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Relative Size in Mergers and Operating Performance:Indian Experience

In today's globalised economy, mergers and acquisitions are being increasingly used the world over as a strategy for achieving a larger size and asset base, faster growth in market share and for becoming more competitive through economies of scale. One of the important factors that could affect the outcome of a merger is the relative size of the acquiring and acquired companies. This paper studies the impact of mergers on the operating performance of acquiring corporates by examining some pre- and post-merger financial ratios with a sample of firms chosen from all mergers involving public limited and traded companies in India between 1991 and 2003. The results suggest that there are minor variations in terms of the impact on operating performance following mergers, when the acquiring and acquired firms are of different relative sizes, as measured by market value of equity.

Relative Size in Mergers and Operating Performance: Indian Experience

In today’s globalised economy, mergers and acquisitions are being increasingly used the world over as a strategy for achieving a larger size and asset base, faster growth in market share and for becoming more competitive through economies of scale. One of the important factors that could affect the outcome of a merger is the relative size of the acquiring and acquired companies. This paper studies the impact of mergers on the operating performance of acquiring corporates by examining some pre- and post-merger financial ratios with a sample of firms chosen from all mergers involving public limited and traded companies in India between 1991 and 2003. The results suggest that there are minor variations in terms of the impact on operating performance following mergers, when the acquiring and acquired firms are of different relative sizes, as measured by market value of equity.

PRAMOD MANTRAVADI, A VIDYADHAR REDDY

I
n today’s globalised economy, competitiveness and competitive advantage have become the buzzwords for cor porates around the world. Mergers and acquisitions are being increasingly used by companies for entering new markets, asset growth, garnering greater market shares/additional manufacturing capacities, and gaining complementary strengths and competencies, to become more competitive in the marketplace

The Indian economy has undergone major transformation and structural change following the economic reforms introduced by the government of India in 1991. In the liberalised economic and business environment, “size and competence” have become the focus of every business enterprise in India as companies realise the need to grow and expand in businesses that they understand well, to face growing competition. Indian corporates have undertaken restructuring exercises to sell off non-core businesses, and to create a stronger presence in their core areas of business interest. Mergers and acquisitions have emerged as one of the most effective methods of such corporate restructuring, and have therefore, become an integral part of the long-term business strategy of corporates in India.

Three distinct trends can be seen in the mergers and acquisitions activity in India after the reforms in 1991. In the initial period, there was intense investment activity, a wave of consolidation within the Indian industry as companies tried to prepare for the potential aggressive competition in domestic and overseas markets, through acquisitions and mergers, to achieve economies of scale and scope.

In the second significant trend, visible since 1995, there was increased activity in consolidation of subsidiaries by multinational companies operating in India, followed by the entry of several multinational companies into Indian markets, through the acquisition route, with liberalised norms in place for foreign direct investments (FDI) [Beena 2000]. Indian companies focused on capital and business restructuring, and cleaned up their balance sheets. There was consolidation in the domestic industries such as steel, cement and telecom.

The third wave of mergers and acquisitions in India, evident since 2002, is that of Indian companies venturing abroad, and making acquisitions in developed and other developing countries, for gaining entry into international markets. Indian companies have been actively pursuing overseas acquisitions in recent years. The opening up of the Indian economy and financial sector, huge cash reserves following some years of great profits, and enhanced competitiveness in the global markets, have given greater confidence to big Indian companies to venture abroad for market expansion. Surges in economic growth and decreasing interest rates have made financing such deals, cheaper. Changes in regulations made by the finance ministry in India pertaining to overseas investments by Indian companies have also made it easier for the companies to acquire abroad. The last five years have seen Indian corporates in several international acquisition deals in developed and emerging markets.

In a survey among Indian corporate managers across various industry sectors, by Grant Thornton (2006), it was observed that mergers and acquisitions (M&A) are a significant form of business strategy today for Indian corporates. The two main objectives (Table 1) behind any M&A transaction, for corporates were found to be: (i) improving revenues and profitability; and

(ii) faster growth in scale and quicker time to market.

Given this background, this study has been undertaken to see if the mergers in the post-reforms period in Indian industry have

Table 1: Objectives of Indian Corporates for M&As

Objective Responses (in Per Cent)

To improve revenues and profitability 33 Faster growth in scale and quicker time to market 28 Acquisition of new technology or competence 22 To eliminate competition and increase market share 11 Tax shields and investment savings 3 Any other reason 3

Source: Grant Thornton (2006).

contributed to the improvement of the operating performance of acquiring firms involved in the deals, since improving revenues and profitability has been stated as a major objective for mergers, by Indian companies.

I Literature Review

Studies in US

Healy, Palepu and Ruback (1992) examined the post-merger cash flow performance for 50 largest US mergers and concluded that the operating performance of merging firms had improved significantly following acquisitions, in comparison with their res pective industries, in the five-year period after the merger. The study observed that the improvement in post-merger cash flows was not achieved at the expense of the merging firms’ long-term viability, and that the increase in industry-adjusted operating returns could be attributed to an increase in asset turnover, rather than an increase in operating margins.

Aloke Ghosh (2001) compared the post- and pre-acquisition operating cash flow performance of merging firms three years after the merger with control firms (based on pre-acquisition performance and size) – results showed that merging firms had systematically outperformed industry-median firms over pre-acquisition years. Once the superior pre-acquisition performance was accounted for, there was no evidence of improvement in the operating performance of acquiring firms following acquisitions.

Malcolm Salter and Wolf Weinhold (1979) compared post-merger operating returns of 36 merging companies with those of other listed firms on the New York Stock Exchange (NYSE) – the study found that the average return on equity (ROE) for merging firms was 44 per cent lower than average, and the average return on assets (ROA) was 75 per cent lower than the average of other firms.

Weston and Mansinghka (1971) compared the profitability of a sample of 63 conglomerates of the 1960s to that of a randomly selected sample of industrials, and a combined industrial and non-industrial sample. Results showed that for the year following the merger, the earnings rates of companies in the control group were significantly higher than the earnings rates of the conglomerate firms. Ten years later, there were no significant differences observed in the performance of two groups – the improvement in the earnings performance of the conglomerate firms was explained as evidence for the successful achievement of defensive diversification undertaken to avoid business and financial risks associated with their industries.

Heron and Lie (2002) investigated the relationship between earnings management and operating performance for a large sample of firms that conducted acquisitions between 1985 and 1997, and found that acquiring firms continued to exhibit operating performance levels in excess of their respective industries and significantly outperformed control firms with similar pre-event operating performances.

Ramaswamy and James Waegelein (2003) used a sample of 162 firms and industry-adjusted cash flow returns on market value of assets as performance criteria, to examine the financial performance of the combined target and acquiring firms over a five-year post-merger period in relation to the corresponding pre-merger period. The study tested the post-merger vs pre-merger financial performance, for a wide range of relative sizes.1 The study reported results similar to those of Healy and Palepu (1992) that there was improvement in the post-merger operating financial performance, measured by industry-adjusted return on assets, for the full sample. Further, it was found that post-merger performance was negatively associated with relative target size – larger relative-sized firms were seen to show poorer post-merger performance than firms that acquired smaller firms. The study interpreted the results as suggesting that firms acquiring relatively larger firms have a more difficult time digesting those firms and in effectively assimilating them into the company’s operations.

Sayan Chatterjee (1986) compared three broad classes of resources that contribute to the creation of value in mergers: cost of capital related (resulting in financial synergy), cost of production related (resulting in operational synergy), and price related (resulting in collusive synergy). Analysis of the wealth gain/loss to rivals of the target firms, and comparison with those of the merged entities, implied that relative size was an indicator of financial synergy, and if financial synergy can be fully exploited (large relative size of acquiring firm), then the merger-related gains appeared to be greater than those that depend primarily on operational synergies.

John B Kusewitt (1985) investigated the relationship of relative size (of acquired firm to acquirer) to the long-run financial performance of acquiring firms, using a database of 138 active acquiring firms, which had accomplished some 3,500 acquisitions during the 1967-76 period. The study found that relative size was significantly statistically related to performance measures, and proposed that both excessively small and large acquisitions should be avoided.

Kitching (1967) suggested that size differences between the bidder and target firms also influence acquisition performance, and that relatively large acquisitions would have a greater combination potential, especially in the case of related acquisitions. When the acquiring firm is substantially larger than the target, combination potential is limited by size constraints. When the target firm is relatively small, the human integration needs of the target firm are suggested as commonly overlooked by the acquirer, and such acquisitions may not receive sufficient managerial attention to realise the projected synergies.

Sara Moellera, Frederik Schlingemannb and Renle M Stulz (2004) examined a sample of 12,023 acquisitions by public firms from 1980 to 2001 and suggested the existence of a size effect in acquisition announcement returns. The announcement return for acquiring-firm shareholders in the sample was observed to be roughly 2 percentage points higher for small acquirers, irrespective of the form of financing and whether the acquired firm was public or private. The size effect was seen robust to firm and deal characteristics, and not reversed over time.

Loderer and Martin (1992) analysed the post-acquisition stock price returns for a sample of 1,298 acquiring firms during 1966-86, segregated by relative size,2 and found that the performance over

Table 2: Relative Size of Merging and Merged Firms

Relative Size Ratio Number of Mergers

From 0.11 up to 0.40 47 Between 0.41 and 0.70 26 Between 0.71 and 1.00 6 Above 1.00 17 Total 96

Source: From Prowess database.

the full five years after the acquisition was zero, irrespective of the acquisition size. However, the middle three quartiles of acquisition size (those comprising between 13 per cent and 55 per cent of acquiring firm value) experienced negative returns, during the second post-acquisition year, the lowest and highest quartiles did not experience statistically significant returns.

Studies in Europe

Geoffrey Meeks (1977) explored the gains from merger for a sample of 233 transactions in the United Kingdom between 1964 and 1971 by studying the change in return on assets (ROA)3 compared to the change in ROA for the buyer’s industry. The study showed a decline in ROA for acquirers following the transaction, with performance dropping to further lower levels five years after the merger. For nearly two-thirds of acquirers, performance was below the standard of the industry.

Mueller edited a collection of studies (1980) of M&A profitability (measured by return on equity, return on assets, and net profit margin) across seven nations in Europe and the US and found that acquiring firms reported worse returns in the five years after acquisition than their non-acquiring counterparts but not significantly. No consistent pattern of either improved or deterio rated profitability could therefore be claimed across the seven countries.

Marina Martynova, Sjoerd Oosting and Luc Renneboog (2006) investigated the long-term profitability of corporate takeovers in the UK, using four different measures of operating performance based on earnings before interest, taxes, depreciation and amortisation, and found that both acquiring and target companies significantly outperformed the median peers in their industry prior to the takeovers but the raw profitability of the combined firm decreased significantly following the takeover.

Manthos Vogiatzogloy, Petros Christodoulou and George Drogalas (2006) empirically examined the operating performance for three years before and after the merger for acquiring firms in Greece, from 1998 to 2002, using selected accounting variables,4 and the t-statistic. The study found that post-merger, for the firms in the sample, gross profit margin decreased slightly, while the liquidity ratios – quick ratio and current ratio did not show a decrease. Solvency ratios – net worth/total assets, and total debt/net worth had decreased slightly in values, while profitability and returns on assets decreased in value after merger.

Studies in Asia

Divesh S Sharma and Jonathan Ho (2002) used accrual and cash flow performance measures (for three years after the merger and for three years before the merger), and found that corporate acquisitions did not lead to significant post-acquisition improvements in the operating performance of acquiring Australian firms during 1986-91. The study also found that the type of acquisition (conglomerate versus non-conglomerate) and the form of acquisition financing (cash, share or a combination) did not significantly influence post-acquisition performance. Similarly, the size of the acquisition did not seem to influence post-acquisition performance.

Timothy Kruse, Hun Park, Kwangwoo Park and Kazunori Suzuki (2003) examined the long-term operating performance (operating returns and operating margin) of Japanese companies in a sample of 56 mergers of manufacturing firms from 1969 to 1997. The study found evidence of improvement in the operating perfor mance of merging companies in the five-year period following mergers, and also that the pre- and post-merger performance was highly correlated. The study also found that the larger the relative size of the target firm to the acquirer, the worse was the post-merger performance – suggesting the inefficiency of “merger of equals”, by blurring the management responsibility between the acquirer and target and sometimes, resulting in a prolonged internal fight between the management and employees of the two firms.

Dickerson, Gibson and Tsakalotos (1997) investigated the impact of acquisitions on company performance using a large panel of UK-quoted companies during 1948-1977, and found that acquisitions had a detrimental impact on company performance and that company growth through acquisition yielded a lower rate of return than growth through internal investment.

Thus, although a number of studies have provided supportive evidence for a positive relationship between relative size and acquisition performance, conflicting results have also been reported by some research studies.

The studies on operating performance of acquiring firms, thus far, in different countries, have shown mixed results in terms of the impact on operating performance. While some concluded that the acquiring firms experienced significantly negative profitability and returns on investment over one to three years after the merger, others have suggested that methodological problems of some studies led to an incorrect interpretation of the actual effects on operating performance, and that mergers have indeed improved the performance of acquiring firms.

Research on Post-merger Performance in India

Surjit Kaur (2002) compared the pre- and post-takeover performance of a sample of 20 merging firms, using a set of eight financial ratios for a period of three years, each immediately preceding and succeeding the merger. The study found that gross profit margin (EBIT/sales), return on capital employed (ROCE) and asset turnover ratio declined significantly in the post-takeover period, suggesting that both the profitability and efficiency of merging companies declined in the post-takeover period. However, the change in the post-takeover performance was statistically not significant when the t test was used.

Beena (2004) analysed the performance of 84 domestic acquiring firms and 31 foreign-owned acquiring firms in the manufacturing sector in India during 1995-2000. The study used some financial ratios5 to test for the difference of means between the pre- and post-merger phase, using the t-statistic and could not find any evidence of improvement in the chosen financial ratios of the acquiring firms in the sample during the post-merger period compared to the pre-merger period. However, the profitability ratios were seen to be relatively better when compared to the overall manufacturing average, and foreign-owned acquiring firms seemed to perform relatively better, compared to Indianowned acquiring firms.

Sudha Swaminathan (2002) studied a sample of five mergers during 1995-96, and found that four of the five acquiring firms improved operating and financial synergies (measured through certain financial ratios6) three years after the merger. While the net profit margin significantly improved post-merger, the asset turnover did not show any significant change – the study concluded that shareholder value improved for mergers of smaller companies but not for mergers of large companies.

Pawaskar (2001) analysed the pre-merger and post-merger operating performance of 36 acquiring firms during 1992-95 using financial ratios of profitability, growth, leverage, liquidity and tax provisions,7 and found that acquiring firms performed better than industry in terms of profitability, and that the mergers led to financial synergies and a one-time growth of the acquiring firm’s asset base. The study also inferred that the type of merger, whether BIFR – revival or those between group companies/ subsidiaries did not affect the post-merger performance.

Empirical testing of operating performance following mergers of Indian companies has been quite limited so far, and focused specifically on the manufacturing sector, using small samples or individual cases, and over limited periods of time. Prior studies have not tested the impact of relative size on post-merger performance, which this study has undertaken.

II Research Methodology

Objectives

The present study has aimed at analysing the post-merger operating performance for acquiring firms in Indian industry during the post-reform period, from 1991-2003, which was expected to provide a large sample size across industries. The post-merger operating performance of acquiring firms for different relative sizes (of acquiring and acquired firms) was analysed to see if differences in sizes of acquiring and acquired firms can cause a different impact on the outcome compared to general results of merger studies.

Methodology

The study has adopted the methodology of comparing pre- and post-merger performance of acquiring companies, using the following financial ratios: operating profit margin (profit before depreciation, interest and tax/net sales8); gross profit margin (profit before interest and tax/net sales); net profit margin (profit after tax/net sales); return on net worth (profit after tax/net worth9); return on capital employed (PBIT/capital employed10); and debt-equity ratio (book value of debt/book value of equity).

The pre-merger (for three years prior to the merger) and postmerger (for five years after the merger) averages of the above financial ratios were compared, and tested for differences, using paired t test for two samples. The observations of each pair of firms in the sample are not independent, since the acquiring firm retains its identity before and after the merger. Therefore, the paired t test was considered appropriate to measure the merger induced operating performance changes. The year of completion of the merger, denoted as year 0, has been excluded from the estimation. For the years prior to the merger, the operating ratios of the acquiring firm alone are considered. Post-merger, the operating ratios for the combined firms were used.

Sample Selection

The sample for the study primarily included mergers by public limited companies listed on the Bombay Stock Exchange/ National Stock Exchange (BSE/NSE), during the period of study. Cross-border mergers have been excluded from the sample, as were Board for Industrial and Financial Reconstruction – registered sick companies acquired by other companies to gain tax benefits. Only stock-for-stock mergers are included in the sample. Only mergers where the equity stock of the acquiring firm has been issued to the acquired firm (target) shareholders, as consideration for the acquisition/merger have been considered. Merger cases where the relative size factor11 was less than 10 per cent have been excluded from the sample (to eliminate cases where merging firm was too big compared to target firm in market value, for merger to make any difference). Further, companies in the sample should not have been engaged in further mergers/ acquisitions within four years after the merger under study.

A list of companies involved in mergers during 1991-2003 was compiled from several sources like newspapers, magazines, investment web sites, web sites of the BSE and NSE (for names of delisted companies), SEBI’s web site (for details of companies making open offers for takeovers), and databases of Capitaline and Prowess. The screening criteria described earlier were applied to such a list to arrive at the final sample. Merger cases where at least two years of data for pre-merger period and at least four years data for post-merger period was not available were removed from the study sample.

Hypotheses

To test the objectives mentioned above, the following hypotheses have been formulated – (i) H1: mergers in India in the post-reform period have improved the operating performance of acquiring firms; and (ii) H2: relative size of acquiring and acquired firms will not have any bearing on the post-merger operating performance of acquiring companies.

III Data Collection and Analysis

Data Collection

Data of operating performance ratios for up to three years prior to and five years after the acquisition year for each acquiring company was extracted from the Prowess database of the CMIE.

Data Analysis

Pre-merger and post-merger operating performance ratios were estimated and compared for the entire set of sample firms, which have gone through mergers during the period 1991 to 2003. The sample list of firms engaged in mergers was divided

Table 3: Mean Pre-merger and Post-merger Ratios for Acquiring Firms

Pre-merger Post-merger t-statistic
(3 Years (5 Years (0.05
Average) Average) Significance)
Operating profit margin 19.847 19.336 0.193
Gross profit margins 15.993 14.321 0.718
Net profit margin 6.555 2.755 2.121
Return on net worth 15.749 9.327 1.523
Return on capital employed 24.291 18.182 3.090
Debt equity ratio 1.258 1.610 -1.677

Source: From authors’ calculations.

into three groups, based on the relative size factor (0.11 to 0.40,

0.41 to 0.70, 0.71 to 1.00, and above 1.00). Mergers in each of the groups were aggregated separately, and analysed for pre-merger and post-merger performance. The break-up of the list of firms as per the relative size factor value is as shown in Table 2.

IV Results

Analysis of All Mergers

The comparison of the pre-merger and post-merger operating performance ratios shows that there is no difference in the mean operating profit margin (19.847 per cent vs 19.336 per cent) and gross profit margin (15.993 per cent vs 14.321 per cent), during the pre-merger and post-merger phases. This is also validated by the low t-statistic (values of 0.193 and 0.718). However, the net profit margin ratios have shown a significant decline (6.555 per cent vs

2.755 per cent), and are statistically confirmed by the t-value of

2.121. Results also show that the mean returns on networth (15.749 per cent vs 9.327 per cent) and returns on capital employed (24.291 per cent vs 18.182 per cent) have declined post-mergers, when compared to the pre-merger period, and the decline in ROCE is found to be statistically significant, with a t-value of 3.090. There is a marginal increase in the leverage of the acquiring firm, as evident from the debt equity ratios before and after the mergers

(1.258 vs 1.610), and the low t-value of -1.677.

These results suggest that stock-for-stock mergers in India in the post-reform period have led to a decline in the net profit margin, while other profitability ratios did not change after the merger. This indicates that the increase in financial leverage after mergers and the consequent increase in interest costs, have affected the net profit of the acquiring firms. Merging firms in the sample also saw a decline in the returns on net worth and capital employed. The results suggest that mergers in Indian industry had not improved the operating efficiency of acquiring firms, and seem in agreement with earlier studies on post-merger operating performance in other countries. Based on these results, the hypothesis H1 has been rejected.

Analysis of Mergers for Different Relative Sizes of Acquiring and Acquired Companies

Mergers with Relative Size Factor from 0.11 up to 0.40

The comparison of the pre-merger and post-merger operating performance ratios for the sample set of firms shows that there is no difference in the mean operating profit margin (21.328 per cent vs 20.539 per cent) and gross profit margin (18.259 per cent vs

16.321 per cent), while there was a decline in net profit margin

(7.951 per cent vs 4.830 per cent) after the merger. This is also validated by the t-statistic values of 1.026, 1.252 and 1.931. Mean returns on net worth (15.113 per cent vs 12.065 per cent) show a marginal decline but it is not statistically significant, indi cated by the t-value of 0.399, while return on capital employed (25.165 vs

20.451 per cent) shows a statistically significant decline (t-value of 2.009). This does not seem to be because of any leverage effect, since there is no difference in the debt equity ratios (1.150 vs 1.479) before and after the mergers (t value of -1.299).

The results for this sample seem to be in line with results for the entire sample of mergers as shown in the section above. However, as Lubatkin (1983) suggested, mergers in Indian industry may also have been prompted by the expectation that a small acquisition may play a role in promoting a capability also linked to enhancing acquisition performance.

Mergers with Relative Size Factor between 0.41 and 0.70

The comparison of the pre-merger and post-merger operating performance ratios for the set of firms in this sample shows that there is no difference in the mean operating profit margin (18.903 per cent vs 19.702 per cent), gross profit margin (14.553 per cent vs 13.602 per cent) and net profit margin ratios (4.255 per cent vs

0.045 per cent) during the pre-merger and post-merger phases. This is also validated by the t-values (-0.656, 0.590 and 1.270 respectively). Mean returns on net worth (14.230 per cent vs

7.611 per cent) and capital employed (24.314 per cent vs 17.326 per cent) both show a decline, following the merger but only the decline in ROCE is found to be statistically significant (t-value of 2.459). In this sample too, there is an increase in leverage after the merger, as indicated by the debt equity ratios (1.650 vs 2.145) before and after the mergers (however, t-value of -1.901 is below the critical value).

The results are again in line with those for the entire sample for the study, which reports a decline in net profit margin and return on capital employed, with an increase in financial leverage following mergers.

Mergers with Relative Size Factor between 0.71 and 1.00

The comparison of the pre-merger and post-merger operating performance ratios for this sample of mergers shows that there is no change in the mean operating profit margin (16.296 per cent vs 14.805 per cent), gross profit margin (12.397 per cent vs

10.975 per cent) and net profit margin (4.875 per cent vs 1.256 per cent), during the pre-merger and post-merger phases. This is validated by the low t-values of 0.602, 0.578 and 1.071. Mean

Table 4: Mean Pre-merger and Post-merger Ratios for Acquiring Firms (with Relative Size Factor from 0.11 up to 0.40)

Pre-merger Post-merger t (0.05 Significance)

Operating profit margin 21.966 20.539 1.026 Gross profit margins 18.259 16.321 1.252 Net profit margin 7.951 4.830 1.931 Return on net worth 15.113 12.065 0.399 Return on capital employed 25.165 20.451 2.009 Debt equity ratio 1.150 1.479 -1.299

Source: From authors’ calculation.

Table 5: Mean Pre-merger and Post-merger Ratios for Acquiring Firms (with Relative Size Factor between 0.41 and 0.70)

Pre-merger Post-merger t (0.05 Significance)

Operating profit margin 18.903 19.702 -0.656 Gross profit margins 14.553 13.602 0.590 Net profit margin 4.255 0.045 1.270 Return on net worth 14.230 7.611 1.295 Return on capital employed 24.314 17.326 2.459 Debt equity ratio 1.650 2.145 -1.901

Source: From authors’ calculation.

returns on net worth (14.695 per cent vs 3.485 per cent) and capital employed (22.682 per cent vs 14.729 per cent) also show no change following the merger, as confirmed by the low t-values of 1.373 and 1.379 respectively. There is again no leverage effect evident – debt equity ratios of 1.290 and 1.073 before and after the mergers, and corresponding low t-value of 1.189.

These results suggest that where the merging and merged firms are of relatively the same size by market capitalisation, there is no impact on the post-merger operating performance compared to the pre-merger performance, i e, that mergers cause no change in operational efficiency of acquiring firms in similar size mergers. These results differ from those observed in the case of the entire sample of mergers, and for samples where relative size was between 0.11 and 0.70.

Mergers with Relative Size Factor above 1.0

The comparison of the pre-merger and post-merger operating performance ratios for the entire sample set shows that there is no difference in the mean operating profit margin (16.839 per cent vs 17.337 per cent), gross profit margin (13.326 per cent vs

11.229 per cent) and net profit margin ratios (6.766 per cent vs

1.624 per cent), during the pre-merger and post-merger phases, and it is validated by the low t-values of -0.126, 0433 and 1.145. In contrast, mean returns on net worth (20.176 per cent vs 6.690 per cent) and capital employed (22.503 per cent vs 14.590 per cent) both show a significant decline, following the merger, and the decline is found to be statistically significant (t-values of

3.056 and 2.849 respectively. However, there seems to be marginal increase in financial leverage, indicated by the debt equity ratios before and after the mergers (0.967 vs 1.406) but this is not statistically significant (low t value of -1.235).

These results suggest that where the relative size of the target firm is more than the acquiring firm, there is no impact on the post-merger operating performance compared to the pre-merger performance. However, in such cases, there has been a significant decline in returns on net worth and capital employed, and a marginal increase in financial leverage. These results again differ from

Table 6: Mean Pre-merger and Post-merger Ratios for Acquiring Firms (with Relative Size Factor between 0.71 and 1.00)

Pre-merger Post-merger t (0.05 Significance)

Operating profit margin 16.296 14.805 0.602 Gross profit margins 12.397 10.975 0.578 Net profit margin 4.875 1.256 1.071 Return on net worth 14.695 3.485 1.373 Return on capital employed 22.682 14.729 1.379 Debt equity ratio 1.290 1.073 1.189

Source: From authors’ calculations.

Table 7: Mean Pre-merger and Post-merger Ratios for Acquiring Firms (with Relative Size Factor above 1.0)

Pre-merger Post-merger t (0.05 Significance)

Operating profit margin 16.839 17.337 -0.126 Gross profit margins 13.326 11.229 0.433 Net profit margin 6.766 1.624 1.145 Return on net worth 20.176 6.690 3.056 Return on capital employed 22.503 14.590 2.849 Debt equity ratio 0.967 1.406 -1.235

Source: From authors’ calculations.

those observed in the case of the entire sample of mergers, and for the samples where relative size was between 0.11 and 0.70.

V Conclusions

This study was undertaken to test whether the relative size of target and acquiring firms, will make a difference to the outcome of the mergers, as measured by the post-merger operating performance of the acquiring firms, in the Indian industry. The analysis of pre- and post-merger operating performance ratios for the acquiring firms in the sample seems to indicate that relative size does make some difference to the post-merger operating performance of acquiring firms. For cases where the relative size was between 0.11 and 0.70, there has been a decline in net profit margin and return on capital employed, along with an increase in financial leverage after mergers. For cases where the relative size was between

0.71 and 1.00, there was no difference in the pre-merger and post-merger operating performance ratios. For cases where the rela tive size of the target firm was more than that of the acquiring firm, there has been a significant decline in returns on net worth and capital employed, and a marginal increase in financial leverage.

The above results contrast with those of Kusewitt (1985) who found that relative size was statistically significant and related to performance measures, and proposed that both excessively small and large acquisitions should be avoided. The results also compare favourably with the findings of Ramaswamy and Wagelein (2003) who found that post-merger performance was negatively associated with relative target size, and that larger relative-sized acquisitions resulted in poorer post-merger performance than acquisition of smaller firms.

The results however, contrast with the findings of Kitching (1967) who suggested that relatively large acquisitions would have a greater combination potential, especially in the case of related acquisitions.

The study has ignored the impact of possible differences in the accounting methods adopted by different companies in the sample, as the sample includes only stock-for-stock mergers. The study has also not used any control groups for comparison (industry average or firms with similar characteristics) as was done in other studies. A sample spanning a longer period was considered adequate to arrive at unbiased results, and to account for cross-sectional dependence. The above differences in methodo logy could likely have affected the out comes reported, when compared with other studies on post-merger performance.

Future research in this area could be an extension of the present study, by estimating and comparing with industry/sector averages, and the differences, if any, could be probed further to derive further insights. Researchers could also analyse the postmerger returns to shareholders of acquiring firms involved in mergers in India, to correlate with findings of studies indicating poor post-merger performance.

EPW

Email: pramodmantravadi@yahoo.com vidyadharaileni@rediffmail.com

Notes

1 Relative size of the target firm to that of the acquiring firm in terms

of market value at the end of the fiscal year prior to the year of

merger.

2 Relative acquisition size was estimated as the payment made for the target divided by market value of acquiring firm, 20 days before the bid announcement.

3 Meeks defined return on assets as pre-tax profits (after depreciation but before tax) divided by the average of beginning and ending assets for the year. The key metric was Rchange = RAfter - RBefore where RAfter and RBefore were measures of performance relative to the weighted average of returns of the buyer’s and target’s industries.

4 Financial variables included profitability (earnings before taxes/net worth), returns on assets, gross profit margin, liquidity (quick ratio), current ratio, solvency (net worth/total assets and total debt/net worth).

5 Price – cost margin (profit after tax/net sales), rate of return (profit before tax/total capital employed), shareholders’ profit (profit after tax/net worth), dividend per equity (dividend per share/earnings per share), debt-equity ratio, export intensity (export/gross sales), R&D intensity (R&D expenditure/gross sales) and capacity utilisation (net sales/total assets).

6 Ratios used were net profit margin (PAT/sales), operating profit margin, return on capital employed, cost of production/sales, debt equity ratio and operating cash flow.

7 Ratios used were: operating return on assets (PBIDT/net assets), growth rate (average growth rate in total assets), leverage (total debt/(total debt

+ equity capital)), tax provision (tax/operating profit) and liquidity ((current assets – inventory)/current liabilities).

8 Net sales: calculated by deducting from gross revenues, any effect of statutory deductions like excise and sales tax, which do not accrue to the company but have to be paid to the government. Net sales reflect the actual sales proceeds received by the company from its business.

9 Net worth = sum of book value of equity and free reserves.

10 Capital employed = total asset base.

11 Relative size factor: the ratio of “amount of new equity issued to ac

quired firm shareholders” to “outstanding equity of the acquiring/ merging firm prior to such issue”.

References

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March 10, 2007

Social, Economic and Educational Conditions of Indian Muslims – Rakesh Basant
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