Strategic financial management

FINAL (NEW) COURSE STRATEGIC FINANCIAL MANAGEMENT ISBN: 978-81-8441-072-3 Board of Studies The Institute of Chartered Accountants of India A-94/4, Sector-58, Noida-201301 Phone : 0120 - 3045900 Fax : 0120 - 3045940 E-mail : bosnoida@icai.org Website : http://www.icai.org FINAL (NEW) COURSE STRATEGIC FINANCIAL MANAGEMENT Board of Studies The Institute of Chartered Accountants of India (Set up by an Act of Parliament) March / 2010 (Revised) New Delhi FINAL (NEW) COURSE STUDY MATERIAL PAPER Strategic Financial Management BOARD OF STUDIES THE INSTITUTE OF CHARTERED ACCOUNTANTS OF INDIA This study material has been prepared by the faculty of the Board of Studies The objective of the study material is to provide teaching material to the students to enable them to obtain knowledge and skills in the subject Students should also supplement their study by reference to the recommended text books In case students need any clarifications or have any suggestions to make for further improvement of the material contained herein, they may write to the Director of Studies All care has been taken to provide interpretations and discussions in a manner useful for the students However, the study material has not been specifically discussed by the Council of the Institute or any of its Committees and the views expressed herein may not be taken to necessarily represent the views of the Council or any of its Committees Permission of the Institute is essential for reproduction of any portion of this material  THE INSTITUTE OF CHARTERED ACCOUNTANTS OF INDIA All rights reserved No part of this book may be reproduced, stored in retrieval system, or transmitted, in any form, or by any means, Electronic, Mechanical, photocopying, recording, or otherwise, without prior permission in writing from the publisher Revised Edition : March, 2010 Website : www.icai.org Department/ Committee : Board of Studies E-mail : bosnoida@icai.org ISBN No : 978-81-8441-072-3 Published by : The Publication Department on behalf of The Institute of Chartered Accountants of India, ICAI Bhawan, Post Box No 7100, Indraprastha Marg, New Delhi-110 002, India Typeset and designed at Board of Studies Printed by : Sahitya Bhawan Publications, Hospital Road, Agra- 282 003 March/ 2010/ 15,000 Copies (Revised) PREFACE Strategic Financial Management is a blend of Strategic Management and Financial Management It has acquired a critical significance now-a-days, due to recent surge in globalization and massive cross border flow of capital The study of this subject opens new opportunities for Chartered Accountancy students The paper stresses the importance of applying the knowledge and techniques of financial management to the planning, operating and monitoring of the finance function in particular as well as the organization in general Further, this paper not only focuses on these aspects at the domestic level but also at the international level as well This study material provides the concepts, theories and techniques relating to Strategic Financial Management and aims to develop the students’ ability in understanding the different concepts and their application in the real life situations The study material is divided into thirteen chapters Latest developments in the field of finance including international finance have been incorporated in almost all the chapters The study material also focuses on the decision making in an international context and it provides comprehensive coverage of important areas like foreign exchange market, derivatives, foreign exchange exposure, risk analysis and management, raising of capital abroad, mergers and acquisitions and portfolio management, capital budgeting and working capital management in a multinational context Chapters have been organised in such a way so as to provide a logical sequence to facilitate easy understanding A number of self-examination questions are given at the end of each chapter, which will be useful to test the understanding of concepts discussed in the chapter Another helpful feature in this study material is the addition of a number of illustrations in each chapter to help students to have a better grasp of the subject Numerous graphs and figures have also been added to make things more appealing Some of the chapters also contain Glossary of terms used Students are advised to supplement their knowledge by referring to the recommended books and the compilation of the subject They need to practice the practical problems thoroughly Students are also advised to update themselves with the latest changes in the financial sector For this they may refer to academic updates in the monthly journal ‘The Chartered Accountant’ and the Students ‘Newsletter’ published by the Board of Studies, financial newspapers, SEBI and Corporate Law Journal etc The concerned Faculty of Board of Studies of Strategic Financial Management CA Ashish Gupta and Ms Nidhi Singh have put their best efforts in preparing the study material The Board has also received valuable inputs from CA Dhaneshchandra P Revawala of Thane (Maharashtra), for which the Board is thankful to him In case students have any suggestions to make this study material more helpful, they are welcome to write to the Director of Studies, The Institute of Chartered Accountants of India, A-94/4, Sector-58, Noida-201 301 SYLLABUS PAPER : STRATEGIC FINANCIAL MANAGEMENT (One paper – Three hours – 100 marks) Level of Knowledge: Advanced knowledge Objective: To apply financial management theories and techniques for strategic decision making Contents: Financial Policy and Corporate Strategy Strategic decision making framework Interface of Financial Policy and strategic management Balancing financial goals vis-à-vis sustainable growth Project Planning and Capital Budgeting Feasibility study Cash flow Projections – Impact of taxation, depreciation, inflation and working capital Capital Budgeting Decisions - Certainty Equivalent approach, Evaluation of Risky Investment Proposals, Risk and Return analysis, Simulation and decision tree analysis, Sensitivity analysis, Capital Rationing, Adjusted Net Present Value, Replacement decisions, Application of Real Options in capital budgeting, Impact of inflation on capital budgeting decisions Preparation of Project Report Social cost benefit analysis Leasing decision including cross border leasing Dividend Decisions Dividend theories, Determinants of dividend policies (a) Indian Capital Market including role of various primary and secondary market institutions (b) Capital Market Instruments Financial derivatives – stock futures, stock options, index futures, index options Option valuation techniques : Binomial model, Black Scholes Option Pricing Model, Greeks – Delta, Gamma, Theta, Rho and Vega Pricing of Futures – Cost of carry model Imbedded derivatives (c) Commodity derivatives (d) OTC derivatives -Swaps, Swaptions, Forward Rate Agreements (FRAs), Caps, Floors and Collors Security Analysis Fundamental analysis - Economic analysis, Industry analysis and Company Analysis Bond valuation, Price Yield relationship, Bond Price forecasting – application of duration and convexity, Yield curve strategies Technical Analysis – market cycle model and basic trend identification, different types of charting, support and resistance, price patterns, moving averages, Bollinger Bands, momentum analysis Portfolio Theory and Asset Pricing Efficient Market Theory – Random walk theory ; Markowitz model of risk return optimization Capital Asset Pricing Model (CAPM) Arbitrage Pricing Theory (APT) Sharpe Index Model Portfolio Management - Formulation, Monitoring and Evaluation Equity Style Management Principles and Management of Hedge Funds International Portfolio Management Financial Services in India Investment Banking Retail Banking On Line Share Trading Depository Service (a) Mutual Funds: Regulatory framework, formulation, monitoring and evaluation of various schemes of Mutual funds, Money market mutual funds (b) Exchange Traded Funds 10 Money Market operations 11 (a) Foreign Direct Investment, Foreign Institutional Investment (b) International Financial Management Raising of capital abroad - American Depository Receipts, Global Depository Receipts, External Commercial Borrowings and Foreign Currency Convertible Bonds International Capital Budgeting International Working Capital Management 12 Foreign Exchange Exposure and Risk Management Exchange rate determination, Exchange rate forecasting Foreign currency market Foreign exchange derivatives – Forward, futures, options and swaps Management of transaction, translation and economic exposures Hedging currency risk 13 Mergers, Acquisitions and Restructuring Meaning of mergers and acquisition, categories, purposes Process of mergers and acquisition – Identification and valuation of the target, acquisition through negotiation, due diligence, post – merger integration Legal and regulatory requirements Merger and Acquisition agreement Reverse merger Potential adverse competitive effects of mergers Corporate Takeovers: Motivations, Co-insurance effect, Cross-border takeovers, Forms of takeovers, Takeover defenses Going Private and Other Control Transactions: Leveraged Buyouts (LBOs), Management Buyouts (MBOs), Spin Offs and Asset Divestitures Corporate Restructuring : Refinancing and rescue financing, reorganizations of debtors and creditors, Sale of assets, targeted stock offerings, downsizing and layoff programmes, negotiated wage give-backs, employee buyouts CONTENTS CHAPTER – FINANCIAL POLICY AND CORPORATE STRATEGY 1.0 Strategic Management Decision Making Frame Work 1.1 2.0 Interface of Financial Policy and Strategic Management 1.5 3.0 Balancing Financial Goals vis-a-vis Sustainable Growth 1.7 CHAPTER – PROJECT PLANNING AND CAPITAL BUDGETING 1.0 Feasibility Study 2.1 2.0 Contents of a Project Report 2.12 3.0 Social Cost Benefit Analysis - What it is? .2.18 4.0 Capital Budgeting under Risk and Uncertainty 2.21 5.0 Selection of Projects 2.30 6.0 Capital Budgeting under Capital Rationing 2.32 7.0 Capital Budgeting under Inflation 2.34 8.0 Decision Trees .2.38 9.0 Capital Asset Pricing Model Approach to Capital Budgeting 2.40 10.0 Replacement Decision 2.43 11.0 Real option in Capital Budgeting 2.45 CHAPTER – LEASING DECISIONS 1.0 Leasing 3.1 2.0 Types of Leasing .3.1 3.0 Advantages 3.3 4.0 Disadvantages 3.4 5.0 Financial Evaluation .3.4 6.0 Cross Border Leasing 3.18 CHAPTER – DIVIDEND DECISIONS Introduction 4.1 Dividend Policy 4.1 Practical Considerations in Dividend Policy 4.2 Theories on Dividend Policies 4.6 CHAPTER – INDIAN CAPITAL MARKET Overview of Indian Financial System 5.1 Capital Markets/Securities Market 5.2 Stock Market and its Operations .5.4 Settlement and Settlement Cycles 5.12 Clearing Houses 5.14 Green Shoe Option 5.15 100% Book Building Process 5.16 IPO through Stock Exchange On-line System (E-IPO) 5.16 10 Introduction to Capital Market Instruments 5.17 Capital Market Instruments 5.18 11 12 13 14 15 16 17 18 19 20 Introduction to Commodity Derivatives 5.66 Necessary Conditions to Introduce Commodity Derivatives .5.66 The Indian Scenario .5.67 Investing in Commodity Derivatives 5.70 Commodity Market 5.72 Commodity Futures 5.73 Commodity Swaps 5.75 Hedging with Commodity Derivatives 5.76 Introduction to OTC Derivatives 5.78 OTC Interest Rate Derivatives 5.78 CHAPTER – SECURITY ANALYSIS Introduction 6.1 Fundamental Analysis 6.1 Technical Analysis 6.12 Bond Valuation 6.30 CHAPTER - PORTFOLIO THEORY Introduction 7.1 Portfolio Theories 7.2 Portfolio Management 7.31 Equity Style Management .7.48 Principles and Management of Hedge Funds 7.52 International Portfolio Management 7.65 CHAPTER – FINANCIAL SERVICES IN INDIA 1.0 Investment Banking 8.1 2.0 Credit Rating - What it is? 8.10 3.0 Consumer Finance - What it is? 8.15 4.0 Introduction to Housing Finance .8.19 5.0 Asset Restructuring/Management Company 8.22 6.0 Depository Services - What it is? 8.23 7.0 Debit Cards - What is it? 8.27 8.0 Online Share Trading .8.30 CHAPTER - MUTUAL FUNDS 1.0 Introduction 9.1 2.0 Mutual Funds could be the Best Avenue for the Risk-Averse Investors 9.3 3.0 Key Players in Mutual Funds 9.5 4.0 Classification of Mutual Funds 9.6 5.0 Advantages of Mutual Funds 9.7 6.0 Mutual Fund Drawbacks 9.8 7.0 Evaluating Performance of Mutual Funds 9.9 8.0 The Criteria for Evaluating the Performance 9.12 9.0 Factors Influencing the Selection of Mutual Funds 9.14 10.0 Signals Highlighting the Exist of the Investor from the Mutual Fund Scheme 9.15 11.0 Money Market Mutual Funds 9.16 CHAPTER 10 - MONEY MARKET OPERATIONS 1.0 Introduction 10.1 2.0 Institutions 10.11 3.0 Instruments 10.12 4.0 Determination of Interest Rates 10.32 5.0 Future Possibilities 10.33 Mergers, Acquisitions & Restructuring 13.39 Companies often merge in the fear that the bigger competitors have economies of scale and may destroy them by exercising a stranglehold on raw material supply, distribution etc What they don’t realise is the drawbacks of being big The acquiring company’s executives would have drawn up elaborate plans for the target without consulting its executives which leads to resentment and managerial attrition This can be avoided by honest discussions with the target company’s executives Most companies merge with the hope that the benefits of synergy will be realised Synergy will be there only if the merged entity is managed better after the acquisition than it was managed before It is the quality of the top management that determines the success of the merger Quite often the executives of the acquiring company lose interest in the target company due to its smallness The small company executives get bogged down repairing vision and mission statements, budgets, forecasts, profit plans which were hitherto unheard of The elaborateness of the control system depends on the size and culture of the company To make a merger successful, • • • • Decide what tasks need to be accomplished in the post-merger period; Choose managers from both the companies (and from outside); Establish performance yardstick and evaluate the managers on that yardstick; and Motivate them 21.0 MAXIMUM PURCHASE CONSIDERATION Maximum purchase consideration is value of vendor’s business from the viewpoint of the purchaser This is given by present value incremental cash flow accruing to the purchaser on acquisition of vendor’s business This cash flow can be different from cash flow generated by vendor’s business due to synergy The discounting rate should reflect risk associated with the business of the vendor The following additional points should be noted (a) The discounting rate represents the rate of return desired from the operating activities This means, the cash flows to be discounted should be the operating cash flow (b) The operating cash flow of a business is the aggregate of cash flows generated by the operating assets The present value of operating cash flow therefore, is the aggregate value of net operating assets of the vendor Where the purchaser takes over nonoperating assets of the vendor, the agreed value of the non-operating assets taken over should be added with present value of operating cash flows (c) the acquisition of business can give rise to certain additional liabilities For example, the purchaser may wish to retrench some of the existing employees of the vendor The compensation payable on retrenchment of employees is an additional liability arising on acquisition These liabilities should be deducted from present value of operating cash flows 13.40 Strategic Financial Management (d) In theory, a business has infinite life Yet, in reality it is very difficult to project cash flows to eternity It is, therefore, usual to assume that the business shall be disposed off after the forecast period The expected disposal value of the business, called the terminal or horizon value, is a cash flow in the terminal year The present value of terminal value is added with the present value of operating cash flows Acquiring for Shares: The acquirer can pay the target company in cash or exchange shares in consideration The analysis of acquisition for shares is slightly different The steps involved in the analysis are: • • • • Estimate the value of acquirer’s (self) equity; Estimate the value of target company’s equity; Calculate the maximum number of shares that can be exchanged with the target company’s shares; and Conduct the analysis for pessimistic and optimistic scenarios Exchange ratio is the number of acquiring firm’s shares exchanged for each share of the selling firm’s stock Suppose company A is trying to acquire company B’s 100,000 shares at Rs.230 So the cost of acquisition is Rs.230,00,000 Company A has estimated its value at Rs.200 per share To get one share of company B, A has to exchange (230/200) 1.15 share, or 115,000 shares for 100,000 shares of B The relative merits of acquisition for cash or shares should be analysed after giving due consideration to the impact on EPS, capital structure, etc Impact of Price Earning Ratio: The reciprocal of cost of equity is price-earning (P/E) ratio The cost of equity, and consequently the P/E ratio reflects risk as perceived by the shareholders The risk of merging entities and the combined business can be different In other words, the combined P/E ratio can very well be different from those of the merging entities Since market value of a business can be expressed as product of earning and P/E ratio (P/E x E = P), the value of combined business is a function of combined earning and combined P/E ratio A lower combined P/E ratio can offset the gains of synergy or a higher P/E ratio can lead to higher value of business, even if there is no synergy In ascertaining the exchange ratio of shares due care should be exercised to take the possible combined P/E ratio into account Illustration Firm A is studying the possible acquisition of Firm B by way of merger The following data are available: Firm After-tax earnings No of equity shares Market price per share A Rs.10,00,000 2,00,000 Rs.75 B Rs.3,00,000 50,000 Rs.60 Mergers, Acquisitions & Restructuring (i) 13.41 If the merger goes through by exchange of equity shares and the exchange ratio is set according to the current market prices, what is the new earnings per share for Firm A (ii) Firm B wants to be sure that its earning per share is not diminished by the merger What exchange ratio is relevant to achieve the objective? Solution (i) the current market price is the basis of exchange of equity shares, in the proposed merger, shareholders of Firm B will get only 40,000 shares in all or shares of Firm A for every shares held by them, i.e., 50,000 × 60 = 40,000 75 The total number of shares in Firm A will then be 2,40,000 and, ignoring any synergistic effect, the profit will be Rs.13,00,000 The new earning per share (EPS) of Firm A will be Rs.5.42, i.e., Rs.13,00,000/2,40,000 (ii) The present earnings per share of firm B is Rs.6/- i.e., Rs.3,00,000 ÷ 50,000 and that of Firm A Rs.5/-, i.e., Rs.10,00,000 ÷ 2,00,000 If Firm B wants to ensure that, even after merger, the earning per share of its shareholders should remain unaffected, then the exchange ratio will be shares for every shares The total number of shares that will produce Rs.3,00,000 profit is 60,000, i.e., 3,00,000 ÷ 5, the EPS in Firm A 60,000 shares of A will be distributed among, shareholders of Firm B, giving a ratio of shares in A for shares in B Proof: The shareholders of Firm B will get in all 60,000 share for 50,000 shares It 13,00,000 In all they means after merger, their earning per share will be Rs.5/-, i.e 2,60,000 will get Rs.3,00,000, i.e., 60,000 x 5, as before Illustration The Board of Directors of X Ltd are considering the possible acquisition (by way of merger) of firm Y The following data are available in respect of both the companies: Company Earnings after Tax (Rs.) No of Equity shares Market value per share (Rs.) X 4,00,000 80,000 15 Y 1,20,000 20,000 12 (a) What shall be the new earning per share for Company X, if the proposed merger takes place by exchange of equity share and the exchange ratio is based on the current market prices? 13.42 Strategic Financial Management (b) Company Y wants to be sure that earnings available to its shareholders will not be diminished by the Merger What should be the exchange ratio in that case? Solution (a) Company E.A.T (Rs.) No of Equity Shares Market Value (Rs.) X Y 4,00,000 80,000 1,20,000 20,000 15 12 12 × 20,000 = 16,000 shares 15 i.e., shares of X Ltd for every shares of Y Ltd Firm Y will get Then, total number of shares of X Ltd., shall be 80,000 + 16,000 = 96,000 Total earnings after tax shall be = 4,00,000 + 1,20,000 = Rs.5,20,000 Therefore, E.P.S = 5,20,000 = 5.42 per share 96,000 (b) Present Earnings per share (E.P.S.) Company X = 4,00,000 = Rs.5 80,000 Company Y = 1,20,000 = Rs.6 20,000 Thus, exchange ratio should be shares of X Ltd for every shares of Y Ltd Number of shares to be issued to Y Ltd = 20,000 x = 24,000 Mergers, Acquisitions & Restructuring 13.43 Total number of shares of X Ltd after merger, shall be: 80,000 + 24,000 = 1,04,000 E.P.S after merger, shall be = = 5,20,000 1,04,000 = Rs.5 4,00,000 + 1,20,000 Total earnings available to shareholders of Y Ltd., after merger, shall be 24,000 x = Rs 1,20,000 Therefore, exchange ratio based on Earnings per share is recommended Illustration Company X is contemplating the purchase of Company Y, Company X has 3,00,000 shares having a market price of Rs.30 per share, while Company Y has 2,00,000 shares selling at Rs.20 per share The EPS are Rs.4.00 and Rs.2.25 for Company X and Y respectively Managements of both companies are discussing two alternative proposals for exchange of shares as indicated below: (i) in proportion to the relative earnings per share of two companies (ii) 0.5 share of Company X for one share of Company Y (.5:1) You are required: (i) to calculate the Earnings Per share (EPS) after merger under two alternatives; and (ii) to show the impact of EPS for the shareholders of two companies under both the alternatives Solution Working Notes Calculation of total earnings after merger Particulars Outstanding shares EPS (Rs.) Total earnings (Rs.) Company X Company Y 3,00,000 2,00,000 2.25 12,00,000 4,50,000 Total 16,50,000 13.44 Strategic Financial Management (i) (a) Calculation of EPS when exchange ratio is in proportion to relative EPS of two companies Company X Company Y 3,00,000 2,00,000 x 2.25/4 1,12,500 Total number of shares after merger 4,12,500 Company X EPS before merger = Rs.4 EPS after merger = Rs 16,50,000/4,12,500 shares = Rs.4 = Rs.2.25 = Rs.4 Company Y EPS before merger EPS after merger = EPS before merger/Share Exchange ratio on EPS basis = 2.25 2.25 = 2.25 / 0.5625 (b) Calculation of EPS when share exchange ratio is 0.5:1 Total earnings after merger = Rs.16,50,000 Total number of shares after merger = 3,00,000 + (2,00,000 x 0.5) = 4,00,000 shares EPS after merger = Rs.16,50,000/4,00,000 = Rs.4.125 (ii) Impact of merger on EPS for shareholders of Company X and Company Y (a) Impact on Shareholders of Company X (Rs.) EPS before merger 4.000 EPS after merger 4.125 Increase in EPS 0.125 (b) Impact on Shareholders of Company Y (Rs.) Equivalent EPS before merger (2.25/0.5 4.500 EPS after merger 4.125 Decrease in EPS 0.375 Mergers, Acquisitions & Restructuring 13.45 Illustration Simpson Ltd is considering a merger with Wilson Ltd The data below are in the hands of both Board of Directors The issue at hand is how many shares of Simpson should be exchanged for Wilson Ltd Both boards are considering three possibilities 20,000, 25,000 and 30,000 shares You are required to construct a table demonstrating the potential impact of each scheme on each set of shareholders: Simpson Ltd Wilson Ltd Combined Post merger Firm ‘A’ 2,00,000 1,00,000 3,50,000 50,000 10,000 ? 10 ? Current earnings per year Shares outstanding Earnings per share (Rs.) (1÷ 2) Price per share (Rs.) 40 100 ? Price-earning ratio [4 ÷ 3] 10 10 10 Value of firm (Rs.) 20,00,000 10,00,000 35,00,000 Expected Annual growth rate in earnings in foreseeable future 0 Solution In a merger, in which shares are issued in payment to the selling company’s shareholders, stockholders will find the merger desirable only if the value of their shares is higher with the merger than without the merger The number of shares that the buying company (Simpson Ltd.) will issue in acquiring the selling company (Wilson Ltd.) is determined as follows: (1) The acquiring company (Simpson Ltd.) will compare its value per share with and without the merger (2) The selling company (Wilson Ltd.) will compare its value with the value of shares that they would receive from Simpson Ltd under the merger (3) The managements of Simpson Ltd and Wilson Ltd will negotiate the final terms of the merger in the light of (1) and (2); the ultimate terms of the merger will reflect the relative bargaining position of the two companies The fewer of Simpson Ltd.’s shares that Simpson Ltd must pay to Wilson Ltd., the better off are the shareholders of Simpson Ltd and worse off are the shareholders of Wilson Ltd However, for the merger to be effected, the shareholders of both the buying and selling company will have to anticipate some benefits from the merger The following table 13.46 Strategic Financial Management demonstrates the potential impact of the three possible schemes, on each set of shareholders:Exchange Number of Fraction Simpson ratio Simpson Firm A (Post Ltd.’s shares [(1)/10,000 Ltd.’s merger) issued Number of of Fraction of Value shares owned Firm A shares by (combined Value of Wilson owned of by shares of shares owned Ltd.’s Post-merger Simpson shareholders Wilson outstanding Wilson Ltd.’s shareholders owned Ltd.’s of Ltd.] after shareholders [(4)x35,00,000] Simpson shareholders merger [(1)/(3)] Ltd.’s [(6) shareholders 35,00,000] to Wilson Ltd by [50,000+(1)] by x [50,000/(3)] (1) (2) (3) (4) (5) (6) (7) 20,000 70,000 2/7 10,00,000 5/7 25,00,000 25,000 2.5 75,000 1/3 11,66,667 2/3 23,33,333 30,000 80,000 3/8 13,12,500 5/8 21,87,500 22.0 M&As : TREAD WITH CAUTION The past couple of years have been an eventful phase for medium-sized companies in the software industry The competitive churn that began in this segment few years ago in the form of IPOs, acquisitions, hive-offs and restructuring have intensified Realising the inherent limitations of organic growth, medium-sized software companies have been quick to seize acquisition opportunities on a large scale The year 2000-01 was a highly eventful, with the industry witnessing 'highs' and 'lows' in the acquisition process The acquisitions put through in 2000 and 2001 were mainly driven by the need : • To bolster revenues by acquiring an established client base; • To use offshore capabilities to offer customers a cost-effective solution; • To broadbase/enhance existing vertical domain expertise of new verticals; • To gain access or strengthen their presence in new geographic markets such as Europe and the Asia-Pacific; • To offer more value-added services such as e-commerce or move up the value chain by entering into Internet consulting The key acquisitions put through by medium-sized companies had aimed to achieve some or all of the objectives outlined above Mergers, Acquisitions & Restructuring 13.47 Prima facie, the moves to acquire medium-sized software companies were initiated with specific objectives in mind However, in the course of their execution, several issues/problems have come to the fore Some of these issues demand the attention of the shareholders: Integration issues: Culture is important in intercultural business communication as explained by Chaney and Martin (2000): Whereas communication is a process, culture is the structure through which the communication is formulated and interpreted Culture deals with the way people live When cultures interact, adaptation has to take place in order for the cultures to communicate effectively In dealing with intercultural business communication, awareness of the symbols of each culture, how they are the same, and how they are different, is important Another important M&A issue is integration planning and post-merger integration Integration is probably the most important issue after a deal is signed between the acquirer and a seller in a cross-border M&A The areas that need to be integrated include the following: (1) organization and staffing plans; (2) product strategies; purchasing and supply chain management strategies; (4) production strategies and plans; (5) marketing strategies and sales forces; (6) information systems; (7) finance and accounting systems; and (8) human resource management systems Integration plans of the earlier and other areas should be formulated by various management teams and assisted by experienced consulting firms The integration teams should also work closely with the teams that conducted the due diligence process After the integration plan is approved for implementation, it should be communicated, and explained to employees impacted by the plan One way to avoid failures is to study failed cross-border mergers and joint ventures, and discover why they failed For example, in the 1998 merger between Daimler-Benz and Chrysler, the “Daimler Chrysler post-merger integration project was ultimately built around a list of a dozen or so major tasks, derived from a list of almost 100 potential pitfalls in the post-merger integration process” (Habeck et al 2000) This list was developed from studying 50 failures in cross-border mergers and joint ventures For specific due diligence and integration issues related to M&A activity in an Asian country, the M&A partners can study a guide such as the Baker and McKenzie Guide to Mergers and Acquisitions by countries or other similar publications Alternatively, the M&A partners may hire an M&A attorney or investment bank to assist with the due diligence and integration processes The success of an acquisition lies in handling complex integration issues associated with the acquisition within a prescribed time frame Given the fact that acquisitions have been a new experience for medium-sized software companies in India, quite a few of these 13.48 Strategic Financial Management acquisitions have been bogged down by post-acquisition integration and restructuring issues To some extent, this has led some of these companies to perform indifferently for a few quarters in the post-acquisition phase For example, in a Securities and Exchange Commission(SEC) filing, Silverline Technologies indicated that the integration with SeraNova had been complex and time consuming Silverline has also added that its financial performance could be affected if the operations of SeraNova were not integrated quickly Other acquisitions such as SSI's acquisition of Indigo Technologies, BFL's acquisition of MphasiS and Leading Edge Systems takeover of Capital Solutions have also had several integration issues that had to be ironed out before the acquisition could start yielding the desired dividends • Low clinch to completion rates : While medium-sized companies have been quick to identify and clinch acquisition targets, the rate of completion/consummation have been fairly low The consummation rates have dropped sharply in recent times mainly due to improper due diligence processes and poor market conditions For example, after proceeding with its acquisition of the New Jersey-based Data Inc to an advanced stage, Polaris Software called it off citing objections raised by its audit committee However, Data Inc's promoter has filed a lawsuit against Polaris in the US on the grounds that the latter had reneged on the terms and conditions of the acquisition agreement Similarly, the acquisition of San Vision Technology initiated by DSQ Software in appears to be hanging fire over purchase considerations At the time of the initial agreement, DSQ Software had planned to pay $30 million in an all-stock deal to acquire San Vision Following a deterioration in market conditions, DSQ has been attempting to renegotiate the agreement's terms, but has not made much headway San Vision has claimed that the deal has been called off, while DSQ has held that the deal is still being renegotiated In a related development, SEBI has asked DSQ Software to cancel its acquisition of US-based Fortuna Technologies over alleged irregularities in the acquisition process DSQ Software has also been barred from accessing the capital market for another year Owing to the complex and dynamic nature of the software industry, it may be desirable for SEBI to make it mandatory for companies planning an acquisition to declare overriding acquisition 'objectives' In addition, in the interests of encouraging good corporate governance, it may also consider making mandatory the following minimum disclosure requirements on acquisitions to help shareholders make meaningful investment decisions : Hidden liabilities: As a harsh reminder of the downside to acquisition, in the high profile acquisition of SeraNova Inc by Silverline Technologies, the former may have to pay a tax liability of $60-$65 million to its former parent, Intelligroup Inc The New Jersey-based Sera Nova Inc had been spun off from the Intelligroup Inc in July, 2000 and merged into Silverline Technologies' US subsidiary Silverline Acquisition Corp in an all-stock deal valued at $39.2 million in March 2001 Obviously future acquirers will have to tread with caution Mergers, Acquisitions & Restructuring 13.49 • Sharing of vision among the two companies; • Cultural compatibility; • Geographical and other synergies; • Short-term/medium-term plans for retention of manpower; • Antecedents of the acquired company — minimum information on revenues, employee profile, key focus areas and projectd revenues and post-tax earnings; • Existing clientele and how the synergies will drive future client profiles; • Total outlay (cash or stock swaps, or a combination of the above) for the acquirer; • Risks — short-and long-term; • Continuing disclosures on the execution/integration of the acquisition by the acquirer 23.0 CROSS-BORDER M&A Cross-border M&A is a popular route for global growth and overseas expansion Crossborder M&A is also playing an important role in global M&A This is especially true for developing countries such as India As explained by Eiteman et al (2006): The 1992 completion of the European Union’s Internal Market stimulated many of these investments, as European, Japanese, and US firms jockeyed for stronger market positions within the EU However, the long-run US growth prospects and political safety in the United States motivated more takeovers of US firms by foreign firms, particularly from the United Kingdom and Japan, than vice versa Other major factors that motivate multinational companies to engage in cross-border M&A in Asia include the following: • Globalization of production and distribution of products and services • Integration of global economies • Expansion of trade and investment relationships on International level • Many countries are reforming their economic and legal systems, and providing generous investment and tax incentives to attract foreign investment • Privatisation of state-owned enterprises and consolidation of the banking industry 24.0 DECADE OF CORPORATE CHURNING AND CHANGE Despite the churning and change that has taken place over the past decade, the corporate sector has still to go a long way in improving its image and become globally competitive The successes and failures have not been industry-specific but company-specific But at the macro-level, the overall efficiency of industry has not shown much improvement 13.50 Strategic Financial Management The internal and external liberalisation measures introduced over the last decade and the dramatic changes that have taken place in the international business environment have had a far-reaching impact on Indian business The face of Corporate India has changed more over the past decade than in the preceding four decades thanks to the U-turn in the Government's economic policy in 1991 Major policy changes: The major policy changes introduced since July, 1991 include : (a) abolition of industrial licensing; (b) lifting of restrictions on the size of firms; (c) a drastic reduction in the areas reserved for the public sector; (d) disinvestments of Government equity in public sector undertakings (PSUs) aimed at eventual privatisation of most of them; (e) liberalisation of foreign investment regulations; (f) substantial liberalisation of import tariffs; (g) removal of all quantitative restrictions on imports; (h) abolition of the office of the Controller of Capital Issues (CC) and freedom to companies to set premia on their share issues; (i) freedom to companies to rasie capital abroad; (j) rationalisation and lowering of excise and Customs duties and (k) a substantial reduction in corporate and personal income tax rates In large measure, these reforms met the longstanding demands of the Indian industry to free it from the plethora of controls and regulations, exorbitantly high rates of direct and indirect taxes and severe restrictions on foreign exchange transactions All the internal liberalisation measures provided greater freedom and opportunities to the Indian companies and entrepreneurs to expand their existing businesses and enter new areas hitherto reserved exclusively for the public sector However, the corporate sector was not quite prepared for the other side of reforms, namely, the external liberalisation and the movement towards globalisation, which opened the Indian economy to competition from abroad Although India was not strictly a closed economy even before the launch of the reforms process, Indian industry was generally insulated from external competition thanks to a variety of import restrictions and high tariff walls, the peak level import duty being some 300 per cent Companies are now obliged to offer better quality products at increasingly competitive prices, their profit margins are constantly under pressure Under the earlier regime of protection, 'cost-plus' pricing was the norm in most cases In the majority of cases, it was possible to pass on the burden of higher costs and inefficiencies to the customer by charging a higher price for the product To succeed in the new environment, companies are required to bring : New insights into understanding the customer who is becoming increasingly demanding; the ability to design, develop and produce new and more customer-friendly products of better quality; skills to develop exclusive positions in the minds of the consumer; new processes, techniques and technologies to ensure that costs are being continuously reduced, ways to restructure organisations so that trained and talented people stay to give their best efforts; and considerable funds to invest in marketing and building brand franchises Mergers, Acquisitions & Restructuring 13.51 Churning and restructuring: It is not surprising, therefore, that the Indian corporate sector is undergoing a process of churning and restructuring The fortunes of the once renowned family business houses such as the Dalmia-Jain group, Sriram group, Walchands, Thapars, Singhanias, Somanis, Wadias, Mafatlals, Khaitans and Modis have witnesssed an unprecedened decline With much erosion in their wealth, they lie scattered because of family splits and mismanagement However, Mr Dhirubhai Ambani's Reliance Group has been an exception It managed to prosper and grow despite all odds by seizing the opportunities provided by liberalisation and globalisation Reliance Industries and Reliance Petroleum are now among the top five companies in the country in terms of market capitalisation The decade also witnessed the phenomenal growth of the so-called New Economy companies such as Infosys, Wipro and Satyam Computers which started creating more wealth than the Tatas and Birlas Mr Azim Premji of Wipro and Mr Narayan Murthy of Infosys are the new breed of entrepreneurs known for very high standards of corporate governance and global outlook It must be said to the credit of at least some of the family business houses and leading individual companies that they have not been silent spectators allowing the events to overtake them For instance, Mr Ratan Tata has initiated measures since 1998 to restructure the Tata empire with the help of management consultants McKinsey & Co with a view to eventually reduce the number of companies in the group from the existing 80 to 30 and cut down the portfolio from 25 to just a dozen core businesses The restructuring exercises also include financial restructuring — restructuring of debt and equity Many companies hve been retiring the earlier high cost debt with the new low interest bearing loans The threat of hostile takeovers following the big slump in share values of Old Economy companies has prompted managements to hike their equity stake Gone are the days when business families could exercise control on the management of companies with a small equity stake, often less than 10 per cent Consolidation of market power: While the first wave of mergers and joint ventures was driven primarily by competitive compulsions and as an outcome of business restructuring, of late, the larger and more aggressive companies have been buying out the smaller ones to assume market leadership Till 1999, the biggest mergers and acquisitions deals were in the FMCG industries that are traditionally intensely competitive and have become more so with the entry of well-known international brands A classic example of the extensions and consolidation of market power is the Hindustan Lever's acquisition and restructuring spree over the last few years By 1998, it wrapped up five acquisitions (Tomco, Dollop's, Kwality, Milkfood and Kissan) and effected a host of mergers — Doom Dooma with Brooke Bond, Brooke Bond with Lipton, Pond's with Quest International, and finally Brooke Bond Lipton India Ltd (BBLIL) with Hindustan Lever Ltd (HLL) It acquired a 74 percent stake in Modern Foods and turned it into a profitable venture 13.52 Strategic Financial Management M&As also took place in cement, aluminium, steel, chemicals and pharmaceuticals Incidentally, the biggest merger in India Inc took place in the telecom sector with BPL Communications and the Birla-Tata-AT&T combine, two of the nation's biggest cellular players, announcing an agreement to merge operations Where mergers were not convenient, companies tried to form strategic alliances Pharmaceutical companies such as Ranbaxy and Lupin Laboratories entered into strategic alliances with some MNCs Another strategy was to form joint ventures with foreign majors, notably in automobile and consumer durable sectors Unfortunately, most of these joint ventures did not last long Some of the prominent joint ventures between Indian and foreign partners, particularly in the high-tech and high capital intensity automobile sectors, failed to mature and the foreign partners assumed full control Despite the churning and change that has taken place over the past decade, the Indian corporate sector has still to go a long way in improving its image and become globally competitive True, there have been notable winners across industries such as HLL, Reliance Industries, Hindalco, Tisco, Hero Honda, Asian Paints, Sundram Fasteners, Ranbaxy, Dr Reddy's Laboratories, and the public sector companies BHEL and Punjab Tractors The successes and failures have not been industry specific but company specific But at the macro level, the overall efficiency of Indian industry has not shown much improvement While there has been some increase in expenditure on R&D and brand building, the Indian companies are still lagging far behind their foreign counterparts Here again, there are a few exceptions Naushad Forbes finds two major changes in corporate R&D One is the emergence of new companies, particularly in the pharma sector, as substantial spenders in R&D With India recognising the foreign product patents, companies hve begun acquiring innovation capacity Ranbaxy & Dr Reddy's have recently licensed out their discoveries to MNCs earning fat royalties Nicholas Piramal bought the R&D laboratory of Hoechst Marion Roussel Second, and more important, is the change in the character of R&D While earlier the R&D expenditure was mostly on import substitution and diversification, today a part of it is on reaching the international technological frontier Unfortunately, the large public sector and the small-scale industries sector still lagging behind in reforms Unless the Government is able to push ahead vigorously with reforming these sectors, along with a viable exit policy and labour reforms, they will continue to act as major impediments to competitiveness Mergers, Acquisitions & Restructuring 13.53 Self-examination Questions Distinguish between Mergers, Acquisition and Takeovers by giving suitable examples What is horizontal, vertical and conglomerate merger? What are the advantages and Disadvantages of mergers and takeovers? Outline the legal framework relating to mergers and takeovers in India what are the basic objectives behind such a legal framework? What are the various defensive tactics which a target company can adopt to defend itself from hostile takeover? ... Agra- 282 003 March/ 2010/ 15,000 Copies (Revised) PREFACE Strategic Financial Management is a blend of Strategic Management and Financial Management It has acquired a critical significance now-a-days,... CHAPTER – FINANCIAL POLICY AND CORPORATE STRATEGY 1.0 Strategic Management Decision Making Frame Work 1.1 2.0 Interface of Financial Policy and Strategic Management 1.5 3.0 Balancing Financial. .. draw new strategic plan and develop new strategic posture to rewinover the competitors in the long run 2.0 INTERFACE OF FINANCIAL POLICY AND STRATEGIC MANAGEMENT The inter face of strategic management