Chapter - 4

Financial Evaluation of Mergers and Acquisitions

Financial evaluation means analyzing whether the merger or acquisition will be
profitable and beneficial for the acquiring company.
It helps management decide if the deal will create value for shareholders or
not.
The main purpose of financial evaluation is to check if the combined value of
the merged company will be higher than the sum of the two individual
companies.
Merger as a Capital Budgeting Decision
A merger or acquisition is treated as a capital budgeting decision, because it
involves large investment and long-term financial commitment — just like
building a new plant or launching a new project.
In capital budgeting, we analyze future cash inflows and outflows to see
whether the project will give positive returns.
Similarly, in a merger, we evaluate whether the expected benefits (synergy,
profits, growth) are higher than the cost of acquisition.
Steps:
1. Estimate future cash inflows from the merger.
2. Calculate the cost of acquisition.
3. Find out the Net Present Value (NPV) or Internal Rate of Return (IRR).
4. If NPV is positive or IRR is higher than the required rate of return, the
merger is financially acceptable.
Example:
If Company A plans to buy Company B for ₹100 crore and expects cash inflows
worth ₹130 crore, the merger is beneficial because it adds value.
Thus, financial evaluation of a merger is similar to investment appraisal in
capital budgeting.
Business Valuation Approaches
Before merging, it’s important to find out the true value of both companies.
This is done through business valuation.
The main goal is to decide a fair exchange ratio (swap ratio) and ensure the
deal is fair for both shareholders.
There are three main approaches to business valuation:
1. Asset-Based Approach
2. Market-Based Approach
3. Income-Based Approach
1. Asset-Based Approach
This method values a company based on its assets and liabilities.
It focuses on the book value or replacement value of the company’s assets
after deducting all liabilities.
Formula:
Company Value = Total Assets – Total Liabilities
Example:
If a company has assets worth ₹120 crore and liabilities worth ₹20 crore, its
value = ₹100 crore.
Types of Asset-Based Valuation:
• Book Value Method: Uses the balance sheet value of assets and
liabilities.
• Liquidation Value Method: Based on the amount received if all assets
are sold.
• Replacement Value Method: Based on the cost to replace the assets
today.
Use:
Good for companies with large tangible assets like manufacturing or real estate
firms.
2. Market-Based Approach
This method values a company based on its market performance or
comparable companies in the same industry.
It considers factors like share price, market capitalization, and the price-to-
earnings (P/E) ratio.
Methods under this approach:
• Market Price Method: Uses the current share price of the company in
the stock market.
• Comparable Company Method: Compares the target company with
similar companies that were recently sold or listed.
Example:
If similar companies are trading at 10 times their earnings, and the target firm’s
profit is ₹10 crore, its estimated value = ₹100 crore.
Use:
Best for listed companies where market data is available.
3. Income-Based Approach
This method values a company based on its ability to generate future income
or cash flows.
It assumes the value of a company is equal to the present value of all expected
future earnings.
Common Methods:
• Discounted Cash Flow (DCF) Method:
Future cash inflows are estimated and discounted to present value using
a discount rate (usually the cost of capital).
• Earnings Capitalization Method:
Value = Expected Annual Earnings ÷ Capitalization Rate
Example (DCF):
If expected future cash flows are ₹20 crore per year and the discount rate is
10%, the present value gives the estimated worth of the company.
Use:
Best for companies with stable profits or predictable cash flows.
Exchange Ratio (Swap Ratio)
When two companies merge, the shareholders of the acquired company are
given shares in the new or acquiring company in exchange for their old shares.
The Exchange Ratio (also called Swap Ratio) shows how many shares of the
acquiring company will be given for one share of the target company.
Formula:
Exchange Ratio = Value of one share of Target Company ÷ Value of one share of
Acquiring Company
Example:
If one share of the target company is worth ₹50 and one share of the acquiring
company is worth ₹100,
Exchange Ratio = 50 ÷ 100 = 0.5
It means shareholders of the target company will get 1 share of acquiring
company for every 2 shares they hold.
Purpose:
To ensure both sets of shareholders are treated fairly based on the relative
value of their companies.
Methods of Determining Exchange Ratio
While deciding the exchange ratio, several methods and factors are considered
to make it fair for both companies.
1. Market Price Method
The exchange ratio is based on the average market price of both companies’
shares over a specific period.
Used mainly when both companies are listed on the stock exchange.
Example:
If Company A’s average share price is ₹200 and Company B’s average share
price is ₹100, the ratio will be 1:2.
2. Earnings Per Share (EPS) Method
This method uses the Earnings Per Share of both companies to decide the
exchange ratio.
Shareholders of the target company receive shares in proportion to the
profitability of their company.
Formula:
Exchange Ratio = EPS of Target Company ÷ EPS of Acquiring Company
Example:
If EPS of target = ₹5 and EPS of acquiring = ₹10,
Exchange Ratio = 5 ÷ 10 = 0.5 → 1 share for every 2 shares.
3. Book Value Method
Based on the book value per share (net worth ÷ number of shares).
The exchange ratio is calculated by comparing the book values of both
companies’ shares.
Example:
If book value of target = ₹60 and acquiring = ₹120,
Exchange Ratio = 60 ÷ 120 = 0.5 → 1 share for every 2 shares.
4. Dividend Yield Method
Here, the exchange ratio is determined by comparing the dividend per share of
both companies.
It is useful when both companies have a record of paying regular dividends.
5. Combined Method (Weighted Approach)
Usually, more than one factor is used — for example, combining market price,
EPS, and book value.
Weights are given to each (for example, 40% market price, 40% EPS, 20% book
value), and the weighted average gives the final exchange ratio.
This method gives a fairer and more balanced result.
Important Questions
1. Give the meaning of Business Valuation.
2. Explain the different approaches to Business Valuation.
3. Give the meaning of Exchange Ratio / Swap Ratio.
4. Explain the methods of determining Exchange Ratio.
Chapter – 5
Amalgamation: Meaning, Types, Accounting Methods, Purchase
Consideration & Journal Entries
Meaning of Amalgamation
Amalgamation means the combination of two or more companies into a new
company.
After amalgamation, the old companies (transferor companies) lose their
identity, and a new company (transferee company) is formed to take over their
business.
Example:
Company A and Company B combine to form a new Company C.
Types of Amalgamation
As per Accounting Standard (AS-14), there are two types of amalgamation:
1. Amalgamation in the Nature of Merger
This happens when two or more companies combine to form a completely
new company, and the shareholders of the old companies become
shareholders of the new company.
Features:
• All assets and liabilities of the transferor company become those of the
transferee company.
• At least 90% of shareholders of the transferor company become
shareholders of the new company.
• The business of the transferor company continues.
• The purchase consideration is satisfied only by the issue of shares (not
cash).
Example:
Company A + Company B → Company C (new company)
2. Amalgamation in the Nature of Purchase
This type of amalgamation occurs when one company purchases another
company.
The identity of the purchasing company continues, while the selling company
ceases to exist.
Features:
• The purchase is treated like an acquisition.
• The shareholders of the transferor company may or may not become
shareholders of the transferee company.
• The transferee company records the assets and liabilities at their fair
value.
• Goodwill or capital reserve may arise.
Example:
Company A purchases Company B → Company A continues.
Methods of Accounting for Amalgamation
There are two methods used for accounting in amalgamation, depending on its
type:
1. Pooling of Interest Method
Used in amalgamation in the nature of merger.
Meaning:
Under this method, all the assets, liabilities, and reserves of the transferor
company are recorded at their existing book values in the books of the
transferee company.
Main Features:
• Assets and liabilities are taken at book value.
• Reserves of the transferor company are preserved.
• No goodwill or capital reserve arises.
• The difference between the amount of share capital issued and the share
capital of the transferor company is adjusted in reserves.
Journal Entry (in transferee’s books):
All Assets A/c........Dr
To All Liabilities A/c
To Share Capital A/c
To Reserves A/c
2. Purchase Method
Used in amalgamation in the nature of purchase.
Meaning:
Under this method, the transferee company records the assets and liabilities of
the transferor company at their fair values.
Main Features:
• Assets and liabilities are recorded at agreed (fair) values.
 • Reserves of the transferor company are not carried forward.
• Goodwill arises if the purchase consideration is more than the net assets
taken over.
• Capital reserve arises if the purchase consideration is less than the net
assets taken over.
Journal Entry (in transferee’s books):
All Assets (at agreed value) A/c........Dr
Goodwill A/c (if any)...................Dr
To All Liabilities (at agreed value) A/c
To Purchase Consideration Payable A/c
Calculation of Purchase Consideration
Purchase Consideration means the amount paid by the transferee company to
the shareholders of the transferor company in exchange for taking over their
business.
As per AS-14, purchase consideration includes all forms of payment made to
shareholders of the transferor company — cash, shares, or other securities —
but excludes payments to debenture holders or creditors.
Main Methods for Calculation:
1. Lump Sum Method
When a fixed total amount is agreed upon for the purchase.
Example: Company A agrees to purchase Company B for ₹50,00,000.
2. Net Assets Method
Purchase Consideration = Total Assets Taken Over – Liabilities Taken Over
Example:
Assets = ₹80,00,000
Liabilities = ₹20,00,000
Purchase Consideration = ₹60,00,000
3. Net Payment Method
Based on the total payment made to shareholders in different forms.
Example:
Cash = ₹10,00,000
Shares = ₹40,00,000
Total Purchase Consideration = ₹50,00,000
4. Intrinsic Value or Share Exchange Method
Based on the exchange ratio (swap ratio) — how many shares of the new
company are given for each share of the old company.
Journal Entries
(A) In the Books of Transferor Company
1. For transfer of assets:
Realisation A/c........Dr
To Assets A/c
2. For transfer of liabilities:
Liabilities A/c........Dr
To Realisation A/c
3. For purchase consideration receivable:
Transferee Company A/c........Dr
To Realisation A/c
4. For receipt of consideration (cash/shares):
Cash/Bank/Share in Transferee Co. A/c........Dr
To Transferee Company A/c
5. For distribution to shareholders:
Shareholders A/c........Dr
To Equity Share Capital A/c
To Reserves A/c
To Cash/Bank A/c (if any)
(B) In the Books of Transferee Company
1. For taking over assets and liabilities:
Assets A/c........Dr
Goodwill A/c (if any)........Dr
To Liabilities A/c
To Purchase Consideration A/c
2. For discharging purchase consideration:
Purchase Consideration A/c........Dr
To Share Capital A/c
To Securities Premium A/c (if any)
To Cash/Bank A/c (if paid in cash)
Ledger Accounts in the Books of Transferor Company
1. Realisation Account – To record transfer of assets, liabilities, and the
gain/loss on realisation.
2. Transferee Company Account – To record the amount due from the
transferee company as purchase consideration.
3. Shareholders Account – To record payment made to shareholders after
settlement.
Ledger Accounts in the Books of Transferee Company
1. Business Purchase Account – To record the purchase consideration payable.
2. Assets Account – To record assets taken over.
3. Liabilities Account – To record liabilities taken over.
4. Goodwill/Capital Reserve Account – To record the difference between
purchase consideration and net assets taken over.
Important Questions
1. Explain the Types of accounting of amalgamations.
2. Differentiate between Pooling of interest method and merger method.
3. Explain Purchase consideration and its types.
Types of Accounting of Amalgamations
According to Accounting Standard (AS-14), there are two types of accounting
methods used when companies merge or combine:
(a) Pooling of Interest Method
• Used when the amalgamation is in the nature of merger.
• All assets, liabilities, and reserves of the old company are recorded at
their book values (as they are).
• No goodwill or capital reserve is created.
• The reserves of the old company continue in the new company.
Example:
If Company A and Company B merge to form a new company, all their values
are added together without changing them.
(b) Purchase Method
• Used when the amalgamation is in the nature of purchase.
• The company taking over records assets and liabilities at fair value
(current market value).
• The reserves of the old company are not carried forward.
• If the price paid is more than net assets → Goodwill is created.
• If the price paid is less than net assets → Capital Reserve is created.
Example:
If Company X purchases Company Y, X will record Y’s assets and liabilities at
their current value.
2. Difference between Pooling of Interest Method and Purchase Method

Pooling of Interest
Points Purchase Method
Method

Used in the nature of Used in the nature of

Type of Amalgamation
merger purchase

Assets & liabilities at book Assets & liabilities at fair

Valuation
value value

Reserves Kept as they are Not carried forward

 Pooling of Interest
Points Purchase Method
Method

Goodwill/Capital
Not created May be created
Reserve

Business continues as Treated like a new

Continuity
before purchase

Company X purchases
Example Company A + B = C
Company Y

3. Purchase Consideration and its Types

Meaning
Purchase consideration means the total amount paid by the new (or acquiring)
company to the shareholders of the old company for taking over its business.
It can be paid in cash, shares, or other securities.
Types of Purchase Consideration
(a) Lump Sum Method
A fixed total amount is decided for the purchase.
Example: Company A buys Company B for ₹50 lakh.
(b) Net Assets Method
Based on the difference between the assets taken and the liabilities taken.
Formula: Purchase Consideration = Assets – Liabilities
Example: Assets ₹80 lakh – Liabilities ₹20 lakh = ₹60 lakh.
(c) Net Payment Method
Based on the total amount actually paid to shareholders.
Example: Cash ₹10 lakh + Shares ₹20 lakh = ₹30 lakh.
(d) Share Exchange Method
Based on how many shares of the new company are given for each share of the
old company.
Example: 1 share of new company for every 2 shares of old company.