Key Definitions:
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Economies of scale, in microeconomics, refers to the cost advantages that an enterprise obtains due to expansion. There are factors that cause a producer’s average cost per unit to fall as the scale of output is increased. "Economies of scale" is a long run concept and refers to reductions in unit cost as the size of a facility and the usage levels of other inputs increase. (http://en.wikipedia.org/wiki/Economy_of_scale)
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Economies of scope are conceptually similar to economies of scale. Whereas 'economies of scale' for a firm primarily refers to reductions in average cost (cost per unit) associated with increasing the scale of production for a single product type, 'economies of scope' refers to lowering average cost for a firm in producing two or more products. The term and concept development are due to Panzar and Willig (1977, 1981). Here, economies of scope make product diversification efficient if they are based on the common and recurrent use of proprietary know-how or on an indivisible physical asset. For example as the number of products promoted is increased, more people can be reached per dollar spent. (http://en.wikipedia.org/wiki/Economy_of_scope)
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Concept of Synergies (Can 2 + 2 = 5?) Synergy is roughly defined as two or more things together being better or more effective than the sum of their parts. As it's used here, it means two or more companies merging such that the combined resources of the merged unit have more than the sum of the value they had individually. For example, suppose XYZ Engineering Company has very skilled sales and marketing people. Through their marketing abilities they have a number of contracts for sophisticated engineering projects. However, their engineering staff leaves something to be desired. The engineers are inexperienced and are not well equipped to handle the contracts that XYZ sales personnel are able to secure. (Gary L. Schine, 2009)”
Methodology:
An acquisition is the purchase of one business or company (target company) by another company (acquirer company) or other business entity. Therefore, it is important to evaluate the valuation of target company.
Acquisition involves using various techniques of valuation to figure out an amount that is fair to be offered to target company. The commonly used valuation techniques are:
- Similar comparable Public limited traded companies – this analysis indicates how the companies similar to the target company are valued by the stock markets.
- Comparable Model Transaction analysis – this study identifies the valuations at which previous acquisition transactions have been done in the same industry for the companies similar to target company.
- Discounted Cash Flow analysis – is one of the most significant valuation technique
- Sum of the lines of operation analysis – If target company has more than one lines of operations / operations, the financial advisor of acquirer company will value each operation line separately. Resultantly, each “line of operation / business” have its own value in terms of comparable Public limited traded companies, comparable Model transaction analysis and discounted cash flow analysis with different Weighted Average Cost of Capital (WACC) for each line. The total value is the sum of the lines of operation.
- Other analysis – financial advisors of the acquirer company will calculate a number of other analysis depending on the characteristics of the transaction, to arrive at fair valuation to be offered for target company (for example dividend growth model).
Alpha Plc (Acquirer Company) directly negotiated with Delta Plc (target company) for the valuation of Delta Plc amounting to £360 million. Three offers proposed by Alpha Plc to Delta Plc equating the valuation are;
- Alpha Plc pay £12.00 per share outstanding i.e. 360 million shares of Delta Plc (Cash Offer);
- Alpha Plc issues Delta Plc Shareholders 0.80 shares of Alpha Plc per share of Delta Plc. Market value of each share of Alpha Plc is £15 (Stock Offer);
- Alpha Plc pay £6.00 per share outstanding i.e. 360 million shares of Delta Plc and 0.40 shares of Alpha Plc per share of Delta Plc. Market value of each share of Alpha Plc is £15 (Mixed Offer).
Motives behind acquisition of Delta Plc by Alpha Plc may be to achieve economies of scale, economy of scope, increase revenue or market share, cross selling, synergy, diluting market competition, reducing tax liability, achieve diversification or resource transfer.
It has been agreed by the Alpha Plc and Delta Plc that the merger will result in economies of scale with a Net Present Value (NPV) of £90,000,000.
In this report we have analyzed “Target shareholders’ gain – (the premium)”, “Acquirer’s gain” and “The post-merger values of the combined companies” in respect of offers proposed by acquirer company.
Formulas used in this report are;
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Target shareholders’ gain = (Pt - Vt)
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Acquirer’s gain = S - (Pt - Vt)
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The post-merger values of the combined companies = (Va) + (Vt) + (S) - (C)
Full form of these abbreviations for better understanding are as follows;
Pt = Price paid for the target company
Vt = pre-merger value of the target company
S = Synergy obtained
Va = pre-merger value of acquirer
C = cash paid to the target shareholders
Findings:
Financial market data on two companies gathered are;
Pre-merger stock price of Alpha Plc is £15 per share while incase of Delta Plc it is £10 per share. Number of shares outstanding in stock market for Alpha Plc and Delta Plc are 75 million shares and 30 million shares respectively. And pre-merger market value of Alpha Plc is £1125 million and £300 million for Delta Plc.
Assuming there are two companies (Alpha Plc and Delta Plc) in the industry then industry figures comes to
- Average stock price £12.50
- Number of shares outstanding 105 million
- Market value of shares outstanding £1425 million
Purchase consideration works out to be;
Cash Offer
£360 million cash paid.
(30 million shares of Delta Plc acquired at £12 per share)
Stock Offer
£360 million shares issued
(24 million shares of Alpha Plc ( 30 million x 0.80) whose stock price is £15 per share)
Mixed Offer
£180 million shares issued and £180 million cash paid
(30 million shares of Delta Plc acquired at £12 per share and 12 million shares of Alpha Plc ( 30 million x 0.40) whose stock price is £15 per share)
It is observed that purchase consideration in each case is £360 million either cash or stock or both. The financial advisor would try to hold liquid assets of the acquirer company as cash outflow may cause finance cost and issue of stock will cause processing fee to the company. Although quantum of cost in both cases of cash and stock are significantly different. Analysis of both costs under each offer are calculated as follows
If we assume that finance cost is 8% per annum then;
- Cash offer can cost extra £29 million (£360 x 8%)
- Stock offer do not incur additional cost
- Mixed offer can cost extra £14 million (£180 x 8%)
If we assume that processing cost is £0.50 per 1000 share certificates issued then;
- Cash offer do not incur additional cost
- Stock offer can cost extra £12,000 (30m/1000m x 80%) x £0.50
- Mixed offer can cost extra £6,000 (30m/1000m x 40%) x £0.50
It is assumed that Alpha Plc is confident that the merger will result in economies of scale with a Net Present Value (NPV) of £90 million, so finance manager may consider stock option.
Cash Offer
Target shareholders’ gain – (the premium) = (Pt - Vt)
price paid for the target company (Pt ) is £360 million and pre-merger value of target company(Vt) is £300 million
Premium under cash offer is (£360 - £300) = £60 million
Acquirer’s gain = S - (Pt - Vt)
Synergy obtained (S) is £90 million, price paid for the target company (Pt ) is £360 million and pre-merger value of target company(Vt) is £300 million
Acquirer’s gains under cash offer is £90 - (£360 - £300) = £30 million
The post-merger values on combined companies = (Va) + (Vt) + (S) - (C1)
pre-merger value of target company(Va) is £1125 million, pre-merger value of target company(Vt) is £300 million, Synergy obtained (S) is £90 million, Cash paid incase of cash offer (C1) is £360 million.
The post-merger values on combined companies under cash offer is
£1,125 + £300 + £90 - £360 = £1,155 million
Stock Offer
Target shareholders’ gain – (the premium) = (Pt - Vt)
price paid for the target company (Pt ) is £360 million and pre-merger value of target company(Vt) is £300 million
Premium under stock offer is (£360 - £300) = £60 million
Acquirer’s gain = S - (Pt - Vt)
Synergy obtained (S) is £90 million, price paid for the target company (Pt ) is £360 million and pre-merger value of target company(Vt) is £300 million
Acquirer’s gains under stock offer is £90 - (£360 - £300) = £30 million
The post-merger values on combined companies = (Va) + (Vt) + (S) - (C2)
pre-merger value of target company(Va) is £1125 million, pre-merger value of target company(Vt) is £300 million, Synergy obtained (S) is £90 million, Cash paid incase of stock offer (C2) is £0.
The post-merger values on combined companies under stock offer is
£1,125 + £300 + £90 - £0 = £1,515 million
Mixed Offer
Target shareholders’ gain – (the premium) = (Pt - Vt)
price paid for the target company (Pt ) is £360 million and pre-merger value of target company(Vt) is £300 million
Premium under mixed offer is (£360 - £300) = £60 million
Acquirer’s gain = S - (Pt - Vt)
Synergy obtained (S) is £90 million, price paid for the target company (Pt ) is £360 million and pre-merger value of target company(Vt) is £300 million
Acquirer’s gains under mixed offer is £90 - (£360 - £300) = £30 million
The post-merger values on combined companies = (Va) + (Vt) + (S) - (C3)
pre-merger value of target company(Va) is £1125 million, pre-merger value of target company(Vt) is £300 million, Synergy obtained (S) is £90 million, Cash paid incase of stock offer (C3) is £180.
The post-merger values on combined companies under mixed offer is
£1,125 + £300 + £90 - £180 = £1,335 million
- Total cost of acquisition
Total cost of acquisition includes purchase consideration , finance cost and processing fee. These are calculated below under each offer;
Offers Consideration Finance cost Processing Total cost
Cash: £360m £29m £0 £389,000,000
Stock: £360m £0m £12,000m £360,012,000
Mixed: £360m £14m £6,000m £374,006,000
Merger & Acquisitions (M&A) term explains the corporate strategy which determines the financial and long term effects of combination of two companies to create synergies or divide the existing company to gain competitive ground for independent units. A study published in the July/August 2008 issue of the Journal of Business Strategy suggests that mergers and acquisitions destroy leadership continuity in target companies’ top management teams for at least a decade following a deal. The study found that target companies lose 21 percent of their executives each year for at least 10 years following an acquisition – more than double the turnover experienced in non-merged firms. If the businesses of the acquired and acquiring companies overlap, then such turnover is to be expected; in other words, there can only be one CEO, CFO, et cetera at a time. http://en.wikipedia.org/wiki/Merger#Effects_on_management
Conclusion:
It is concluded that purchase consideration under each offer is as same as £360,000,000 but total cost of acquisition is different for cash offer, stock offer and mixed offer amounting to £389,000,000, £360,012,000 and £374,006,000 respectively suggesting stock offer is the cheapest offer for Alpha Plc while cash offer is the most beneficial offer for Delta Plc.
It is also concluded that the post merger values on combined companies only under Stock offer (£1,515 million) is greater that value of whole industry (£1,425 million) assuming that Alpha Plc and Delta Plc are the only companies in the industry.
Recommendation:
it is recommended that Alpha Plc should issue Delta Plc shareholders 0.80 shares of Alpha Plc per share of Delta Plc stock and save cash outflow which may cause additional finance cost ranging from £14 million to £29 million.
While Delta Plc should negotiate to receive £12.00 per share for the shares of Delta Plc from Alpha Plc to invite cash inflow.
List of References:
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(James Kristie, editor of Directors & Board) http://www.directorsandboards.com/BBFall06.pdf
- Economies of scale
(http://en.wikipedia.org/wiki/Economy_of_scale)
- Economies of scope
(http://en.wikipedia.org/wiki/Economy_of_scope)
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(Gary L. Schine, 2009) Author of book Strategic Acquisition: A Smarter Way to Grow a Small or Medium Size Company . www.strategic-acquisitions.com
- Effect on Management
http://en.wikipedia.org/wiki/Merger#Effects_on_management