1.2.

FINANCIAL GOALS AND STRATEGY

1.2.1. Financial Strategy
1.2.1.3. Components of Financial Strategy
1) Financial Planning: Financial planning means the determination of the
need of required funds, the period and the proportion of these funds for
the achievement of organizational objectives. The plan should be prepared
from long-term viewpoint so that necessary funds required for the
expansion programmes of the firm, and renewal of plant of plant and
machinery could be arranged and the available funds could be properly
used.
2) Financing Decision : Second important component of financial policy is
to collect funds from different sources for the fulfillment of business needs.
3) Investment Decision : Investment decisions are concerned with the
selection of assets in which the investment will be made by the company.
The assets acquired for business can be divided into two parts:
i)
ii)

Long- term or fixed assets which are used for earning over a
longer period,
Short-term or current assets which can be converted into cash
within an accounting period.

4) Dividend Policy Decision : Dividend Policy Decision is one of the main

areas of concern of financial policy. Income of the firm can be used in two
ways :
i)
To distribute it as dividend to the shareholders, and
ii)
To retain it in business in the form of accumulated profits.
5) Financial Control : Financial control is a main constituent of financial
policy. Financial control helps prevent deviations from the objectives. For
the purposes of financial control, budgetary control and cost control
methods are employed.
1.2.2 Financial Goals
1.2.2.1 Characteristics of Effective Financial Goals
3) Achievable :
4) Rewarding:
5) Time-Bounded:

1.2.2.2
Types of Financial Goals
1) Profit Maximization : Profit is the life- blood of business, without
which no business can survive in a competitive market. In fact profit-

2)

3)
4)
5)
6)
7)
8)

making is the primary objective for which a business unit is brought

into existence.
Sales Maximization : Sales maximization is an approach to business
where the companys primary objective is to generate as much
revenue as possible. Sales or revenue is the generation of cash flow
through the sale of goods and services.
Long-Run Survival : This is a long-term goal. Of course profitability is
required for survival. But it need not be maximum profits but
reasonable profits.
Market Leadership: Each business firm tries to become a leader in
the market. Efforts are made to maintain reputation, goodwill, and
dominance in market.
Market Share: Market share refers to share of a firms sales of a
particular product in the total sales made by all firms in the market.
The strength and success of a firm depends on market share.
Prevention of Potential Entry: A new entrant in an industry
represents a competitive threat to established firms (called as
incumbents).
Desire for Liquidity : The liquidity motive to be more important than
that of profit maximization. This refers to the desire of a firm to keep
adequate amount of cash so that it can avoid a liquidity crisis.
Building-Up Public Confidence for the Product : This is an
objective secondary to the goal of survival.

1.3. SHAREHOLEDR

VALUE CREATION (SVC)

1.3.1.Introduction
More than ever, corporate exectives are under increasing pressure to
demonstrate on a regular basis that are creating shareholder value. This
pressure has led to an emergence of a variety of measures that claim to quantify
value- creating performance.

1.3.2.Meaning of Shareholder Value Creation

The essence of investing is putting funds at risk with the hopes of receiving a
greater amount in return. If this is accomplished, it can be said that one has
created value.
Creating shareholder value is the key to success in todays marketplace. There is
increasing pressure on corporate executives to measure, manage and report the
creation of shareholder value on a regular basis. In the emerging field of
shareholder value analysis, various measures have been developed that claim to
quantify the creation of shareholder value and wealth.

1.3.3.Value Drivers

1) Investments: Investment is a fundamental direct shareholder value

variable. If an investment project earns more than its capital costs the
company creates shareholder value.
2) Flexibility : Flexibility of executives during life-time of an investment
project increases the probability to earn more than precaculated at the
beginning of the project, and so allow increment further shareholder value.
3) Human Resource Policy : An adequate human resource policy motivates
staff and helps to save costs (e.g., prevention of costly labor accidents).
An outstanding factor is a compensation system considered as a powerful
sub-variable.
4) Dividend Policy : Dividend payments as such do not alter a firms value.
However, dividend policy is a powerful instrumnent in managers hands to
communicate important news in an efficient way to investors,and thus
reduces monitoring costs.
5) Growth : Growth of turnover contributes to the creation of shareholder
value if and when additional projects earn more than their capital costs.
6) Merger and Alliance: A merger adds value only if the two companies
are worth more together than a part. Sometimes a merger does not fulfil this
stringent condition but an alliance may strengthen competitive advantages of
the implicated companies, or help cutting costs , e.g., through a common
research and development program.
7) Liquidity : Liquidity of shares may also be a major determinant ( as
important in fact as systematic risk or beta) on the level of expected stock
returns, Less liquid stocks earn proportionally higher rates of return (before
transaction costs) over long periods of thime thus representing a higher cost
of capital for corporate management.
8)Risk : Risk determines the value of project or the value of the total
enterprise as the sum of all projects if the time-structure of cash flows is
given. Therefore, risk is a highly important shareholder value variable.
9) Competitive Advantage : Microeconomics teaches that in competitive
markets high margins tend to be eliminated rapidly because innovative
processes, products, or services are imitated by other firms in a short time.
10) Costs: Costs in general are a very important variable. Every monetary
unit a company can save ceteris paribus contributes to the creation of
shareholder value.

1.3.8. Market Value Added (MVA)

Market Value Added, a measure created by Stem Stewart, is the difference
between total market valuewhat investors can take out of the company-and
the total capital invested.

1.3.8.1 Calculation of MVA

In short a MVA is the total of all capital that is held against the company
which also includes the market value of debt and equity. If the value is higher
then the shareholders are definitely profited. The value added should be
higher than the firms investors this could help investing in the market
portfolio.

MVA = Total Market Value Total Capital Supplied.

Example 1 :
Suppose, Supreme Industries has an equity market
capitalization of Rs.3,400 crore in current year. Assume further that its equity
share capital is Rs. 2,000 crore and its retained earnings are Rs.600 crore
Determine the MVA and interpret it.

Solution:
MVA = (Rs 3,400 crore Rs.2,600 crore) = Rs 800 crore.

The value of Rs. 800 crore implies that the management of Superme
Industries has created wealth/value to the extent of Rs.800 crore for its equity
shareholders.

Well-managed companies (engaged in sunrise businesses), having good

growth prospects, and perceived so by the investors, have positive
MVA.Investors may be willing to pay more than the net worth. In contrast,
companies relatively less known or engaged in businesses that do not hold
future growth potentials may have negative MVA.

1.3.8.2 Advantages of Market Value Added

1) By forecasting economic profit for each year it shows how much value will
be added to the capital employed each year.
2) It is the only method that can clearly connect capital budgeting and
strategic investment decisions with a methodology for subsequent
evaluation of actual performance.
3) By forecasting economic profit amounts it automatically produces a series
of targets for management to achieve in order to justify the valuation.
4) It can be readily communicated to and understood by operational
management.

1.3.9.Market to- Book Value Ratio (MBVR)

The market-to-book-financial ratio, also called the price to book ratio,
measures the market value of a company relative to its book or accounting
value. The market value of the company is its value at any point in time as
determined by the financial marketplace. The book value, or historical value,
is almost always lower than the market value since some assets may be offbalance sheet items.
1.3.9.1 Calculation of Market-to-Book Value Ratio
At its most simple, market/book ratio measures the market capitalization
(expressed as price per stock) of a business divided by its book value ( the
value of assets minus liabilities). The book value of a company refers to what
would be left if the business paid its liabilities and shut its doors, although, of
course, a growing business will always be worth more than its book value
because it has the ability to generate new sales.

To calculate market/book ratio, take the current price per stock and divide by
the book value per stock, i.e;

Market/Book Ratio =Market Price per Stock/Book Value per Stock

Or
Market to Book Ratio = Share Price of Stocks /Book Value per Stocks

For example, Company A might be trading at $2.20 per stock. However, the
book value per stock in actually $3.00. This results in a market/book ratio of
0.73, suggesting the companys assets may in fact be under-valued by 27%.

Market/Book Ratio = Market Price per Stock /Net Asset Value per Stock.

1.3.9.4. Advantages of Market-to-Book Value Ratios

Following are the advantages of Market-to-Book Value ratios:
1) It provides a relatively stable, intuitive measure of value which can be
compared to the market price.
2) Given reasonably consistent accounting standards across firms, marketbook value ratios can be compared across similar firms for signs of underor over-valuation.
3) Even firms with negative earnings, which cannot be valued using PE ratios,
can be evaluated using market-book value ratios.

1.3.10. Economic Value Added

Traditional approaches to measuring Shareholders Value Creation have used
parameters such as earnings capitalization, market capitalization and present
value of estimated future cash flows. Extensive equity research has now
established that it is not earnings perse, but value which is important. A new
measure called Economic Value Added(EVA) is increasingly being applied to
understand and evaluate financial performance.
1.3.10.2. Uses of EVA Method
EVA Can be used for the following purposes:
1)
2)
3)
4)
5)
6)
7)
8)

Setting Organization Goals

Performance Measurement
Determining Bonuses
Communication with Shareholders and Investors
Motivation of Managers
Capita Budgeting
Corporate Valuation
Analyzing Equity Securities.

1.2.10.3. Calculation of EVA

1) Step 1: Review the Companys Financial Data : EVA is based on the
financial data. Most of these data are available form the general purpose
financial statement consisting of at least income statement and balance sheet.
Sometimes additional data from the notes to financial statements may also be
required. In most of the cases, the last two years information prove sufficient
to get all the required information to calculate EVA for any specific year.
Income statement is used to calculate Net Operating Profit after Tax (NOPAT)
and balance sheet is used to identify the capital invested in the business.
Notes are used to find out the adjustments in NOPAT and Cost of Capital (COC)
invested.

2) Step 2: Identify the Necessary Adjustments Required to be

Considered : The conventional GAAP income statement and balance sheet
are required to be adjusted to find out net operating profit and the true capital.
Companies cannot replace GAAP earnings with EVA in their public reporting, of
course. The first departure from GAAP
Accounting is to recognize the full COC. EVA also fixes the problems with GAAP
by converting accounting earnings to economic earnings and accounting book
value to economic book value or capital. The result is a NOPAT figure that gives
a much truer picture of the economics of the business and a capital figure that
is far better measure of the funds contributed by shareholders and lenders.

4) Step 3: Determine the Companys COC Rate for the Individual

Sources of Capital in Capital Structure: Estimation of COC is a great
challenge so far as EVA calculation for a company is concerned. It
becomes more complex when small companies are considered whose
sources of capital are unstructured and varied over the years. The cost of
capital depends primarily on the use of the funds, not the source. It
depends on so many factors like financial structures, business risks,
current interest level, investors expectation, macro economic variables,
volatility of incomes and so on. It is the minimum acceptable rate of return
on new investment made by the firm from the viewpoint of creditors and
investors in the firms securities. Some financial management tools are
available in this case to calculate the COC. A more common and simple
method is Weighted Average Cost of Capital (WACC).
5) Step 4: Calculate the Companys NOPAT: NOPAT is derived from NOP
simply by deducting calculated taxes from NOP, i.e., NOPAT= NOP x (1- Tax
rate). These calculated taxes does not correspond the taxes actually paid
because, e.g., interest on debt decreases real taxes. The tax shield of debt
is however taken into account with the capital costs. NOPAT is a measure
of a companys cash generation capability from recurring business
activities, while disregarding its capital structure.
6) Step 5: Calculation of Economic Value Added: At last, the EVA can be
calculated by subtracting capital charges from NOPAT as follows:
EVA=NOPAT- Capital Charges
=NOPAT-C x COC
Where, C and COC include all types of capital proportionately.

Positive EVA indicates value creation while negative EVA indicates value
destruction for the companys owners.

2.1.

CAPITAL STRUCTURE

2.1.1 Meaning & Definitions of Capital Structure

Capital structure represents the relationship among different kinds of long
term capital. Normally, a firm raises long term capital through the issue of
shares-common shares, sometimes accompanied by preference shares.
The share capital is often supplemented by debenture capital and others
long-term borrowed capital.

According to James C. Van Horne, The mix of a firms permanent

long-term financing represented by debt, preferred stock, and common
stock equity.

According to Prasanna Chandra, The composition of a firm financing

consists of equity, preference, and debt.

According to Gerstenbeg, Capital structure of accompany refers to a

composition or make-up of its capitalization and it includes all long term
capital resources viz: loans, reserves , shares and bonds.
2.1.2 Features of Appropriate Capital Structure
1) Profitability: The capital structure of the company should be most
profitable., The most profitable capital structure is one that tends to
minimize cost of financing and maximize earning per equity share.
2) Solvency: The use of excessive debt threatens the solvency of the
company, In a high interest rate environment, Indian companies are
beginning to realize the advantage of low debt, Companies are now
launching public issues with the sole purpose of reducing debt.
3) Flexibility: The capital structure should be such that it can be easily
maneuvered to meet the requirements of changing conditions.
4) Conservatism: The capital structure should be conservative in the sense
that the debt content in the total capital structure does not exceed the limit
which the company can bear.
5) Control: The capital structure should be so devised that it involves minimum
risk of loss of control of the company.

2.1.3.

Components of Capital Structure

The long-term funds can broadly be divided into two categories, viz., owners
capital and borrowed capital as discussed below:
1. Owners Capital: Following items are included in owners capital:
i)

Equity Shares: Equity shares are fundamental and basic

source for financing the activities of a business. They own
the company and bear the ultimate risk associated with
ownership. Among all the sources of finance, cost of equity
capital is considered to be the highest, as its holders bear
the maximum risk of the business.

ii)

Preference Shares: Those shares which carry following

preferential rights are termed as preference shares:
a) A preferential right as to the payment of dividend during
the lifetime of a company.
b) A preferential right as to the return of capital when the
company is wound-up.

iii)

2)

Retained Earnings: Retained earnings or Ploughing back

of profits are considered to be the best source of internal
financing. This type of financing is considered to be most
convenient as no efforts are required to raise such finance.

Borrowed Capital: Borrowed capital comprises the following:

i).Debentures: A debenture is an acknowledgement of debt or loan raised by a

company. Company has to pay interest to debenture holders at an agreed rate
under contractual obligation.
ii).Term Loans: Term loans are loans provided by banks and other financial
institutions which carry a fixed rate of interest for a period of three or more
years.
2.1.4.Financial Options and Value of the Firm
There are two basic ways for a company to raise capital:
1. Equity Financing: Through equity financing, equity investors get
ownership in the company but do not have a guaranteed return.
Issuing stock is the most obvious way to raise funds using equity.
Retained earnings (when the company uses its own earning to
finance projects) are also an equity investment. With retained
earnings, the company takes money that could have been returned
to shareholders and uses it to fund capital projects. Effectively, it is
using the shareholders money to fund these projects, increasing the
value of their equity holdings. Because of this, both retained
earnings and newly-issued shares are used as examples of equity
financing.
Advantages of Equity Financing
i)Capital Profit: In the case of progress and profit to the company the market
value of the share increases, In this case the shareholders can sell the shares at
higher prices to get the capital gains.
ii)Interest in the Companys Activities: Equity shareholders are the owners
of the company. They take a lot of interest in the companys affairs.
iii)Best for Investment: The person who enjoys to take risks for them
investment in equity share is good investment.
iv)More Income: Dividend in the case equity shares is not fixed. It depends on
the profits generated by the company. If the company is progressive then it can
be a good source of income to investors.
v)Right to Interfere in Management: Equity shareholders have the right to
participate in management. They can take part in the general meetings with
voting rights. They elect the board of directors.

vi)No-Fixed Burden of Dividend: The dividend on equity shares is not fixed. It

depends on the profits generated. Dividends are not the burden as in the case of
fixed preference share.
Disadvantages of Equity Financing
i)Uncertainty of Income: It is not obligatory on the part of the management to
pay dividend even in the case of huge profits, management can retain all of its
earnings for companys expansion or diversification.
ii)Irregular Income: Payment of the dividend is dependent at the profits of the
company. Many times when these are merge profits the dividends are very less.
iii)Capital Loss: At the time of reduction of share prices it is not in the favor of
investors to sell the shares. If one shareholder has the urgency to sell his shares
then he has to incur capital loss.
iv)Less Attractive to Modest Investors: Those investors who want regular
and consistent income on their investment, the investment in equity shares is
not very attractive.

Debt Financing: Debt financing is borrowing; investors get a promise of

fixed future payments, but do not have any ownership. Borrowing can be done
through a financial intermediary, such as a bank, or directly by issuing bonds.
Advantages of Debt Financing
i)Lower Rate of Interest: The rate of interest payable on debentures is not
only fixed but is also usually lower than the rate of dividend paid on shares.
ii) Trading on Equity: By issuing debentures, company is enabled to trade on
equity as because the rate of interest on debentures is usually lower than the
rate of earnings and thus the company can declare a higher rate of dividend on
equity shares.
iii) Freedom in Management: Debenture holders are not given any voting
right to control the affairs of the company and thus the company can raise the
finance without surrendering control to the debenture holders.
iv) Tax-benefits: The payment of interest on debentures is charged against
profits of the company as per income tax rules whereas the payment of dividend
is an appropriation of profit hence not a charge against profits.
v) Certainty of Finance: Debentures are
According to the new guidelines issued by the
secured debentures shall not be redeemable
Hence there is a certainty of finance for that
may adjust its financial plans accordingly.

issued for a fairly long period.

Government of India in 1982, the
before a period of seven years.
specific period and the company

vi) Fixed and Stable Income: Debentures carry a fixed rate of interest. An
Investor can estimate his income well in advance.
vii) Safety Investment: Debenture holders have specific or general charge on
the assets of the company, so their investment is quite safe.
Disadvantages of Debt Financing
i)

ii)

iii)

iv)

v)

vi)

Fixed Charge on Assets: Debentures carry a fixed charge on all

assets of the company hence the company cannot raise loan on such
assets again, if needed.
Fixed Burden: Interest payable on debentures is a charge on the
profits of the company. It will be paid even if there is no profit. Thus, it
is a burden on the company especially when there is no a profits or
inadequate profits.
Risk of Winding up: The debenture holders have a right to claim
winding up of the company, in case, the interest on debentures are and
paid by the company. So, debenture issue is risky in lean period.
No Control : Debenture holders are creditors and not the owners of
company and hence get no controlling authority over the affairs of the
company.
No Extra Profits: Debentures holders get a fixed income as interest
irrespective of the quantum of profits earned by the company. They
cannot share the profits even if company earns huge amount as profits.
Uncertainty: In case of redeemable debentures payable within a
specified period, investors have uncertainty in their minds as to their
redemption.

Capital Structure is the major part of the firms financial decision which affects
the value of the firm and it leads to change EBIT and market value of the
Shares.

Different Types of Capital Structure Policy

1) Weighting
Capital Policy: Many financial managers use weighted
average calculations as part of the businesss capital structure policy
because it factors in the cost of raising each type of capital.
2) Financial Leverage Variability policy: The degree of financial leverage
given to each source helps quantify the variability of the financial weight
of debt financing. A company using a leverage capital structure policy
figures that the amount of debt affects other aspects of the capital
structure, including stock prices.
3) Sinking Funds Policy: Businesses using bonds as a source of money
include a sinking fund as part of the capital structure policy. A sinking
fund is a cash reserve set aside for bonds that bondholders choose to cash
in before the bonds have fully matured.
Factors Considered for Capital Structure planning and policy

1) Financial Leverage:
2) Operating Leverage: This is the first-stage leverage that depends on the
operating fixed costs of the firm. if a higher percentage of a firm`s total costs are
fixed operating costs, the firm is said to have a higher degree of operating
leverage. It measures the operating risk of a firm. Operating risk is the variability
of operating profit or EBIT.
3) EBIT-EPS Analysis: This is another important tool for examining the effect of
leverage by analysing the relationship between EBIT and EPS. The firm will
measure the effect on EPS at varying levels of EBIT under alternative financing
plans.
4) Cash flow Analysis: while considering the appropriate capital structure, it is
extremely important to analyse the solvency position, which is determined by
the cash flow ability of the firm to meet its fixed charges.
5) Flexibility: In this context, flexibility implies the firm`s capacity to adapt its
capital structure to the changing needs. Normally, debt capital is more flexible
than the equity source because it can be redeemed when the conditions are
favourable.
6) Control: Ordinary or equity shareholders have voting rights. They are the
owners of the firm and can exercise control over its overall affairs. Preference
shareholder do not have the voting right except under special circumstances.
7) Industry Standard: While planning the capital structure, the firm has to
evaluate the capital structures of other firms belonging to the same risk class, on
the one hand, and that of the industry as a whole, on the other hand. If the firm
adopts a capital structure significantly out of line with that of similar units in the
same industry.
8) Cost of Capital: Cost is an important consideration in capital structure
decision. It is obvious that a business should be at least capable of earning
enough revenue to meet its cost of capital and finance its growth.
Leverage :
Meaning and Definitions of Leverage: Leverage means use of assets and
sources of funds having fixed costs in order to increase the potential returns to
shareholders. The term leverage, in general, refers to the relationship between
two interrelated variables. In financial matters, one financial variable influences
another variable. Those financial variables may be cost, sales revenue, earnings
before interest and tax (EBIT), output, earnings per share, etc. In the leverage
analysis, the emphasis is on the measurement of the relationship of the two
variables, rather than on measuring the variables.

Leverage = % Change in dependent variable

% Change in independent variable

According to Ezra Soloman, Leverage is the ratio of the net rate of return on
shareholders equity and the net rate of return on total capitalization.
According to J.E.Walter, Leverage may be defined as percentage return on
equity to percentage return on capitalization.
According to James C. Van Horne, Leverage may be defined as the
employment of an asset of funds for which the firm pays cost or fixed return. The
fixed cost or return may be thought of as the fulcrum of Lever.

Meaning and Definition of Dividend

The term dividend refers to that part of profits of a company which is distributed
by the company among its shareholders after execution of retained earning. It is
the reward of the shareholders for investments made by them in the shares for
the company.
Major Forms of Dividend/Types of Dividend
Dividends can be classified in various forms. Dividends paid in the ordinary
course of business are known as Profit dividends, while dividends paid out of
capital are known as Liquidation dividends. Dividends may also be classified
on the basis of medium in which they are paid:

Divide
nd
I
On the Basis of
the Basis of

On the Basis of

Types of Shares
Payment

Mode of Payment

Equity
Dividend

Preference
Dividend

On
Time

of

Preference Dividend: Preference dividend is the dividend paid to preference

shareholders. The preference dividend is paid at pre-determined rate and like
equity shares, dividend on preference shares is also recommended by the Board
of Directors.
On the Basis of Modes of Payment:
1) Cash Dividend: A cash dividend is a usual method of paying dividends.
Payment of dividend in cash results in outflow of funds and reduces the
companys net worth, though the
shareholders get an opportunity to
invest the cash in any manner they desire.
2) Stock Dividend / Bonus Share: Stock Dividend means the issue of
bonus shares to the existing shareholders. If a company does not have
liquid resources it is better to declare stock dividend.
3) Scrip or Bond Dividend:
A scrip dividend promise to pay the
shareholders at a future specific date. In case a company does not have
sufficient funds to pay dividends in cash, it may issue notes or bonds for
amounts due to the shareholders.
4) Property Dividend: Property dividends are paid in the form of some
assets other than cash. They are distributed under exceptional
circumstances and are not popular in India.
5) Composite Dividend: When dividend is paid partly in the form of cash
and partly in other form, it is called as composite dividend.

On the Basis of Time of Payment:

i)

Interm Dividend: Generally dividend is declared at the end of

financial year, but some time company pays dividend before it declares
dividend in its annual general meeting. In other words, we can say that
it is dividend paid between two annual general meetings.
Regular Dividend: Dividend declared in Annual General Meeting is
called as Regular dividend. Every year company declares dividend in its
Annual General Meeting.
Special Dividend: A sound dividend policy should be formed in such a
way that rate of dividend should not be changed frequently year to
year. Rate of dividend should be static.

ii)

iii)

Factors Affecting the Dividend Policy:

1)
2)
3)
4)
5)
6)
7)
8)

Legal Restrictions.
Magnitude and Trend of Earnings.
Desire and Type of Shareholders.
Nature of Industry.
Age of the Company.
Future Financial Requirements.
Taxation Policy.
Policy of Control.

9) Stage of Business Cycle.

10)
Cost of Capital.
11)
Regularity.
12)
Requirements of Institutional Investors.
13)
Liquid Resources.
Types of Dividend Policy: The different types of dividend policy are as follows:
1) Regular Dividend Policy: Payment of dividend at the usual rate is
termed as regular dividend. The investors such as retired persons, widows
and other economically weaker person prefer to get regular dividends.
2) Stable Dividend Policy: The term stability of dividends means
consistency or lack of variability in the stream of dividend payments. In
more precise terms, it means payment of certain minimum amount of
dividend regularly. A stable dividend policy may be established in any of
the following three forms:
i)
Constant Dividend per Share: Some companies follow a policy of
paying fixed dividend per share irrespective of the level of earnings
year after year. Such firms, usually, create a Reserve for Dividend
Equalization to enable them pay the fixed dividend even in the year
when the earnings are not sufficient or when there are losses. A policy
of constant dividend per share is most suitable to concerns whose
earnings are expected to remain stable over a number of years.
ii)
Constant Pay Out Ratio: Constant pay-out ratio means payment of a
fixed percentage of net earnings as dividends every year. The amount
of dividend in such a policy fluctuates in direct proportion to the
earnings of the company. The policy of constant pay-out is preferred by
the firms because it is related to their ability to pay dividends.
iii)
Stable Rupee Dividend plus Extra Dividend: Some companies
follow a policy of paying constant low dividend per share plus an extra
dividend in the years of high profits. Such a policy is most suitable to
the firm having fluctuating earnings from year to year.
3) Irregular Dividend Policy: Some companies follow irregular dividend
payments on account of the following:
i)
Uncertainty of earnings
ii)
Unsuccessful business operations
iii)
Lack of liquid resources
iv)
Fear of adverse effects of regular dividends on the financial
standing of the company.
4) No Dividend Policy: A company may follow a policy of paying no
dividends presently because of its unfavorable working capital position or
on account of requirements of funds for future expansion and growth.
Types of Risks:
1) Systematic Risks: Systematic risk is non-diversifiable and is associated
with the securities market as well as economic, sociological, political and
legal considerations of the prices of all securities in the economy. The
effect of these factors is to put pressure on all securities in such a way
that the prices of all stocks will move in the same direction.

i)

Market Risk: Market risk is that portion of total variability of return

caused by the alternating forces of bull and bear markets. When the
security index moves upward haltingly for a significant period of time,
it is known as bull market.
ii)
Interest Rate Risk: Interest rate risk is the variation in the single
period rates of return caused by the fluctuations in the market interest
rate. Most commonly interest rate risk affects the price of bonds,
debentures and stocks.
iii)
Purchasing Power Risk: Variations in the returns are caused also by
the loss of purchasing power of currency.
2) Unsystematic Risks: Unsystematic risks stem from a managerial
inefficiency, technological change in the production process, availability of
raw material, changes in the consumer preference, and labour problems.
a) Internal Business Risk:
Fluctuations in the sales.
Research and Development.
Personal Management.
Fixed Cost.
Single Product.
b) External Risk:
Social and Regulatory Factors.
Political Risk.
Business Cycle.
ii) Financial Risk: It refers to the variability of the income to the equity capital
due to the debt capital. Financial risk in a company is associated with the capital
structure of the company.
Risk Adjusted Net Present Value:
Risk adjusted net present value is little different from normal net present value.
In normal net present value, just normal cut-off rate for calculating present value
of cash inflows and present value of cash outflow is used. But for calculating risk
adjusted Net Present Value (eNPV), risk adjusted return on investment as cut-off
rate is used. This risk adjusted return on investment is more than normal cut-off
rate because this includes some margin for unexpected risk. This excess will be
of risk premium rate. To calculate eNPV is very useful to evaluate risky assets
alternatives. This is also called expected net present value.
Steps in Decision Tree Process:
1) Investment Proposal: The investment proposal should be defined
clearly in the first stage. The proposal may be initiated by any department
of the organization, i.e., it may be marketing production, finance or any
other department, the proposal may be to enter a new market, to produce
a new product, to introduce a new technology and so on.
2) Various Decision Alternatives should be Identified: For example, if
the company is thinking of entering a new market, it may decide to sell
the same product in the new market, introduce a new product for the new

market or introduce the same product with variations in the new market.
Each alternative will have different consequences.
3) Decision Tree should be Graphed: The decision tree should be graphed
indicating various decision points, chance events and other data.
4) Relevant Data should be Presented: Relevant data should be
presented on the decision tree branches such as the projected cash flow,
probability distribution, expected present value, etc.
5) Analyze The Result: The result should be analyzed and the best
alternative should be selected.
Capital Rationing:
Capital rationing situations arise when a firm operates within a fixed budget. A
firm can not accept all projects which are expected to increase its present value.
The constraints which lead to a decision to hold capital expenditures to a fixed
sum may arise due to market conditions or may be entirely self imposed.
Capital rationing refers to a situation where the firm is constrained for external,
or self imposed, reasons to obtain necessary funds to invest in all profitable
investment projects. Under capital rationing, therefore, the management has
not simply to determine the profitable investment opportunities, but ranked
them according to their relative profitabilitys. With limited funds, the firm must
obtain the optimum combination of investment proposals.

Types of Capital Rationing:

1) Hard Capital Rationing: Hard rationing refers to the existence of real
constraints, often tied to serious consideration such as sound financial
judgment or legal concerns.
2) Soft Capital Rationing: Soft rationing to the practice of placing limits on
the amount of funds available for the execution of projects, based on the
judgment of senior managers. Typically, the practice of soft rationing also
includes a placement of limits at the divisional or departmental level,
commonly referred to as capital budget allocation. A companys
management may be motivated to limit capital spending for a variety of
reasons.
Reasons for Capital Rationing:
1) External Reasons: External Capital Rationing mainly occurs due to the
imperfections of the capital markets. Imperfections may be caused by
deficiencies in market informations, by rigidities that hamper the free flow
of capital between firms, and by a difference between the interest at
which the firm can obtain capital in the market (i.e., the borrowing rate)
and the interest rate it could earn by lending its own capital to others in
the market (i.e., the lending rate).
2) Internal Reasons:

i)

ii)

iii)
iv)
v)

Private Owned Company: Owners might decide that expansion is a

trouble not worth taking. For example, there may that management
fear to lose their control in the company.
Divisional Constraints: Upper management allocates a fixed amount
for each division as part of the overall corporate strategy. This arises
from a point of view of a department, cost centre or wholly owned
subsidiary, the budgetary constraints determined by senior
management or head office.
Human Resource Limitations: Company does not have enough
middle management to manage the new expansions.
Dilution: For example, there may be a reluctance to issue further
equity by management fearful of losing control of the company.
Debt Constraints: Earlier debt issues might prohibit the increase in
the firms debt beyond a certain level, as stipulated in previous debt
contracts. For example, bondholders requiring in the bond contract,
that they would accept a maximum Debt-to-Asset ratio = 40%.

Types of Mergers: following are the types of mergers :

Types of Merger
Horizontal Merger
Conglomerate Merger

Vertical Merger
Congeneric Merger

Reverse Merger

1) Horizontal Merger: When two or more concerns dealing in same product

or service join together, it is known as a horizontal merger. The idea
behind this type of merger is to avoid competition between the units. For
example, two manufacturers of same type of cloth, two book sellers and
two transport companies operating on the same route - the merger in all
these cases will be horizontal merger.
2) Vertical Merger: Vertical merger occurs when a firm acquires firms
upstream from it and / or firms downstream from it. In the case of an
upstream merger, it extends to the firms supplying raw materials and to
those firms that sell eventually to the consumer in the event of a
downstream merger. For example, merger of Reliance Petroleum Ltd.
with Reliance Industries Ltd.
3) Conglomerate Merger: When two concerns dealing in totally different
activities join hands it will be a case of conglomerate merger. The merging
concerns are neither horizontally nor vertically related to each other. For
example, L & T and Voltas Ltd are examples of such mergers and
manufacturing company may merge with an insurance company.
Types of Conglomerate Mergers:

i) Product Extension Merger: A product extension merger occurs when

firms merge who sell non-competing products but use related
marketing channels or production process.
ii) Market Extension Merger: A market extension merger is the joining
of two firms selling the same product but in separate geographic
markets, and
iii) Pure Merger: There is the pure category of conglomerate mergers
between firms with no relationship between them.
4) Congeneric Merger: It occurs where two merging firms are in the same
general industry, but they have no mutual buyer/customer or supplier
relationship, such as a merger between a bank and a leasing company.
For example, Prudentials acquisition of Bache & Company.
5) Reverse Merger: A unique type of merger called a reverse merger is
used as a way of going public without the expense and time required by
an IPO. In case of an ordinary merger, a profit making company takes over
another company which may or may not be making a profit. The objective
is to expand or diversify the business. However, in case of a reverse
merger, a healthy company merges into a financially weak company and
the former company is dissolved. The basic philosophy of reverse merger
is to take advantage of the provisions of Income Tax Act, 1961 which
permits a company to carry forward its losses to set off against its future
profits.
Theories of Mergers:
1) Efficiency Theories.
i)
Differential Managerial Efficiency: The most general theory of
mergers that can be formulated involves differential efficiency. In
everyday language, if the management of firm A is more efficient
than the management of firm B and if after firm A acquires firm B,
the efficiency of firm B is brought upto the level of efficiency of firm
A, efficiency is increased by merger. Note that this would be a social
gain as well as a private gain.

Theories of Mergers
Efficiency
Theories
Distribution

Information Agency Problems Free Cash

Reand Signaling
and Managerialism flow
Hypothesis

1) Differential Managerial 1) Agency Problem

Efficiency/Managerial Synergy. 2) Managerialism
2) Inefficient management
3) Hubris Hypothesis.
3) Pure Diversification
4) Operating Synergy
5) Financial Synergy
6) Strategic Re-Alignment

Market

Tax

power

Consi

duration

7) Undervaluation
ii)

Inefficient Management: The inefficient-management theory may

be difficult to distinguish from the differential efficiency theory
previously discussed or the following agency problem theory. In one
sense, inefficient management is simply not performing upto its
potential.
iii)
Pure Diversification: Diversification refers to a strategy of buying
firms outside of a companys current primary lines of business.
There are two commonly used justifications for diversification. The
first relates to the creation of financial synergy, resulting in a
reduced cost of capital. The second common argument for
diversification is for firms to shift from their core product-lines or
markets into product-lines or markets that have higher growth
prospects. Such diversification can be either related or unrelated to
the firms current products or markets.
iv)
Operating Synergy/Business Synergy: Operating synergy
consists of both economies of scale and economies of scope. Gains
in efficiency can come from either factor and from improved
managerial practices. Such synergies are important determinants of
shareholder wealth of acquisition.
v)
Financial Synergy: (Lowering the Cost of Capital): Financial
synergy refers to the impact of mergers and acquisitions on the cost
of capital (i.e., the minimum return required by investors and
lenders) of the acquiring firm or the newly formed firm, resulting
from the merger or acquisition.
vi)
Strategic Re-Alignment to Changing Environments: The
strategic re-alignment theory suggests that firms use M&As as ways
of rapidly adjusting to changes in their external environments.
vii) Undervaluation: Some studies attribute merger motives to the
undervaluation of target companies. One cause of undervaluation
may be that management is not operating the company upto its
potential. This is then an aspect of the inefficient management
theory. A second possibility is that the acquirers have inside
information.
2) Information and Signaling: It has been suggested in the literature
that the shares of the target firm in a tender offer experience upward
revaluation even if the offer turns-out to be unsuccessful.
Two forms of this information hypothesis can be distinguished. One is
that the tender offer disseminates information that the target shares
are undervalued and the offer prompts the market to revalue those
shares.
3) Agency Problems and Managerialism:
i)
Agency Problems: It arises basically because contracts
between managers (decision or control agents) and owners (risk

bearers) cannot be costlessly written and enforced. Resulting

(agency) costs include.
ii)
Managerialism:
The
managerialism
explanation
for
conglomerate mergers was set forth most fully by Mueller.
Muller hypothesizes that managers are motivated to increase
the size of their firms. He assumes that the compensation to
managers is a function of the size of the firm, and he argues,
therefore, that managers adopt a lower investment hurdle rate.
But in a study critical of earlier evidence, Lewellen and
Huntsman present findings that managers compensation is
significantly correlated with the firms profit rate, not its level of
sales.
iii)
Hubris Hypothesis: When bidding takes place for a valuable
object with an uncertain value, the winning bid is likely to
represent a positive valuation error. This result is likely to hold
even though the valuable object is worth the same amount to all
bidders (a common value auction) and the estimates of value
are unbiased, so the mean of the estimates is equal to the
common value of the valuable object.
4) Free Cashflow Hypothesis (FCFH): The pay-out of free cashflow can
serve an important role in dealing with the conflict between managers
and shareholders. Free cashflow as cashflow in excess of the amounts
required to fund all projects that have positive net present values when
discounted at the applicable cost of capital. Such free cash flow must
be paid-out to shareholders if the firm is to be efficient and to
maximize share price. The pay-out of Free Cash flow (FCF) reduces the
amount of resources under the control of managers and thereby
reduces their power.
5) Market Power: The market power theory suggests that firms merge to
improve their monopoly power to set product prices at levels not
sustainable in a more competitive market. There is very little empirical
support for this theory. Many recent studies conclude that increased
merger activity is much more likely to contribute to improved operating
efficiency of the combined firms than to increased market power.
6) Re-Distribution: Tax saving is a form of re-distribution from the tax
collector to the firm that achieves tax benefits.
Merger Procedure:
In order to avoid the above pitfalls, and to make the merger activity successful,
firms should follow a systematic action plan for their merger activities. The
following steps involved in merger:
1) Defining the Corporate Strategy: A firm needs to first clearly define its
corporate strategy - what business the firm is currently in? What business
it intends to be in? How does it wish to grow, and be known as?
2) Implementing the Corporate Strategy: Next, the firm should define a
route or roadmap to implement its corporate strategy - whether it intends
to use mergers or joint ventures/strategic alliances, or internal

development as a strategy for its growth/diversification plans. This stage

clearly entails a detailed evaluation of the various alternatives available
with the firm in terms of M&A vis--vis internal development.
3) Target Identification: If the firm finds it attractive to pursue the M&A
route, sufficient effort should be devoted to identification of the right kind
of a target firm to merge/acquire. The parameters for identification should
include the financial considerations, business strengths and weaknesses,
the specific resources, competencies and capabilities the target firm will
bring in to the merger, market power the merger would bring about, as
well as the effort required in integrating the two firms - their structures,
strategies, culture, and processes.
4) Valuation of the Merger: Then, a financial valuation of the merger
should begin. The specific cost and the premium that the firm would like
to pay for acquiring shares/management control of the target firm would
again depend on the projected synergies that the merger is likely to bring
about.
5) Merger Implementation: The tax, regulatory, and market issues
dominate the next stage of the merger process - the merger
implementation. In this stage, when the merger is being implemented,
depending on the local laws, conditions, and shareholder preferences, the
merger could happen through a stock swap, a tender offer, a cash offer, or
any other method. Issues like registration of the merger, obtaining board
and shareholder approvals, announcement to the public, and notifying the
stock exchanges are activities that form part of this stage of the merger
activity.
6)
7)
8)
9) Defining
the
Corporate
Strategy
10)
Imple
menting
the
Corporate
Strategy
11)
Targe
t
Identificatio
n
12)
Valua
tion of the
Merger
13)
Merge
r
Implementa

tion
14)
Post Merger
Integration
15)
16)

17)
Post - Merger Integration: The final stage called the post-merger
integration includes activities like asset stripping (selling off those assets
in the target company that are not likely to add value to the
merged/acquired firm); efforts at improving the operating efficiency and
setting up managerial systems at the acquired firm; efforts at streamlining
the operations of the combined firm to ensure that the projected synergies
are reaped; and initiatives in establishing the right kind of corporate
culture, providing the right management direction/leadership, and
ensuring the competitiveness of the combined firms.
18)
Concepts of Value:
19)
1) Fair Market Value: Fair market value is the price at which the property
would change hands between a willing buyer and a willing seller, where
both are not under any compulsion to buy and sell and they have
reasonable knowledge of relevant facts and information. This means that
representative price would not work if it affects buyers or sellers unique
motivations.
2) Fair Value: Fair value is sometimes construed as fair market value
without discounts. The meaning of fair value may depend upon the
context and the purpose of valuation. In business valuation, the term
value applies to certain specific transactions relating to mergers,
acquisitions, takeovers, sell-offs, spin-offs, and issue of shares.
3) Book Value: Book value is the historical value, synonymous to
shareholders equity, net worth, and net book value. It is the difference
between total assets and the total liabilities appearing in the balance
sheet a company on a particular date.
4) Intrinsic Value: Intrinsic value is the fundamental value which is
estimated for a security such as stocks, based on all facts and
circumstances of the business or investment. Intrinsic value of a security
IS determined based on earning power and earning quality. The earning
power of the investment is measured in terms of the underlying entitys
capability to constantly increase the rate of return with plausible
assumptions including internal resources, external economic data, and
benchmarks.
5) Replacement Value: Replacement value is the current cost of acquiring
a similar new property which is likely to produce the nearest equivalent
utility to the property being valued. An estimate of replace cost takes into
account how an asset would be replaced with newer materials and current
technology.
6) Liquidation Value: Liquidation value is the net amount that can be
realized if the business is terminated and the assets are sold piece-meal.
There are two types of liquidation value - orderly liquidation and forced
liquidation. When assets are sold over a reasonable period of time to
maximize proceeds received it is called orderly liquidation. Forced
liquidation value arises when assets sold as quickly as possible.
Sometimes, some companies are worth more when dead than alive (like
Michael Jackson).

7) Going Concern Value: Going concern value is the value of a business

that is expected to continue to the future. It takes into account various
intangible assets of the organization.
8) Equity Interest Value: Equity interest of an investor in a business can be
considered as an investment. The purchase of an equity interest in a
closely held company can be considered as a long-term investment and in
a listed company.
20)
21)
22)
Return on equity investment = Cashflow (dividend) +
(closing market price-opening market price)
23)
Opening
market
price
9) Insurable Value: Insurable value is the value of destructible portion of an
asset that requires to be insured to indemnify the owner in the event of
loss. This type of value has significant relevance, sometime in M&A
decisions as insurance reduces the risk of the property. Of course, postacquisition review of insurance coverage of property can be done with
little impact on the valuation.
10)
Value-in-Use and Value-in-Exchange: Value-in-use or value-inexchange is a condition under which certain assumptions are made in
valuing assets. It is associated with assets that are already in productive
use and can be described as the value of an asset, for a particular use or
to a particular user, as part of a going concern.
11)
Goodwill Value: Goodwill is a specific type of intangible asset that
arises when a business as a whole has value greater than the value of its
identified intangible assets. Goodwill is also the sum total of imponderable
qualities of a company which attract the customers to a business and it
makes the stakeholders of the company give continued patronage.
12)
Salvage Value: Salvage value is the amount that can be realized
upon sale or disposal of an asset after it is found no longer useful to the
current owner and is to be taken out of service.
24)
25)

26)

Merger and Dilution Effect on Earnings per Share:

27)
28)
When a merger takes place, there may be a favourable or
unfavourable effect on net income and market price per share of stock.
29)
Dilution means a reduction in earnings per share of common stock
that occurs through the issuance of additional shares or the conversion of
convertible securities. The dilution effect refers to the possible decrease in
earnings per share from any action that might lead to an increase in the
number of shares outstanding. As evidenced in surveys, managers,
especially in the United States, weigh these potential dilution effects
heavily in decisions on what type of financing to use, and how to fund
projects. For example, consider the choice between raising equity using
a rights issue, where the stock is issued at a price below the current

market price, and a public issue of stock at the market price. The latter is
a much more expensive option, from the perspective of investment
banking fees and other costs, but is chosen, nevertheless, because it
results in fewer shares being issued (to raise the same amount of funds).
The fear of dilution is misplaced for the following reasons:
1) Investors measure their returns in terms of total return and not just in
terms of stock price. While the stock price will go down more after a rights
issue, each investor will be compensated adequately for the price drop (by
either receiving more shares or by being able to sell their rights to other
investors). In fact, if the transactions costs are considered, stockholders
will be better-off after a rights issue than after an equivalent public issue
of stock.
2) While the earnings per share will always drop in the immediate aftermath
of a new stock issue, the stock price will not necessarily follow suit. In
particular, if the stock issue is used to finance a good project (i.e., a
project with a positive net present value), the increase in value should be
greater than the increase in the number of shares, leading to a higher
stock price.
30)
31)
Ultimately, the measure of weather a company should issue stock to
finance a project should depend upon the quality of the investment. Firms
that dilute their stockholdings to take good investments are choosing the
right course for their stockholders.
32)
33)
Many corporations have a more complex capital structure. Their
capital structure includes securities such as share options and warrants,
convertible preferred stock and convertible bonds, participating securities
and two-class stocks, and contingent shares. These securities are referred
to as potential common shares because they can be used by the holder to
acquire common stock. Since conversion of these securities into common
stock would affect the earnings available to each common stockholder,
they are considered in computing a corporations earnings per share.
34)
35)
Instead of single earnings per share disclosure, a corporation with a
complex capital structure is required to report two earnings per share
amounts on the face of its income statement. The two amounts are basic
earnings per share and diluted earnings per share. Diluted earnings per
share shows the earnings per share after including all potential common
shares that would reduce earnings per share. If a corporation has a loss
from continuing operations then it does not include potential common
shares in diluted earnings per share (even if it reports a positive net
income). In this case, the corporations basic and diluted earnings per
share are the same.
36)
37)
When a corporation with a complex capital structure computes
diluted earnings per share, it must consider the impact of potential
common shares. It considers these in addition to the weighted average

common shares calculation, stock dividends and stock split assumptions,

and earnings presentations.
38)
39)
To be included in the diluted earnings per share calculation, any
potential common share must have a dilutive effect on (i.e., decrease)
earnings per share. Thus, a corporation may include a potential common
share in the diluted earnings per share computation in one accounting
period and not in another.
40)
41)
To evaluate the dilutive effect of each security, a corporation must
include potential common shares in the Diluted Earnings Per Share (DEPS)
calculations in a certain order.
42)
43)
Therefore, the steps for computing DEPS are follows:
44)
45)
Step 1: Compute the basic earnings per share.
46)
47)
Step2: Include dilutive share options and warrants and compute a
tentative DEPS.
48)
49)
Step3: Develop a ranking of the impact of each convertible
preferred stock and convertible bond on DEPS.
50)
51)
Step4: Include each dilutive convertible security in DEPS in a
sequential order based on the ranking and compute a new tentative DEPS.
52)
53)
The effect of merger and dilution on earnings per share can be
explained as follows:
54)
55)
56)
For Example, The following data are presented:
57)
59)
60)
Com
Com
pa
pa
ny
ny
58)
X
Y
62)
63)
61)
Net
30,00
54,00
Income
0
0
64)
Shar
es
Outstandin
65)
66)
g
4,000
9,000
67)
Earni
ngs
per
68)
69)
Share
7.50
6.00
70)
P/E
71)
72)
Ratio
10
13

73)
Mark
74)
75)
et Price
575
75
76)
77)
Company Y is the acquiring company and will exchange its shares
for company Xs shares on a one-for-one basis. The exchange ratio is
based on the market prices of X and Y. The impact on EPS follows:
78)
81)
80)
EPS
82)
E
Y
Pri
PS
Shares
or
Subse
Owne
to
quent
d after
Me
to
Merge
rg
Merge
79)
r
er
r
83)
X
Stock
84)
4
85)
86)
6
holders
,000
7.50
.46
87)
Y
Stock
88)
9
89)
90)
6
holders
,000
6.00
.46
91)
To
92)
1
tal
3,000
93)
94)
95)
96)
Total net income is calculated as follows:
97)
98)
4,000 Shares x 7.50 = 30,000/99)
9,000 Shares x 6.00 = 54,000/100)
New EPS
84,000/101)
102)
EPS= Total Net Income
= 84,000/- =6.46/103)
Total Shares
13,000
104)
105)
EPS decreases by 1.04 /- for X stockholders but increases by 0.46/for Y stockholders. The impact on market price is not clear. Assuming the
combined company has the same P/E ratio of as that of company Y, the
market price per share will be 80.75/- (125x6.46/-). In this example, the
stockholders of each firm enjoy a higher market value per share. The
increased market value comes about because the net income of the
combined company is valued at a 12.5 P/E ratio, the same as company Y,
while before the merger, Company X had a lower P/E multiple of 10. But if
the combined company is valued at company Xs multiplier of 10, the
market value would be 64.60 (10 x 6.46/-). In this instance, the
stockholders in each firm will have experienced a decline in market value
of 10.40/- (75 - 64.60).
106)
107)
Since the effect of a merger on market value per share in not clear,
EPS is given the prime consideration.
108)

109)

110)

Merger and Dilution Effect on Business Control:

111)
112)
Stock dilution also has the effect of diluting the control of existing
shareholders. For example, if 100 shareholders collectively hold 10,
00,000 shares, and the company decides to carry out a public offering of
an additionally created 30, 00,000 shares, the previous share holding
control will automatically reduce by 75%. This can affect the decision
making process of a company if the new shareholders have a policy
direction which is at variance with that of the previous shareholders.
113)
114)
One negative way in which stock dilutions affect shareholders is
that it cuts their dividends and earnings in proportion to the degree of
dilution. This is most common in companies that give out stock trading
options to key employees. For example, if an investor John owns 2,000
shares in a company with a share capital of 2, 00,000 Shares (i.e. he owns
1 % of the company), and the company makes profits of 10,000/- his share
of the profits is 1% of 10,000/- which is 100/-. If the CEO of the company
exercises his stock options (i.e. shares are created and issued to him to
sell on the open market) and he is given 50,000 shares, then the share
capital is 2,50,000 shares. John ownership stake will now be reduced to
0.8 % and his share of the profits now drops to 80/-. Larger stock dilutions
will drop the value of his holdings even further. This is one effect.
115)

116)
Types of Takeovers:
117)
118)
There are different types of takeovers, depending on the
status of the acquiring business and the business being acquired, as
well as the method used by the acquiring business to purchase the
order. Takeover may be categorized in the following types:
1) Hostile takeover.
2) Friendly takeover.
3) Others types of takeover.
119)
1) Hostile Takeover: A hostile takeover of a company will very likely be
extremely emotional. A hostile takeover means that the acquired company
(i.e., the Board of Directors, senior management, and /or employees) does
not want to be acquired, for business reasons (valuations are opportunistic
for the acquirer, due to market factors), personal reasons (management
believes that it is doing an excellent job and does not believe the acquirer
will do as well), or perhaps job security reasons. It is a hostile takeover if
the management of the company being taken over is opposed to the deal.
A hostile takeover is sometimes organized by a corporate raider.
120)
121)
Hostile Takeover Approaches:

122)
The primary methods of conducting a hostile takeover are as
follows:
i) Tender Offer: A tender offer is an offer to stockholders of a publiclyowned corporation to exchange their shares for cash or securities at a
price above the quoted market price. It is a public bid for a large chunk of
the targets stock at a fixed price, usually higher than the current market
value of the stock. The purchaser uses a premium price to encourage the
shareholders to sell their shares.
ii) Proxy Fight: In a proxy fight, the buyer does not attempt to buy stock.
Instead, they try to convince the shareholders to vote-out current
management or the current Board of Directors in favour of a team that will
approve the takeover. The term proxy refers to the shareholders ability
to let someone else make their vote for them- the buyer votes for the new
board by proxy.
iii) Creeping Tender Offer: The purchase of a target firms stock at varying
prices in the open market rather than through a formal tender offer is
known as creeping tender offer.
123)
2) Friendly Takeover:
124) A friendly takeover causes much less concern than a hostile
takeover. A friendly takeover may be the result of negotiations by senior
management to assure that all constituents of the acquired company have
been fairly treated. This does not necessarily mean that management
desires the acquisition, but rather that they are meeting their fiduciary
responsibility to sell or maximize the companys value. A very healthy,
positive merger may have dissatisfied groups.
125) The merger of Citicorp and Travelers Insurance Company is
the result of a friendly consolidation.
126)
3) Other Types of Takeover: Other types of takeover includes following:
i)
Reverse Takeovers: A reverse takeover is a type of takeover
where a private company acquires a public company. This is usually
done at the instigation of the larger, private company, the purpose
being for the private company to effectively float itself while
avoiding some of the expense and time involved in a conventional
IPO.
ii)
Back Flip Takeovers: Back flip takeover is any sort of takeover in
which the acquiring company turns itself into a subsidiary of the
purchased company. This type of a takeover rarely occurs.
iii)
Bail Out Takeovers: Bailout takeover is the takeover of a
financially weak company by a profitable company. These forms of
takeovers are resorted to bailout the sick companies, to allow the
company for rehabilitation as per the schemes approved by the
financial institutions. The lead financial institution will evaluate the
bids received for acquisitions the financial position and track record
of the acquirer.
127)

128)
129)
130)
Takeover Procedure:
131)
As the chances of failure in an acquisition can be high, it should be
planned carefully. It pays to develop a disciplined acquisition programme
consisting of the following steps:
132)
133)
134)
135)
136)
137)
Step 1: Manage the Reacquisition Phase: A good starting point
of a merger and acquisition programme for an acquiring company is to
institute a thorough valuation of the company itself. This will enable the
acquiring company to understand well its strengths and weaknesses, and
deepen the acquirers insights into the structure of its industry. It will also
help in identifying ways and means of enhancing the value of the
acquiring firm, so that the firm can minimize the chances of becoming a
potential acquisition candidate itself.
138)
139)
140)
Manage
the
PreAcquisition Phase
141)

142)

Screen Candidates

143)
I
144)
Evaluate
Remaining Candidates

the

145)
I
146)
Determine the Mode
of Acquisition
147)
I
148)
Negotiate
Consummate the Deal

and

149)
I
150)
Manage the Postacquisition Integration
151)

152)
Armed with this knowledge, managers of the acquiring firm can do
brainstorming that will throw up worthwhile acquisition ideas.
Opportunities that strengthen or leverage the core business, or provide
functional economies of scale, or result in transfer of skill or technology
need to be identified.
153)
154)
Step 2: Screen Candidates: The ideas generated in the
brainstorming sessions and the suggestions received from various
quarters (merchant bankers, consultants, corporate planners, and so on)
will have to be filtered. Screening criteria that make sense for the
acquiring companys perspective need to be used. For example, an
acquirer may eliminate companies that are:
1) Too large (market capitalization of equity in excess of 100 crore) or
2) Too small (revenue less than 10 crore), or
3) Engaged in a totally unrelated activity, or
4) Commanding a high price-earnings multiple (in excess of 25), or
5) Not export-oriented (exports account for less than 20 percent of the
turnover), or
6) Not amendable to acquisition (existing management is not inclined to
relinquish control).
155)
156)
Step 3: Evaluate the Remaining Candidates: The screening
criteria applied in step 2 will narrow down the list of candidates to a fairly
small number. Each of them should be examined thoroughly. A
comprehensive evaluation must cover in great detail the following
aspects: operations, plant facilities, distribution network, sales, personal,
and finances (including hidden and contingent liabilities). Special attention
should be paid to the quality of management. Experienced, competent,
and dedicated management is a scarce resource. When a company is
acquired, the quality of its management is as, if not more, important as
the rest of its assets.
157)
158)
Each candidate ought to be valued as realistically as possible.
Valuation should not be clouded by wishful thinking; it should not be
vitiated by an obsession to acquire the target company.
159)
160)
Step 4: Determine the Mode of Acquisition: As discussed
earlier, the three major modes of acquisition are merger, purchase of
assets, and takeover. In addition, one may look at leasing a facility or
entering into a management contract. Though these do not tantamount to
acquisition, they give the right to use and manage a complex of assets at
a much lesser cost and commitment. They may eventually lead to
acquisition.
161)
The choice of the mode of acquisition is guided by the regulations
governing them, the time frame the acquirer has in mind, the resources
the acquirer wishes to deploy, the degree of control the acquirer wants to

exercise, and the extent to which the acquirer is willing to assume

contingent and hidden liabilities.
162)
163)
Step 5: Negotiate and Consummate the Deal: For successful
negotiation, the acquiring firm should known how valuable the acquisitions
candidate is to the firm, to the present owner, and to other potential
acquirers. While negotiating the deal, an acquirer would do well to
remember the following advice of Copeland. Your objective should be to
pay one dollar more than the value to the next highest bidder, and an
amount that is less than the value to you. This implies that the acquiring
firm should identify not only the synergies that it would derive but also
what other acquirers may obtain. Further, the acquiring firm should assess
the financial condition of the existing owner and other potential acquirers.
164)
165)
Step 6: Manage the Post-acquisition Integration: Generally
after the acquisition, the new controlling group tends to be much more
ambitious and is inclined to assume a higher degree of risk. It seeks to:
1) Quicken the pace of action in an otherwise settled organization,
2) Encourage a proactive, rather than a reactive, stance towards external
developments, and
3) Emphasize achievement over adherence to organizational procedures.
166)
167)
168)
Takeover Defenses:
169)
Takeover defenses include all actions by managers to resist having
their firms acquired. Attempts by target managers to defeat outstanding
takeover proposals are overt forms of takeover defenses. Resistance also
includes actions that occur before a takeover offer is made which make
the firm more difficult to acquire.
170)
171)
Principles of Takeover Defenses: Takeover defense measures
should conform to the following principles in order to protect and enhance
corporate value and shareholders common interests:
i)
Principle of Protecting and Enhancing Corporate Value and
Shareholders Common Interests.
ii)
Principle of Prior Disclosure and Shareholders will.
iii)
Principle of Ensuring the Necessity and Reasonablenesss.
172)
1) Shark-Repellent: Some companies use formal methods that are put into
place prior to an actual takeover attempt, known as shark-repellent
devices; they are designed to make a takeover more difficult.
173) For example The Company may include in loan agreements or
some other agreements conditional covenants that in the event of the
company passing under the control of a third party, the other party to the
agreement has the right to accelerate the debt or terminate the contract.
2) Golden Parachute: Golden Parachutes are employee severance
arrangements that are triggered whenever a change in control takes

place. Such a plan usually covers only a few dozen employees and
obligates the company to make a lumpsum payment to employees
covered under the plan whose jobs are terminated following a change in
control. A change in control usually is defined to occur whenever an
investor accumulates more than a fixed percentage of the corporations
voting stock. Such severance packages may serve the interests of
shareholders by making senior management more willing to accept an
acquisition.
3) White Mail: White mail, coined as an opposite to blackmail is an antitakeover arrangement in which the target company will sell significantly
discounted stock to a friendly third party in return, the target company
helps to thwart takeover attempts, by:
i)
Raising the acquisition price of the raider,
ii)
Diluting the hostile bidders number of shares, and
iii)
Increasing the aggregate stock holdings of the company.
174) It is strategy that a takeover target uses to try and thwart an
undesired takeover attempt.
4) Staggered Board of Directors: A staggered board of Directors (B of D),
in which groups of directors are elected at different times for multiyear
terms, can challenge the prospective raider.
5) Super Majority: Super majority provisions typically increase the
shareholder approval requirement for a merger to the range, thus
superseding the approval requirement of the charter of the state in which
the firm is incorporated.
6) Poison Pills: Under this method, the target company gives existing
shareholders the right to buy stock at a price lower than the prevailing
market price if a hostile acquirer purchases more than a predetermined
amount of the target companys stock.
7) Crown Jewels: The most valuable unit(s) of a corporation, as defined by
characteristics such as profitability, asset value and future prospects. The
origins of this term are derived from the most valuable and important
treasures that sovereigns possessed.
175)
A) Greenmail: It is a situation in which a large block of stock is held by an
unfriendly company. This forces the target company to repurchase the
stock at a substantial premium to prevent a takeover.
B) Standstill Agreements: A standstill agreement refers to the agreement
between a target firm and a potential acquirer wherein the potential
acquirer agrees not to increase his/her stake in the company, for a fee.
Normally standstill agreements are executed when the potential acquirer
has bought a significant stakes in the company.
C) Litigation: Bringing administrative claims or court proceedings against
the raider is regarded as one of the most common anti-takeover
measures.
D) Self-Tender: Under the Business Associations Act of Ukraine, a joint stock
company has the right to acquire the paid-up shares from the other
shareholders only by sums that exceed the share capital.

E) White Knight: A White Knight is a company (the good guy) that gallops
to rescue the company that is facing a hostile takeover from another
company (a Black Knight) by making a friendly offer to purchase the
shares of the target company.
176) For example, if company T (target) is going to be acquired by
company H (hostile firm), but company A (acquirer) can acquire ownership
of company T, then company A would be acting as the white knight.
F) People Pill: Here, management threatens that in the event of a hostile
takeover, the management team and the core specialists will resign at the
same time en masse. This is especially useful if they are highly qualified
employees who are crucial in identifying and developing business
opportunities of the company. Losing them could seriously harm the
company.
177)
178)
Meaning of Distress Restructuring Strategy:
179)
The term distress re-structuring belongs in the corporate finance
realm rather than change and organization. When a firm is in a financial
crisis or facing bankruptcy, this umbrella term is used to indicate the
corporate turnaround from severe financial distress through methods such
as Debt/Equity Re-structuring, Working Capital Management and
Corporate Valuation.
180)
181)
Distress reorganization will bring in the change in Capital
structure, which depends on the following factors:
1) Management control,
2) Cost of different sources of capital,
3) Floatation cost,
4) Cost of servicing the equity and debt,
5) Risk and return profile of the industry,
6) Financial risks involved in debt financing,
7) Flexibility in capital structure,
8) Legal formalities, etc.
182)
183)
The poor capital structure may be due to:
1) Project cost over-run,
2) Technological obsolescence,
3) Accumulated loss and unrepresented value of assets in balance sheet,
4) Insufficient working capital,
5) Financing of fixed assets with short-term funds,
6) Financing of current assets with long-term funds,
7) Investment in non-core business and assets which does not contribute to
profitability,
8) Over-gearing increases financial risk of the firm,
9) Operating profits insufficient to service debt,
10)
Poor current ratio,
11)
Inadequate return on capital employed.
184)

185)
Types of Distress Restructuring Strategy:
186)
i)
Licensing: Under a licensing agreement, a company (the
licensor) grants rights to intangible property to another company
(the licensee) for a specified period; in exchange, the licensee
ordinarily pays a royalty to the licensor.
ii)
Management Buy-Outs (MBO): In a Management Buy-Out
(MBO), the management of a firm buys-out the controlling
interest in the firm from the existing shareholders. Management
buy-outs are usually structured in such a manner that
management only contributes a small portion of the purchase
price from personal resources and borrows most of the purchase
price from financial institutions.
187)
Management Buy-Out may be defined as, Purchase of a
business from its existing owners by members of the
management team, generally in association with a financing
institution.
iii)
Going Private: Going private means the repurchase of shares
from the market - not on a piecemeal basis but the entire
outstanding stock issue - so that ownership is no longer public
but is concentrated in a small private group typically centered on
management.
iv)
Buy-Back of Shares: Buy-back of shares means a corporations
repurchase of stock or bonds it has issued. In the case of stocks,
this reduces the number of shares outstanding, giving each
remaining shareholder a larger percentage ownership of the
company.
v)
Reverse Merger: In corporate merger, relative size in terms of
either capital employed or turnover of the companies in deal
determines which will be acquired by whom. In normal practice, it
is the larger company which acquires a smaller one. But in case
of reverse merger, it is a smaller company which acquires the
larger company.
vi)
Leverage Buyout: A Leveraged Buy-Out (LBO) involves the
acquisition of a company, the assets and cash flow of which are
used by an investor to obtain and service the financing required
for making the acquisition.
188)

189)

Sell-off:

190)
A sell-off by far the most common divestitures (and usually
refer to as divestitures), is the sale of one or more company units to
another company. Normally, sell-offs are done because the
subsidiary doesnt fit into the parent companys core strategy.

191)
192)
Sell - Off Process:
1) Developing Sale Strategy: The Company has to decide on the
type of sale process to be adopted. The two different sale processes
are:
i)
Negotiated Sale: In this method, the potential buyers are
directly approached by the firm or by its investment banker. In
case they show serious interest in acquisition, the negotiations
are conducted between the seller and the buyer. On
successful completion of the negotiations, the deal is publicly
declared. This Process ensures secrecy, avoids staff unrest
and controls market receptivity.
ii)
iii)
iv)
v)
vi)
vii)
viii)
ix)
x)

xi)
xii)

xiii)
xiv)

xv)
xvi)
xvii)

Developing
Sale Strategy
I
Valuation
I
Drafting
of
Offer
Memorandum
I
Identify
Potential
Buyer
I
Negotiation
and
Closing
the Deal

xviii) Auction Sale: In an auction sale, the intention to sell is

publicly announced. Competitive bids are invited from various
interested buyers. The companies select the most favorable
bid and divestiture is made in favor of the bidder. The biggest
advantage of the auction process is that it enables the
realization of the maximum possible price. It also draws the
attention of a large universe of potential buyers and
eliminates the biases in the selection of target buyers. It also
makes the entire sale process time bound.
2) Valuation: The firm generally seeks professional help for the
valuation of the asset/business put-up for sale. This helps as an
anchor in the later process of negotiation. This is the basis on which
the minimum cut-off price for the divestiture is determined.
3) Drafting of Offer Memorandum: A detailed Offer Memorandum is
drafted by the firm, in consultation with their investment bankers,
for the benefit of potential buyers. The contents of the same are:
i)

Executive Summary: It summarizes the key points about the

business, assets on offer and reason for the sale. It
emphasizes on the benefits that would accrue to the buyers.

ii)

Sale Procedure: It explains in detail the procedure for

divestment. It also sets the dates for indication of interest,
initial bid submission, detailed presentation and submission of
final bids. It also clarifies on the expected mode of payment
and the acceptable and unacceptable deal structures.

iii)

Background: It describes the history of the seller, details of

the asset/business on offer, geographical coverage, existing
management structure, reasons for divestment, etc. It also
states the past contractual obligation which would bind the
buyer.

iv)

Operations: This part gives the details of technology,

capacity, production processes, quality policy, Research and
Development, scope for expansion/integration, patents,
systems and schedule of fixed assets.

v)

Marketing: It explains about the products, size of the market,

industry life cycle, entry barriers, market share, growth rate,
customer profile, competition, seasonality, pricing policies,
brands and trademarks, etc.

vi)

Human Resources: It gives details of the employees,

managers, remuneration policies, industrial relations, etc.

vii)

Financial: The information provided includes:

a) Balance Sheet for the last five years,
b) Profit and Loss Account for the last five years,
c) Cash Flow Statement for the Last five years,
d) Future Projections

Revenue Analysis: Product-wise,

region-wise and customer -wise.

Expense Analysis: Product-wise, region-wise, breakeven point, cost behavior (Fixed and Variable)

Receivable Analysis: Age-wise, bad debts.

month-wise,

4) Identify Potential Buyers: The most obvious target segment is

competitors. Normally, they pay the highest price for acquiring rival
business.
5) Negotiation and Closing the Deal: The preliminary discussions
with the potential buyers should help in short listing a few serious
buyers.
xix) Spin-Off/Demerger:
xx)

A Spin-off is a series of transaction through which a company

divests of spin-off one or more unit-typically a small portion of
its business with some common theme by turning them into
an independent company and selling the companys share to
the investing public.

xxi)

Spin-off or demerger is the opposite of a merger (the

practice of combining several companies under one corporate
roof). A demerger hives-off parts of a company into separate
operations because in a belief that they will perform better
that way. It is a corporate strategy to sell-off subsidiaries or
divisions of a company.

xxii) Reasons for Demerger: The strategic reasons resulting for

demerger may be as follows:

1) Restructuring the existing business, by segregating

uncommon activities into different corporate bodies.

different

2) Separation of management of different undertakings.

3) Introduction of the concept of Responsibility Accounting and
Accountability.
4) Protection of business from high risk activities and undertakings
which are continuously incurring cash losses.
5) Bringing clear lines of management.
6) Protection of crown jewel from the predator through hostile
takeover.
7) A voidance of frequent interference of Government and its agencies
in business.
8) Division of family managed business.
9) Tapping more opportunities and counter against threats.
10)
Separation of unwanted activities and to concentrate on core
activites.
11)

Enable management buy-out.

xxiii)
xxiv)
xxv)
xxvi) Types of Demerger: Following are the two major types of
spin off:
xxvii)

Types of Demerger
xxviii)

Split -Off Split-Up

xxix) Split-Off: Split-off is the process, whereby a parent

corporation organizes a subsidiary corporation to which it
transfers part of its assets in exchange for all of the
subsidiarys capital stock, which is subsequently transferred to
the shareholders of the parent corporation in exchange for a
portion of their parent stock.
xxx) Split-Up: It is a corporate action in which a single company
splits into two or more separately run companies. Shares of
the original company are exchanged for shares in the new
companies, with the exact distribution of shares depending on

each situation. This is an effective way to break-up a company

into several independent companies. After a split-up, the
original company ceases to exist.
xxxi) Disadvantages
of
Demerger:
disadvantages of demerger.

Following

are

the

1) Loss of economies of scale.

2) Increase in overheads.
3) Loss of ability to raise extra finances.
4) Lower turnover and profitability.
5) Loss of benefits from synergy.
xxxii)

Characteristics of LBO Candidates:

1) Stable Cash Flows.

2) Stable and Experienced Management.
3) Room for Significant Cost Reductions.
4) Equity Interest of Owners.
5) Ability to Cut Costs.
6) Limited Debt on the Firms Balance Sheet.
7) Separable, Non-Core Businesses.
8) Other Factors.
xxxiii)

Stages of LBO Operation: Four distinct but related

stages are envisaged for the proper implementation of an LBO
programme. These are explained below:

1) Arrangement of Finance: The first stage of the operation consists

of raising the cash required for the buy-outs and working out a
management incentive system. The equity base of the new firm
consists of around 10% of cash put up by the companys top
management or buy-out specialists.
2) Taking Private: In this stage, the organizing or sponsoring group
purchases all the outstanding shares of the target company and
takes it private through stock purchase format or purchases all
assets through asset purchasing format.

3) Restructuring: In this stage, the new management would try to

enhance the generation of profit and cash flows by reducing certain
operating costs and changing the marketing strategy.
4) Reverse LBO: Under this stage, the investor group may take the
company to public again, if the already restructured company
emerges stronger and the goals set by the LBO groups have already
been achieved.
xxxiv)
xxxv)
xxxvi)
xxxvii)
xxxviii)
xxxix)
xl)
xli)