wealth is measured as the difference between the market value and the book value of a firms equity. The book value, B, is a measure of approximate capital contributed by shareholders, while market value, M, is a reflection of how productively a firm employs that capital. Hence, the management creates value if M exceeds B and vice-versa. M/B = ( r g ) / ( k g ) Where; M = market value of equity, B = book value of equity, r = return on equity, g = growth rate in dividends, k = cost of equity.

Understand the Strategic Determinants of Value Important financial determinants of value include the spread (i.e., difference between return on equity and the cost of equity) and the growth rate in dividends. These are influenced through market economics and the competitive position of the firm. Market Economics or Profitability depend on the following factors:

Intensity of indirect competition Threat of entry Suppliers pressures Regulatory pressures Intensity of direct competition Customers pressures

The Competitive Position of a firm refers to its relative position in terms of equity spread and growth rate against the average competitor in its product market segment. It is dependent upon product differentiation and economic cost positioning. Formulate Higher value Strategies Value creation involves participating in a lucrative market and building competitive advantage by adopting efficient strategies. The Participation strategy defines the product markets, in which the firm will compete, and also new businesses that it should enter, and the ones that it should exit. Competitive strategy includes defining means to build competitive advantage and avoiding competitive disadvantages in the existing markets. Develop Superior Organisational Capabilities After dealing with competition, the company needs to develop superior organisational capabilities to overcome internal barriers to value creation and find a balance between the organisational objectives (Executives) and those of the shareholders. The key organisational capabilities are:

A competent and energetic chief executive committed towards maximising value A compensation plan following relative pay for relative performance principle

An efficient resource allocation system based on principles of zero based allocation and funding strategies rather than projects, no capital rationing, and zero tolerance for bad growth A corporate governance mechanism with high accountability for creation or destruction of wealth

The Marakon approach is a popular value-based planning model because:

The various parameters included in the model- Return on equity, growth rate, and cost of equity are widely used as important measures of business performance and are easily assessable The market value of the firm is regarded as an external scorecard by the business sector. The approach is based on an intuitively appealing valuation theory

Capital Asset Pricing Model The Capital Asset Pricing Model (CAPM) reflects the market for different financial assets. The model suggests that asset prices will adjust to achieve the precise return, and to compensate investors for the risk of the asset, when it is held with a perfectly diversified portfolio. By showing how increasing the diversification lowers portfolios standard deviation and variance, Markowitz in 1952 proposed a model. His idea was based on the assumptions that stock returns are normally distributed, and that people like returns but not risks. Hence, they want a high mean, low standard deviation portfolio. Portfolios with the highest returns for a given level of risk are known as Mean-Variance Efficient frontier (MVE). CAPM Assumptions

Investors are risk averse. Investors maximise expected utility of the portfolios over a single period planning horizon. There exists Perfect Competition (individual investors are price takers) Securities are completely divisible. Investments are limited to traded financial assets. No taxes or transactions costs are involved. Investors are rational mean-variance optimisers.

Investors have homogeneous expectations.

In the CAPM, risk is defined using the concept of beta. It is the ratio of the movements of an individual stock relative to the movements of the overall market portfolio. It is calculated using daily, weekly or monthly historical data, taken over a year or more. Statistically, beta is defined as the covariance of the returns of the stock and the market divided by the variance of the returns of the market. Once beta is calculated, it is assumed a predictor of future market behaviour. If the stock market goes up (or down) by a particular percentage, then there is a tendency for the stock also to go up (or down) by the same percentage multiplied by beta. Stock with a beta greater than 1 are considered riskier; however the market fluctuates, the high-beta stocks fluctuate even more. If the beta is negative, the tendency of the stock is to move in the direction opposite to that of the market. CAPM computes E(R), the Expected rate of Return on a stock, using the formula E(R) = r + ERP (beta), where r is the risk-free interest rate and ERP is the Equity Risk Premium for the overall market portfolio. The risk-free interest rate is usually based on one or other of the government treasuries Let us consider an example: Consider, Stock A with a beta of 1.37, a risk free return r = 5%, and an ERP of 5.5. The Expected Return on Stock A = 5 + 5.5 (1.37) = 12.54%. On the other hand, consider stock B with a beta of 1.85, the expected return is 5 + 5.5 (1.85) = 15.17%. Therefore, extra money is invested in stocks with a high beta. Capital Market Line (CML) CML is the line used in the Capital Asset Pricing Model to illustrate the rates of return for efficient portfolios, depending on the risk free rate of return and the level of risk (beta) for a particular portfolio.

In the given diagram, an assumption is made that the risk-free rate is 5%, and a tangent line called the capital market line is drawn to the efficient frontier passing through the risk-free rate. The point of tangency indicates a portfolio on the efficient frontier, also referred to as the "super efficient" portfolio. CAPM demonstrates that under given assumptions, the super-efficient portfolio must be the market portfolio. Using the risk-free asset, investors who hold the super-efficient portfolio may: (1) Leverage their position by shorting the risk-free asset and investing the proceeds in additional holdings in the super-efficient portfolio. (2) Deleverage their position by selling some of their holdings in the superefficient portfolio, and investing the proceeds in another risk-free asset. Any portfolio that falls within the efficient frontier is referred to as an efficient portfolio. When an efficient portfolio offers the same return as another portfolio, then the efficient portfolio will be better in terms of less risk. Similarly, if an efficient portfolio has the same risk as another portfolio, then the efficient portfolio will be better in terms of higher returns.

Costs and Benefits of Merger When a company A acquires another company say B, then it is a capital investment decision for company A and it is a capital disinvestment decision for company B. Thus, both the companies need to calculate the Net Present Value (NPV) of their decisions. To calculate the NPV to company A there is a need to calculate the benefit and cost of the merger. Thebenefit of the merger is equal to the difference between the value of the combined identity (PVAB) and the sum of the value of both firms as a separate entity. It can be expressed as Benefit = (PVAB) (PVA+ PVB) Assuming that compensation to firm B is paid in cash, the cost of the merger from the point of view of firm A can be calculated as Cost= Cash - PVB Thus NPV for A = Benefit Cost = (PVAB (PVA + PVB)) (Cash PVB) the net present value of the merger from the point of view of firm B is the same as the cost of the merger for A. Hence, NPV to B = (Cash - PVB) NPV of A and B in case the compensation is in stock In the above scenario we assumed that compensation is paid in cash, however in real life compensation is paid in terms of stock. In that case, cost of the merger needs to be calculated caarefully. It is explained with the help of an illustration Firm A plans to acquire firm B. Following are the statistics of firms before the merger Market price per share Number of Shares 500,000 Market value of the Rs.25 firm million A Rs.50 B Rs.20 250,000 Rs.5 million

The merger is expected to bring gains, which have a PV of Rs.5 million. Firm A offers 125,000 shares in exchange for 250,000 shares to the shareholders of firm B. The cost in this case is defined as

Cost = AB - PVB PV Where a represents the fraction of the combined entity received by shareholders of B. In the above example, the share of B in the combined entity is = 125,000 / (500,000 + 125,000) = 0.2 assuming that the market value of the combined entity will be equal to the sum of present value of the separate entities and the benefit of merger. Then, PVAB = PVA+ PVB+ Benefit = 25 + 5 + 5 = Rs.35 million Cost = PVAB - PVB = 0.2 x 35 5= Rs.2 million thus NPV to A =Benefit Cost = 5 2 = Rs.3 million NPV to B = Cost to A = Rs 2 million.

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