Chapter 6 - Business Strategy

MODULE VALUATION CONCEPTS AND METHODS
CHAPTER 6: BUSINESS STRATEGY
Objectives:
1. Strategy for entering a new business
2. Forces Driving Merger and Acquisition Activities
3. Types of Mergers
Strategy for entering a new business:

Strategies define the policies, plans and culture of an organization in a long-
term horizon. It is a basic proposition that all Mergers & Acquisition (M&A)
policies and decisions should take place within the general framework of an
organization’s strategic planning process.
An organization can enter into a new or unrelated business in any of the following
three forms:
1. Acquisition
2. Internal start-up
3. Joint Ventures or strategic partnerships
Acquisition is the most popular means of diversifying into another industry. It
represents a much quicker way to enter the target market than trying to launch
a brand-new, right-from-scratch venture from the ground up.
Merging with or acquiring other businesses is a frequent route to intended higher
profits. The aim may be to eliminate part of the competition, to acquire new
customers and products or simply
to realize higher efficiencies through the synergies of a combined operation,
such as integrated sourcing conferring increased purchasing power.
Some of these strategies are not without their obstacles and pitfalls. For instance,
abuse of market position can attract the attention of Competition Commission.
Many an acquisition has both proved more costly than anticipated as well as more
difficult to convert into predicted benefits.
Merging with or acquiring rivals to form an enterprise that has greater competitive
strength and a larger share of the overall market is one of the most frequently
used growth strategies employed by ambitious companies. For a company to
succeed with this strategic approach, the senior management must have the skills
to assimilate the operations of the acquired companies, eliminate duplication and
waste, generate efficiencies and cost savings, and structuring the combined
resources in ways that create substantially stronger competitive capabilities.
The advantages of an acquisition are numerous:
1. Overcome easily many entry barriers
2. Acquiring technological experience
3. Establishing supplier relationships
4. Scaling up fast to match rivals’ efficiency and cost competitiveness
5. Attaining visibility and brand recognition from day one, without having to spend
large amounts of money on advertising and product promotions
6. Securing adequate distribution.
Forces Driving M&A Activities:

The major forces which drive M&A activities since the early 1990’s have
been identified as the following:
1. Rapid pace of technological change
2. Low costs of communication and transportation
3. Globalization and global markets
4. Nature of competition in terms of forms, sources and intensity
5. Emergence of new types of industries
6. Regulation in some industries and sectors
7. Liberalization in some industries and sectors
8. Growing inequalities in incomes and wealth
Industry Characteristics:
The industry characteristics related to strong M&A pressures are
presented in the following Table:
Sl. Indu Characte

No. stry ristics
1. Telecommunications Technological change and deregulation
2. Media Technological change
3. Financial services Globalization
4. Chemicals, Pharmaceuticals Technological change, increased
risks due to competitive pressures
5. Automotive, Oil & Gas, Requirement of scale, volatility in price,
Industrialmachinery supply instability
6. Utilities Deregulation
7. Food, Retailing Expanding into new markets
8. Natural resources, Timber Limited and exhausting sources of supply
Types of Mergers:
In mergers, the combining companies engage in prior negotiations which may

ultimately lead to a transaction. In tender offers, the acquiring company may seek
to hold initial discussions with the top executives of the target company. If they
are not able to move towards a mutual agreement, the acquirer may make an
open offer to the shareholders of the acquiring company to tender
their shares at a specified offer price. Mergers are generally friendly. Tender
offers may become hostile.
There are three types of mergers:
a. Horizontal integration, when two similar firms, in the same line of
business, tie the knot; eg. Coca-Cola and Parle, Exxon and Mobil, BP and
Amoco, Chevron and Texaco.
b. Vertical integration, in which two firms at different points in the supply
chain or different stages of production get together; eg. Mircosoft and
Hotmail, Google and YouTube, and
c. Diversification, also called conglomerate merger, when two companies
in unrelated lines of business with nothing in common jump into bed.
These can be a voluntary merger of equals, a voluntary takeover of one firm by
another; or a hostile takeover - in which the management of one firm tries to buy
a majority of shares in another.
In the context of acquisitions, there are several distinct concepts of value:

1. Intrinsic Value: This is based on the net present value of expected future
cash flows completely independent of any acquisition.
2. Market Value: Commonly known as ‘current market capitalization’, it is
the same as share price. It reflects the market’s valuation of a company.
3. Purchase Price: It is the price that a bidder anticipates having to pay to
be accepted by the target company’s shareholders.
4. Synergy Value: It is the net present value of expected future cash flows
that will result from the combined operations and additional benefits
expected to accrue.
5. Value Gap: The difference between the intrinsic value and the purchase price.
Synergy value is expected to accrue on account of cost savings, revenue
enhancements, process improvements, financial engineering and tax
benefits.
Estimating Merger Gains and Costs:

Mergers increase value when the value of the combined entity is greater than
the sum of the pre- merger values of the independent entities. There should be
an economic gain from the merger for it to make sense. According to Brealy and
Myers, “There is an economic gain only if the two firms are worth more together
than apart”.
NPVc = PVbt – (PVb + PVt)
Where,
NPVc = the net present value
increase or gain
PVbt = Present Value of the
combined entity
PVb = Present Value of the
bidder alone
PVt = Present Value
of the target alone
Cost = Cash paid - PVt
Decision Rule:
The net present value to the bidder of a merger with a target company is measured
by the difference between the gain and the cost. The bidder should go ahead with
the merger only if its net present value, represented as given below, is positive.
NPV = Gain – Cost
= [PVbt – (PVb + PVt)] – (Cash paid - PVt)
Comparable Companies or Transactions Approach:
In the Comparable Companies or Transactions approach, the key relationships

are computed for a group of similar companies or transactions as a basis for
valuation of companies involved in a merger or takeover. Being simple,
straight-forward, plain commonsense, and using marketplace transactions, this
approach is quite popular with investment bankers and in legal cases.
The approach is illustrated with a simple illustration, given in Table 1. For the
purpose of testing for similarity, three companies of comparable size, similar
products, age, growth rates, and recent trends are considered.
COMPARABLE COMPANIES APPROACH
Step 1: Working out Comparable Companies Ratios
Ratio Comparable Companies Average Ratio
A B C
Enterprise Market Value/Revenues 1.4 1.2 1.0 1.2
Enterprise Market Value/EBITDA 15.0 14.0 22.0 17.0
Enterprise Market Value/Free cash flows 25.0 20.0 27.0 24.0
Step 2: Application of Valuation Ratios for Target Company T
Rs. In crores Average Ratio Enterprise Market

Value of T
Revenues 100 1.2 120.0
EBITDA 7 17.0 119.0
Free cash flows 5 24.0 120.0
Total 359.0
Average 120
For more knowledge, please follow the link provided;
https://www.youtube.com/watch?v=0yHwUp87xcI
https://www.youtube.com/watch?v=S7DoKFPOhZk&t=5s
https://www.youtube.com/watch?v=uOO4ClVUrkw&t=57s

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MODULE VALUATION CONCEPTS AND METHODS

CHAPTER 6: BUSINESS STRATEGY

Strategy for entering a new business:

Forces Driving M&A Activities:

Sl. Indu Characte

In mergers, the combining companies engage in prior negotiations which may

In the context of acquisitions, there are several distinct concepts of value:

Estimating Merger Gains and Costs:

Comparable Companies or Transactions Approach:

In the Comparable Companies or Transactions approach, the key relationships

Step 2: Application of Valuation Ratios for Target Company T

Rs. In crores Average Ratio Enterprise Market

For more knowledge, please follow the link provided;

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