FINMAN202

Financial Management#

Financial Management [FINMAN202]

 STUDENT
Name:
Student Number:
Program:
Section:
Home Address:
Email Address:
Contact Number:

PROFESSOR
Name: Annieleah D. Debasa; Dr. Ramon George Atento
Academic Department: Department of Business and Accountancy
Consultation Schedule: Monday to Friday, 5:30 pm – 8:30 pm
Email Address: [email protected]
Contact Number:

General Instructions

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GENERAL INSTRUCTIONS:

MODE OF STUDY AND ATTENDANCE

For this school year, the City College still adopted a blended study program – a mix of offline and online
instructions. This learning modality entails that there shall be scheduled online classes requiring student
attendance and interaction for the entire semester. Likewise, in this learning approach, the College still crafted
modular materials in three (3) correlated modules designed for synchronous and asynchronous instructions to be
given to the student through e-Guro--the in-house Learning Management System adopted by the school.

LEARNING MATERIALS AND REFERENCES

The inclusive topics of this module shall also be the basic flow of virtual discussion. The students are
encouraged to read the module before joining the scheduled online interaction. As for study references and
materials, several textbooks are available in the college library, wherein you can collectively or individually
request an electronic/physical copy. Alternatively, you can source related references available in the web
portal. When looking for study resources and materials either offline or across the net, please be reminded of the
so-called law on Data Privacy Act of 2012. The City College of Calamba owns the content of the modular
materials provided to you, henceforth the author of the books, websites, journals/videos content, etcetera unless
tolerable for learning duplication. You shall be mindful and practice due diligence in dealing with exclusive rights
issues, especially our modular materials, to avoid mishaps on your part.

GRADING SYSTEM
The student's learning progress will be measured through output activities in the form of enrichment and
assessment. These activities are pre-formatted designed by your respective instructor, which can be given to the
student synchronously or asynchronously. You can expect a combination of fill-in-the-blank, true-or-false,
traditional multiple-choice, analytical illustrations, and essays in a time-bounded manner. The outputs, including
the virtual performance, shall be the basis for your grade. The grading scheme for these activities shall be 40% for
assessment, 40% for enrichment, and 20% for virtual performance, and it is to be uploaded per activity per student
and can be viewed through the LMS. For final grade merit, the following are the weight of each Module: Module
1, 30%; Module 2, 30%; and 40% for Module 3.

Starting this school year, a student who cannot complete and pass the assessment and evaluation
activities given during the term in the prescribed manner by the professor with or without a valid reason will be
marked as failed. Likewise, the original grading scheme to evaluate the student shall be reverted and take effect
without reservations.

COMMITMENT OF INTEGRITY
As an enrolled student in this institution, you shall always uphold and perform your task with utmost honesty
and integrity. The City College will NOT tolerate any misconduct or misbehavior, especially any protocol violation
in the implemented learning modality. Whoever is found guilty of these shall be given sanctions written in your
student's manual.

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LEARNING MODULE INFORMATION

I. Course Code FINMAN202

II. Course Title FINANCIAL MANAGEMENT

III. Module Number 3

IV. Module Title CAPITAL BUDGETING AND BUSINESS RESTRUCTURING

V. Overview of the Module This final module has two (2) topics mainly for Capital Budgeting and
Business Restructuring, which is presented through discussion and
application at the same time, followed by a summary of the lesson and
enrichment activities at the end of each lesson. Then, an assessment
activity through a Final Examination shall be given to the students to test
their in-depth learning and understanding of the module's topics.
VI. Module Outcomes At the end of this module, the students are expected:
➢ To apply knowledge of capital budgeting, its risks and how it is
measured.
➢ To calculate the cash flows of new capital investment proposal in
relation to the net present value, internal rate of return, profitability
index, and discounted payback period as well as the payback
period, payback reciprocal, and accounting rate of return of such
proposal.
➢ To apply knowledge as to how restructuring affects firm’s asset mix
and financial structure through mergers and divestitures; the nature
and types of mergers and acquisitions, its motives and approach
in valuation; and the nature and different types of divestitures.
➢ To apply knowledge of international aspects of corporate finance
and distinguish between direct and indirect quotes in the spot
exchange market of foreign currency.

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LESSON 1: CAPITAL BUDGETING

LESSON OBJECTIVES
At the end of the lesson, the students are expected:
➢ To apply knowledge of capital budgeting, its risks and how it is measured and
➢ To calculate the cash flows of new capital investment proposal in relation to the net present value, internal
rate of return, profitability index, and discounted payback period as well as the payback period, payback
reciprocal, and accounting rate of return of such proposal.

DISCUSSION AND APPLICATION

Capital Budgeting
Capital budgeting is the process of allocating financial resources to new long-term investment projects.
Engaging in profitable activities such as new investments determine a firm’s sustainability in the future. Such
engagements involve a considerable amount of money so a firm has to be cautious before making them.
However, with increased financial risks, it can expect to yield benefits for years. The success of a firm is ultimately
attributed to its ability to make wise capital budgeting decisions.

Importance of Capital Budgeting

❖ Capital budgeting involves investments of different amounts. Normally, capital expenditure entails a
substantial amount of resources. However, regardless of the amount involved, a firm must have a high
chance of success in undertaking such an investment. Thus, the benefit must be greater than its cost.
❖ It limits the firm’s flexibility. Capital expenditure restricts a firm’s flexibility because it requires the commitment
of funds. If a wrong decision is made, resources are tied up for a long period in an investment that may not
be profitable. Conversely, if a right decision is made, a firm will be benefited for a long time.
❖ It defines a firm’s strategic direction. Firms that want to penetrate new markets or develop new products
and/or services have to undertake the capital budgeting process. A firm’s strategy affects its future.
❖ It is concerned with the planning and control of investments. Capital budgeting involves the upgrading of
machinery and equipment, acquisition of new product lines, and expansion.

Capital Budgeting Process

To arrive at a long-term investment decision, a firm needs to identify the following:
1. The estimated cash flows which are the inflows and outflows over the entire life of the investment proposal.
The cash inflows must exceed the cash outflows to be acceptable. The cash flows, generally, are as follows:
a. The initial investment which is the initial cash outlay needed to undertake the investment.
b. The annual cash returns which are computed by adding the non-cash expenses to the firm’s net income
after tax. In capital budgeting, firms are more concerned with the cash inflow rather than the net income.
Included also in the cash returns are the increase or decrease in the working capital over the entire life of
the project.
c. The terminal cash flow which is associated with the termination of the project. For example, the scrap
value of the equipment purchased and used which is added to the firm’s cash inflows at its discounted
amount.
2. The estimated cost of capital or the weighted average cost of capital. A firm’s cost of capital plays a vital
role when financial decisions are made, i.e., the project with the lowest cost of capital is preferred. Moreover,
the lower the cost of capital, the more projects the firm can accept.
3. The acceptance criteria which are the rules that enable a firm to resolve issues concerning long-term
investments. The acceptance criteria are the methods used to evaluate the “attractiveness” of an
investment proposal.

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Capital Budgeting Risks

Riskier projects need a higher rate of return to be deemed profitable. Some of the risk involved in capital
budgeting are:
❖ Project-specific Risk. Some of the risk you face from a long-term investment is from the project itself. Project
risk approximates the chance that the project will not be as profitable as expected due to errors from the
company or from the project's initial evaluation. Project risk is increased when a company invests in a business
that is not in its area of expertise. This increases the chance that management will not be able to properly
value the project's cash flows and that the company will make errors while running the business.
❖ Market Risk. Market risk measures the part of a project's risk from macroeconomic factors such as inflation
and interest rates. Market risk is increased during a weak economy. A poor economy can decrease demand
for a product, potentially turning a project unprofitable. Banks may be more reluctant to lend in a weak
economy, raising the cost of capital for the project. High inflation can also be a problem at it weakens the
long-term real return of the project. These factors increase the market risk of a project and contribute higher
total risk.
❖ International Risk. If a company's capital budget project will involve another country, it will be exposed to
international risk. This entails political and exchange-rate risk of the project. If a project is based in a country
with an unstable political structure, civil or political unrest could cause the entire investment to be lost. If
currency rates move in an unfavorable direction, the company could face higher relative costs and lower
relative gains. Domestic projects are completely devoid of this type of risk.
❖ Competitive or competition risk. Unanticipated actions of a firm’s competitors will materially affect the cash
flows expected from a project. As a result of this, the actual cash flows from a project will be less than that
of the forecast.

Inflation’s Impact
Inflation affects capital budgeting in a significant way. It makes up a part of the market rate of return,
and capital budgets reveal the true project cost when using the real rate of return, rather than the market rate.
Calculating the real rate of return begins with the market rate of return, then subtracting inflation. This is sometimes
stated as its inverse, the real cost of capital.
Inflation also affects capital budgeting analyses since the market cost of capital is not completely
representative of the real cost of borrowing funds. However, performing the analysis in a manner that
compensates for inflation removes its impact from the results of the capital budget.
Inflation impacts can be removed from a capital budgeting analysis by calculating the real rate of return
and using it in the capital budgeting cash flow calculations. When formulating a capital budgeting scenario with
the real rate of return, the answer has been adjusted for inflation. Conversely, if the rate of return is not adjusted,
the cash flows can be adjusted for inflation to match the inflation that is "built in" to the market rate of return. In
either scenario, it is important to make sure the cash flows and rate of return are on the same basis, either with or
without inflation.

Capital Budgeting Techniques

1. Payback Period
This method measures the length of time it takes to recover a project’s initial investment and does
not consider the time value of money. It adopts the most direct approach to an investment problem, i.e.,
measures length of time it will take before the receipts from the investment are sufficient to recover the cost
of the investment. The receipts from the investment are measured as the net cash inflows resulting from the
project being undertaken. Annual cash inflows may be even or uneven depending on the forecast of the
firm and would have different approach in computing the payback period.
The acceptance criterion under the payback period method is dependent on the firm’s minimum or
required payback. Thus, the decision rule would be:

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If the computed payback < required payback → accept the project

If the computed payback > required payback → reject the project

Example (even cash inflow):

Mr. X plans to purchase a piece of equipment which amounts to P180,000 in accordance with an
investment proposal from a member of his staff. If the equipment is bought, it is expected to generate an
annual cash inflow of P30,000. A five-year payback period is acceptable to Mr. X.

Payback = Investment – Scrap Value = 180,000

Annual after-tax cash savings 30,000

= 6 years

Decision: The investment proposal should be rejected since the computed payback period exceeds
the acceptable payback period set by Mr. X.

Example (uneven cash inflow):

Assume the same set of facts in the preceding example for the annual cash inflows which have now
been changed as follows:

First year P20,000

Second year 30,000
Third year 40,000
Fourth year 50,000
Fifth year 50,000
The payback period is computed as:
Cash Inflows Balance Years
P180,000
First year P20,000 160,000 1
Second year 30,000 130,000 1
Third year 40,000 90,000 1 4.80 years
Fourth year 50,000 40,000 1
Firth year 50,000 0 (40,000/50,000) 0.80

Decision: The investment proposal should be accepted because the payback period of 4.80 year is
less than the acceptable payback set by the owner.

Advantages:
▪ It is simple to compute and easy to understand. While simplicity is valuable, however, it should not be
considered the principal factor when deciding on alternative investments.
▪ It handles investment risks well. The idea behind this method is that the cash inflows in the far future are
riskier than those in the near future. The payback period method focuses its attention on early cash
inflows and requires the project’s payback period be within a span of time which is acceptable to the
company. The result is that risky projects are easily avoided and the risk of incurring loss is minimized.

Disadvantages:
▪ It does not recognize the time value of money. In this method, the value of the money (whether in
present or in the future) does not matter to the decision-maker. He/she does not consider the fact that
the purchasing power of money changes overtime.

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▪ It ignores the impact of cash inflows received after the payback period. Essentially, cash flows after the
payback period determine the profitability of an investment.
▪ There is a possibility of lower return. The payback period method is biased towards risky assets. Thus, by
demanding rapid payback, companies incline towards risky projects. It is very seldom that a higher
return is received for projects with a lesser risk.
▪ There is no rational way of determining the payback period.

2. Discounted Payback Period

This method refers to the number of years in which the investment may be recovered at its discounted
cash inflows. The acceptance criterion and computation are similar to those of the regular payback period
except that the annual cash inflows are discounted by the firm’s cost of capital.

Example:
Mr. Y plans to put up a small stall in front of his house. The overall cost of the construction is P150,000.
The stall is expected to generate annual cash inflow of P40,000 for 7 years. A four-year discounted payback
period is acceptable to Mr. Y. The cost of capital is at 12%.

The discounted payback period is as follows:

Annual Cash Present Discounted Balance of
Returns Value Amount Investment
P150,000
First year P 40,000 (1.12)-1 P35,714 114,286 1
Second year 40,000 (1.12)-2 31,888 82,398 1
Third year 40,000 (1.12) -3 28,471 53,927 1 5.29 years
Fourth year 40,000 (1.12)-4 25,421 28,506 1
Fifth year 40,000 (1.12)-5 22,697 5,809 1
Sixth year 40,000 (1.12)-6 20,265 0 (5,809/20,265) 0.29

Decision: The plan of Mr. Y should be rejected because the discounted payback period is longer
than the acceptable payback period.

In some cases, the decision arising from using regular and discounted payback period contradicts
because some projects are accepted when using the former but rejected using the latter. The reason is that
the annual cash return under the discounted payback period is smaller than the regular payback period
due to the recognition of time value of money.

3. Accounting Rate of Return (ARR)

It is sometimes called the average rate of return. It is determined by dividing the average accounting
profit (after taxes) expected from the project by the investment. Although the ARR is more advantageous
than the payback period method since it takes into account the profits over the entire life of the project, it
still suffers from a number of shortcomings, e.g., this method does not consider the time value of money on
the non-cash expenses related to the project.

Accounting Rate of Return = Average Annual Profit after Taxes

Investment
Example: Initial investment P8,000
Estimated life 20 years
Annual cash inflow P1,000
Annual Depreciation P400

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Answer:
ARR = 1,000 – 400 = 7.5%
8,000

In other variation of this method, the investment is “averaged” by dividing the initial investment by 2.
Thus, the ARR is:

ARR = 1,000 – 400 = 15%

8,000/2

The computed ARR must then be compared with the firm’s required ARR, thus, the rule on investment
would be:

If ARR < required ARR → reject the project

If ARR > required ARR → accept the project

Advantages:
▪ It is easy to understand. Similar to payback period method, it is straightforward.
▪ It is simple to compute. The variables needed in the formula are easily obtained.
▪ It recognizes the profitability factor. It uses the net income (after tax) obtained from the income
statement.

Disadvantages:
▪ It ignores the time value of money.
▪ It uses accounting income instead of cash inflows. The cash generated is far more important than the
net income to attain the main objective of the firm. It is cash, not the net income, that is used in
investment.
▪ It is difficult to determine the minimum acceptable rate of return. It allows the decision-makers to
manipulate the appraisal of investments for personal gain or interest.
▪ It does not take into account the amount of the investment. For instance, it could be possible that the
ARR of 20% on P20,000 may be more preferable than a rate of return of 12% on P100,000.

4. Net Present Value (NPV)

This method is obtained by getting the present value of all cash inflows using the cost of capital less
the initial investment. As far as advantages are concerned, this method recognizes the time value of money
and it is easy to compute whether the cash flows form an annuity or vary from period to period. Any positive
net present value is acceptable.
In situations where all projects are independent and there are no constraints on the level of
investments to be made, a firm should undertake projects which are consistent with its goals. This involves
greenlighting all projects in which the NPV is positive. Such projects will increase shareholders’ wealth and
can be considered profitable given the firm’s cost of capital.
The formula for future cash flow is:
1
1 − (1 + i)−n 1 − (1 + i)n
PV = or
i i

The formula for even future cash flow is:

1
PV = (1 + i)−n or
(1 + i)n

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Example:
Luffy Corporation invested P6,854 in a 4-year project. Luffy’s cost of capital is 8%. Additional bits of
information on the project are as follows:

Year After-tax Cash Inflow of P1 Present Value at 8% Present Value

1 P 2,000 0.926 P1,852
2 2,200 0.857 1,885
3 2,400 0.794 1,906
4 2,600 0.735 1,911
Total PV P 7,554
Less: Investment 6,854
NPV P 700

Using the cost of capital as the reinvestment rate is theoretically correct when directly measuring the
increase in value that the proposed project is expected to produce. However, using the NPV method is
difficult for people without formal training in business, especially when the concept of the time value of
money is involved.

5. Internal Rate of Return

This is the rate of return that equates the present value of all cash inflows to the initial investment. In
other words, it is the interest rate that causes the net present value to be zero. The rule in decision-making is
that projects with the highest internal rates of return are accepted. This method is very tedious because there
is no exact formula.
Computing the internal rate of return presents two complications. First, the actual internal rate of
return will most likely not coincide with the rates available in the present value tables. In other words, it is
unlikely that the actual rate of return will exactly be 15% or 20%. The actual rate of return will probably lie
somewhere between two rates of return included in the table. A fair estimation of the internal rate of return
can be determined by means of trial and error and the mathematical process known as interpolation.
Second, the cash flows may be unequal. Computing the internal rate of return then becomes a “hit-or-miss”
proposition.
Detailed computer routines ease the computational drudgery. Manually, the process is burdensome,
i.e., one simply tries a rate, and then tries another, until the applicable rate is finally determined.
Decision rule:
If IRR < required rate of return → reject the project
If IRR > required rate of return → accept the project

Advantages
▪ It acknowledges the time value of money. Cash inflow and cash outflow are translated into their present
values using the computed IRR before arriving at a decision.
▪ It is more exact and realistic than ARR.
▪ If not constantly changing, the streams of cash flows can provide a rate of return that is useful in making
a decision.
▪ It provides a decision similar to NPV if the project is independent.

Disadvantages
▪ It requires a lot of time to compute especially when the cash flows are not even.
▪ It provides multiple IRRs in situations where the movement of cash flows is erratic.
▪ Under mutually exclusive projects, the IRR may provide results conflicting with the NPV.

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Example: Assume that: Initial Investment P 12,950

Estimated Life 10 years
Annual Cash Inflows P 3,000
Cost of Capital 12%
Answer: Trial and Error
At 18%
1−(1.18)−10
= P3,000 [ ]
0.18

= P 13,482.26

At 20%
1−(1.20)−10
= P3,000 [ ]
0.20

= P 12,577.42

By interpolation:
13,482.26 13,482.26 at 18%
12,950.00 initial investment
________ 12,577.42 IRR at 20%
532.26 904.84

IRR = 18% + (532.26 / 904.84) (20% - 18%)

= 19.18%

If the cash flows are unequal, firstly, compute the sum of the present value of all the cash inflow;
secondly, proceed to the trial-and-error procedure; and lastly, interpolate.

6. Profitability Index
It is the ratio of the total PV of future cash inflows to the initial investment, i.e., PV/I. It is used to rank
projects in a descending order of attractiveness. If the profitability index is greater than 1, the project is
accepted.
A profitability ratio of 1 is logically the lowest acceptable measure on the index. Having a value of 1
simply means that the present value of the future cash flows is equal to the investment. Thus, any value lower
than 1 indicates that the project’s PV is less than the initial investment. As the value of the profitability index
increases, so does the financial attractiveness of the proposed project.

SUMMARY OF THE LESSON

✓ Capital budgeting is the process of allocating financial resources to new long-term investment projects.
✓ Importance of capital budgeting includes:
▪ It involves investments of different amounts.
▪ It limits the firm’s flexibility.
▪ It defines a firm’s strategic direction.
▪ It is concerned with the planning and control of investments.
✓ Capital budgeting risks includes project-specific risk, market risk, international risk, and competitive or
competition risk.
✓ Some of the Capital Budgeting Techniques are: Payback Period, Discounted Payback Period, Accounting
Rate of Return (ARR), Net Present Value (NPV), Internal Rate of Return, and Profitability Index.

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REFERENCES
1. Cabrera, Cabrera, Cabrera (2021-2022) Financial Management: Principles and Applications
2. Timbang, Ferdinand L. (2015) Financial Management Part II
3. https://smallbusiness.chron.com/factors-increase-riskiness-capital-budgeting-project-15829.html
4. http://mytypings.com/risks-in-capital-budgeting/
5. https://bizfluent.com/info-8132966-effect-inflation-capital-budgeting.html

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LESSON 2: BUSINESS RESTRUCTURING

LESSON OBJECTIVES
At the end of the lesson, the students are expected:
➢ To apply knowledge as to how restructuring affects firm’s asset mix and financial structure through mergers
and divestitures; the nature and types of mergers and acquisitions, its motives and approach in valuation;
and the nature and different types of divestitures, and
➢ To apply knowledge of international aspects of corporate finance and distinguish between direct and
indirect quotes in the spot exchange market of foreign currency.

DISCUSSION AND APPLICATION

MERGERS & ACQUISITIONS

Mergers and Acquisitions (M&A) is a general term used to describe the consolidation of companies or
assets through various types of financial transactions, including mergers, acquisitions, consolidations, tender
offers, purchase of assets, and management acquisitions.
The term M&A also refers to the desks at financial institutions that deal in such activity. The terms "mergers"
and "acquisitions" are often used interchangeably, although, in fact, they hold slightly different meanings. When
one company takes over another and establishes itself as the new owner, the purchase is called an acquisition.
On the other hand, a merger describes two firms, of approximately the same size, that join forces to move forward
as a single new entity, rather than remain separately owned and operated. This action is known as a merger of
equals. Case in point: Both Daimler-Benz and Chrysler ceased to exist when the two firms merged, and a new
company, Daimler Chrysler, was created. Both companies' stocks were surrendered and new company stock
was issued in its place.
A purchase deal will also be called a merger when both CEOs agree that joining together is in the best
interest of both of their companies.
Unfriendly or hostile takeover deals, where target companies do not wish to be purchased, are always
regarded as acquisitions. A deal can be classified as a merger or an acquisition, based on whether the
acquisition is friendly or hostile and how it is announced. In other words, the difference lies in how the deal is
communicated to the target company's board of directors, employees and shareholders.

Types of Mergers and Acquisitions (M&A)

❖ Mergers. In a merger, the boards of directors for two companies approve the combination and seek
shareholders' approval. For example, in 1998 a merger deal occurred between Digital Computers and
Compaq, whereby Compaq absorbed Digital Computers. Compaq later merged with Hewlett-Packard in
2002. Compaq's pre-merger ticker symbol was CPQ. This was combined with Hewlett-Packard's ticker symbol
(HWP) to create the current ticker symbol (HPQ).
❖ Acquisitions. In a simple acquisition, the acquiring company obtains the majority stake in the acquired firm,
which does not change its name or alter its organizational structure. An example of this type of transaction
is Manulife Financial Corporation's 2004 acquisition of John Hancock Financial Services, where both
companies preserved their names and organizational structures.
❖ Consolidations. Consolidation creates a new company by combining core businesses and abandoning the
old corporate structures. Stockholders of both companies must approve the consolidation, and subsequent
to the approval, receive common equity shares in the new firm. For example, in 1998, Citicorp and Traveler's
Insurance Group announced a consolidation, which resulted in Citigroup.

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❖ Tender offers. In a tender offer, one company offers to purchase the outstanding stock of the other firm, at
a specific price rather than the market price. The acquiring company communicates the offer directly to
the other company's shareholders, bypassing the management and board of directors. For example, in 2008,
Johnson & Johnson made a tender offer to acquire Omrix Biopharmaceuticals for $438 million. While the
acquiring company may continue to exist— especially if there are certain dissenting shareholders—most
tender offers result in mergers.
❖ Acquisition of assets. In an acquisition of assets, one company directly acquires the assets of another
company. The company whose assets are being acquired must obtain approval from its shareholders. The
purchase of assets is typical during bankruptcy proceedings, where other companies bid for various assets
of the bankrupt company, which is liquidated upon the final transfer of assets to the acquiring firms.1
❖ Management acquisitions. In a management acquisition, also known as a management-led buyout (MBO),
a company's executives purchase a controlling stake in another company, taking it private. These former
executives often partner with a financier or former corporate officers, in an effort to help fund a transaction.
Such M&A transactions are typically financed disproportionately with debt, and the majority of shareholders
must approve it. For example, in 2013, Dell Corporation announced that it was acquired by its founder,
Michael Dell.

Reasons Behind Each Type Of M&A

There are various reasons as to why a company might to decide to merge or acquire another company,
although there has to be a strategic reasoning or logic behind the merger. All the successful mergers and
acquisitions have a specific, well thought-out logic behind the strategic move. Mergers and acquisitions usually
create value for the company in different ways, some of which are listed below:
1. Improve the company’s performance
This involves improving the performance of the target company, as well as the company itself. It is one of
the most important reasons of value-creating strategies of M&A. If another company is taken over, its
performance can be radically improved, due to economies of scale. Also, the two companies’ combined
would have a greater impact in the market as they are more likely to capture a greater market share, hence
higher revenue and profits. Operating-profit margins can be significantly improved under the new
management if wastage and redundancies are removed from the operations.
2. Remove Excess capacity
In many cases, as industries grow, there comes a point of maturity, which leads to excess capacity in the
industry. As more and more companies enter the industries, the supply continues to increase, which brings
the prices considerably down. Higher production from existing companies and entry of new companies in
the industry disrupts the balance as supply increases more than demand, which lead to a fall in price. In
order to correct this, companies merge with or acquire other companies in the industry, hence getting rid of
excess capacity in the industry. Factories and plants can be shutdown, since it is no longer profitable to sell
at that low prices. Usually least productive plants or factories are retired in order to bring the balance back
to the industry. Reducing excess capacity has a lot of benefits as it extends less tangible forms of capacity
in the industry. It makes companies rethink their strategy, and nudges them to work towards improving quality
rather than quantity.
3. Accelerate growth
Mergers and acquisitions are often undertaken to increase the market share. If competitor company is
taken over, its share of sales is also absorbed. As the result, the acquirer gets higher sales, revenues and
consequently higher profits. Some industries have a mix of very loyal customers, which means that it is very
difficult to attract customers from competition by other means, as the industry is highly competitive and

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consumers are disinclined to make the switch. In such circumstances, merger or acquisition are highly
beneficial, since they provide an opportunity to drastically increase market share. It also allows economies
of scale, as per unit cost decrease due to higher volume. Smaller players in the market are sometimes taken
over to penetrate the market further, where big companies fail to make an impact. Controlling smaller firms
in the industry can greatly accelerate sales of those smaller companies’ products and services, since a big
name is now attached to them. The acquirer also brings in its expertise and experience to bring efficiency
to the operations of the target company. The combined company also benefit from exposure to various
segments of the industry, which were previously unknown to the acquirer. The new combined company
could help introduce new products tailored for the unchartered markets, hence finding new consumers for
the same products and services.
4. Acquire skills and technology
Companies often acquire or merge with other companies in hopes to acquire skills and/or technology of
the target company. Some companies control certain technologies exclusively, and it is too costly to
develop these technologies from scratch. This means that it is easier to take over a company with the desired
technology. A merger / an acquisition provides an opportunity for both companies to combine their
technological progress and generate greater value from the sharing of knowledge and technology. These
kinds of merger usually lead to innovation and entirely new products and services, hence are beneficial not
only to the companies themselves, but to the industry as well. Same goes for skills, which are in certain cases
exclusive, and can only be sought out, if the said company is taken over.
5. Roll-up strategies
Some firms are too small in the market and are highly fragmented, which means they experience higher
costs, and it is not feasible for them to keep up operations because there are no economies of scale due to
a very small volume. An acquisition is such case is more common and can be hugely beneficial to the target
company, as it could keep on operating only with an element of economies of scale. It would also help an
acquirer, since it would be able to penetrate smaller fractions of the market, as smaller companies have
access to these markets. Hence this kind of merger creates value for both companies, and promises greater
efficiency in the operational activities. Advertising campaigns can be coordinated together in order to
increase revenues and save on costs.
6. Encourage competitive behavior
Many companies decide to take over other companies in an attempt to improve the overall competitive
behavior in the industry. This is done by eliminating price competition, which leads to improvement in rate of
internet return of the industry. If the competition is kept at bay, and new entrants are not allowed, firms don’t
have to compromise on quality as price is no longer a competing factor. Smaller businesses can only gain
share through offering at lower prices, but price competition reduces overall profits for the industry. In order
to restore the balance, and invest all effort an energy on quantity, mergers and takeovers are initiated to
improve the overall competitive environment in the industry.

How Mergers Are Structured

Mergers can be structured in multiple different ways, based on the relationship between the two
companies involved in the deal:
1. Horizontal merger: Two companies that are in direct competition and share the same product lines and
markets.
2. Vertical merger: A customer and company or a supplier and company. Think of an ice cream maker merging
with a cone supplier.

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3. Congeneric mergers: Two businesses that serve the same consumer base in different ways, such as a TV
manufacturer and a cable company.
4. Market-extension merger: Two companies that sell the same products in different markets.
5. Product-extension merger: Two companies selling different but related products in the same market.
6. Conglomeration: Two companies that have no common business areas.

Mergers may also be distinguished by following two financing methods, each with its own ramifications
for investors.
1. Purchase mergers – As the name suggests, this kind of merger occurs when one company purchases another
company. The purchase is made with cash or through the issue of some kind of debt instrument. The sale is
taxable, which attracts the acquiring companies, who enjoy the tax benefits. Acquired assets can be written
up to the actual purchase price, and the difference between the book value and the purchase price of the
assets can depreciate annually, reducing taxes payable by the acquiring company.
2. Consolidation mergers – With this merger, a brand-new company is formed, and both companies are bought
and combined under the new entity. The tax terms are the same as those of a purchase merger.

How Acquisitions Are Financed

A company can buy another company with cash, stock, assumption of debt, or a combination of some
or all of the three. In smaller deals, it is also common for one company to acquire all of another company's assets.
Company X buys all of Company Y's assets for cash, which means that Company Y will have only cash (and
debt, if any). Of course, Company Y becomes merely a shell and will eventually liquidate or enter other areas of
business.
Another acquisition deal known as a reverse merger enables a private company to become publicly-
listed in a relatively short time period. Reverse mergers occur when a private company that has strong prospects
and is eager to acquire financing buys a publicly-listed shell company, with no legitimate business operations
and limited assets. The private company reverses merges into the public company, and together they become
an entirely new public corporation with tradeable shares.

How Mergers and Acquisitions Are Valued

Both companies involved on either side of an M&A deal will value the target company differently. The
seller will obviously value the company at the highest price possible, while the buyer will attempt to buy it for the
lowest possible price. Fortunately, a company can be objectively valued by studying comparable companies in
an industry, and by relying on the following metrics:
1. Price-earnings ratio (P/E ratio) – With the use of a price-to-earnings ratio (P/E ratio), an acquiring company
makes an offer that is a multiple of the earnings of the target company. Examining the P/E for all the stocks
within the same industry group will give the acquiring company good guidance for what the target's P/E
multiple should be.
2. Enterprise-value-to-sales ratio (EV/sales) – With an enterprise-value-to-sales ratio (EV/sales), the acquiring
company makes an offer as a multiple of the revenues, while being aware of the price-to-sales ratio of other
companies in the industry.
3. Discounted cash flow (DCF) – A key valuation tool in M&A, discounted cash flow (DCF) analysis determines
a company's current value, according to its estimated future cash flows. Forecasted free cash flows (net
income + depreciation/amortization – capital expenditures – change in working capital) are discounted to
a present value using the company's weighted average costs of capital (WACC). Admittedly, DCF is tricky
to get right, but few tools can rival this valuation method.

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4. Replacement cost – In a few cases, acquisitions are based on the cost of replacing the target company. For
simplicity's sake, suppose the value of a company is simply the sum of all its equipment and staffing costs.
The acquiring company can literally order the target to sell at that price, or it will create a competitor for the
same cost. Naturally, it takes a long time to assemble good management, acquire property and purchase
the right equipment. This method of establishing a price certainly wouldn't make much sense in a service
industry where the key assets (people and ideas) are hard to value and develop.
Why do Companies go International?
In general, companies go international because they want to grow or expand operations. The benefits
of entering international markets include generating more revenue, competing for new sales, investment
opportunities, diversifying, reducing costs and recruiting new talent.
Going international is a strategy that is influenced by a variety of factors and is typically implemented
over time. Sometimes, a government will incentivize companies to enter their country's market in an effort to build
their economies.
Companies expand into international markets for a variety of reasons, such as increasing brand
awareness and reducing costs. There is one overarching goal that all international businesses share: increased
profit.
1. Improving Profit Margins
Improving profit margins is one of the most common reasons for entering international markets. When
growth strategies are used up on the national level, the next path is often to seek out international growth.
Distributing your products in additional countries increases your customer base. As you offer compelling
solutions and build loyalty across international markets, revenue strengthens and escalates as well.
There are also significant cost savings that can be associated with going international. A company may
want to reduce costs by relocating closer to a supplier or benefit from lower production costs by expanding
operations to another country. Doing business internationally may open up new investment opportunities.
Further, a lower cost of acquiring customers may be another compelling reason to expand internationally.
2. Competing for New Sales
Closely connected to the goal of improved profit margins is the desire to increase sales. Even if company
operators generally are satisfied with revenue levels, international expansion can further improve overall
revenues. The race to expand internationally is often about gaining a presence in foreign markets. Being the
first to arrive in a new market can provide significant advantages.
If you don't enter a ripe market with your solution, competitors do. Not only do you miss the revenue
source, but you lose out on other valuable assets that you could use to promote your company at home
and abroad. In some cases, a strong domestic company gets overrun by a lesser player that succeeds
globally and grows big through global synergy.
Bear in mind that in the modern economy, many companies are already global thanks to technology.
Companies develop specific international strategies in order to gain competitive advantages in the new
global economy.
3. Diversifying the Business
The international expansion allows a company to diversify its business in a couple of key ways. First, you
spread the risk of slowing demand across multiple countries. If one market never gains or loses interest in your
offerings, you can pick up the slack with success in other countries. In addition, you can connect with
suppliers in international markets and take advantage of raw materials and resources unavailable in
domestic markets.

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Also, companies often enhance innovation and develop additional variations of their solutions when
they operate in multiple countries. Product diversification similarly insulates you from the risks of declining
interest in a particular item.
For example, Xiaomi, one of the most popular smartphone manufacturers in China, seeks to expand in
India over the next few years. In addition to mobile devices, the company is planning to sell electric folding
bikes, self-balancing scooters, fitness bands and other products. This will allow it to reach a wider audience
and diversify its operations.
Diversifying your brand's offerings and its customer base are two popular reasons for international
business expansion. Sometimes, a product isn't a bad product, but a bad fit for the market where it was
originally launched. Launching that product again in a different market, toward people with a different
culture and a different budget can mean an entirely different, much more positive reception for that
product.
4. Recruiting New Talent
Operating in international markets also gives businesses access to a larger and more diversified talent
pool. Employees who speak different languages and understand different cultures enhance connections
with a broader customer base. Having an international brand that is well reputed will invite top talent to the
company. Businesses can also structure global work teams in a way that allows for synergy in building a
global brand.

International Business Finance

The different aspects of international business finance include the corporate finance, foreign exchange
markets, global financial systems and foreign investment policies.
1. International finance is the study and analysis of how money moves from the home country to an
international destination. The level of risk influences how cash flows between countries, such as those
associated with the currency exchange rate, central bank policies, political environment and foreign
investment policies. These different aspects of international finance provide the financial structure to
conduct business abroad, while also identifying and monitoring potential risks.
2. Corporate finance plays a central role in international business finance by setting its capital structure, process
for acquiring assets, capital budgeting and optimizing rates of return. It makes sure that corporations have
the financing they needs to fulfill business objectives and reach both domestic and international goals. The
corporate finance policies a business up for how it will handle and manage the other aspects of international
business finance. For instance, a business may want to invest in technological advancements in order to be
able to monitor and manage its overseas capital.
3. Foreign exchange is an important aspect of international business finance since a slight change can greatly
affect the movement of cash flow between countries. The foreign exchange is where currencies can be
purchased or sold on the open market. If the value of a currency decreases, then foreign investment may
also decrease since the price of purchasing the foreign currency is higher. For example, if the value of the
US dollar decreases against the Euro, then investors in the European Union may reduce their investment in
the United States since their costs are higher. International businesses often use financial hedging methods
in order to reduce their risks of changing exchange rates.
In the spot exchange market, foreign currencies are also affected to these two kinds of quotations namely
direct and indirect quotes. A direct quote is a foreign exchange rate quoted in fixed units of foreign currency
in variable amounts of the domestic currency. In other words, a direct currency quote asks what amount of
domestic currency is needed to buy one unit of the foreign currency—most commonly the U.S. dollar (USD)
in forex markets. In a direct quote, the foreign currency is the base currency, while the domestic currency is

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the counter currency or quote currency. On the other hand, an indirect quote expresses the variable amount
of foreign currency required to buy or sell fixed units of the domestic currency. It is also known as a “quantity
quotation” since it expresses the quantity of foreign currency required to buy units of the domestic currency.
In other words, the domestic currency is the base currency in an indirect quote, while the foreign currency is
the counter currency. An indirect quote is the opposite or reciprocal of a direct quote, also known as a
“price quotation,” which expresses the price of a fixed number of units of a foreign currency as compared
with a variable number of units of the domestic currency.
4. Global financial systems, such as the International Monetary Fund and central banks, are institutions that
regulate money on the international level. This aspect of international business finance can cause large
ripples in the market when it changes policies or enacts new measures, such as lending to countries in
financial distress or changing its lending rates. Business finance monitors global financial systems closely in
order to prepare or take advantage of impending changes.
5. Foreign investment policies affect the company’s ability to conduct business in the foreign country. New
laws and legislation in regards to creating a business, human resources and copyright can result in significant
cost increases or its inability to continue business in that country. Foreign investment policies are generally
stable in developed countries, but must be monitored regularly in emerging or undeveloped economies.

SUMMARY OF THE LESSON

✓ Mergers and acquisitions (M&A) is a general term used to describe the consolidation of companies or assets
through various types of financial transactions, including mergers, acquisitions, consolidations, tender offers,
purchase of assets, and management acquisitions.
✓ Types of mergers and acquisitions include: Mergers, Acquisitions, Consolidations, Tender offers, Acquisition of
assets, and Management acquisitions.
✓ M&A are reasonably decided in order to: improve the company’s performance, remove excess capacity,
accelerate growth, acquire skills and technology, roll-up strategies, and encourage competitive behavior.
✓ Mergers can be structured using: Horizontal merger, Vertical merger, Congeneric mergers, Market-extension
merger, Product-extension merger, and Conglomeration.
✓ Mergers may also be distinguished by two financing methods namely: Purchase mergers, and Consolidation
mergers.
✓ A company can be objectively valued by studying comparable companies in an industry and by relying on
different metrics such as: Price-earnings ratio (P/E ratio), Enterprise-value-to-sales ratio (EV/sales), Discounted
cash flow (DCF), and Replacement cost.
✓ Companies go international for: Improving Profit Margins, Competing for New Sales, Diversifying the Business,
and Recruiting New Talent.
✓ The different aspects of international business finance include the corporate finance, foreign exchange
markets, global financial systems and foreign investment policies.

REFERENCES
1. Cabrera, Cabrera, Cabrera (2021-2022) Financial Management: Principles and Applications
2. Timbang, Ferdinand L. (2015) Financial Management Part II
3. https://www.investopedia.com/terms/m/mergersandacquisitions.asp
4. https://www.cleverism.com/different-types-of-mergers-and-acquisitions-ma/
5. https://bizfluent.com/facts-5256365-do-companies-go-international.html
6. https://www.wise-geek.com/what-are-the-different-aspects-of-international-business-
finance.htm#:~:text=The%20different%20aspects%20of%20international%20business%20finance%20inclu

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de%20the%20corporate,systems%20and%20foreign%20investment%20policies.&text=The%20corporate%
20finance%20policies%20a,aspects%20of%20international%20business%20finance.
7. https://www.investopedia.com/terms/d/directquote.asp
8. https://www.investopedia.com/terms/i/indirectquote.asp

Financial Management [FINMAN202]