The next important point is increasing the earning per share (EPS). The process whereby the firm seeks to increase the EPS through takeover is bootstrapping. The table below is the example of this process.
However, following Watson and Head, 2007, and Singh 1971, in practice, it is the market price of the share that determines the PE ratio. This is only the guide to company performance on the paper, since it uses the historical numbers and it ignores both cash flow and risks.
The last one is the managerial motives. Takeover can arise because of the agency problem where conflicts of interest between shareholders and managers. In my opinion I think that it is difficult to give the example for this, because it seems like an internal issue inside the company, and as I presented, keeping information is part of the Vietnamese culture. Therefore, after taking over, the larger their firm, the less likely it is to be taken by the others, so the more secure for the job of managers.
However, everything has two sides. Now the researcher will present about the against-acquisition aspect, why the firm may not choose takeover as the solution.
Because Jebb plc is going to take over the rival, assuming they are in the same industry – car producer, the target - rival company can go to the court to ask for stopping the takeover when it leads to monopoly or it affects the fair competition, according to the Competition commission referral 1999. For instance, Jebb plc and B ltd are two biggest car producer companies in Hanoi and in Hochiminh city. When Jebb plc buys B, it will affect the price of products, the services serving to the customers, the distribution area, and it might lead to the monopoly market. Therefore, it will damages image and wealth of B, and it is not a good new for another car producer in Vietnam.
Besides, when the number of shares increase through issuing new shares, it is harder to gain majority. Also if after acquisition, the bidder only has 49% of shares, then it is still no authority on running business, and is considered as useless action. Hence, Jebb plc will be in big trouble, and it will make the bridge turning 180 degree around, when B ltd can threaten against Jebb.
For more understanding about the theories, please refer to the appendix 1 where the researcher presented about the basic theories of reasons profits behind takeovers, and against takeover.
With the assumption as above, we now move to the method for Jebb plc to take over B. Based on the assumption above, we choose the horizontal acquisition, and we will finance it by cash offers mixed with share-for-share offer, because it will be attractive to the target firm shareholders, due to the reasons that compensation they receive for their share is surely in value. Also, it will retain equity interest, no broker costs from re-investing cash and reducing capital gain tax liability (Watson and Head, 2007).
Besides, if we do not have cash in hand, and the new issue is rejected, we can issue the right issue, or borrow the issue bonds before we borrow from the bank. However, after acquisition, we will have problems with the interest rate (liquidity problem), gearing, and may be changes in capital structure among with the impacts on employees, managers on top, shareholders for both Jebb plc and B ltd (please refer to the appendix 1).
When we borrow money, we must pay the interest, so the expenses will be increased, the profit goes down, the share price goes down, then the market value goes down, and this will lead to the company performance. The figure 1 and figure 2 in the appendix 1 will show for more detail.
Besides, the gearing ratio will change also. For definition and more information, please refer to the appendix 3.
Gearing = Long term Debt/Total (Debt + Equity)
Following FuturePlus Financial Services Pty Limited, 2009, gearing increases the returns of an investment, whether they are losses or gains. When you gear, you usually multiply your gains in a rising market, but also multiply your losses in a falling market.
At times when investment returns are negative, the value of your investment will fall. If this occurs, you may be required to pay back part of the loan or provide extra security by investing more money. This is referred to as a margin call and you are generally required to respond to it within 24 hours. Other risks include rising interest rates or changing taxation legislation. Using a home mortgage facility or internally geared managed fund negates the risk of a margin call.
Following Watson and Head 2007, because interest must be paid before dividend, so the volatility of equity returns arises, and the risk of bankruptcy also occurs. The investors will not trust on company anymore. Also, because short term payback period does not mean the company will achieve more profit, so managers’ focus will be moved away from shareholders wealth maximization (Watson and Head 2007).
In addition, as in FuturePlus Financial Services Pty Limited, 2009, we have some types of gearing, as below.
Margin loan – A margin loan is, in effect, a mortgage arrangement where you borrow against investments that you already own up to a certain limit (70% generally being the maximum). Shares or managed funds purchased become the security for the loan. The disadvantages of such loans may include you having to contribute additional funds (to repay the loan principal), sell some of the shares or provide further shares as security, should the value of your equity fall.
Geared managed funds – Some fund managers offer funds using gearing as a strategy. The fund borrows within strict guidelines to increase the amount that it has to invest. The fund also receives the tax benefits, as would an individual using gearing. Therefore, in using such a product you are reducing the risk level by relying on specialist management expertise. You can greatly increase your potential gains as the amount to be invested is geared i.e. $100 invested equates to $160 (60% is usually the maximum gearing level) invested. However, like all investments, the higher the return, the higher the risk of a loss.
Before the takeover, gearing ratio of Jebb is assumed to be nil. Now, after the takeover, gearing is 50%. Hence, we can not have enough capital to invest in further business, for liquidity problem, then the market that Jebb is risky, so they do not want to sell shares even the shareholders require higher dividend, and debt holders require higher interest.
To determine if gearing may be an appropriate strategy for Jebb plc, the managers should consider the following:
■ Do the firm have the resolve to ride out falls in investment markets and have a long term investment timeframe?
■ Do they have a reliable income and expect this to continue for the term of the investment and the loan?
■ Do they have an emergency fund to meet potential interest rate rises and/or margin calls?
■ If the company can’t rely on the returns from your investment to pay the interest on the loan, are they prepared to use some of the income to pay the interest?
If the answer is yes to all of these questions, then gearing may be appropriate for you. It is also important to consider appropriate income protection/disability insurance and life cover before undertaking an acquisition strategy.
The question is that, after gearing, with optimal capital structure like that, it does or does not affect the weighted cost of capital WOCC and the average cost of capital ACC. If the target company can operate then there is no problem (Watson and Head 2007).
After considering all the information about taking over, we must then calculate if this project is good or not to make the final decisions, from the investment appraisal techniques.
Following Turner and Guilding, 2009, we should both use the qualitative and quantitative method for capital investment appraisal techniques (CIATs), the quantitative first and then the qualitative one to prevent from biases. The quantitative calculation will show the real figures of the project, and then we use the qualitative thinking based on experiences, facts, evidences, data in the quantitative calculation above to make the final decisions.
There are four basic methods usually used in quantitative calculation, including Payback Period (PP), Return On Investment (ROI)/ Accounting Rate of Return (ARR), Net Present Value (NPV), and Internal Rate of Return (IRR).
Following Milis, Snoeck, and Haesen , 2009, most commonly used for ICT appraisals are payback period (PP) and Accounting Rate of Return/Return On Investment (ARR/ROI). Techniques as Internal Rate of Return (IRR) and Net Present Value (NPV) –which are perceived as being more difficult- are used to a lesser extent, as we can see in the example from table B below.
Table B: Percentage of organisations using CIATs to justify capital investments
Source: Adapted from Ballantine & Stray, 1998 and Bacon, 1994, Richardson, 2004 & 2008
Following Milis, Snoeck, and Haesen , 2009, we have table C below to show in general about these four CIATs’ pros and cons.
Table C: Overview traditional CIAT-techniques
As we can see from above, the NPV has the most pros, so in my opinion, I will rank it the first to consider for the new investment. Then the IRR is the second. However, the ARR/ROI ranks the third in the table C above, but in my opinion, because:
ARR/ROI = Average annual accounting profit/Average investment
Average investment = (Initial investment + Scrap value)/2
But the real scrap value is able to calculate after the asset is sold, we can only estimate it at the present, so it is not possible here to consider it the third. Although the PP ignores all the inflation, cash flows, time value of money, and risk, but it is still easy to calculate, and take a picture for the new investment. Hence, we move to the PP third, and lastly the ARR/ROI.
Also, please refer to the appendix 2 for more information about definition, calculation and examples of CIAT techniques.
- Conclusion
In conclusion, in my opinion, I think that depending on the motives that Jebb plc wants to gain through acquisition, the company will find out the way to do it. For example, if the motive for acquisitions is control, then the target firm will be a poorly managed firm in an industry where there is potential for excess returns; or if the motive for acquisitions is operating synergy, the typical target firm will vary depending upon the source of the synergy, and so on.
Here, with all the assumption and justification above, Jebb plc can takeover B ltd, due to the reason to widen business scope, through horizontal acquisition, financing by both equity and debt, and take into account the NPV, IRR, PP, and ROI/ARR continuously to examine this project
- Appendices
- Theories about takeovers (all from Watson and Head, 2007)
Following Watson and Head, 2007, those below are the reasons and justifications why Jebb plc should choose an acquisition.
Economies of scales
The economies of scale- operating synergy can occur in production, distribution, marketing and etc. Larger scale of operations or more efficient use of assets under acquisitions will lead to a decrease in average unit cost
Elimination of inefficient management
If the company is poorly run, its share price will fall and it becomes a target for acquisition. Increased output or revenue and lower costs can arise from transfer of managerial skills or elimination of inefficient managers. Also, managerial skills of acquirer complements assets of target firm will lead to the higher profits.
Increased cash flows from a range of market-related factors
The company can set up a new market entry for existing products, e.g. an acquisition will be faster and more suitable than organic growth. Therefore, we can achieve the critical mass, e.g. minimum size to effectively carry costs such as R&D. Because Jebb plc chose the horizontal acquisition, so the market power and share will be increased.
Financial synergy
The cost of capital decreases through acquisition. Increased size can lead to financing scale economies, e.g. lower issue costs. Increased size can yield lower interest rates and lower costs of debt due to lower risks. Decreased cash flow volatility can also decrease risks and lower cost of capital.
Target under-valuation
Proponents of the theory believe that there is in the . This that whatever information is available about a to one is available to all investors (except, of course, , but is illegal). Since everyone has the same information about a stock, the of a stock should reflect the and of all investors. The is that an investor should not be to beat the market since there is no way for him/her to know something about a stock that isn't already reflected in the stock's price. Proponents of this theory do not try to pick stocks that are going to be winners; instead, they simply try to the market's . However, there is ample to dispute the basic of this theory, and most investors don't believe it.
(available from )
The target under-valuation happens when the share price does not present the company value. Therefore, if target company shares are under-valued, capital markets cannot be efficient. Whether a valid reason for acquisition can be justified on these grounds, so it will depend on the view of capital market efficiency. While the evidence strongly supports market efficiency, valuation uncertainty does leave scope for undervaluation.
Tax consideration
A tax-exhausted company can gain the tax-allowable benefits through an acquisition over a company that is not tax exhausted. Companies with insufficient profits which to set off capital allowances and interest may apply this.
Increased earnings per share
Price earning ratio (PER) is calculated as:
Price earning = Share price/ Earning per share
Earning per share (EPS) is calculated as:
Earning per share = Net profit after tax/ Number of shares
As we can see from those above, if acquirer has higher PER than target, it can increase EPS by using share-for-share offer (where the acquiring its for an equal number of shares in the firm. If accepted, of the both pre-merger become of the merged one).
If PER stays the same, the market value will rise. Also, one example of increasing EPS is “bootstrapping”. However, it does not increase the wealth of shareholders as it does not generate cash, because changes in EPS do not indicate whether an acquisition is wealth creating. It ignores both cash flows and risks, and it uses historical numbers based on accounting profit. Also, this is only in the document. In fact, bootstrapping may be considered as merely an exercise in creative accounting.
Managerial motives
Agency problems can lead to takeovers, whereby the managers are more concerned with satisfying their own objectives than with increasing the wealth of shareholders. Motives for acquisitions may be power, remuneration, perks, and job security. Managerial motives can lead to decrease in shareholder wealth. Also, the acquiring shareholders of the buying company rarely benefit at all.
The table below will show the conclusion for motives of takeover.
Table : Motives of takeovers
(Available from )
Besides, another picture arises if we consider about justifications against acquisitions, why the company may not choose acquisitions. Following Watson and Head 2007, these are as below.
Referral to Competition Commission
It replaced the Monopolies and Mergers Commission, 1999. It damages image and wealth of the acquirer. A formal investigation resulting from this means long costly delay. Also, depending on the result of the investigation, the takeover may not even be allowed to proceed.
Bid is contested
Here, the bidding company may pay a large acquisition premium. Indeed, takeover premiums between 30 and 50 per cent are not uncommon.
Cost of financing a takeover
If takeover bid is financed by share-for-share offer, the bidder must pay dividends on new shares. There will also be ownership and control changes. On the other hand, if the bid is financed by debt, the gearing levels may increase sharply, and interest payments may be hard to be paid. Also, the transaction costs for both debt and equity financing must be met.
The table below will show the summary of valuation of the takeover.
Table : Valuation of takeover
(Available from )
Method of takeover: Horizontal acquisition
The two companies must be in the same industry and stage of production combine into a single entity. This is the most common kind of acquisition and the most likely to succeed. Also, it is the most likely kind of acquisition to be referred to the Competition Commission.
Impact of takeover
Abstract:
Just as mergers and acquisitions may be fruitful in some cases, the impact of mergers and acquisitions on various sects of the company may differ. Mergers and acquisitions are aimed at improving profits and productivity of a company. Simultaneously, the objective is also to reduce expenses of the firm. However, mergers and acquisitions are not always successful. At times, the main goal for which the process has taken place loses focus. The success of mergers, acquisitions or takeovers is determined by a number of factors. Those mergers and acquisitions, which are resisted not only affects the entire work force in that organization but also harm the credibility of the company. In the process, in addition to deviating from the actual aim, psychological impacts are also many. Studies have suggested that mergers and acquisitions affect the senior executives, labor force and the shareholders.
Employees:
· Impact of Mergers and Acquisitions on workers or employees:
Aftermath of mergers and acquisitions impact the employees or the workers the most. It is a well known fact that whenever there is a merger or an acquisition, there are bound to be lay offs. In the event when a new resulting company is efficient business wise, it would require less number of people to perform the same task. Under such circumstances, the company would attempt to downsize the labor force.
If the employees who have been laid off possess sufficient skills, they may in fact benefit from the lay off and move on for greener pastures. But it is usually seen that the employees those who are laid off would not have played a significant role under the new organizational set up. This accounts for their removal from the new organization set up. These workers in turn would look for re employment and may have to be satisfied with a much lesser pay package than the previous one. Even though this may not lead to drastic unemployment levels, nevertheless, the workers will have to compromise for the same. If not drastically, the mild undulations created in the local economy cannot be ignored fully.
Management at the top:
· Impact of mergers and acquisitions on top level management:
Impact of mergers and acquisitions on top level management may actually involve a "clash of the egos". There might be variations in the cultures of the two organizations. Under the new set up the manager may be asked to implement such policies or strategies, which may not be quite approved by him. When such a situation arises, the main focus of the organization gets diverted and executives become busy either settling matters among themselves or moving on. If however, the manager is well equipped with a degree or has sufficient qualification, the migration to another company may not be troublesome at all.
Shareholders:
· Impact of mergers and acquisitions on shareholders:
We can further categorize the shareholders into two parts:
· The Shareholders of the acquiring firm
· The shareholders of the target firm.
Shareholders of the acquired firm:
The shareholders of the acquired company benefit the most. The reason being, it is seen in majority of the cases that the acquiring company usually pays a little excess than it what should. Unless a man lives in a house he has recently bought, he will not be able to know its drawbacks. So that the shareholders forgo their shares, the company has to offer an amount more then the actual price, which is prevailing in the market. Buying a company at a higher price can actually prove to be beneficial for the local economy.
Shareholders of the acquiring firm:
They are most affected. If we measure the benefits enjoyed by the shareholders of the acquired company in degrees, the degree to which they were benefited, by the same degree, these shareholders are harmed. This can be attributed to debt load, which accompanies an acquisition.
( available from )
If a company, which has a strong market presence, buys out the weak firm, then a more competitive and cost efficient company can be generated. Here, the target company benefits as it gets out of the difficult situation and after being acquired by the large firm, the joint company accumulates larger market share. This is because of these benefits that the small and less powerful firms agree to be acquired by the large firms.
Gaining Cost Efficiency
When two companies come together by merger or acquisition, the joint company benefits in terms of cost efficiency. A merger or acquisition is able to create economies of scale which in turn generates cost efficiency. As the two firms form a new and bigger company, the production is done on a much larger scale and when the output production increases, there are strong chances that the cost of production per unit of output gets reduced.
Mergers and Acquisitions are also beneficial
· when a firm wants to enter a new market
· when a firm wants to introduce new products through research and development
· when a forms wants achieve administrative benefits
Mergers and Acquisitions may generate tax gains, can increase revenue and can reduce the cost of capital.
(available from )
Figure 1 below illustrates the origin of value, and the significance of lowering the Weighted cost of capital (WCOC) that results from selecting the optimal Debt/Equity (D/E) ratio for a company. Recall that value arises from earning a net economic return that exceeds the cost of capital. For example, the net present value of a project represents the dollar value of having earned economic returns in excess of the cost of capital while the capital is in a project.
In Figure 1, with no debt the economic returns are labeled NER @ D/E = 0. Moving down the WCOC curve in the diagram increases the net economic returns, with attendant increases in value. The WCOC is for projects that do not alter the business risk of the firm.
Figure 1. WCOC and net economic returns as D/E ratio varies
Figure 2 graphically illustrates the impact of capital structure on stock price, keeping in mind that as we go from no debt to an increasing D/E we are reducing the number of shares. The use of too little debt (L) results in a lower stock price, and too much debt (M) also lowers the stock price.
(Capital structure: Implication, Groth J., available from http://www.qfinance.com/mergers-and-acquisitions-best-practice/capital-structure-implications?full)
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Theories (all from Milis, Snoeck, and Haesen , 2009) and examples about CIATs:
Following Milis, Snoeck, and Haesen , 2009, the Payback Period technique (PP) is defined as the time period needed to compensate for the initial investment expenditure using the money flow that is produced by the investment. The payback period should be considered as the least suitable CIAT for the appraisal of IT projects.
Due to the fact that projects are judged on the period needed to compensate the initial investment, projects with fast payback are favoured. As a result, companies using the PP technique will tend to accept too many short-lived projects and reject too many long-lived ones. In a services context this means the selection of services that deliver quick results are favoured. The gains generated by reuse are ignored if they are realized after the initial investment is compensated. As such, one of the fundamentals of service architecture –the reuse of services– is not fully accounted for. Furthermore, the inability to incorporate risk into the appraisal and the ignorance of the time value of money make this technique inapt for the evaluation of IT projects.
PP may be an adequate rule of thumb, but, considering the shortcomings, major investment decisions should not be based solely on the results of PP calculations.
For example: we assume Jebb plc in the UK have two proposed projects as below:
Accounting Rate of Return (ARR)/Return On Investment (ROI) are defined as the ratio between the annual gains (measured responses by the annual income after tax or by the cash flow) and the amount of money investment. ARR/ROI is more adequate than PP because the total lifecycle of the investment is taken into account. This technique is considered useful by IBM researchers in a services environment. Nevertheless, as with PP, the time value of money is not taken into consideration. Risk can be entered into the appraisal to a certain extent by adjusting the hurdle by which the IS services are judged, but this is not useful when dealing with mutually exclusive projects (selecting between similar services offered by two different developers for example).
For examples, we assume that to invest in the new market Vietnam, Jebb plc needs to buy a machine costs $10,000, with useful economics life is 10 years. Scrap value after 10 years is $1,000. Net cash inflows from the machine would be $3,000 per year. Also we want to achieve the target value for 30%, ignoring the taxation.
In result, we will have:
Depreciation: ($10,000 - $ 1,000)/10 = $1,800
Average annual profit: $3,000 – $1,800 = $1,200
Average investment: ($10,000 + $1,000)/2 = $5,500
Return on investment: $1,200/$5,500 x 100% = 21.82% < Target value 30%
- Therefore, this project is not chosen.
The Net Present Value (NPV) technique calculates the present value of the investment’s money flows, using a discount rate. In opposite to IRR, different rates can be used to reflect the risk-levels of mutual exclusive investments. The NPV technique is considered as being theoretically superior to the IRR technique.
The example below will show for more detail. We assume that cumulative present value factor is 10%, and when choosing to take over the rival company, Jebb plc will have the cash flows as:
The Internal Rate of Return (IRR) corresponds to the rate for which the present value of the investment’s money in-flows are equal to the present value of the money out-flows. Unlike the previously mentioned techniques, Internal Rate of Return (IRR) takes the time value of money into consideration by introducing a discount factor. This is a major improvement and makes this technique more useful. Still, there are some disadvantages:
- The result of IRR is a percentage. This makes it difficult to compare services that differ substantially in size and outcome. Services can vary substantially in terms of granularity and functions offered.
- If the IRR differs substantially from the cost of capital, it will become difficult to compare investments in IS services with a different time pattern.
- When this technique is used as a selection tool for mutual exclusive services, risks are not accounted for. It lacks the possibility of entering risk-levels into the selection. This is a major disadvantage, especially when used in a services architecture where levels of future use are often highly uncertain.
- Theories of gearing (all from FuturePlus Financial Services Pty Limited, 2009)
Benefits of gearing
Gearing gives you the potential to accumulate wealth faster than if you relied on your own funds to invest. As long-term returns on growth assets such as shares have generally exceeded the costs of borrowing to invest it will help you reach your long-term goals sooner.
It also has the potential to help you own a more diversified portfolio. With more funds to invest, you can avoid putting all your eggs into one basket.
Gaining tax concessions through gearing is one of the usual benefits of this form of investment. You can usually claim your loan expense as a tax deduction where the loan funds are used for business or investment purposes. This experience can be applied against your other taxable income received during the year (for example your salary). This reduces the overall after-tax cost of your borrowings.
- References
Standard Federal Bank Company history, available from:
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Gearing, a journal of FuturePlus Financial Services Pty Limited, 2009, 28 Margaret Street, Sydney.
Berkovitch, Elazar and M. P. Narayanan, 1993, "Motives for Takeovers: An Empirical Investigation," Journal of Financial and Quantitative Analysis 28. (No. 3, September),
347-362
Dr. Charles Byles, C., Huvard, S., Salcedo, R., Tuppince, L., Wentz, M., and Zolad L., 2006, Vodafone Air Touch: The Acquisition of Mannesmann, Virginia Commonwealth University, USA.
REITs (real estate investment trusts), available from:
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Capital structure: Implication, Groth J., available from
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Milis, K., Snoeck, M., Haesen, R. (2009). Evaluation of the applicability of investment appraisal techniques for assessing the business value of IS services. FBE Research Report KBI_0910, 1-19 pp. Leuven (Belgium): K.U.Leuven
Houston, Joel F. and Michael D. Ryngaert, 1996, "The Value Added by Bank Acquisitions: Lessons from Wells Fargo's Acquisition of First Interstate," Journal of Applied Corporate Finance 9 (No. 2, Summer), 74-82.
Sirower, Mark L., 1997. The Synergy Trap. New York, Free Press Goold, Michael and Andrew Campbell, 1998, "Desperately Seeking Synergy," Harvard Business Review 76 (No. 5, September/October), 130-143.
Eccles, Robert G., Kersten L. Lanes, and Thomas C. Wilson, 1999, "Are You Paying Too Much for That Acquisition?" Harvard Business Review 77 (No. 4, July/August), 136-146.
Watson D., and Head A., Corporate Finance: Principles and Practice, 2007, Prentice Hall, Pearson Education.
Benefits of Mergers and Acquisitions, 2010, available from:
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