STRUCTURE MERGERS & ACQUISITIONS TO

EXPLOIT THE COST REDUCTION

Satish Kumar Matta

Asstt. Professor

Department of Management

Lloyd Business School, Greater Noida (U. P.)

Mob. 9811288869, 9876050556

Email: skmatta@yahoo.co.in

Avanish Kumar Tyagi

Asstt. Professor

Department of Management

Lloyd Institute of Management & Technology, Greater Noida (U.P.)

Arun Kumar Singh

Asstt. Professor

Department of Management

Lloyd Business School, Greater Noida (U.P.)

STRUCTURE MERGERS & ACQUISITIONS TO

EXPLOIT THE COST REDUCTION

Abstract

Synergy is the magic force that allows for enhanced cost efficiencies of the new

business. Synergy takes the form of revenue enhancement and cost reduction. One of the most

basic reasons to merge is that a combined firm may operate more efficiently than two separate

firms. A firm can achieve greater operating efficiency in several different ways through a merger

or an acquisition. Improved efficiency from cost reduction is one of the most often cited reasons

for mergers. The link between this and value creation is easy for investors to understand and the

benefits from cost reductions are relatively easy to quantify. These benefits can come from

economies of scale, vertical integration, complementary resources, and the elimination of

inefficient management.

Key Words: Synergy, Cost Reduction, Mergers, Acquisition, Economies of Scale

Mergers and Acquisitions – An Overview

“Much of what is called investment is actually nothing more than mergers and acquisitions, and

of course mergers and acquisitions are generally accompanied by downsizing”. 

                                                                                                               Susan George

Introduction

The phrase mergers and acquisitions (abbreviated M&A) refers to the aspect of

corporate strategy, corporate finance and management dealing with the buying, selling and

combining of different companies that can aid, finance, or help a growing company in a given

industry grow rapidly without having to create another business entity. In today's competitive

environment, one of the most eye-catching strategies being discussed in the board rooms is

"Mergers and Acquisitions". The global M&A activity had reached record highs during the

previous few years beating all-time record of $3. 3 trillion M&A value in 2000. Economic and

political stability across the globe have facilitated the same, encouraging corporate growth which

in turn is generating more and more M&A activities.

In today’s business world, mergers & acquisitions (as a form of corporate restructuring)

have become a major force in the financial & economic environment all over the world primarily

due to globalization, liberalization, technological development & intensely competitive business

environment. This article focuses on one of the largest mergers in India between Reliance

Petroleum Ltd. with Reliance Industries Ltd. in 2002 creating the country’s largest private sector

company on all financial parameters, including sales, assets, net worth, cash profits & net profits.

Corporate restructuring refers to those activities that enhance or compress a firm’s

operations or substantially change its financial structure or bring about a significant change in its

organizational structure and internal functioning. It includes mergers, acquisitions, takeover etc.

A merger refers to the absorption of one firm by another firm. The acquiring firm retains

its name and its identity, and it acquires all of the assets and liabilities of the acquired firm. After

a merger, the acquired firm ceases to exist as a separate business entity. For example, suppose

Firm A acquires Firm B in a merger. Further suppose Firm B’s shareholders are given one share

of Firm A’s stock in exchange for two shares of Firm B’s stock. From a legal standpoint, Firm

A’s shareholders are not directly affected by the merger. However, Firm B’s shares cease to

exist.

An acquisition refers to an act of acquiring control by one company over the assets or

management of another company without any combination of companies. However, a

fundamental feature of merger is that the acquiring company takes over the ownership of other

companies and combines their operations with its own operations.

When the acquisition is against the will of target management, it is generally called

takeover. Takeover generally takes the form of tender offer wherein the offer to buy the shares

by the acquiring company will be made directly to the target shareholders without the consent of

target management. Though, the terms ‘merger’, ‘amalgamation’, ‘consolidation’, ‘acquisition’

& ‘takeover’ have specific meanings but they are generally used interchangeably.

Mergers may be horizontal, vertical or conglomerate. Horizontal merger is a combination

of two or more firms involved in similar type of production, distribution or area of business. The

firms compete with each other in their product market. Vertical Merger is a combination of two

or more firms involved in different stages of production or distribution. Conglomerate merger is

a combination of firms engaged in completely unrelated lines of business activity. Further

mergers may be ‘friendly’ or ‘hostile’. Generally, mergers are friendly whereas tender offer

takeovers are hostile.

Two important points to be noted in case of merger are:

A merger must be approved by a vote of the stockholders of each firm. Typically, votes

of the owners of 2/3 of the shares are required for approval. Also the shareholders of the

acquired firm have appraisal rights. This means that they can demand that their shares be

purchased at a fair value by the acquiring firm. Often the acquiring firm and the

dissenting shareholders of the acquired firm cannot agree on a fair value, which results in

expensive legal proceedings.

A merger is legally straightforward. It avoids the necessity of transferring title of each

individual asset of the acquired firm to the acquiring firm. It does not cost as much as

other forms of acquisition.

The principal economic rationale of a merger is that the value of the combined entity is

expected to be greater than the sum of the independent values of the merging entities. The most

plausible reasons for mergers are strategic benefits, economies of scale, economies of scope,

utilization of surplus funds, complementary resources, tax shields, economies of vertical

integration and managerial effectiveness.

The synergy from an acquisition is defined as the value of the combined firm V(AB) less the

value of the two firms as separate entities V(A) and V(B) or

Synergy = V (AB)-[V (A)-V (B)]. The shareholders of the acquiring firm will gain if the synergy

from the merger is greater than the premium.

The term synergy comes from the ancient Greek word syn-ergos, meaning 'working

together'. The Strategy Reader, Edited by Susan Segal-Horn, The Open University, 1998 Great

Britain,

Synergical effect occurs when two substances or factors combine to produce a greater

effect together than the sum of those together operating independently. The principle of 2+2 =5,

this theory expects that there is really "something out there which creates the merged entity to

maximize the shareholders value". To put in other words, synergy is the ability of a merged

company to create more shareholders value than standalone entity.

Trautwein (1990) distinguishes between three types of synergy benefits: operating,

financial and managerial synergies.

Operating synergy assumes that economies of scale exist in an industry and that prior to

their M&A, firms are operating at levels of activity that fall short of achieving the potential for

economies of scale (Weston et al., 2001). Expansion through M&A increases the size of the

company and hence may reduce per unit cost. Economies of scale and economies of scope exist

in the industry and before the merger; the activities of the individual firms are insufficient to

exploit these.

Synergy takes the form of revenue enhancement and cost reduction. Speaking of cutting

down costs, this goal is typically achieved through economies of scale, particularly when it

comes to sales and marketing, administrative, operating, and/or research and development costs.

As for revenue synergies, these are achieved through product cross-selling, higher prices due to

less competition, or staking a larger market share.

When two companies in the same industry merge, the combined revenue tends to decline

to the extend, they overlap with one another and some of the customers may also become

alienated. For the merger to benefit the shareholders there must be ample opportunities for the

cost reduction, so that the initial lost value is recovered in due course through synergy.

Mergers and acquisitions are strategic decisions taken for maximization of a company's

growth by enhancing its production and marketing operations. They are being used in a wide

array of fields such as information technology, telecommunications, and business process

outsourcing as well as in traditional businesses in order to gain strength, expand the customer

base, cut competition or enter into a new market or product segment.

Financial synergy refers to the impact of an M&A on the firms combined cost of capital.

This can be achieved by lowering the systematic risk of the firm’s investment portfolio.

Alternatively, increasing firm size may improve company access to cheaper financing and/ or

create an internal market where capital can be allocated more efficiently. The resultant feature of

corporate merger or acquisition on the cost of capital of the combined or acquiring firm is called

as financial synergy. It occurs as a result of the lower cost of internal financing versus external.

A combination of firms with different cash flow positions and investment scenario may

produce the synergic effect and achieve lower cost of capital. It means when the rate of cash flow

of the acquirer firm is greater than that of the acquired firm, there is tendency to relocate the

capital to the acquired firm and the investment opportunity of the latter increases. If the cash

flows of the two entities are not perfectly correlated, the financial synergy can be expected thus

reducing risk. The perceived reduction of the instability of the cash flow, would lead the

suppliers to trust the firm, the combined debt capacity of the combined firm may be greater than

the individual firms.

Finally, managerial synergies may arise from combining firms of unequal managerial

capabilities. Synergy also can create value through the improvement of managerial decision-

making. Often an acquiring company has greater managerial and financial resources than the

acquired company. The depth of these resources can result in better working capital

management, shorter production cycle times, and less need for future capital expenditures, each

of which may create value. Better management decisions also can result in the sale of noncore

businesses, technology, and intellectual property, which can create value not only from the cash

received from the sale but also through shifting greater managerial resources to value creation in

the company's core competencies. 

Operating synergies are those synergies that enable a firm to increase its operating

income or increase growth or both. Operating synergies can be categorized into following types:

Economies of Scale: Enabling the combined firm to become more cost-efficient and

profitable. Economies of scale result when a certain percentage increase in output results

in a smaller increase in total costs, resulting in reduced average cost. It Profitable Growth

by Acquisition doesn’t matter whether this increased output is generated internally or

acquired externally. When the firm grows to its “optimal” size, average costs are

minimized and no further benefits are possible. There are many potential sources of

economies of scale in acquisitions, the most common being the ability to spread fixed

overhead, such as corporate headquarters expenses, executive salaries, and the operating

costs of central computing systems, over additional output.

Vertical integration acquisitions can reduce costs by removing supplier volatility, by

reducing inventory costs, or by gaining control of a distribution network. Such benefits can come

in any industry and for firms of all sizes.

Personnel reductions are often used to reduce costs after an acquisition. The savings can

come from two sources, one being the elimination of redundancies and the second the

replacement of inefficient managers. When firms combine, there may be overlapping functions,

such as payroll, accounts payable, and information systems. By moving some or all of the

acquired firm’s functions to the bidder, significant cost reduction may be possible. In the second

case, the target firm managers may actually be making decisions that limit or destroy firm value.

By acquiring the firm and replacing them with managers who will take value-maximizing

actions, or at least cease the ones that destroy value, the bidder can effect positive changes.

The U.S. oil industry in the late 1970s provides an excellent example of this. Excess production,

structural changes in the industry, and macroeconomic factors resulted in declining oil prices and

high interest rates. Exploration and development costs were higher than selling prices and

companies were losing money on each barrel of oil they discovered, extracted, and re- fined. The

industry needed to downsize, but most oil company executives were unwilling to take such

action and as a result, continued to destroy shareholder value. T. Boone Pickens of Mesa

Petroleum was one of the few industry participants who not only understood these trends, but

was also willing to act. By acquiring several other oil companies and reducing their exploration

spending, Pickens created significant wealth for his and the target’s shareholders. Making Key

Strategic Decisions

Combination of different functional strengths: In case a firm with strong marketing

skills acquires a firm with a good product line.

Greater pricing power from higher market share & reduced competition, which

should result in higher margins and operating income.

Higher growth in new or existing markets, in case a firm acquires another firm with

an already established distribution channels and brand name recognition and is able to

increase its sales by using these strengths.

Reductions in Capital Needs: All firms must make investments in working capital and

fixed assets to sustain an efficient level of operating activity. A merger may reduce the

combined investments needed by the two firms. For example, it may be that Firm A

needs to expand its manufacturing facilities whereas Firm B has significant excess

capacity. It may be much cheaper for Firm A to buy Firm B than to build from scratch. In

addition, acquiring firms may see ways of more effectively managing existing assets.

This can occur with a reduction in working capital resulting from more efficient handling

of cash, accounts receivable, and inventory. Finally, the acquiring firm may also sell off

certain assets that are not needed in the combined firm. Firms will often cite a large

number of reasons for merging. Typically, when firms agree to merge, they sign an

agreement of merger, which contains, among other things, a list of the economic benefits

that shareholders can expect from the merger.

Complementary Resources: Some firms acquire others to make better use of existing

resources or to provide the missing ingredient for success. Think of a ski equipment store

that could merge with a tennis equipment store to produce more even sales over both the

winter and summer seasons, and thereby better use store capacity.

Vertical integration: Vertical integration occurs when upstream and downstream firms

merge (or one acquires the other). There are several reasons for this to occur. One reason

is to internalize an externality problem. A common example is of such an externality is

double marginalization. Double marginalization occurs when both the upstream and

downstream firms have monopoly power; each firm reduces output from the competitive

level to the monopoly level, creating two deadweight losses.

Acquiring new technology: To stay competitive, companies need to stay on top of

technological developments and their business applications. By buying a smaller

company with unique technologies, a large company can maintain or develop a

competitive edge.

Operating synergies can affect margins and growth, and through these the value of the firms

involved in the M&A.

With financial synergies, the payoff can take the form of either higher cash flows or a

lower cost of capital. Included are the following:

A combination of a firm with available cash & few project opportunities and a firm with

high return project & limited amount of cash can yield a payoff in terms of higher value

for the combined firm. The increase in value comes from the projects that otherwise

would not have been taken except with the excess cash available with the combined firm.

This synergy becomes available when large firms acquire smaller firms.

Debt capacity also increases when two firms combine thereby making their earnings

and cash flows more stable and predictable. This enables them to borrow more than they

could have as individual entities. It creates a tax benefit for the combined firm. This tax

benefit can either be shown as higher cash flows or take the form of a lower cost of

capital for the combined firm.

Tax benefits can arise either from the acquisition taking advantage of tax laws or from

the use of net operating losses to shelter income. Thus, a profitable firm by acquiring a

loss making firm may be able to use the net operating losses to reduce its tax burden.

Also, a firm that is able to increase its depreciation charges after an acquisition will save

in taxes and increase its value.

Synergy is a stated motive in many M&As. Bhide (1993), who examined the motives behind

77 acquisitions in 1985 and 1986, reported that operating synergy was the primary motive in

one-third of these takeovers. A number of studies examine whether synergy exists and, if it does,

how much it is worth. If synergy is perceived to exist in a takeover, the value of the combined

firm should be greater than the sum of the values of the bidding and target firms, operating

independently. M&As can also be used as a means to transfer knowledge in situations where

collaborative and contractual schemes do not work (Lehto & Lehtoranta, 2006). Consistent with

the above argument, Lehto & Lehtoranta show that a firms R&D stock positively contributes to

its likelihood of its becoming an acquirer.

Mergers and Acquisitions are means of growth for many companies. In 2005 alone, 29585

deals were announced worldwide, accounting for an aggregate deal value of US $ 1 trillion in

USA and US $ 883 billion in Europe. There are various advantages of growing through M&As

instead of expanding internally. It has been observed that the faster way to expand than internal

expansion is to acquire a firm in same line of business. It is because of the simple reason that the

target firm is an organization which is already in place, has its own production capacity,

distribution network, and clientele. This also reduces the risk of investing for the growing

company. Besides, growing through M&As may be a cheaper alternative than internal

expansion, in particular when the replacement cost of assets is higher that the market value of

target assets. Finally, and in contract to organic growth, M&As can be (partly) paid for with

stock. This may be interesting for firms that do not have enough cash reserves and/or have fully

used their debt capacity.

However, a growing company can choose to grow through M&As in addition to internal

expansion. Firms with many investment opportunities and easy access to financial resources may

engage in both internal and external growth in order to take full advantage of their competitive

advantages in the fastest possible way.

Studies of stock returns around merger announcements generally conclude that the value of

the combined firm increases in most takeovers and that the increase is significant. Bradley, Desai

and Kim (1988) examined a sample of 236 inter-firm’s tender offers between 1963 and 1984 and

reported that, on the average, the combined value of the target and bidder firms increased 7.48%

($117 million in 1984 dollars) on the announcement of the merger. This result has to be

interpreted with caution, however, since the increase in the value of the combined firm after a

merger is also consistent with a number of other hypothesis explaining acquisitions, including

undervaluation and a change in corporate control. Thus, it is a weak test of the synergy

hypothesis.

The merger of Reliance Petroleum Ltd. (RPL) with Reliance Industries Ltd. (RIL) in 2002

represents the largest ever merger in India creating the country’s largest private sector company

on all financial parameters including sales, assets, net worth etc.

According to Prashant Kale and Harbir Singh, in general, acquisitions do not create value.

Empirically, in over 70% of the transactions acquirers earn a negative return. This is mainly

because acquisitions are often driven by illusory synergies, acquirers have to pay a substantial

premium over pre-acquisition value, and post-acquisition integration is not successfully

anticipated and managed.

Review of Existing Literature

Review of existing literature has a great relevance in the research of any project as it acts

as a backbone for new studies. Review of existing literature includes the history of the study,

previous studies that had already being done on the subject. It lets the researcher explore on all

these dimensions which have remain untouched in previous studies on the said topic. Therefore,

it provides a necessary base and acts as a broader frame work and guideline to give researcher a

clear cut focus for the fresh attempt.

Here are some of the views and studies by some of the researchers about the impact of corporate

restructuring on shareholders’ value:

Guru of corporate restructuring: Bruce Wasserstein, Porter (1987), Aggarwal, Jaffe and

Mandelkar (1992), A study done by J. Fred Weston and Samual C. Weaver, Anslinger and

Copeland (1996), Robert W. Holthausen "The Nomura Securities Company Professor,

Professor of Accounting and Finance and Management" , Prashant Kale of University of

Michigan, and Harbir Singh of Wharton

Merger of Reliance Petroleum Ltd. (RPL) with Reliance Industries Ltd. (RIL)

Reliance Petroleum Ltd. (RPL)

Reliance Petroleum Ltd. is a subsidiary of Reliance Industries Ltd. RPL is setting up a

Greenfield petroleum refinery & polypropylene plant in a Special Economic Zone at Jamnagar in

Gujarat. With an annual crude processing capacity of 5,80,000 barrel capacity per stream day

(BPSD), RPL will be the sixth largest refinery in the world.

Reliance Industries Ltd. (RIL)

Reliance Industries Ltd. (RIL) is India’s largest private sector company on all major

financial parameters with turnover of Rs. 1,50,771 crore (US$ 29.7 billion), cash profit of Rs.

21,566 crore (US$ 4.3 billion), net profit (excluding exceptional income) of Rs. 15,607 crore

(US$ 3.1 billion) as of March 31, 2009.

RIL is the first private sector company from India to feature in the Fortune Global 500

list of “World’s Largest Corporations” and ranks 103 amongst the world’s top 200 companies in

terms of profit. RIL is amongst the 30 fastest climbers ranked by Fortune. RIL features in the

Forbes Global List of the world’s 400 best big companies and in the FT Global 500 list of the

world’s largest companies. RIL ranks amongst the “World’s 25 Most Innovative Companies” as

per a list compiled by the US financial publication-Business Week in collaboration with the

Boston Consulting Group.

CRISIL has reaffirmed its ratings of ‘AAA/Stable/P1+’ on the debt instruments of RIL

and ‘P1+’ on the bank facilities of RPL. The Board of Directors of Reliance Petroleum Ltd.

(RPL) & Reliance Industries Ltd. (RIL) unanimously approved the merger of RPL with RIL on

2nd March, 2009 (subject to necessary approvals). The exchange ratio recommended by both

Boards I 1(One) share of RIL for every (16) sixteen shares of RPL. RIL will issue 6.92 Crore

new Shares, thereby increasing its equity capital to Rs. 1,643 Crore from Rs. 1,574 Crores.

CRISIL in arriving at its analytical approach regarding its rating view on RIL, has taken a

consolidated view of the financial and operational profiles of RIL & RPL together with other

groups and associate companies, which are strategically important and have a significant degree

of operational integration with RIL & RPL.

The shareholders and the creditors of RIL approved the scheme of amalgamation of RPL

with RIL on 6th April, 2009.

In the Court convened meeting of equity shareholder, secured creditors and unsecured

creditors of RIL held on 4th April, 2009, 98.86% of the shareholders present in person/proxies

representing 99.9998% of the total value of equity shares held by them, voted in favour of the

Scheme of Amalgamation. Shareholders representing 0.0002% of the total value of equity shares

voted against the Scheme. 100% of the Secured Creditors & Unsecured Creditors present in

person/proxies voted in favour of the Scheme of Amalgamation.

Merger Benefits & Synergies

The merger will unlock significant operational and financial synergies that exist between

RIL and RPL. It creates a platform for value enhancing growth and reinforces RIL’s position as

an integrated global energy company.

The merger will enhance value for shareholders of both the companies. The merger is

EPS accretive for RIL. Through this merger, RIL consolidates a world-class, complex refinery

with minimal residual project risk, while complementing RIL’s product range. There will be

further gains from reduced operating costs arising from synergies of a combined operation.

The Merger is expected to reduce the earnings volatility for RPL shareholders and allows them

to participate in the full energy value chain of RIL.

The Merger will result in RIL

1. Operating two of the world’s largest, most complex refineries.

2. Owning 1.24 million barrels per day (MBPD) of crude processing capacity, the largest

refining capacity at any single location in the world.

3. Emerging as the world’s fifth largest producer of polypropylene.

4. RIL to be among the top 10 private sector refining companies globally.

The merger will expand the scale of RIL’s refining operations. The company’s low

operating and capital costs, ability to process a wide range of products & capability to produce

high- quality products that meet stringent regulatory requirements, will provide it with a

sustainable competitive advantage in a commodity industry. The ratings continue to reflect RIL’s

leadership in the domestic petrochemicals industry, strong competitive position in the global oil-

refining business, and exceptional financial flexibility. Further, increasing revenue diversity and

highly integrated operations help mitigate the impact of price volatility that is inherent to RIL’s

business. The company had cash and marketable securities of Rs. 285 billion at the end of Dec,

2008.

RPL’s Jamnagar refinery supplied some critical raw materials to the Hazira and Jamnagar

complex of RIL. The table below indicates the quantity of raw materials (in million tonnes per annum)

that was supplied by RPL to RIL:

Raw Material

Naphtha

Aromatic Naphtha

C3

Supplied to

Cracker unit at its Hazira Complex

Paraxylene/PTA plants in the Jamnagar Complex

Production of polypropylene at the Jamnagar Complex

Quantity

2.5

1.5

1.8

With the merger, all these transactions would turn into inter- divisional transfers from

inter-company transfers. Gujrat Government had given sales tax waiver to RPL. This waiver was

predominantly being used for naphtha & propane sales to RIL. By merging these two companies,

the sales tax benefit that RPL enjoyed would have been optimized.

RPL also brought with it additional tax shield in the form of depreciation. The book depreciation

amounted to Rs. 660.75 crore in FY 2000-01 & Rs. 802 crore in FY 2001-02. This was a valuable tax shield

for the merged entity considering the projected rise in polymer prices from the end of 2002.

Particulars

Sales

Net Profit

Equity

Net Worth

Book Value (Rs.)

EPS (Rs.)

Loan

RIL

24520

2856

1053

14765

140.2

27.1

10631 (2001)

RPL

33996

1692

5202

8727

16.8

3.3

7492 (2001)

Merged Entity

51016

4548

1396

23492

168.3

32.6

16906 (2002)

Source: Outlook Money Magazine; March 31st 2002. Notes: All figures are in Rs crore unless

stated. Nine months figures have been annualized; the sales figures have been reduced by the

inter- company sales of Rs. 7500-crore. *Source: www.capitaline. Com, RIL.

The most important benefit of the strength of the combined balance sheet was the much

needed financial support for marketing of RPL’s product. RIL’s debt rating post-merger was to

remain the same at AAA+. RPL, however, had a slightly lower AA rating & consequently a

relatively higher interest cost on its debts. The merger should have allowed the cost of this debt

to be reduced to the levels enjoyed by RIL.

Conclusion:

One size doesn't fit all. Many companies find that the best way to get ahead is to expand

ownership boundaries through mergers and acquisitions. For others, separating the public

ownership of a subsidiary or business segment offers more advantages. At least in theory,

mergers create synergies and economies of scale, expanding operations and cost reduction.

Investors can take comfort in the idea that a merger will deliver enhanced market power.

By contrast, de-merged companies often enjoy improved operating performance thanks to

redesigned management incentives. Additional capital can fund growth organically or through

acquisition. Meanwhile, investors benefit from the improved information flow from de-merged

companies. 

M&A comes in all shapes and sizes, and investors need to consider the complex issues

involved in M&A. The most beneficial form of equity structure involves a complete analysis of

the costs and benefits associated with the deals. 

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