CHAPTER 1: INTRODUCTION AND BACKGROUND

1.0 Introduction

In today's globalized economy, competitiveness and competitive advantage

have become the buzzwords for corporates around the world. Corporates

worldwide have been aggressively trying to build new competencies and

capabilities, to remain competitive and to grow profitably. Strategic decisions

such as mergers, acquisitions, overseas expansions, divestments, new product

/ market / service offerings, etc., though quite in vogue for long, have become

more relevant in recent years, for exploiting profitable future opportunities for

growth and success.

Globally, companies are increasingly using mergers and acquisitions for one or

more of the following reasons:

i. As an opportunity to attain greater market share and higher revenue growth

ii. Access to greater amounts of capital through expanding debt capacity or

gaining financial advantage through tax credits

iii. Gaining complementary strengths and enhancing managerial skill sets and

competencies

iv. Acquiring new customers or expanding the customer / market / product /

service portfolio

v. Enhancing infrastructure base through acquisition of under-valued

infrastructural assets or brands or additional manufacturing capacities from

weaker competitors

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 vi. Creating new synergies through product market efficiencies and/or

economies of scale1

vii. Globalizing in a short span of time

1.1 Global Trends in Mergers and Acquisitions

Mergers and Acquisitions in the developed countries of the world (particularly

USA) were said to have been occurring in waves, with different motives behind

each wave, according to researchers2.

1.1. 1 The first wave occurred in the early part of the 20 th century, when

companies undertook M&As with the explicit objective of dominating their

industries and creating monopolies.

1.1.2 The second wave coincided with the rising market of 1920s, when firms

again embarked on M&A as a way of extending their reach into new markets and

expanding their market share.

1.1.3 The third wave occurred in 1960s and 1970s, when firms focused on

acquiring firms in other lines of business, with the intent of diversifying and forming

conglomerates.

1.1.4 The fourth wave occurred in the mid-1980s, when firms were acquired

primarily for restructuring assets. In some cases, acquisitions were financed by

debt and were initiated by the managers of the firms being acquired. This wave

ended as deals became pricier and it became more difficult to find willing lenders.

1.1.1.e The fifth wave occurred towards the end of 1990s when firms

focused on the acquired firms with the aim of restructuring.

1
Economies of scale can be defined as producing more at increased efficiency levels, thus
reducing per unit costs of manufacturing / services
2
Fred Weston, Kwang Chung and Susan Hoag, Mergers, Restructuring and Corporate Control,
Prentice Hall, 1996

2
In recent years, there has been increased merger and acquisition activity

globally, aided by accelerated changes in technology, globalisation of market

places, pursuit of global competitiveness, easing of regulatory systems through

international bilateral and multilateral agreements and treaties, and adoption of

international standards of accounting & valuation practices. The following table

captures the global M&A activity, during 1997 to 2003.

Figure 1: Global M&A Market activity (1997 – 2003)

Source: KPMG press release on 4 July, 2003 about global M&A Trends

Mergers and acquisition deals worldwide have reached an all-time high in

2006, with a total value of $3.7 trillion, surpassing the 2000 high of $3.4 trillion 3.
The numbers indicate that the US was the most targeted country for
acquisitions, representing over 40% of global M&A activity, while the UK was

3
Richard Dobbs, Marc Goedhart and Hannu Suonio, Are companies getting better at M&As?,
McKinsey on Finance, Winter 2007

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the most targeted European country for acquisitions, with $339 billion of cross-
border and domestic transactions.

Figure 2: Global M&A Deal Announcement Activity 1995 - 2006

Source: Richard Dobbs, Marc Goedhart and Hannu Suonio, Are companies getting better at
M&As?, McKinsey on Finance, Winter 2007

1.2 Mergers and Acquisitions in Indian Industry

The first indications of a move towards mergers and acquisitions in India

became visible during the 1980s, with the emergence of corporate raiders like

Swaraj Paul, Manu Chabbria and R.P.Goenka. The pace for mergers and

acquisitions activity in India picked up in response to various economic reforms

introduced by the Government of India since 1991, for economic liberalization

and globalization. The economic reforms included

– Industrial reforms which involved removal of restrictions on corporate

investments & growth contained in the Monopolies and Restrictive Trade

Practices (MRTP)

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 – Trade reforms involving lowering of tariff and physical barriers on imports

– Financial sector reforms permitting public sector banks and financial

institutions to tap capital markets, and

– Policy to encourage the inward flow of foreign direct investments and

foreign portfolio investment

The Indian economy has undergone a major transformation and structural

change following the economic reforms. In the liberalized economic and

business environment, “size and competence" have become the focus of every

business enterprise in India, as companies realised the need to grow and

expand in businesses that they understand well, to face growing competition.

Several leading corporates had undertaken restructuring exercises to sell off

non-core businesses, and to create stronger presence in their core areas of

business interest. Mergers and acquisitions have emerged as one of the most

effective methods of such corporate restructuring, and have therefore, become

an integral part of the long-term business strategy of corporates in India. Since

1992, mergers and acquisitions in the Indian industry have increased in terms

of numbers and market value. Over the past decade and half, many industries

in India have experienced a wave of mergers and acquisitions. The enthusiasm

in consolidation was based on the belief that synergistic gains can result from

scale of economies in production and capital through cost / expense reduction,

product and marketing scope expansion, and increased market power.

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1.2.1 Trends in Indian M&As

Three distinct trends are visible in the mergers and acquisitions activity in India

since the economic liberalization in 1991. In the initial period, there was intense

investment activity and a wave of consolidation within the Indian industry, as

companies tried to prepare for the potential aggressive competition in the

domestic and overseas markets. They engaged in acquisitions and mergers, to

achieve economies of scale, size and scope. The major reasons for increased

M&A activity during this period were considered to be:

(a) Legal and economic reforms which increased threat from foreign entrants

into Indian markets

(b) Slowdown of Indian economy & depressed stock markets and

(c) Change in shareholders’ attitude particularly that of Foreign Institutional

Investors (FII), who wanted to exit from some of their investments, following

removal of exit barriers.

In the second significant trend, visible since 1995, there was increased activity

in consolidation of subsidiaries by multinational companies operating in India,

followed by entry of several multinational companies into Indian markets,

through the acquisition route, in the wake of liberalised norms for Foreign Direct

Investments (FDI)4. Since such restructuring exercises and foreign investments

should promote fair competition for the overall benefit of public shareholders

and consumers, government regulation was introduced through the Securities

and Exchange Board of India (SEBI). SEBI had notified the Takeover Code in

February 1997, which laid down the rules, for regulating corporate takeovers in

4
2. Beena P.L (2000), An Analysis of Mergers in the Private Corporate Sector in India,
Working Paper 301, Centre for Development Studies, Trivandrum pp 1-61

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India5. The following table shows the trends in M&As during the first decade

following economic reforms in India

Table 1: Trends of M&As during 1990 to 2000

Year Non-mfg Mfg Total

1990-95 116 175 291 (20)
1995-00 233 510 743 (236)
1990-00 349 685 1034 (256)

Source: P. L. Beena, Towards understanding the merger wave in the Indian corporate sector – a
comparative perspective, working paper 355, February 2004, CDS, Trivandrum, pp 1-44.
Figures in brackets represent the number of MNE related deals

Further to the announcement of the takeover rules by SEBI, Companies

focused on capital and business restructuring after 1997. They cleaned up their

balance sheets, and there was consolidation in the domestic industries like

steel, cement and telecom. Venture capital also started coming into India during

this period, attracted by the growth potential offered by the Indian economy,

particularly in the Information Technology and Information Technology enabled

services industries. A large number of buyback offers were made by promoters

of Indian companies, for consolidating their holdings and to de-list the company

from the bourses. Several multinationals also made offers for companies

already owned by them In India, for consolidating their holdings in the Indian

subsidiaries. Some open offers for acquiring controlling stakes, were made by

Multi National Corporations (MNCs), following changes in ownership of

overseas parents. The government of India also started divesting stakes in

some of the public sector companies during 2001-02, which aided the market

5
3. Surjit Kaur, PhD Thesis Abstract, A study of corporate takeovers in India, submitted to
University of Delhi

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sentiments. A pickup in the open offers and buybacks also spurred the mergers

and acquisition activity in the country.

The table below, captures the trends in the M&A deals in India in volume and

value terms, since 1998-99.

Table 2: Mergers and Acquisitions in India from 1998 to 2004

Year Deals
Number Amount (Rs. Crore)
1998-1999 292 16071
1999-2000 765 36963
2000-2001 1177 32130
2001-2002 1045 34322
2002-2003 838 23106
2003-2004 834 35980
Source: I.M. Pandey, Financial Management, Tata McGraw Hill, Ninth Edition, 2005

The third wave of mergers and acquisitions in India, which is apparent since

2002, is that of Indian companies venturing abroad, and making overseas

acquisitions for gaining entry into international markets. Indian companies have

been actively pursuing overseas acquisitions in recent years, following the

opening up of Indian economy and financial sector, aided by huge cash

reserves following some years of great profits. The enhanced competitiveness

in global markets, have given greater confidence for big Indian companies to

venture abroad for market expansion. Their efforts have also been aided by the

surge in economic growth and fall in interest rates, which have made financing

such deals, cheaper. Many small and medium size companies in India have

also been seeking to expand abroad in recent years. The strong growth in

stock markets and ready access to funds through various avenues, including

private equity have been making it easier for Indian companies to raise funds

for overseas acquisitions.

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Several Indian companies had also divested their businesses at large

valuations, and became cash-rich. With high levels of business confidence,

easy availability of funding from investors and financial investors, many Indian

companies have been pursuing international acquisitions to gain ready access

to export business and overseas customers. Some of the large acquisition

deals are being driven in particular by the traditional sectors such as

pharmaceuticals, telecommunication, auto components and other

manufacturing sectors. Changes made in regulations made by the Finance

Ministry in India, pertaining to overseas investments by Indian companies, had

also made it easier for the Indian companies to make cross-border

acquisitions6.

Since 2002, the growing ambitions of Indian corporates to go global through the

M&A route have been strikingly visible, as they were seeking to emerge as

Indian Multi-Nationals. International M&A deals by Indian corporates have been

increasing steadily and becoming bigger in size, both in developed and

emerging markets, and they are slowly emerging as major competitors in global

markets. The overseas investments by Indian companies have increased from

$0.7 billion in 2000-01 to $2.7 billion in 2005-06. The industries that attracted

Indian investments included metal, energy, pharmaceutical, IT and banking.

The reasons that seem to drive overseas M&As by Indian companies include

the following:

6
Harsh Vardhan, Vice-President & Director, Boston Consulting Group, quoted in Business
World

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 – Accessing new markets

– Maintaining growth momentum

– Acquiring visibility and international brands

– Buying cutting-edge technology rather than importing it

– Developing new product mixes, improving operating margins and

efficiencies, and

– Taking on the global competition.

The value of M&A deals in India have grown from US $ 4 billion in 1999 to more

than US $ 15 billion 7 in 2005. The growth in the number and value of the deals

reflect the fast pace at which the Indian industry was trying to consolidate to

compete aggressively in a globalised market place. The following table gives

the sector-wise break-up of all M&A deals in India in 2005, which shows that

the fast-growing Telecom sector accounted for almost a third of the total deal

value.

Table 3: Sector wise break-up of all M&A Deals in India in 2005

Sector % of Total Deals
by Value
Telecom 31%
Energy 13%
IT & ITES 9%
Steel 6%
Pharma, Healthcare & bio-tech 6%
Chemicals and Plastics 6%

7
There were 343 M&A deals in India with a total value of about $ 16.3 billion in 2005. The average deal
size was $ 48 million. The deal value in telecom sector was the highest, amounting to one-third of all M&A
deal value in 2005.
Source: Grant Thornton (India) 2006

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 Banking and Financial Services 5%
Food and Beverages & FMCG 5%
Automotive 4%
Oil & Gas 3%
Manufacturing 3%
Others 9%
Source: Grant Thornton India, 2006

1.2.2 Cross Border M&A Deals in Indian industry

The significant trend in 2005 in the M&A transactions in India is the high

proportion of cross border deals to the total M&A activity - at 58% of the deal

value amounting to $ 9.5 billion and 56% of the deal volume at 192 deals. Key

highlights of the cross-border deal activity are shown in the following Table:

Table 4: Cross-border M&A Deals in India in 2005

Cross No. of Value of Average % of total % of total
border Deals Deals Deal Size M&A M&A deal
Deals $ Bn $ Mn Volume value
Inbound 56 5.2 92 16% 32%
Outbound 136 4.3 32 40% 26%
Total 192 9.5 49 56% 58%
Source: Grant Thornton (India), The M&A and Private Equity Scenario, 2006

1.2.3 Rationale for M&As according to Indian Industry

In a survey among Indian corporate managers on M&As in 2006 by Grant

Thornton8, it was found that Mergers & Acquisitions are a significant form of

business strategy today for Indian Corporates. The two main objectives behind

any M&A transaction, for corporates today were found to be:

– Improving Revenues and Profitability

– Faster growth in scale and quicker time to market

8
Grant Thornton (India), The M&A and Private Equity Scenario, 2006

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The three most important factors according to corporate India that contribute to

the success of an M&A Transaction are:

– Timing

– Intrinsic Fit

– Personnel

The survey was done across companies in Information Technology & ITES,

Power, Oil & Gas Sector, Banking & Financial Services, Manufacturing &

Engineering, Business Consulting, Pharma & Healthcare, Media &

Entertainment, Venture Capitalist, Business Consulting, Pharma & Healthcare,

Construction, and Others. The results were as tabulated as per table 5 below:

Table 5: Objectives of Indian Corporates for M&As

Responses
Objective behind the
(in %)
M&A Transaction
To improve revenues & 33%
Profitability
Faster growth in scale and 28%
quicker time to market
Acquisition of new 22%
technology or competence
To eliminate competition & 11%
increase market share
Tax shields & Investment 3%
savings
Any other reason 3%
Source: Grant Thornton (India), The M&A and Private Equity Scenario, 2006

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1.3 Theoretical background

The combination of two companies, for operating as a single business entity

going forward, is called a merger. Merger involves an operation by which two or

more companies transfer their assets and liabilities to another existing or newly

established company, and thereby one or more of the entities dissolve

themselves. The company that merges another company into itself is called the

merging company. The company that gets merged into another company and

consequently loses its identity is called the merged company.

An acquisition occurs when one entity buys out another entity, whereby it can

deal with the entity in two possible ways – operate as a holding company and

keep the bought-out company as a separate business entity / subsidiary, OR

combine the bought-out company into itself. For the purpose of the current

study, the entity which buys and mergers another company into itself and

continues its identity, is called as the acquiring company. The company that has

been bought and merged into another company is called the acquired company

or target company. Through out this study, the terms “acquiring firm” and

“merging firm” are used interchangeably

1.3.1 Types of mergers and acquisitions

Mergers and Acquisitions can be categorised into three broad types:

1. Horizontal Acquisitions / Mergers: Acquisition / Merger of a firm in the same

industry or business as the acquiring firm

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 Horizontal Mergers involve two companies operating in the same kind of

business activity (stage of production), usually in the same industry. The main

purposes of such mergers usually could be: to obtain economies of scale and

scope, eliminate a competitor company, increase market share, buy up surplus

capacity or obtain a more profitable firm. Besides such benefits, this type of

mergers has the drawbacks of restricting new entries into the market and

harming outsiders due to diminishing competition

2. Vertical Acquisitions / Mergers: Acquisition / Merger of a firm at a different

stage of production from the acquiring firm or a firm operating in a different

segment in the same industry value chain as the acquiring firm

Vertical mergers involve two or more companies that operate at different stages

of production process, where buyer-seller relation or manufacturing at different

stages of the same product is possible. A vertical merger results in the

consolidation of firms that have actual or potential buyer-seller relationships.

The objectives usually are to stabilize sales, reduce inventories and save

operating costs.

There are two types of vertical mergers:

(i) ‘Backward or upstream vertical integration’, in which the primary motive is

usually to move towards a dependable source of supply

(ii) ‘Forward or downstream vertical integration’, in which the primary motive is

to move towards the final customer, who may be another industrial user or the

public

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3. Conglomerate Acquisitions / Mergers: Acquisition / Merger of a firm in a

business which is unrelated to the acquiring firm’s current business

Conglomerate mergers involve firms engaged in unrelated business activities,

usually with the basic purpose of risk reduction through diversification, and to

gain financial synergy. A conglomerate merger occurs when unrelated

enterprises combine. Conglomerate mergers result in joining of firms which

compete in different product or inputs markets - neither the products nor the

inputs of these merging firms are the same.

Conglomerate mergers create significant advantages to merging firms, by

providing fast means of entry into different activity fields in the shortest possible

time span. Moreover, they reduce the financial risks by “not putting all the eggs

in one basket”.

The types of conglomerate mergers include

(a) Product Extension: In this type of mergers, firms that sell non-competing

products and use related marketing channels of production processes merge

(b) Market Extension: In such mergers, merging firms manufacture the same

products or services but market them in different territorial markets

(c) Pure Conglomerate Mergers: In such mergers, there is no relationship

between firms neither in respect to manufacturing nor in respect to marketing,

and mergers are realized between firms operating in entirely different fields

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Reverse mergers: Mergers generally involve integration of a financially weak

company into a strong and capital rich company. However, in a reverse merger,

this trend is reversed i.e. the strong company merges with the weak company.

This sometimes occurs when a parent (bigger) company merges with its

subsidiary (smaller) company. Reverse mergers are usually undertaken to take

advantage of tax benefits or due to regulatory requirements

The three salient features of a reverse merger are:

a) The assets of the merging company are greater than the surviving company

b) The surviving company issues new equity capital to the shareholders of the

merging company, which results in increase in the original issued capital of

the surviving company

c) Change of control takes place in the surviving company

1.3.2 Reasons for Mergers and Acquisitions

The primary motivation for most mergers and acquisitions is to increase the

market value of the combined enterprise. That would mean that the combined

firm is more efficient, or worth more than the sum of the worth of individual

firms. This is often called " synergy". From the existing management theory, the

synergy profits are likely to come from one or more of the following factors:

1. Economies of scale

This could be achieved through sharing of costly equipment, facilities

and personnel for multiple product / large volume manufacturing, and

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 also to reduce the cost of flotation when raising new capital – benefits

primarily coming from lower per unit cost due to increased scale or

volume of operations

2. Acquisition of valuable technologies and resources

The benefit from this approach is derived when it is cheaper to buy

access to technology, natural resources, manufacturing capacity,

competent manpower, or other reserves than to explore or build such

capabilities in-house.

3. Undervaluation of target company by the market

Sometimes, the target firm's management may not be operating the firm

to its full potential, leaving room for another firm to takeover and realize

the value through better management processes. Alternatively, the

acquiring firm may have insider information on the target firm, which may

lead them to believe that the target firm has an intrinsic value higher

than its current market value. Another possibility is that a company's

break-up value (sum of the individual values of the broken parts of a

company) might be perceived to exceed the company's aggregate

market value – in this scenario, a takeover specialist could acquire the

firm at or somewhat above the current market value, sell it off in pieces,

and earn a substantial profit.

4. Tax considerations

A firm with large tax loss carry-forwards may be attractive to another firm

that can use the tax benefits to set off against its profits and achieve

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 savings in tax outgo. Some firms which have unused debt capacity may

acquire loss-making companies, so that it can deduct more interest

payments from profits, and reduce taxes.

5. Inefficient management of the target company

If the management of the target company is poor relative to others in the

same industry, this could lead to a horizontal acquisition by a competitor-

or acquisition by a diversifying firm leading to a conglomerate merger. In

this case, the acquiring firm can provide better management

competencies to improve the performance of such acquired company.

6. Market power

One firm may acquire a competitor firm, to reduce competition. If so,

pricing power can be increased, and monopoly rents obtained

7. Risk Diversification

A cash rich company may use the excess cash for acquisitions, rather

than to pay it out as dividends. A frequent argument for this is that it

reduces the investor's risk in the company, thus achieving diversification.

1.3.3 Merger Theories

Mergers and acquisitions have been one of the more actively studied areas

globally, for past few decades. There are several theories explaining the

possible sources of gains following corporate acquisitions and mergers. Three

of the common theories are (i) the synergy or efficiency theory, (ii) the market

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for corporate control theory and (iii) the free cash flow theory. All three theories

predict enhanced operating performance through some sort of efficiency

improvements following mergers.

1.3.3.1 The Synergy (Efficiency) Theory

A popular explanation for acquisition is improved efficiency - that a combination

of firms will result in improved operations and a better financial & operational

profile. Proponents of free markets for corporate control have long maintained

that acquisitions are value-increasing events, derived from ` synergy'. Synergy

occurs when two firms can be run more efficiently (i.e., with lower cost) and/or

more effectively (i.e., with a more appropriate allocation of scarce resources,

given environmental constraints) together than when they operate separately.

The commonly perceived benefit is improved resource allocation, whereby an

improvement in allocative efficiency is expected to promote overall economic

gains. Synergies are generally categorised into three types: (i) Financial, (ii)

Operational and (iii) Managerial synergies

i. Financial Synergies

Financial Synergies are derived by achieving a lower cost of capital due to an

increase in size or risk diversification. When the earnings streams of the

acquirer and target firm are imperfectly correlated, it is expected to increase the

optimal amount of debt after the acquisitions. Since the value of the tax savings

on incremental debt is greater than incremental leverage-related cost (interest),

by increasing debt after acquisition, the combined firm stands to create

additional value. Also, when returns of the two combining firms are imperfectly

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correlated, the existence of various market imperfections such as costly

information or indivisibility of financial assets may lead to gains from pooling

risk through acquisitions. The above benefits are generally expected to be

more important in case of conglomerate mergers than in related mergers

(horizontal or vertical).

ii. Operational synergies

Operational Synergies accrue from combining separate units or from

knowledge transfer – thus reducing costs for the involved units, or enabling the

firm to offer unique products or services. Operational synergies can be created

through (a) economies of scale, (b) economies of scope and (c) market power.

(a) Economies of Scale

Economies of scale (cost efficiencies through increase in transaction size) can be

derived if the merged firm achieves unit cost savings as it increases the scale of a

given activity. Production-linked economies of scale are commonly considered as the

main driver of cost-cutting, but economies of scale may also be achieved in other

functional areas of a business (e.g., R&D, distribution, sales or administrative

activities) through the spreading of fixed costs over a higher total volume. In addition,

sharing activities can also enable merging firms to obtain cost reduction based on

learning curve economies, since each merging business, when acting independently,

might not have a sufficiently high level of cumulative volume of production to exploit

learning curve economies. Production linked economies may be achieved in the areas

of purchasing or inventory management, in the case of mergers involving firms using

common raw materials or input components. Consequently, these economies of scale

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should manifest in lower operating and financing expenses thereby improving

operating performance. The other source of gain could be because the new combined

firm may have a much higher debt capacity and thus be able to borrow at a lower cost

through better access to capital markets - these economies may be exploited by both

conglomerate and non-conglomerate acquisitions.

(b) Economies of Scope

Economies of scope exist when managers are able to produce multiple products jointly

at a single location than if production were spread across multiple firms. Most

commonly, both partners in an acquisition bring some complementary skills to the

combination, such that value is created as a result of the acquisition. For instance,

managers who acquire skills of firm A may find those skills very useful in lowering

costs and increasing profits in firm B. Economies of scope may also arise from reuse

of an input, such as sharing of production know-how or other intangible assets by

more than one product. Economies of scope also arise when the merged firm achieves

cost savings as it increases the variety of the activities it performs. This is the case

when the shared factor of production is imperfectly divisible, so that the manufacture of

a subset of goods leaves excess capacity in some stages of production. Horizontal

acquisitions commonly increase the scope of the firm and allow spreading the firm’s

resources over a broader range of products. Horizontal acquisitions provide

opportunities for sharing assets characterized by some indivisibility and under-

utilization before the acquisition, by rationalizing two sets of product lines, and

divesting the less efficient assets. Efficiencies from economies of scope are typical of

non-conglomerate or horizontal acquisitions (merging of two competitors in a market)

and tend to improve operating performance through lower costs.

(c) Market Power

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Market power or pecuniary economies represent another source of synergies. Market

power offers the ability to control the price, quantity or nature of the products sold in

the output market. Such market power benefits are supposed to result in revenue-side

benefits for the acquiring firm, achieved primarily through increase in market share and

absolute size, through monopolistic or oligopolistic opportunities. Monopoly refers to

the ability of a firm to force buyers to accept higher prices. Oligopoly refers to the firm's

collusion with few other suppliers to the market, through cartelisation. Market power

supposedly enhances profit margins and therefore profitability of the new economic

entity.

Among the three merger types, horizontal acquisitions are most likely to benefit from

economies of scale and scope, and market power. Vertical mergers are mostly

expected to benefit from economies of scope, arising from a greater control of the

input and out price variability in the value chain, due to better predictability and

integration of the operational planning processes, thus reducing the risk of the

combined firm

iii. Managerial Synergies

Managerial synergies are derived from infusing superior new management into

target firms, which may be suffering due to inadequate competence or

motivational deficiencies amongst the existing management team

1.3.3.2 The Market for Corporate Control Theory

There is an established recognition that corporate acquisitions provide a

mechanism for more effective management of the acquired company's assets.

The corporate control market is one in which several teams of management

compete to acquire the right to manage the target firm. Competition among

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these management teams ensures, at least theoretically, that the most efficient

team manages the firm. The market therefore expects the new management to

be more effective than the incumbent management. This increased

effectiveness and efficiency is expected to subsequently manifest in improved

operating performance of the combined firm.

1.3.3.3 The Free Cash Flow Theory

The theory of Free Cash Flow states that managers have a tendency to invest

`free cash flow' of the firm in negative net present value projects, which is

contrary to shareholders' wealth maximisation policy. This agency problem is

particularly severe for firms with substantial free cash flow and limited growth

potential. If acquisition of this company is made through debt, the interest load

created in the process limits management's freedom to use future cash flows,

thereby reducing the possibility of misuse of free cash flows. The increased

fixed interest charges of debt also compel management to be more efficient.

Thus, according to free cash flow theory, post-acquisition performance in such

cases should also improve relative to the pre-acquisition period.

The three theories described above suggest that corporate acquisitions are

attempted to achieve gains in operating performance, and for enhancing

shareholder wealth.

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1.3.4 Legal Aspects of M&As

1.3.4.1 Income Tax Act of India with respect to M&As

Section 2 (1B) of the Income Tax in India 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--

a) 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;

b) 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;

c) 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

otherwise than 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

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1.3.4.2 Accounting Procedure for Mergers in India

When mergers and acquisitions take place, the combined entity's financial

statements have to reflect the effect of combination. According to the

Accounting Standard 14 (AS 14) issued by the Institute of Chartered

Accountants of India, an amalgamation can be in the nature of pooling of

interests, referred to as "amalgamation in the nature of merger', or acquisition.

The conditions to be complied for an amalgamation to be treated as an

"amalgamation in the merger" are as follows:

 All assets and liabilities of the "Transferor Company" before amalgamation should

become assets and liabilities of the "Transferee Company".

 Shareholders holding not less than 90% of shares (in value terms) of the

"Transferor Company" should become the shareholders of the "Transferee

Company".

 The consideration payable to the shareholders of the "Transferor Company" should

be in the form of shares of the "Transferee Company" only; cash can however be

paid in respect of fractional shares.

 Business of the "Transferor Company" is intended to be carried on by the

"Transferee Company."

 The "Transferee Company" incorporates, in its balance sheet, the book values of

assets and liabilities of the "Transferor Company" without any adjustment except to

the extent needed to ensure uniformity of accounting policies. An amalgamation

that does not satisfy all the conditions stated above will be regarded as an

"Acquisition".

The accounting treatment of an amalgamation in India, in the books of

"Transferee Company" is dependent on the nature of amalgamation. The

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'pooling of interest' method is to be used for a merger, and the 'purchase'

method is to be used for an acquisition. Under 'pooling of interest' method, the

balance sheet of the combined entity is arrived at by a line-by-line addition of

the corresponding items in the balance sheets of the combining entities. Hence,

there is no asset write-up or write-down or even goodwill. Under 'purchase'

method, however, the "acquiring company" treats the "acquired company" as

an acquisition investment and, hence, reports its tangible assets at fair market

value. So there is often an asset write-up. Further, if the consideration exceeds

the fair market value of tangible assets, the difference is accounted as goodwill,

which has to be amortized over a period of five years. Since there is often an

asset write-up as well as some goodwill, the reported profit under purchase

method is lower because of higher depreciation as well as amortization of

goodwill

1.3.4.3 Legal/ Statutory approvals for mergers

In India, the process of mergers or amalgamations is governed by sections 391

to 394 of the Companies Act, 1956 and requires the following approvals for

consummating the same:

i. Approval by Shareholders

The shareholders of the amalgamating and the amalgamated companies are

directed to hold meetings by the respective High Courts to consider the scheme

of amalgamation. The scheme is required to be approved by at least 75% of

the shareholders, present and voting, and in terms of the voting power of the

shares held (in value terms). Further, Section 395 of the Companies act

stipulates that the shareholding of dissenting shareholders can be purchased

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provided 90% of the shareholders, in value terms, agree to the scheme of

amalgamation. In terms of section 81(IA) of the Companies Act, the

shareholders of the "amalgamated company" also are required to pass a

special resolution for issue of shares to the shareholders of the "amalgamating

company".

ii. Approval from Creditors/Financial Institutions/Banks

Approvals from these are required for the scheme of amalgamation in terms of

the agreement signed with them for lending / borrowing.

iii. Approval from High Court

Approvals of the High courts of the States in which registered offices of the

amalgamating and the amalgamated companies are situated are required for

formalising the arrangement

iv. Approval from Reserve Bank of India

In terms of section 19 of FERA 1973, permission of Reserve Bank of India is

required when the amalgamated company issues shares to the non-resident

shareholders of the amalgamating company or any cash option is exercised.

1.3.4.4 SEBI's Takeover Code for substantial acquisitions of shares in listed

companies

On 4th November 1994, Securities Exchange Board of India (SEBI) announced

a take-over code for the regulation of substantial acquisition of shares, aimed at

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ensuring better transparency and minimizing the occurrence of clandestine

deals. In accordance with the regulations prescribed in the code, on any

acquisition of shares in a company, which makes the acquirer’s aggregate

shareholding exceed 15%, the acquirer is required to make a public offer. The

take-over code covers three types of takeovers-negotiated takeovers, open

market takeovers and bailout takeovers.

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