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Mergers and Acquisitions
As a CEO, you are trying to acquire a foreign firm. The size of your firm will double, and it will become the largest in your industry. What does your firm do and what does the foreign firm you are trying to acquire do? Where are the firms based?
Before any M&A proceeding should occur. An analysis of the macroeconomic factors and industry related factors should be conducted. In this particular M&A case, as CEO, my primarily job is chief risk officer. Here, I do not want to overpay for a company with underlying operational issues that I am oblivious too. The M&A team must first place a value on the business that corresponds to the synergy or business enhancements it will provide. This figure must also include a margin of safety in order to prevent overpaying for the company in question. For example, if the underlying business is valued at $100, it would be imperative for the acquiring firm to pay less than that figure to compensate for any uncertainty present within the business. The foreign or target firm, should have a similar approach, but will have the added task of salesmanship. The target firm will want to showcase the merits of a potential merger or acquisition. They too will conduct due diligence on the firm's financial operations. However, the target company's value that is placed on it may seem overinflated relative to its merits. This overinflated figure is often used as a ploy in the negotiation proceedings. The target firm wants to benefit the owner, or in this instance, the shareholders in the most benefitial manner. By overinflating the value of the firm initially, the target firm can then wager the price down. This seems like a concession on the part of the target firm, when in reality the firm did not intend to receive the overinflated price in the first place. Likewise, the target firm will attempt to correct any errors or problem areas within its business operations that would result in a devaluation of the overall business. By correcting these issues, the target firm, can use salesmanship to acquire the highest possible price for its owners and shareholders.
You are very enthusiastic about the opportunity to be a leading captain of industry and the associated power, prestige, and income. (You expect your salary, bonus, and stock option to double next year). However, you are troubled by the fact that 70% of mergers and acquisitions (M&As) reportedly fail. How would you proceed?
70% of mergers fail to result in their intended profit and cash flow forecasts. This is due primarily to the issues I mentioned above. As such, the CEO must proceed with caution when proceeding with an M&A negotiation. What areas should be valued in the event of an M&A? I believe it prudent to value a company and its merits based on 6 standards which include: Economics, Strategy, Organization, Brand, Law, and Ethics.
Economics refers to the quantitative aspects of the attractiveness of the business. These figures include but are not limited to revenue, fixed costs, variable costs, required rates of return, and other measures. With these inputs, companies can better determine realistic expectations of future cash flow. These future cash flow expectations can then be incorporated in the net present value calculation to further determine a fair price for the target company. If the economic factors are not favorable, then one should question the efficacy of a misguided and often costly M&A. In many instances the quantitative figures of companies can be misleading. The nature of generally accepted accounting principles (here forth referred to as GAAP), are such that they provide flexibility in determining appropriate financial figures. On occasion, management or executives may misrepresent these figures to make the company seem more or even less attractive during certain periods. For example, a company may take more losses in the current period, in order to seem more profitable in subsequent periods that follow. Likewise, companies may also seem to be more profitable than they are in an effort to hide substantial losses that have occurred in the business operations. Complicating the financial issue further is the fact many transactions don't appear within the financial statements at all. These transactions, called "Off-balance sheet transactions" can have a profound impact on the value placed on M&A target companies. This…[continue]
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