Month: October 2021

University of Mumbai BMS Notes

Human Resource Accounts Practices in India

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Human resource accounting has very high significance not only for the management, but also for analyst and even for employees. It helps management in better utilization, planning management of human resources in the organization while for analyst, Even today, when a good deal of work has been done in this field, it is very much unfortunate that there is not only set pattern or generally accepted method either for valuation of human resource or for their recording in books of accounts or for the disclosure of information by means of different statements. The study focuses on the calculation of the value of human resources at different levels of organization & to determine the human resource efficiency quotient.

The rationale behind introduction of HRA lies in the fact that human resources should be treated as physical assets and should be shown on the asset side of the balance sheet. Failing to exhibit such assets on the face of the balance sheet in the traditional accounting system indicates lack of reliability of the financial picture. Recognition of human resource as asset removes the obstacles of traditional accounting practice and reflects the actual financial status of an organization. HRA deserves the following benefits:

  1. Any change in the investment in human resources affecting the earning capacity and growth of an organization cultivates the concept of HRA in which assets status is accorded to human resources and accordingly brought into account like other assets.
  2. Acquisition, training and placement costs of human resources for productive purposes should be capitalized. HRA first justifies this truth. It will help the management in planning and executing personal policies.
  3. Expansion of building, plant & machinery etc. obviously leads to enhancement in human resources. Hence, information in the form of HRA is necessary.
  4. Additional information in the form of HRA inspires the shareholders and creditors to make long-term investment with confidence.
  5. Cordial relationship among the employees in an organization is possible only when management realizes the importance of contribution made by the employees and workers in an organization.
  6. HRA can be used as a tool in detecting the spirit of labor turnover, return on investment and utilization of potential capacity of an organization.
  7. HRA helps in solving industrial disputes and collective bargaining process as management representative can put forward data in a systematic manner.
Management Notes

Methods of Human Resource Accounting

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It involves measuring the data of human resources, the cost involved in recruiting and maintaining them, and the returns achieved from them.

The more specific objectives of human resource accounting are as follows:

  1. To provide information for effectiveness of human resource utilization.
  2. To provide information for determining the status of human asset whether it is conserved properly; it is appreciating or depleting.
  3. To provide cost value date for managerial decisions regarding acquiring, developing, allocating and maintaining human resource so as to attain cost effective organizational objectives.
  4. To assist in the development of effective human resource Management practices by classifying the financial consequences of these practices.

Historical Cost:

Historical cost is based on actual cost incurred on human resources. Such a cost may be of two types ; acquisition cost and learning cost. Acquisition cost is the expense incurred on training and development. This method is very simple in its application but it does not reflect the true value of human assets. For example, an experienced employee may not require much training and, therefore, his value may appear to below though his real value is much more than what is suggested by historical cost method.

Replacement Cost:

As against historical cost method which takes into account the actual cost incurred on employees, replacement cost takes into account the national cost that may be required to acquire a new employee to replace the present one.

In calculating the replacement cost, different types of expenses are taken into account which may be in the form of acquisition and learning cost. Replacement cost is generally much higher than the historical cost.

For example, Friedman has estimated that the replacement cost of an executive in middle management level is about 1.5 to 2 times the current salary paid in that position. Replacement cost is much better indicator of value of human assets though it may present certain operational problems. For example, true replacement of a person may not be found easily with whose cost the valuation is done.

Standard Cost:

Instead of using historical or replacement cost, many companies use standard cost for the valuation of human assets just as its used for physical and financial assets. For using standard cost, employees of an organization are categorized into different groups based on their hierarchical positions.

Standard cost is fixed for each category of employees and their value is calculated. This method is simple but does not take into account differences in employees put in the same group. In many cases, these differences may be quite vital.

Present value of future earnings:

In this method, the future earnings of various groups of employees are estimated up to the age of their retirement and are discounted at a predetermined rate to obtain the present value of such earnings. This method is similar to the present value of future earnings used in the case of financial assets. However, this method does not give correct value of human assets as it does not measure their contributions to achieving organizational effectiveness.

Acquisition Cost Method:

Under this method the costs of acquisition, namely, the costs incurred in recruitment. Hiring and induction of employees are taken into account. The process involves capitalization of historic costs. The cost so capitalized has to be written off over a period of time for which the employee remains with the firm.

If for some reason the employee leaves the organization prematurely, the unamortized cost remaining in the books has to be written off against the profit and loss account of the particular year.

Replacement Cost Method:

While in the case of acquisition cost past costs are considered, under this approach one takes in to account how much it costs to replace a firm’s existing resources and thus represents a current value approach. So, this is a method resource and thus represents a current market conditions. This exercise may be redundant unless the management desires to replace its present resources. It is also difficult exercise as in many cases the replacement may not be exactly similar.

Present Value of Future Earnings Method:

This model is developed by Lev and Schwartz and is popular in India. This is also known as capitalization of salary method. Under this method the future earnings of an employee or grades of employees are estimated up to the age of retirement and are discounted at a rate appropriate to the person or the group in order to obtain the present value.

The model may be expresses as follows:

V = The human capital value of a person y years old

I (t) = The person’s annual earnings up to retirement

R = discount rate specific to the person

T= retirement age.

The above formula does not take into account the probability of a person dying before retirement or leaving the organization.

Expected realizable value:

The above methods discussed so far are based on cost consideration. Therefore these methods may provide information for record purpose but do not reflect the true value of human assets. As against these methods.

Expected realizable value is based on the assumption. And this is true also. That there is no direct relationship between cost incurred on an individual and his value to organization can be defined as the present worth of the set of future services that he is expected to provide during the period he remains in the organization.

Flamholtz has given the variables affecting an individual’s expected realizable value (IERV):

Individual conditional values and his like hood of remaining in the organization. The former is a function of the individual’s abilities and activation level. While the later is a function of such variables as job satisfaction, commitment, motivation, and other factors.

Economic Value Method:

The economist’s concept of the value of an asset is equal to the present worth of its estimated future economic benefits. This approach has a strong theoretical appeal.

But this method involves the following steps:

(a) Estimation of the future benefits, and

(b) Ascertaining the present value of such benefits by using an appropriate interest (discount) rate.

Competitive Bidding Method:

This is also known as the opportunity cost method. Opportunity cost is defined as the measurable value of benefits that could be obtained by choosing an alternative course of action. In the case of HRA. Opportunity costs are determined by a process of competitive bidding in which various divisions and departments bid for the services of various officers. The amount of bid is added to the capital employed of the successful bidder for determining the return on investment.

University of Mumbai BMS Notes

Opportunity cost Model Meaning, Advantages and Limitations

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This method was first advocated by Kiman and Jones for a company with several divisional heads bidding for the services of various people they need among themselves and then include the bid price in the investment cost.

Opportunity cost is the value of an asset when there is an alternative use of it.

There is no opportunity cost to those employees that are not scarce, and also, those at the top will not be available for auction. As such, only scarce people should comprise the value of human resources.

The value of a human resource is determined based on the value of an individual employee in alternative use. If an employee is hired from an external source, there is no opportunity cost to him.

Benefits:

Relative Price: Another important benefit of considering your opportunity cost is it allows you to compare relative prices and the benefits of each alternative. Compare the total value of each option and decide which one offers the best value for your money. For instance, a business with an equipment budget of $100,000 may buy 10 pieces of Equipment A at $10,000 or 20 pieces of Equipment B at $5,000. You could buy some of A and some of B, but relative pricing would mean comparing the value to you of 10 pieces of A versus 20 pieces of B. Assuming you choose 20 pieces of B, you effectively decide this is more valuable to you than 10 pieces of A.

Awareness of Lost Opportunity: A main benefit of opportunity costs is that it causes you to consider the reality that when selecting among options, you give up something in the option not selected. If you go to a grocery store looking for meat and cheese, but only have enough money for one, you have to consider the opportunity cost of the item you decide not to buy. Recognizing this helps you make more informed and economically sensible decisions that maximize your resources.

Limitations:

  • The total valuation of human resources for the competitive bid price may be misleading or inaccurate. It may be because a person may be an expert for one department and not so for the other department. He may be a valuable person for the department in which he is working and thus commands a high value but may have a lower price in the bid by the other department.
  • It has specifically excluded from its preview the employees scarce or not being ‘bid’ by the other departments. This is likely to lower the morale and productivity of the employees who are not covered by the competitive process.
  • Under this method, valuation based on opportunity cost is restricted to alternative use within the organization. In real life, such alternative use may not be identified because of the constraints in an organizational environment.
  • Opportunity costs take time to calculate and consider. You can make a more informed decision by considering opportunity costs, but managers sometimes have limited time to compare options and make a business decision. In the same way, consumers going to the grocery store with a list and analyzing the potential opportunity costs of every item is exhaustive. Sometimes, you have to make an instinctive decision and evaluate its results later.
University of Mumbai BMS Notes

Replacement cost Model Meaning, Advantages and Limitations

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Replacement cost is that cost which is incurred on replacing the existing human resource by an identical one i.e. human resource capable of rendering similar services.

Replacement Cost Method was introduced by Rensis Likert and Eric G. Flamholtz. This method is different from the historical cost method. The historical method takes into account only the sunk cost which is immaterial to calculate the value of human resources and take a decision on that basis.

The replacement cost method is very realistic as it considers the current value of human resources in its financial statement.

Advantage of replacement cost method

  • This method estimates the present value of human resources. This method is very logical and representative.
  • This method can easily adjust the human value of price trends and can provide real value at the time of the rise in prices.

Disadvantage of replacement cost method

  • The identical replacement of an employee is not always possible to find.
  • The determination of replacement value is affected by subjective considerations to a marked extent, and therefore, the value is likely to differ from man to man.
  • The cost of replacing the human resource is inconsistent with traditional accounting system based on the cost concept.
University of Mumbai BMS Notes

Statutory provisions governing HR accounts

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Statutory Compliance of rules and regulations in HRMS& payroll is a grave legal matter for both employees and the organization’s social security. The Indian Government has declared various regulations and acts to process employee’s payment. Every company is liable to follow these rules to avoid any legal consequences. Though to follow it or not might be a company’s individual decision, but it may have some severe implications.

Statutory Compliance in HR is important, as seen from both employee and employer’s perspective. Indian Government provides employee benefit acts like industrial relations, minimum wages, social security, women and child employment, health and safety, and organization benefit acts like provident fund, trade union, ESI, professional tax, etc. We will further check all the details of these acts. These acts can vary from state to state and country to country. In India, these acts sometimes change for every state, but not necessary.

Non-agreement to such laws implicate legal consequences on business existence, that is why business representatives put a considerable amount of money, time, and people to adhere to these laws. Additionally, they also seek laws and finance taxation expert’s advice. To be a statutory compliant company, you must practice an efficient way to minimize these risks and update them with these laws.

Every type of organization, whether private, LLP, partnership-based, which provides a salary to their employees, must stick to these laws to avoid reputation and business threats during any statutory audit.

These regulations are checked during the statutory audit. A Statutory Audit is an inspection mandated by law to ensure the books of accounts presented by organizations are true according to the statutory audit checklist finalized.

Importance and Advantages of Statutory Compliance

The most important advantage of the list of statutory compliance to employees is that it ensures fair treatment of labour. It prevents employees from being exploited or made to work for unmanly hours or in inhuman conditions. It also ensures that they are paid fairly in proportion to the work that they have done, and that companies comply with the minimum wage rate.

The advantage to organizations is the timely payment of taxes, which avoids a lot of legal trouble like penalties and fines. A set of predefined rules makes it easier for the Government to collect revenue as well as for companies to organize their financials. Statutory compliance is important to prevent legal troubles. Companies can be fined monetarily as well as be tried in a court of law, depending on the scale of non-compliance. The Importance of statutory compliance in hr cannot be overlooked anymore. It needs to be taken far more seriously to reduce the frequency of fines and penalties.

Statutory Benefits Applicable

For Employee’s:

  1. Ensures minimum wages and equal remuneration to men and women.
  2. Fair treatment to employee and betterment of industrial relations.
  3. Help avoids inhuman conditions of work and guarantees workplace health and security.
  4. Provides social security through compensation and incentives.

For Employer’s:

  1. Protection to the organization’s existence.
  2. Protection against illegal wage demands from trade unions and employees.
  3. Maintains the organization’s reputation and client engagement.
  4. No risk of fines and penalties.

Industrial Relations Guide for Statutory Compliance

The Industrial Disputes Act, 1947

The industrial disputes act, enacted in 1947, to make provisions for investigating and settling disputes between employee-employee or employee-employer. The main objective of this Act is to ‘maintain peace and harmony in work culture in Indian Establishments.’

This Act applies to the whole Indian nation, including establishments for business, trade, manufacture, and distributions. However, it does not encircle persons in the managerial or administrative field and persons subject to Army, Air force, and Navy.

Women Benefits

Equal Remuneration act, 1976

As the name suggests, the Equal Remuneration Act encloses a gender-based payment equality policy of industrial. It ensures uniform payment to the employees irrespective of men or women to avoid gender bias. It came into the picture because payment given to women was lower than that of men, though the work amount being the same. Non-compliance with this Act can implicate serious fines and penalties.

Provisions under this Act include 1. Not to reduce employees’ salary to adhere to the Act 2. For the same nature and amount of work, no discrimination is allowed for women. 3. During the formation of an advisory committee that works to increase employment opportunities for women, work hours and its nature shall consist of half women members.

Maternity Benefit Act, 1961

The maternity benefit act passed in 1961. It helps women protect her employment and provides her certain months of paid leaves during her maternity to take care of her child. After maternity, she can continue with her job without any disturbance of made leaves.

This Act applies to all establishments like factories, shops, private and Government sectors with ten or more employees. During her maternity, she will be paid based on average daily wages. But to gain this benefit, she must be working for an organization for at least 80 days within the past 12 months.

Further amendments of this Act in 2017, guarantees

  1. Increased amount of paid leaves during maternity ‘leaves are increased from the existing 12 weeks to 26 weeks.
  2. Leave for adoption ‘women can leave for adopting a child below the age of 3 months and the commissioning mothers.
  3. Work from home option ‘women, can now continue her work directly from her home with no leave requirements and is comfortable to her.

The Payment of Gratuity Act 1972

Payment of gratuity act guarantees benefits like gratuity and incentives to the employees working in railways, mines, factories, ports, oilfields, shops, and private sectors.

A certain amount is deducted from monthly wages and further provided after an employee’s retirement, offering monetary help, called gratuity. Gratuity is allowed to an employee who has given continuous service for at least five years for a particular organization. As per section 4(1), gratuity is mandatorily payable for employee death or disablement, even though five years of service is pending. Under section 4(3), the maximum gratuity amount an employee is beneficial for is Rs. 20,00,000, and is liable to tax for gratuity amount more than stated.

According to section1(2), state Jammu and Kashmir are not liable for this Act for plantation or ports. As per section1(3-A), in case the employee rate somehow drops below 10 for an establishment, the employer must not request for reducing gratuity. Under section2(e), this Act doesn’t apply to apprentices or civil service employees under the Central and State government.

Gratuity depends on the years of service and the last drawn salary and is calculated according to the formula

Gratuity = Last drawn salary *number of completed service years * 15/26

According to the above formula, the service year with more than six months will be considered one full year, and less than six years will be regarded as zero years.

For example, a service period of seven years and eight months will be eight years, and a service period of six years and four months will be six years.

The Employees’ Compensation (Amendment) Act, 1923

Many services involve hard work, risk of losses, critical injuries, or even death. Employees’ compensation act, enacted in 1923, protects an employee or his/her dependents through compensation during any conditions mentioned above.

According to Section 17A, every employee must be well-informed about his compensations at the time of joining by the employer. Failure of such tasks may result in penalties and fines of Rs. 5000 to 50,000 as imposed by Government, under section 18A.

The Employees’ Provident Fund & Miscellaneous Provisions (Amendment) Act, 1952

The statutory provident fund act is issued for the social security of the employee. Employees’ Provident Fund Act is liable for any establishment employing more than 20 employees. To make this possible, every employee during his/her employment contributes some amount from their salary to the Provident Fund. Even their employer is also required to contribute to this fund. This fund then ensures social security after employees’ termination or retirement. EPF of every corresponding employee must be deducted from his/her salary and filled before the PF return due date, which is the 15th of each month.

Employees’ PF calculation is based on basic salary and DA. Other allowances like HRA, overtime allowance, incentives, etc. are not included under this. The basic wage covered in this is Rs. 15,000 monthly. PF divides into two funds; EPF (Employees’ Provident Fund) & EPS (Employees’ Pension Scheme). Consider the following PF rates declared by the government:

– Employee Employer
EPF 12% of Gross 3.67%
EPS 0 8.33%
Total contribution 12% 12%

Any failure in this Act may lead to 3 years of imprisonment and a penalty of Rs. 10,000. Apart from EPF, other provident fund meanings and types include

SPF: Statutory Provident Fund

SPF is only meant for employees who are enrolled in Government and Semi-government enterprises.

UPF: Unrecognized Provident Fund

Started by employers or employees in any organization, UPF is not a government-approved scheme.

PPF: Public Provident Fund

Whether an employer or not, PPF scheme that is savings-cum-tax-savings options, is open to every Indian citizen

The Employees’ State Insurance ESI Act, 1948

Employees’ State Insuranceactensures absolute medical security, including sickness, maternity, and injuries for employees working in non-seasonal factories, including power with more than ten employees and non-power and other establishments with more than 20 employees.

The wage limit covered under this Act is Rs. 15,000 per month. This Act applies to all states except Manipur, Sikkim, Arunachal Pradesh, and Mizoram. Benefits can be availed through ESIC online appointment for hospitals, clinics, and practitioners.

Both employee and the employer contributes to the ESI scheme on ESIC payment portal and ESI Percentage contributions made to the same are

Contribution % of Gross pay
Employees’ contribution 0.75
Employer’s contribution 3.25

Management Notes

Value of the Firm, Needs, Steps, Theories, Factors Affecting

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The Value of the Firm refers to the total economic worth of a business based on the present value of its expected future cash flows and the claims of both debt holders and equity shareholders. It represents the value created by the company’s assets, operations, investment opportunities and financing decisions. In financial management, firm value is an important measure for evaluating the overall financial position and performance of a company. Management aims to maximise firm value by making efficient investment, financing and dividend decisions. The value of the firm is influenced by profitability, risk, growth prospects, cost of capital, cash flows and market conditions.

Needs of Determination of Value of the Firm:

1. Investment Decisions

Determining the value of the firm helps management assess whether the company’s investments are creating sufficient economic value. The value reflects the expected future cash flows generated by business assets and projects. By comparing the present value of expected benefits with investment costs, management can identify profitable investment opportunities and avoid projects that may reduce firm value. This is particularly important in capital budgeting, expansion and replacement decisions. Therefore, determining firm value provides a financial basis for selecting investments that are expected to contribute positively to the company’s long term financial performance.

2. Financing Decisions

The value of the firm is important when making financing decisions because the choice between debt and equity can influence risk and the overall cost of capital. Management can evaluate how different financing structures affect the present value of future cash flows and the claims of investors. An appropriate financing mix may help reduce the cost of capital and increase firm value. Therefore, determining firm value helps management assess whether a proposed financing decision is likely to improve financial efficiency, maintain financial stability and contribute to the long term interests of shareholders.

3. Shareholder Wealth Maximisation

Determining the value of the firm is essential for achieving the objective of shareholder wealth maximisation. Shareholders are interested in the economic value of their investment, which is influenced by the firm’s future earnings, cash flows, growth opportunities and risk. Management can use firm valuation to assess whether business decisions are increasing or decreasing shareholder wealth. Investment, financing and dividend decisions can then be evaluated according to their impact on firm value. Therefore, accurate valuation provides a useful basis for aligning managerial decisions with the objective of creating long term shareholder value.

4. Mergers and Acquisitions

Firm valuation is important in mergers, acquisitions and business combinations because both the acquiring and target companies need to determine a reasonable transaction value. The value of the target firm helps the acquiring company decide how much it should pay and whether the expected benefits justify the investment. Similarly, the target company can use valuation to assess whether the offer adequately reflects its economic worth. Therefore, determining firm value supports negotiation, pricing and decision making in mergers and acquisitions and helps reduce the risk of paying an excessive or inadequate price.

5. Business Performance Evaluation

Determining the value of the firm helps management evaluate the overall performance of the business. Changes in firm value over time may reflect changes in profitability, cash flows, growth opportunities, risk and efficiency of resource utilisation. If firm value increases, it may indicate that management decisions are generating economic benefits for investors. A decline in value may indicate problems requiring corrective action. Therefore, firm valuation provides a broader performance measure than accounting profit alone and helps management assess whether business operations are contributing to sustainable economic value creation.

6. Capital Structure Planning

Firm value is important in determining an appropriate capital structure. Different combinations of debt and equity can influence interest obligations, financial risk, tax benefits and the overall cost of capital. Management can evaluate how changes in leverage affect the value of the firm and determine whether additional borrowing is beneficial or excessive. Excessive debt may increase financial distress risk and reduce firm value, while an appropriate level of debt may provide financing advantages. Therefore, valuation helps management identify a capital structure that balances financing benefits with financial risk.

7. Dividend Policy Decisions

Determining the value of the firm helps management evaluate the effect of dividend decisions on shareholder wealth. Paying dividends provides immediate returns to shareholders, while retaining earnings provides funds for future investment and growth. The appropriate decision depends on the company’s investment opportunities, expected returns and cost of capital. Management can assess whether retaining profits is likely to increase future firm value or whether distributing them would better serve shareholders. Therefore, firm valuation provides a useful framework for balancing dividend payments with reinvestment requirements.

8. Business Sale or Restructuring

Firm valuation is necessary when a company plans to sell a business division, restructure operations or dispose of specific assets. Management needs to understand the economic value of the business or assets before deciding whether a proposed transaction is financially beneficial. Valuation helps identify whether the expected sale proceeds adequately reflect the future income generating capacity of the business. It can also support decisions regarding restructuring, asset disposal and strategic changes. Therefore, determining firm value helps management make informed decisions when changing the size or structure of the organisation.

9. Attracting Investors

Determining firm value is important for attracting potential investors because investors need information about the economic worth and future prospects of a company. A valuation based on expected cash flows, growth and risk can provide an indication of the company’s intrinsic value. Existing and potential investors can compare this value with the market price of shares when making investment decisions. A strong valuation supported by sound financial performance may improve investor confidence. Therefore, firm valuation supports investment decisions and helps communicate the financial strength and future potential of the business.

10. Strategic Decision Making

Firm valuation supports strategic decisions involving expansion, diversification, new product development and entry into new markets. Such decisions can require substantial financial resources and may significantly affect future cash flows and risk. Management can estimate how a proposed strategy may influence the overall value of the firm before committing resources. Strategies expected to increase future cash flows or reduce risk may enhance firm value, while unsuccessful strategies may reduce it. Therefore, determining firm value provides a long term financial perspective for evaluating major strategic choices and supporting sustainable business growth.

Steps of Determination of Value of the Firm:

1. Estimate Future Cash Flows

The first step in determining the value of a firm is to estimate its future cash flows. Management forecasts the cash that the business is expected to generate from its operations and investments over the relevant period. Revenue, operating expenses, taxes, working capital requirements and capital expenditure are considered while preparing these estimates. The quality of valuation depends heavily on the reliability of these forecasts. Therefore, realistic assumptions based on historical performance, industry conditions, market trends and expected business growth should be used to estimate future cash flows accurately.

2. Determine the Forecast Period

The next step is to determine the period for which future cash flows can be reasonably forecast. This period depends on the nature, stability and growth prospects of the business. During the forecast period, individual annual cash flows are estimated based on expected operating and investment activities. For mature companies, forecasts may be relatively stable, while rapidly growing businesses may require more detailed projections. Therefore, selecting an appropriate forecast period is important because unrealistic long term assumptions can significantly affect the estimated value of the firm.

3. Estimate Terminal Value

After the explicit forecast period, the firm is assumed to continue generating cash flows. The value of these future cash flows is represented by the terminal value. It is particularly important because a significant portion of the firm’s total value may arise from cash flows beyond the forecast period. The terminal value can be calculated using the perpetuity growth method or an exit multiple approach. Under the perpetuity method, sustainable growth and the appropriate discount rate are considered. Therefore, realistic assumptions are essential while estimating terminal value.

Formula:

TV = FCFₙ₊₁ / K−g ​​

Where:

TV = Terminal Value
FCFₙ₊₁ = Cash flow in the following year
K = Appropriate discount rate
g = Long term growth rate

4. Determine the Appropriate Discount Rate

The next step is to determine the appropriate discount rate for converting future cash flows into their present values. The rate should reflect the time value of money and the risk associated with the expected cash flows. For firm valuation using Free Cash Flow to Firm, the Weighted Average Cost of Capital is generally used. A higher discount rate reduces the present value of future cash flows, while a lower rate increases it. Therefore, accurate estimation of the discount rate is essential for obtaining a reliable value of the firm.

5. Calculate Present Value of Cash Flows

Once future cash flows and the appropriate discount rate have been estimated, each future cash flow is converted into its present value. This recognises that money received in the future is worth less than money available today because of the time value of money and investment risk. The present values of annual cash flows are calculated using the selected discount rate. The present value of terminal value is also calculated. Therefore, discounting future cash flows provides the foundation for determining the current economic value of the firm.

Formula:

PV = CFₜ / (1+K)t​​

Where:
PV = Present Value
CFₜ = Cash flow in year t
K = Discount rate
t = Time period

6. Calculate Enterprise Value

Enterprise value represents the value of the firm’s operating business before considering the separate claims of debt and cash. It is generally calculated by adding the present values of forecast Free Cash Flows to Firm and the present value of terminal value. This provides an estimate of the total value attributable to all providers of capital. Enterprise value is useful for comparing businesses because it focuses on operating value rather than only the market value of equity. Therefore, calculating enterprise value is an important stage in firm valuation.

Formula:

EV = PV of Forecast FCF + PV of Terminal Value

7. Adjust for Debt and Other Claims

After determining enterprise value, adjustments are made for debt and other claims that have priority over ordinary equity shareholders. Financial debt and certain other liabilities may be deducted, while excess cash and relevant non operating assets may be added, depending on the valuation framework. This adjustment converts enterprise value into the value attributable to equity shareholders. Careful identification of debt and other claims is important to avoid overstating or understating equity value. Therefore, this step establishes the portion of total business value belonging to ordinary shareholders.

Basic Formula:

Equity Value = Enterprise Value − Debt + Cash

8. Determine Equity Value per Share

The final step is to determine the value attributable to each equity share. After calculating the total equity value, it is divided by the number of outstanding equity shares. This provides an estimated intrinsic value per share. Management and investors can compare this estimated value with the current market price to assess whether the shares appear relatively undervalued or overvalued. The reliability of the result depends on the accuracy of cash flow forecasts, growth assumptions, discount rate and other valuation inputs. Thus, per share value provides a practical conclusion to the valuation process.

Formula:

Theories of Determination of Value of the Firm:

1. Net Income Approach

The Net Income Approach states that the value of a firm is influenced by its capital structure and the cost of debt and equity. According to this approach, debt is generally considered a cheaper source of finance than equity because interest cost is relatively lower. Therefore, increasing the proportion of debt can reduce the overall cost of capital and increase the total value of the firm, assuming other conditions remain unchanged. The approach suggests that an optimum capital structure can be achieved by using more debt. However, it assumes that the cost of debt and cost of equity remain constant.

Formula:

V = E + D

Where,

V = Value of Firm

E = Value of Equity

D = Value of Debt.

2. Net Operating Income Approach

The Net Operating Income Approach argues that the total value of the firm is independent of its capital structure. According to this theory, changes in the proportion of debt and equity do not affect the overall value of the firm because any benefit from cheaper debt is offset by an increase in the cost of equity. As financial leverage increases, equity shareholders perceive greater financial risk and demand higher returns. Consequently, the overall cost of capital remains constant. Therefore, under this approach, firm value is determined mainly by operating income and the overall capitalisation rate.

Formula:

V = NOI / Ko​

Where

V = Value of Firm

NOI = Net Operating Income

Kₒ = Overall Cost of Capital.

3. Traditional Approach

The Traditional Approach takes a balanced view between the Net Income and Net Operating Income approaches. It suggests that capital structure can influence the value of the firm up to a certain point. Initially, increasing debt may reduce the overall cost of capital because debt is relatively cheaper than equity. After reaching an optimum level of debt, further borrowing increases financial risk and raises the cost of equity and debt. Consequently, the overall cost of capital begins to increase and firm value decreases. Therefore, this approach supports the existence of an optimal capital structure.

Basic Relationship:

V = EBIT(1−T) / Ko

The optimum structure occurs where

Kₒ is minimum and firm value is maximum.

4. Modigliani and Miller Theory

The Modigliani and Miller Theory states that, under certain ideal market assumptions, the value of a firm is independent of its capital structure. Investors can make their own financing adjustments, so changing the debt and equity mix does not create additional firm value. In the original proposition without taxes, the overall cost of capital remains constant. When corporate taxes are introduced, debt can increase firm value because interest provides a tax advantage. The theory provides an important framework for understanding the relationship between capital structure, financing decisions and firm value.

Without Tax:

Vₗ = Vᵤ

Where Vₗ = Levered Firm Value and Vᵤ = Unlevered Firm Value.

With Corporate Tax:

Vₗ = Vᵤ + (T x D)

Where

T = Corporate Tax Rate

D = Debt.

5. Dividend Capitalisation Approach

The Dividend Capitalisation Approach determines the value of equity based on the present value of expected future dividends. It assumes that investors value shares according to the income they expect to receive from them. Expected dividends, required rate of return and dividend growth are therefore important factors in determining share value. A higher expected dividend or growth rate can increase the estimated value, while a higher required return generally reduces it. This approach is particularly useful for companies with stable dividend policies and predictable dividend growth.

Formula:

P₀ = D1 / Kₑ − g​​

Where,

P₀ = Current Share Value,

D₁ = Expected Dividend,

Kₑ = Cost of Equity and

g = Growth Rate.

6. Free Cash Flow Approach

The Free Cash Flow Approach determines the value of a firm based on the present value of its expected future free cash flows. It focuses on the cash generated by business operations after meeting necessary operating expenses and investment requirements. These future cash flows are discounted using an appropriate rate, commonly WACC for Free Cash Flow to Firm. The approach is widely used because cash flow reflects the economic benefits generated by the business. Therefore, firm value depends on expected future cash generation, growth prospects, investment requirements and the risk associated with those cash flows.

Formula:

Where,

FCF = Free Cash Flow

WACC = Weighted Average Cost of Capital

TV = Terminal Value.

Factors Affecting the Value of the Firm:

1. Profitability and Earnings Potential

The value of a firm is fundamentally driven by its profitability and capacity to generate sustainable earnings over time, as higher and more consistent profits translate into greater cash flows available for shareholders and reinvestment. Firms demonstrating strong operating margins, efficient cost management, and consistent revenue growth are typically valued higher by investors and markets. Profitability reflects the firm’s competitive positioning, operational efficiency, and ability to convert business activities into tangible financial returns. Since most valuation models, including discounted cash flow and earnings multiples, are anchored in earnings or cash flow projections, a firm’s demonstrated and expected profitability remains one of the most significant determinants of overall firm value.

2. Capital Structure and Cost of Capital

The mix of debt and equity financing a firm employs significantly influences its overall value through its impact on the weighted average cost of capital. An optimal capital structure minimizes the overall cost of financing, thereby maximizing firm value, while excessive debt increases financial risk and potential distress costs, and excessive reliance on equity may dilute returns and increase the cost of capital. Firms that strategically balance leverage to exploit tax benefits of debt while managing associated risks tend to achieve a lower cost of capital, which directly enhances the present value of future cash flows and, consequently, overall firm valuation.

3. Growth Prospects and Future Opportunities

A firm’s anticipated future growth, including expansion into new markets, product innovation, and increasing market share, plays a critical role in determining its value, as investors price in expected future cash flows rather than solely historical performance. Firms with strong growth prospects, supported by sustainable competitive advantages, innovative capabilities, or favorable industry positioning, typically command higher valuations due to the expectation of increasing future earnings and cash flows. Growth potential is often reflected in valuation multiples and terminal value calculations within discounted cash flow models, making a firm’s credible and achievable growth trajectory a key driver of overall enterprise value.

4. Dividend Policy

A firm’s dividend policy, reflecting decisions on the proportion of earnings distributed to shareholders versus retained for reinvestment, influences firm value by signaling financial health and shaping investor expectations regarding future returns. Consistent and sustainable dividend payments can enhance investor confidence and attract income-focused investors, potentially supporting share price stability. Conversely, firms retaining earnings for high-return growth opportunities may achieve greater long-term value creation if reinvested capital generates returns exceeding shareholders’ required rate of return. The appropriateness of a firm’s dividend policy, aligned with its growth stage and investment opportunities, therefore directly impacts market perception and overall valuation.

5. Business and Financial Risk Profile

The overall risk profile of a firm, encompassing both business risk arising from operational and industry factors, and financial risk stemming from leverage and capital structure choices, significantly affects its value through the discount rate applied to future cash flows. Higher perceived risk increases the required rate of return demanded by investors, thereby reducing the present value of expected future cash flows and lowering overall firm valuation. Firms that effectively manage and mitigate operational uncertainties, market volatility, and financial leverage tend to enjoy lower risk premiums, resulting in higher valuations compared to firms with similar earnings but greater underlying risk exposure.

6. Quality of Management and Corporate Governance

The competence, strategic vision, and integrity of a firm’s management team, along with robust corporate governance practices, significantly influence firm value by affecting operational efficiency, strategic decision-making, and stakeholder confidence. Strong management teams capable of effectively allocating capital, navigating competitive challenges, and executing growth strategies tend to enhance long-term value creation. Additionally, transparent governance structures, effective board oversight, and alignment of management interests with shareholders reduce agency costs and investor uncertainty. Markets often assign valuation premiums to firms perceived as having capable leadership and sound governance, while poor management or governance failures can lead to significant value destruction.

University of Mumbai BMS Notes

Financial Goals and Strategy

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Strategic financial management means not only managing a company’s finances but managing them with the intention to succeed that is, to attain the company’s goals and objectives and maximize shareholder value over time. However, before a company can manage itself strategically, it first needs to define its objectives precisely, identify and quantify its available and potential resources, and devise a specific plan to use its finances and other capital resources toward achieving its goals.

Strategic financial management is about creating profit for the business and ensuring an acceptable return on investment (ROI). Financial management is accomplished through business financial plans, setting up financial controls, and financial decision making.

  • Strategic financial management is about creating profit for the business.
  • A financial plan that is strategic focuses on long-term gain.
  • Strategic financial planning varies by company, industry, and sector.

Planning

  • Define objectives precisely.
  • Identify and quantify available and potential resources.
  • Write a specific business financial plan.

Budgeting

  • Help the company function with financial efficiency, and reduced waste.
  • Identify areas that incur the most operating costs, or exceed the budgeted cost.
  • Ensure sufficient liquidity to cover operating expenses without tapping external resources.
  • Uncover areas where a firm may invest earnings to achieve goals more effectively.

Managing and Assessing Risk

  • Identify, analyze, and mitigate uncertainty in investment decisions.
  • Evaluate the potential for financial exposure; examine capital expenditures (CapEx) and workplace policies.
  • Employ risk metrics such as degree of operating leverage calculations, standard deviation, and value-at-risk (VaR) strategies.

Establishing Ongoing Procedures

  • Collect and analyze data.
  • Make financial decisions that are consistent.
  • Track and analyze variance that is, differences between budgeted and actual results.
  • Identify problems and take appropriate corrective actions.
Management Notes

Amalgamation, Meaning, Reasons, Types, Advantages, Disadvantages

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Amalgamation refers to the process where two or more companies combine to form a single new entity or where one company absorbs another. It is undertaken to achieve various objectives such as expansion, increased market share, synergies, and economies of scale. In amalgamation, the assets and liabilities of the transferor company (or companies) are taken over by the transferee company. The shareholders of the transferor company are usually compensated through shares or other securities of the transferee company. Amalgamation can be in the nature of a merger or a purchase, depending on whether the companies continue their business as a going concern or not. It is regulated by legal frameworks such as the Companies Act and relevant accounting standards.

Objectives of Amalgamation

  • Achieving Economies of Scale

One of the main objectives of amalgamation is to achieve economies of scale by combining the resources, operations, and production capacities of the merging companies. Larger-scale operations lead to cost savings, more efficient utilization of resources, better bargaining power, and improved profitability. The merged entity can produce goods or services at a lower cost per unit due to increased production levels.

  • Enhancing Market Competitiveness

Amalgamation helps companies strengthen their competitive position in the market. By joining forces, companies can gain a larger market share, reduce competition, and enhance their brand presence. The merged entity may also diversify its product or service offerings, making it more resilient to market fluctuations and better equipped to cater to customer needs.

  • Expansion and Diversification

Amalgamation facilitates business expansion and diversification, either by entering new geographical markets or expanding product lines. Through amalgamation, companies can diversify their risk by tapping into different markets, reducing dependency on a single product, service, or region. This expansion can lead to increased revenue streams and more stable earnings.

  • Financial Synergy

Amalgamation creates financial synergy by pooling financial resources, improving access to capital, and enhancing creditworthiness. The combined entity may benefit from a stronger financial position, enabling better borrowing terms and increased investor confidence. It also allows for better utilization of financial resources, leading to higher returns on investment.

  • Tax Benefits

In some cases, amalgamation is pursued to gain tax advantages. Companies may be able to carry forward and set off losses of one company against the profits of another, leading to lower tax liabilities. Additionally, certain tax exemptions and deductions may be available to the merged entity.

  • Eliminating Competition

Amalgamation can be a strategic move to eliminate direct competition by merging with or acquiring a competitor. This reduces market rivalry, stabilizes prices, and improves market control for the merged entity.

Characteristics of Amalgamation

  • Combination of Companies

Amalgamation involves the merging of two or more companies into a single entity. This combination can occur either by forming a new company or by one existing company taking over another. In either case, the merging entities cease to exist independently after the amalgamation is complete, and their assets, liabilities, and operations are transferred to the combined entity.

  • Transfer of Assets and Liabilities

In an amalgamation, all assets and liabilities of the amalgamating companies are transferred to the new or surviving company. The transfer is comprehensive, including both tangible and intangible assets, as well as all liabilities. This ensures that the newly formed entity or the surviving company gains complete control over the resources and obligations of the amalgamating companies.

  • Shareholder Compensation

Shareholders of the merging companies receive compensation in the form of shares in the new or surviving company. The ratio at which shares are exchanged is usually determined based on the valuation of the merging companies. Shareholders may also receive cash or other benefits as part of the arrangement. This compensation is crucial in ensuring that the interests of the shareholders are protected during the amalgamation.

  • Legal Process

Amalgamation is a legal process that involves approval from regulatory authorities, courts, and shareholders. It is governed by laws such as the Companies Act in India. The legal procedure ensures transparency and protects the rights of all stakeholders involved, including creditors, employees, and shareholders.

  • Economies of Scale

One of the primary objectives of amalgamation is to achieve economies of scale. By combining resources, operations, and expertise, the amalgamated entity can reduce costs, increase efficiency, and improve competitiveness in the market.

  • Loss of Identity for Amalgamating Companies

In an amalgamation, the identity of the merging companies is lost, as they either form a new company or are absorbed by an existing one. Their separate legal existence comes to an end, and they function as a single, unified entity moving forward.

Reasons of Amalgamation

  • Economies of Scale

Amalgamation enables companies to achieve economies of scale by combining their resources, infrastructure, and operations. The larger volume of production often leads to reduced per-unit costs in manufacturing, marketing, and administration. Shared facilities and workforce help in reducing duplication of efforts and expenses. Bulk purchasing of raw materials and centralized operations also bring down procurement and operational costs. This makes the amalgamated entity more cost-efficient and competitive in the market. Additionally, the optimization of resources leads to better utilization of capacity and a stronger financial position, helping the company operate more profitably in the long term.

  • Business Expansion

Amalgamation allows companies to expand their operations geographically and functionally. By joining forces, companies can enter new markets or strengthen their presence in existing ones without starting from scratch. This expansion can cover products, services, distribution channels, or customer bases. The combined entity may also gain access to new technology, R&D capabilities, or skilled employees. Expansion through amalgamation is often faster and less risky than organic growth. It enables companies to diversify their portfolios and reduce dependence on a single segment, thereby increasing growth potential and enhancing their competitive edge in both domestic and international markets.

  • Elimination of Competition

Amalgamation can eliminate direct competition between companies operating in the same industry. When competitors merge, it leads to reduced price wars and market rivalry. This helps stabilize prices and improve profit margins. The combined entity often gains better control over market share and pricing power. By reducing competition, companies can focus more on innovation, customer satisfaction, and long-term strategic goals rather than short-term survival tactics. Additionally, amalgamation helps prevent hostile takeovers by competitors. It is a strategic move to consolidate market position, streamline operations, and strengthen bargaining power against suppliers, customers, and regulators.

  • Tax Benefits

Amalgamation can offer significant tax advantages under prevailing tax laws. Loss-making companies, when amalgamated with profit-making ones, allow the latter to set off the accumulated losses and unabsorbed depreciation of the former against their taxable income. This results in reduced tax liability for the amalgamated entity. Furthermore, certain amalgamations qualify for tax exemptions under specific provisions of the Income Tax Act, making the process financially beneficial. These tax benefits improve the post-merger profitability and cash flows of the new entity. Companies often consider amalgamation as a strategic tool to optimize their tax planning and enhance shareholder value.

  • Improved Managerial Efficiency

Amalgamation brings together the managerial talents and administrative strengths of the combining companies. The pooling of experienced and skilled professionals enhances decision-making, planning, and execution capabilities. It eliminates overlapping positions and departments, leading to a more streamlined and efficient organizational structure. The best practices of both companies can be adopted and implemented across the merged entity, improving productivity and innovation. Additionally, better leadership and governance may emerge from the amalgamation, strengthening corporate strategy and culture. Overall, managerial synergy results in enhanced organizational performance and supports the long-term success of the amalgamated business.

  • Diversification of Risk

Amalgamation facilitates risk diversification by enabling companies to operate in multiple sectors, markets, or product lines. When companies with different business models or market focuses combine, they reduce their dependence on a single income stream or market condition. This diversification helps stabilize revenue and protects the company from industry-specific downturns or economic fluctuations. For example, if one segment performs poorly, profits from other segments can balance the overall financial health. It also allows for better capital allocation and investment planning. In this way, amalgamation serves as a strategic move to minimize business risk and enhance sustainability.

  • Better Utilization of Resources

Through amalgamation, idle or underutilized resources such as plant, machinery, human capital, and financial assets can be better deployed. Combining operations often reveals overlapping capacities that can be optimized to increase efficiency. For instance, surplus cash from one company can be used to fund profitable projects in another. Similarly, excess workforce or production capacity can be redirected for maximum productivity. Better asset utilization leads to higher returns on investment and improved financial ratios. Moreover, amalgamation encourages effective internal restructuring, resource sharing, and cost control, ensuring that the new entity operates at an optimal performance level.

Types of Amalgamation:

1. Amalgamation in the Nature of Merger

This type of amalgamation involves the blending of two or more companies where both companies combine on equal terms, and no significant alterations occur in the identity or ownership of the combined entity. This type of amalgamation is based on the principle of continuity of business and shareholders’ interest. There is no adjustment to the book values of assets and liabilities, and the business of the transferor company continues in the same manner under the transferee company. At least 90% of the equity shareholders of the transferor company become shareholders of the transferee company. Such amalgamations are treated as a unification of interests and follow the Pooling of Interests Method under Accounting Standard (AS) 14. It aims to create synergies and enhance overall business value.

The characteristics of this type of amalgamation:

  • Pooling of Interests

The assets and liabilities of the amalgamating companies are pooled together, and they continue at their existing book values.

  • Continuity of Business

The business of the amalgamating companies is carried on by the new or existing company without any major changes.

  • Shareholders’ Continuity

The shareholders of the amalgamating companies become shareholders in the new or combined entity, retaining similar ownership stakes.

  • No Adjustments to Assets and Liabilities

There are usually no adjustments made to the assets and liabilities transferred, except for alignment with accounting standards.

This form of amalgamation is also known as a “genuine merger” and is typically pursued for business expansion, achieving economies of scale, or strengthening market position.

2. Amalgamation in the Nature of Purchase

Amalgamation in the nature of purchase occurs when one company acquires another, and the transferor company is dissolved without forming a new entity. This is not a merger of equals but rather a business acquisition. In this case, the transferee company does not necessarily take over all assets and liabilities of the transferor company. Also, there is no requirement that the shareholders of the transferor company become shareholders of the transferee company. The consideration paid may be in the form of cash, shares, or other assets. This type of amalgamation is recorded using the Purchase Method under AS 14, where the assets and liabilities are recorded at their fair values, and the difference is treated as goodwill or capital reserve.

The key characteristics are:

  • Acquisition

The acquiring company takes over the assets and liabilities of the acquired company.

  • Adjustments in Valuation

Assets and liabilities of the acquired company are revalued and recorded at fair market value or adjusted according to the acquirer’s accounting policies.

  • Shareholders’ Rights

The shareholders of the acquired company may receive compensation in the form of shares, cash, or a combination of both, but their stake in the new entity might differ from their previous ownership.

  • Change in Business Identity

The acquired company loses its identity and operates under the acquirer’s brand or business model.

Advantages of Amalgamation

  • Economies of Scale

Amalgamation allows companies to combine resources, leading to cost savings through bulk purchasing, shared infrastructure, and streamlined operations. Larger production scales reduce per-unit costs, improving profitability. Merged entities can negotiate better terms with suppliers and optimize distribution networks. Additionally, administrative expenses (like accounting, HR, and legal costs) are reduced when functions are consolidated. This efficiency makes the new entity more competitive in the market.

  • Enhanced Market Share & Competitive Strength

By merging, companies eliminate competition between themselves and gain a stronger market position. The combined entity can leverage a larger customer base, diversified products, and stronger brand recognition. This increased market power helps in negotiating better deals, resisting price wars, and expanding into new regions. Competitors find it harder to challenge a larger, more resourceful firm, ensuring long-term stability.

  • Diversification of Risk

Amalgamation helps spread business risks across different industries or markets. If one sector faces a downturn, losses can be offset by profits from other segments. This reduces dependency on a single revenue stream, ensuring financial stability. For example, a manufacturing firm merging with a logistics company can balance operational risks. Diversification also attracts investors seeking lower-risk portfolios.

  • Access to New Technologies and Expertise

A smaller firm merging with a technologically advanced partner gains immediate access to R&D, patents, and skilled personnel. This accelerates innovation without heavy upfront investment. The combined expertise improves product quality and operational efficiency. For instance, a traditional bank merging with a fintech firm can quickly adopt digital banking solutions, staying ahead of competitors.

  • Improved Financial Strength and Creditworthiness

After amalgamation, the combined balance sheet shows higher assets, revenues, and reserves, improving credit ratings. Banks and investors are more willing to lend at lower interest rates due to reduced risk. The merged entity can also raise capital more easily through equity or debt, funding expansions and modernization projects that were previously unaffordable.

  • Tax Benefits & Synergies

Governments often provide tax incentives for amalgamations, such as carry-forward losses or deferred tax liabilities. Operational synergies (like shared marketing or R&D) further reduce costs. The merged entity can optimize tax planning by offsetting profits of one unit against losses of another, leading to significant tax savings and improved cash flows.

Disadvantages of Amalgamation

  • Loss of Identity

Amalgamation often leads to the loss of individual identity of one or more companies involved. The smaller or absorbed company may lose its brand name, culture, and goodwill built over years. Employees and customers who were loyal to the original entity may feel disconnected or dissatisfied with the merged entity. This loss can affect customer relationships, market perception, and internal morale. Additionally, stakeholders of the transferor company may feel alienated or undervalued post-amalgamation. Such identity dilution may impact brand loyalty and could reduce the competitive edge that the original company once held independently in its market segment.

  • Cultural Clashes

Different companies often have distinct corporate cultures, management styles, and operational philosophies. When they amalgamate, cultural differences may lead to internal conflicts, reduced morale, and lack of coordination among employees. Misalignment in work ethics, communication practices, and decision-making approaches can result in misunderstandings and inefficiencies. Employees may resist changes, leading to reduced productivity and engagement. Management may also struggle to integrate teams and establish a cohesive culture. If not handled properly, cultural clashes can impact the overall success of the amalgamation and result in a decline in employee satisfaction, talent retention, and organizational performance.

  • Redundancy and Layoffs

One major drawback of amalgamation is redundancy in job roles, departments, or resources. To reduce costs and improve efficiency, companies may lay off employees performing similar roles across merged entities. This can lead to widespread job insecurity, dissatisfaction, and unrest among the workforce. The psychological impact of layoffs can lower employee morale and productivity, even among retained staff. In some cases, valuable talent may be lost due to voluntary resignations. Moreover, labor unions and regulatory bodies may raise concerns over workforce reduction, leading to legal or reputational challenges for the new entity.

  • High Cost of Amalgamation

The process of amalgamation can be expensive and time-consuming. It involves legal, financial, and administrative costs such as due diligence, asset valuation, consultancy fees, regulatory approvals, and integration planning. The actual execution of amalgamation—merging operations, aligning systems, and training staff—may demand significant financial resources. If the anticipated synergies are not realized, these upfront costs can outweigh the benefits. Also, unexpected liabilities of the transferor company may surface post-merger, adding to financial burdens. Therefore, improper planning and execution can result in financial strain and poor return on investment for the amalgamated entity.

  • Management Disputes

Amalgamation often results in the restructuring of management, which can lead to power struggles, ego clashes, or differences in strategic vision between executives of the merging companies. Lack of clarity in leadership roles and responsibilities may create confusion and reduce efficiency. Competing interests among senior management can slow down decision-making and negatively impact employee confidence in leadership. If not managed carefully, such disputes can erode trust, derail integration efforts, and cause long-term instability in the organization. Ultimately, poor management alignment after amalgamation may weaken the strategic direction and performance of the new entity.

University of Mumbai BMS Notes

Meaning, Types, Limitations of Merger

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A merger is a corporate strategy to combine with another company and operate as a single legal entity. The companies agreeing to mergers are typically equal in terms of size and scale of operations.

Types of Mergers:

  1. Conglomerate merger

Conglomerate merger is a union of companies operating in unrelated activities. The union will take place only if it increases the wealth of the shareholders.

  1. Congeneric/Product extension merger

Such mergers happen between companies operating in the same market. The merger results in the addition of a new product to the existing product line of one company. As a result of the union, companies can access a larger customer base and increase their market share.

  1. Market extension merger

Companies operating in different markets, but selling the same products, combine in order to access a larger market and larger customer base.

  1. Vertical merger

A vertical merger occurs when companies operating in the same industry, but at different levels in the supply chain, merge. Such mergers happen to increase synergies, supply chain control, and efficiency.

  1. Horizontal merger

Companies operating in markets with fewer such businesses merge to gain a larger market. A horizontal merger is a type of consolidation of companies selling similar products or services. It results in the elimination of competition; hence, economies of scale can be achieved.

Limitations:

  • If executives of the absorbed company are not placed at senior ranks in the new company, it will lower third morale and decrease productivity.
  • Empirical studies have shown that growth rate of the merged companies is generally lower than that of merging companies.
  • Merger can result in social ills like monopoly, concentration of economic and social power, restricted supply, high prices etc.
  • In an aggressive merger, a company may opt to eliminate the underperforming assets of the other company. It may result in employees losing their jobs.
  • The companies that have agreed to merge may have different cultures. It may result in a gap in communication and affect the performance of the employees.
University of Mumbai BMS Notes

Meaning, Types, Limitations of Takeover

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A takeover occurs when one company makes a successful bid to assume control of or acquire another. Takeovers can be done by purchasing a majority stake in the target firm. Takeovers are also commonly done through the merger and acquisition process. In a takeover, the company making the bid is the acquirer and the company it wishes to take control of is called the target.

Takeovers are typically initiated by a larger company seeking to take over a smaller one. They can be voluntary, meaning they are the result of a mutual decision between the two companies. In other cases, they may be unwelcome, in which case the acquirer goes after the target without its knowledge or some times without its full agreement.

Types

Friendly Takeover

A friendly takeover is an acquisition which is approved by the management of the target company. Before a bidder makes an offer for another company, it usually first informs the company’s board of directors. In an ideal world, if the board feels that accepting the offer serves the shareholders better than rejecting it, it recommends the offer be accepted by the shareholders.

In a private company, because the shareholders and the board are usually the same people or closely connected with one another, private acquisitions are usually friendly. If the shareholders agree to sell the company, then the board is usually of the same mind or sufficiently under the orders of the equity shareholders to cooperate with the bidder. This point is not relevant to the UK concept of takeovers, which always involve the acquisition of a public company.

Hostile Takeover

A hostile takeover allows a bidder to take over a target company whose management is unwilling to agree to a merger or takeover. A takeover is considered hostile if the target company’s board rejects the offer, and if the bidder continues to pursue it, or the bidder makes the offer directly after having announced its firm intention to make an offer. Development of the hostile tender is attributed to Louis Wolfson.

A hostile takeover can be conducted in several ways. A tender offer can be made where the acquiring company makes a public offer at a fixed price above the current market price. An acquiring company can also engage in a proxy fight, whereby it tries to persuade enough shareholders, usually a simple majority, to replace the management with a new one which will approve the takeover. Another method involves quietly purchasing enough stock on the open market, known as a creeping tender offer, to effect a change in management. In all of these ways, management resists the acquisition, but it is carried out anyway.

Reverse Takeover

A reverse takeover is a type of takeover where a public company acquires a private company. This is usually done at the instigation of the private company, the purpose being for the private company to effectively float itself while avoiding some of the expense and time involved in a conventional IPO. However, in the UK under AIM rules, a reverse takeover is an acquisition or acquisitions in a twelve-month period which for an AIM company would:

  • Exceed 100% in any of the class tests; or
  • Result in a fundamental change in its business, board or voting control; or
  • In the case of an investing company, depart substantially from the investing strategy stated in its admission document or, where no admission document was produced on admission, depart substantially from the investing strategy stated in its pre-admission announcement or, depart substantially from the investing strategy.

Backflip Takeover

A backflip takeover is any sort of takeover in which the acquiring company turns itself into a subsidiary of the purchased company. This type of takeover can occur when a larger but less well-known company purchases a struggling company with a very well-known brand. Examples include:

  • The Texas Air Corporation takeover of Continental Airlines but taking the Continental name as it was better known.
  • The SBC takeover of the ailing AT&T and subsequent rename to AT&T.
  • Westinghouse’s 1995 purchase of CBS and 1997 renaming to CBS Corporation, with Westinghouse becoming a brand name owned by the company.
  • NationsBank’s takeover of the Bank of America, but adopting Bank of America’s name.
  • Norwest purchased Wells Fargo but kept the latter due to its name recognition and historical legacy in the American West.
  • Interceptor Entertainment’s acquisition of 3D Realms, but kept the name 3D Realms.
  • Nordic Games buying THQ assets and trademark and renaming itself to THQ Nordic.
  • Infogrames Entertainment, SA becoming Atari SA.
  • The Avago Technologies takeover of Broadcom Corporation and subsequent rename to Broadcom Inc.

Drawbacks of Takeovers include:

  • High cost involved with the takeover price often proving too high
  • Problems of valuation (see the price too high, above)
  • Upset customers and suppliers, usually as a result of the disruption involved
  • Problems of integration (change management), including resistance from employees
  • Incompatibility of management styles, structures and culture
  • Questionable motives
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