Introduction
In an organization, the corporate level of management carries out the growth strategies of the organization. Growth strategies are employed to seek growth, sales, profit and market share or any other objectives the organization may have set. The growth strategies are expected to result to an increase in the organization value. Some of the growth strategies which may be implemented are vertical integration, horizontal integration, and diversification, take over, mergers and acquisition, strategic alliance and joint ventures. The strategies discussed leads to an increase in the market share of a firm. The strategies are also adopted to help the firm in achieving competitive advantage over its competitors. This study is going to focus on mergers and acquisition, and the benefits a company receives from adopting the two growth strategies.
Peer-reviewed academic literature on mergers and acquisitions
Merger and acquisition growth strategies are meant to increase the market share of the firm. According to Douma, merger refers to the combination of two firms. The two companies must be in existence for a merger to take place. After the merger has taken place, one company ceases to exist. The company formed may either retain its original name or come up with a new name. Acquisition, on the other hand, refers to the purchase of assets and liabilities by one company from another existing company. The acquiring company is known as the predator while the acquired company is known as the target company. After acquisition, both companies may continue to exist. The operations of the target company are controlled by the predator company depending on the percentage acquired. The acquiring company is also referred to as the acquirer company.
Mergers are very important in a business. Synergy is the increase in economies of scale of the firm after merging. After the merger has taken place, the two firms are going to realize higher revenues than before merging. The operating expenses of the firm are going to decrease. The overall firm's cost of capital is also going to be lower than for individual firms.
According to Eugene, it is cheaper to acquire another existing company than to invest internally. This is referred as a bargain purchase. For example, a company may be considering expansion of its factory. Instead of building the factory extension, the company may merge with another company which is carrying out activities similar to its activities. Merging also helps in diversification of the business operations. Diversification involves the acquisition of firms from other industries or lines of business. The acquired firm may have poor technology, which may be, improved after acquisition by the predator.
Mergers may be carried out for financial reasons. A company may acquire another company which is not performing well. Upon merging, management of the poor performing company may be replaced in order to improve on the financial position of the company.
Commercial justification of the proposed takeover strategy
Henry Boot Group Limited is intending to acquire Alumasc Public limited company. Take over involves the acquisition of the target company by the acquirer company. In the United Kingdom, the term take over is used to mean the acquisition of a public company with shares being listed in the United Kingdom stock exchange. Take over may be in the form of friendly takeover or hostile takeover. Friendly takeover is where the management of the two companies is in agreement on forming a merger. Forced takeover is where the management of the target company is unwilling to form a merger or takeover.
The takeover is going to be beneficial to Henry Boot Group Limited since Alumasc Company has a higher weighted average cost of more capital than the Henry Boot Group Limited. Weighted average cost of capital is the minimum return investors expect from their investment. It can also be defined as the cost of the firm’s funds. The weighted average cost of capital of the Henry Boot Group Limited is 19.66% while that of Alumasc Company is 29.76%. This implies the rate of return on investment in Alumasc is higher than for Henry Boot Group Company Limited. The takeover is going to increase the weighted average cost of capital of Henry Boot Group Company Limited. Investors are going to invest in the company since the cost of capital would be higher than before the merger occurred. The target company is going to have a positive impact on the acquirer.
The return on share of the Alumasc public limited company is higher than return of shares of Henry Boot Company Limited. The return on shares is also the cost of equity. The cost of capital is the return paid to investors at the end of the financial period. The cost of equity is the sum of risk free rate of return and the premium expected to risk. Premium expected to risk is the difference between the market rate of return with the risk free rate of return multiplied by the beta. The cost of equity for the acquirer is lower than for the target company. The takeover process leads to a rise in the cost of equity of Henry Boot Company Limited.
Beta, also known as financial elasticity, measures the sensitivity of returns from assets to market returns. Beta is a systematic risk which management of a firm does not have control. The beta of the Alumasc public company limited is 0.74. This shows that the returns on stock vary more than returns from the market. When the market returns increases by 1, the return on the stock increases or by 1.74. The stock of the target company is highly volatile than those of the acquirer company. Stocks, which have high beta, are considered to be riskier than those with small beta. However, the stocks provide better returns than those with small beta. Stocks with a lower beta are considered to be less risky, but they provide lower returns to the investor. The target company is expected to increase the returns of the acquirer company. The management should consider going on with the proposed takeover.
A security market line is an important tool used in determining whether an asset under consideration for the portfolio is going to yield good returns for the risk. The securities are plotted on the security market line. The security is undervalued if the security risk and the expected return are above the security market line. In the case of Alumasc Company Limited, the security market line is undervalued. This means that investors would get a high return from their investment. The following are the market security lines for both the target and predictor companies.
Security market line for Henry boot Plc
Security Market Line (SML) Alumasc Plc
Explanation of the financial classification attributed to the proposed acquisition with due emphasis on capital structure and risk assessment
The capital structure of the Alumasc Company Limited is made up of debt, worth 13.2 million, and equity, worth 13.2 million. The acquirer company is going to inherit more debts than liabilities. The target company had more debt in its capital structure than equity. The company was highly geared. The activities of the target company were mainly financed by funds borrowed. It is recommended that the equity component in the capital structure should be higher than the debt component. The ratio of equity to debt should be 2.1. This helps to ensure that the company meets its obligation when they fall due. Creditors and long term loans can be repaid on time. On the other hand, the capital structure of Henry Boots Public Company Limited is made up of equity, which is valued at 213.69 million dollars, and debt which is valued at 22 million dollars. Acquisition of the target company may lead to an increase in the amount of debt in the capital structure of the acquirer company. The liabilities may be more than the assets. The debt ratio of 2.1 is not going to be achieved. The acquirer company is going to have more debt in the capital structure than before the takeover process. This could be a source of risk since the company may be unable to settle its liabilities when they fall due. Failure to pay preferential creditors may lead to liquidation of the company.
An increase in the amount of debt in the capital structure of the acquirer leads to dilution of ownership of the acquirer company. Henry Boot Group had a profit of £5.8 million in June 2012. In June 2011, the company had reported a net profit of £9.1 million. Profits had increased in the current year. The dividend per share had also decreased from the previous period. The debt level of the company increased to £22 million from £2.3 million. It would be risky for the company to take over the target company. This is because the capital structure of the acquirer company has more debt than the previous period. The target company, also, has more debt in its capital structure than equity. If the takeover process is implemented, there is going to be dilution of ownership in the acquirer company. Dilution of ownership means that the par value of the share may decrease, and the number of shareholders would increase. We can, therefore, conclude that the takeover strategy would have a negative impact on the capital structure of the acquirer company. This is a source of financial risk. The company would be straining to pay its liabilities and dividends to shareholders.
Offer price valuation of the target firm using standard value-assessment methods and computing the likely wealth creation for shareholders
Valuation is the process carried out to determine the value of something. Valuation is mainly done for financial assets and securities. The valuation may be carried out for capital budgeting purposes, investment analysis decisions, and merger and acquisition reasons.
The valuation of the target company can be made based on the relative value. This method involves valuing the assets and liabilities of the company at the market value. In the statement of financial position, assets are recorded on the basis of historical cost. The historical cost, however, does not reflect the actual market value of the assets.
The securities of the target company can be valued using the option pricing models. The model can also be used to value the financial assets of the target company such as warrants and employee stock options. The valuation of the company in terms of consideration to be paid is given as the total value of all the assets taken over. From the annual reports of the year 2012, the valuation of company assets is as follows;
The consideration that should be paid in regard to the acquisition should be 64,887,000, less any liability paid. The net book value method establishes the price of acquisition that the predictor should pay. Goodwill on acquisition can be amortized over a defined period of time whereby the amortized amount is written off as an expense in the income statements.
Conclusion
References
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