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Mergers & Acquisitions : A Conceptual Overview
July, 10th 2009

In todays dynamic Business world Mergers & Acquisitions (M&As) are becoming a common and regular feature for majority of corporate houses. This article throws light on various implications and aspects connected with a Merger & Acquisition transaction. A merger is said to occur when two or more business combine into one. This can happen through absorption of an existing company by another. In a consolidation, which is a form of merger, a new company is formed to takeover existing business of two or more companies. In India, mergers are called amalgamations in legal parlance. The acquisition refers to the acquisition of controlling interest in an existing company. A takeover is same as acquisition, except that a takeover has a flavor of hostility in majority of cases. For this reason, the company taken over is usually called the target company and the acquirer is called the predator. The mergers are different from acquisitions in the sense that acquisitions generally do not involve liquidation of the target company.

1. Why Mergers and Acquisitions take place?
The common objective of both the parties in a M&A transaction is to seek synergy in operating economies by combining their resources and efforts. Now we shall see the reasons for M&A from the perspective of both, the buyer company as well as the seller company.

1.1 What is the buyer looking for in a M&A transaction?
An opportunity for achieving faster growth
Obtaining tax concessions
Eliminating competition
Achieving diversification with minimum cost
Improving corporate image and business value
Gaining access to management or technical talent

1.2 Why Companies go for sale or offer themselves for sale?
Declining earnings and profitability
To raise funds for more promising lines of business
Desire to maximize growth
Give itself the benefit of image of larger company
Lack of adequate management or technical skills

2. Procedural aspects under the Companies Act, 1956
The procedure for putting through a M&A transaction under the Companies Act, 1956 is very tedious and a lot of time is consumed in completion of the process. Sections 391 to 396 deal with the procedure, powers of the court and allied matters. The basic difference between a court merger and an acquisition is that the transferor company will be dissolved in case of a merger, whereas in case of acquisition the transferor company continues to exist.

3. Implications under the Income Tax Act, 1961
Tax implications can be understood from the following three perspectives:
a) Tax concessions to the Amalgamated (Buyer) Company
b) Tax concessions to the Amalgamating (Seller) Company
c) Tax concessions to the shareholders of an Amalgamating Company

3.1 Tax concessions to the Amalgamated Company
If the amalgamating company has incurred any expenditure eligible for deduction under sections 35(5), 35A(6),35AB(3), 35ABB, 35D, 35DD, 35DDA, 35E and/or 36(1)(ix), prior to its amalgamation with the amalgamated company as per section 2(1B) of the Act and if the amalgamated company is an Indian company, then the benefit of the aforesaid sections shall be available to the amalgamated company, in the manner it would be available to the amalgamating company had there been no amalgamation. Also under section 72A of the Act, the amalgamated company is entitled to carry forward the unabsorbed depreciation and unabsorbed accumulated business losses of the amalgamating company provided certain conditions are fulfilled. The CBDT is expected to reckon on the possibility of extending the benefits of section 72A to M&As in the financial sector. Currently, the benefits of this section are applicable to manufacturing sector only.

3.2 Tax concessions to the Amalgamating Company
Any transfer of capital assets, in the scheme of amalgamation, by an amalgamating company to an Indian amalgamated company is not treated as transfer under section 47(vi) of the Act and so no capital gain tax is attracted in the hands of the amalgamating company.

3.3 Tax concessions to the Shareholders of an Amalgamating Company
When the shareholder of an amalgamating company transfers shares held by him in the amalgamating company in consideration of allotment of shares in amalgamated company in the scheme of amalgamation, then such transfer of shares in not considered as transfer under section 47(vii) of the Act and consequently no capital gain is attracted in the hands of the shareholder of amalgamating company. The above are only few out of the various tax concessions available to the aforementioned categories of the assesses due to M&A transaction.

4. Valuation of Target Company
The principal incentive for a merger is that the business value of the combined business is expected to be greater than the sum of the independent business values of the merging entities. The difference between the combined value and the sum of the values of individual companies is the synergy gain attributable to the M&A transaction. Hence,
Value of acquirer + Stand alone value of Target + Value of Synergy = Combined Value.
There is also a cost attached to an acquisition. The cost of acquisition is the price premium paid over the market value plus other costs of integration. Therefore, the net gain is the value of synergy minus premium paid.
Suppose VA = Rs. 200, VB = Rs. 50 and VAB = Rs. 300, where VA and VB are the values of companies A and B before merger respectively and VAB is the combined value after merger. Therefore, Synergy = VAB ( VA + VB ) = Rs. 50.
If the premium is Rs. 20,
Net gain from merger of A and B will be Rs. 30 (i.e. Rs. 50 Rs. 20). One of the essential steps in M&A is the valuation of the Target Company. Analysts use a wide range of models in practice for measuring the value of the Target firm. These models often make very different assumptions about pricing, but they do share some common characteristics and can be classified in broader terms. There are several advantages to such a classification : it is easier to understand where individual models fit into the bigger picture, why they provide different results and where they have fundamental errors in logic.
There are only three approaches to value a business or business interest. However, there are numerous techniques within each one of the approaches that the analysts may consider in performing a valuation.

4.1 Income Approach
Under this approach two primary used methods to value a business interest include :
a) Discounted Cash flow method
b) Capitalized Cash flow method
Each of these methods depend on the present value of an enterprises future cash flows.

4.1.1 Discounted Cash flow Technique
The Discounted Cash flow valuation is based upon the notion that the value of an asset is the present value of the expected cash flows on that asset, discounted at a rate that reflects the riskiness of those cash flows. The nature of the cash flows will depend upon the asset : dividends for an equity share, coupons and redemption value for bonds and the post tax cash flows for a project. The Steps involved in valuation under this method are as under :

Step I : Estimate free cash flows available to all the suppliers of the capital viz. equity holders, preference investors and the providers of debt.
Step II : Estimate a suitable Discount Rate for acquisition, which is normally represented by weighted average of the costs of all sources of capital, which are based on the market value of each of the components of the capital.
Step III: Cash flows computed in Step I are discounted at the rate arrived at in Step II.
Step IV : Estimate the Terminal Value of the business, which is the present value of cash flows occurring after the forecast period.
TV = CFt (1+ g ) ,
k - g
where CFt is the cash flow in last year,
g is constant growth rate and
k is the discount rate
Step V : Add the present value of free cash flows as arrived at in Step III and the Terminal Value as arrived at in Step
IV. This will give the value of firm.
Step VI: Subtract the value of debt and other obligations assumed by the acquirer to arrive at the value of equity.

4.1.2 Capitalized Cash flow Technique
The Capitalized Cash flow technique of income approach is the abbreviated version of Discounted Cash flow technique where the growth rate (g) and the discount rate (k) are assumed to remain constant in perpetuity. This model is represented as under :
Value of Firm = Net Cash flow in year one
( k g )

4.2 Market Approach
The market approach to business valuation has its origin in the economic principle of substitution which says, Buyers would not pay more for an item than the price at which they can obtain an equally desirable substitute. The market price of the stocks of publicly traded companies engaged in the same or similar line of business can be a valid indicator of value when the transactions in which stocks are traded are sufficiently similar to permit a meaningful comparison. The difficulty lies in identifying public companies that are sufficiently comparable to the subject company for this purpose.
Suppose a company operating in the same industry as ABC with comparable size and other situations has been sold at Rs. 500 crores in last week provides a good measurement for valuation of business. Considering the circumstances, value of the business of ABC should be around Rs. 500 crores under market approach.

4.3 Assets Approach
The first step in using the assets approach is to obtain a Balance Sheet as close as possible to the valuation date. Each recorded asset including intangible assets must be identified, examined and adjusted to fair market value. Now all liabilities are to be subtracted, again at fair market value, from the value of assets derived as above to reach at the fair market value of equity of the business. It is important to note here that any unrecorded assets or liabilities should also be considered while arriving at the value of business by the assets approach.

None of the above methods is the best or none of them is the worst but each one has its own advantages and view points different from others. All these methods should be used in combinations to arrive at proper valuation of the business.

5. Accounting for Mergers and Acquisitions
In India, Accounting Standard (AS) 14 Accounting for Amalgamations deals with the accounting to be made in the books of Transferee Company. This AS is applicable where the acquired company is dissolved and its separate entity ceased to exist and the purchasing company continues the business of acquired company.
As per AS-14 there are two types of amalgamations : (a) Amalgamation in the nature of Purchase and (b) Amalgamation in the nature of Merger. An amalgamation will be in the nature of Purchase if any of the conditions regarding amalgamation in the nature of merger is not satisfied. An amalgamation is in the nature of Merger if all the conditions as prescribed in AS-14 for it are satisfied.

5.1 Accounting treatment for amalgamation in the nature of Merger
In preparing the Balance Sheet of transferee company after amalgamation, all the assets and liabilities of the transferor and transferee company will be added line by line except share capital.
The difference between the purchase consideration paid by the transferee company to the transferor company and the share capital of the transferor company should be adjusted with reserves.
If the purchase consideration is more than the share capital of the transferor company, then the excess shall be debited to reserves, if reverse is the case, then credited to reserves.

5.2 Accounting treatment for amalgamation in the nature of Purchase
In the books of the transferee company assets and liabilities (except fictitious assets and reserves & surplus) shall be recorded at the value at which they are taken over by the transferee company from the transferor company.
If the purchase consideration exceeds the net assets taken over (Net Assets = Agreed value of assets less agreed value of liabilities), the difference will be debited to Goodwill account which is to be amortized over a reasonable period of time generally not exceeding five years and if reverse is the case then the difference is credited to Capital Reserve.
To fulfill the requirement of maintenance of Statutory Reserves, the transferee company maintains such reserves created by transferor company for some more years in its books by passing the following journal entry,
Statutory Reserve Account Debited
To Amalgamation Adjustment Account
The accounting treatment in the books of the transferor company is not a big issue. The assets and liabilities which are being takenover in the M&A transaction are to be reversed in its books i.e. assets are to be credited and liabilities are to be debited.

6. Conclusion
These aspects which we talked about in this article will justify the exchange process in a Merger & Acquisition transaction if they are duly considered and their impact is properly arrived at. Hence their review becomes a prime and critical stage before proceeding with the big deal.

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