Study on Financial Issues of Merger & Acquisition

Study on Financial Issues of Merger & Acquisition LUO Dancheng, SUN Binglei School of economics, Shenyang University of Technology, P.R.China, 110870 donna_luo@sina.com Abstract: With the advancing of globalization, mergers and acquisitions trend has intensified in China which has became a trend in economic life. However, there are a series of problems in the merger and acquisitions because the theory, practice and the market environment are immature in China. Therefore, the research operation in China of M & A financial problems existing in the process of merger and acquisition activity continued to guide the healthy development of great theoretical and practical significance. According to the financial risk in M&A, we can use the fault tree method and the flow chart method to obtain the hierarchy of financial risk. M & A financial risk is divided into three-level indicator system of X, Y, Z, and each level is divided into three two indicators. Indeed, each index should adopt the Delphi method to assess by experts. Because of being fuzzy features, it is difficult to accurately quantify. Therefore, it requires the use of fuzzy mathematics to model. Fuzzy analysis method and the concept of membership is adopted to divide risk into five score levels. Then we use the percentage method to assign each indicator. In order to specify the application of financial risk in M &A, the article which choose the form of a virtual case to analyze the financial risk in M&A.From the perspective of financial issue, through the establishment of M & A financial risk model, the article analyzes the causes of the financial risk and proposes preventive measures, to promote mergers and acquisitions be carried out smoothly and efficiently. Keywords: M &A, financial risk model 1 Introduction In recent years, as China's "accession" the end of the transitional period, some foreign multinationals into the domestic market so that domestic M & A market has become increasingly active, which indicates that our business will face more intense international competition, mergers and acquisitions. However, the time of construction of a socialist market economy in China start relatively late, there is still a considerable gap on M & A in the theories, methods, strategies and procedures. Mergers and acquisitions in the financial problem is the core of the problems and focus. Therefore, the research operation on M & A financial problems existing in the process of merger and acquisition activity in China continued to guide the healthy development of great theoretical and practical significance. 2 Overview M & A Financial Risk M & A is the consolidation or merger between companies, often referred to as the international Mergers and Acquisition (M & A). As the opening up of China's reform and the gradual establishment of market economy, mergers and acquisitions has become a distinctive theme in China s socialist market economy. However, we must recognize that investment is bound to be at risk. Because of information asymmetry, the uncertainty of the external environment, management activities, the complexity and the limited capacity of the enterprises, M & A exist a number of risks. Among of them, the financial risk is a very important position in M & A. 3 M & A Financial Risk Model According to the preparatory stage of the pre-merger, merger and acquisition phase and the integration phase, the financial risk classified into three categories: objective business valuation risk, financing risk and integration risk. 217

The so-called objective assessment of risk is the value of corporate financial condition which leads to the loss of M & A possibilities in M & A process. The value assessment of target corporate is the essence of mergers and acquisitions, which depends on the expectation of future earnings, including: the risk of the financial statements, profit forecast risk, the discount coefficient risk. Financing risk mainly refers to the acquisition of enterprises which whether can raise funds in full and on time to ensure the merger going smoothly or not. How to make use of internal and external funding sources to raise the necessary funds in the short term is related to the success of M & A. From the perspective of risk assessment, financing risks are: capital structure risk, the risk of financing costs, and financial leverage risk. As the target enterprises and new businesses operating, integration of risk refers to a subjective estimate of the actual problem. It will inevitably lead to fail to achieve profitability targets, resulting in a performance prediction risk. During the integration of organizational mechanisms, it includes financial organization risk, capital operation risk, and profitability risk. According to the financial risk in M&A, we can use the fault tree method and the flow chart method to obtain the hierarchy of financial risk. M & A Financial Risk Objective business valuation risk X Financing risk Y Integration risk Z Financial risk X 1 Profit forecast riskx 2 discount coefficient riskx 3 Capital structure risk Y 1 Financing costs risk Y 2 Financial leverage risk Y 3 Financial organization risk Z1 Capital operation risk Z2 Profitability risk Z3 Above Index system, M & A financial risk is divided into three-level indicator system of X, Y, Z, and each level is divided into three two indicators. Indeed, each index should adopt the Delphi method to assess by experts. Because of being fuzzy features, it is difficult to accurately quantify. Therefore, it requires the use of fuzzy mathematics to model. Fuzzy analysis method, and the concept of membership is adopted to divide risk into five score levels, namely 5 (high risk), 4 (higher risk), 3 (general risk), 2 (lower risk), 1 (low risk). Then we use the percentage method to assign each indicator. If the 20 experts assess that the project has a high-risk person, the number of the high-risk assessment of the project is 1 / 20, equal to 0.05. According to fuzzy decision method, we establish the model of financial risk rating in M&A as follows: B=A * R (1) B is the evaluation of risk; R is the level of risk assessment matrix; A is the weight matrix Based on the diagram: R = [X, Y, Z] T, A = [a x, a y, a z ] a x, a y, a z is respectively the weight of X, Y, Z, and the a x + a y + a z =1. Model-level indicators: X =A X * [X 1, X 1, X 3 ] T (2) Y=A Y [Y 1, Y 1, Y 3 ] T (3) Z= Az * [Z 1, Z 1, Z 3 ] T (4) 218

A X, Ay, Az respectively means the two indexes weight matrix of X, Y, Z. A X = [a X1, a X2, a X3 ] A Y = [a Y1, a Y2, a Y3 ] Az = [a Z1, a Z2, a Z3 ] 4 The Application of the Measurement Model of Risk in M&A In order to specify the application of financial risk in M &A, the article which choose the form of a virtual case to analyze the financial risk in M&A. 20 experts assume that the M & A activity, according to Delphi method to choose the identification of indicators and weights. According to the model: X 1 = [2/20, 5/20, 5/20, 6/20, 2/20] [5, 4, 3, 2, 1] T = 2.95 X 2 = [8/20, 5/20, 2/20, 3/20, 2/20] [5, 4, 3, 2, 1] T = 3.7 X 3 = [5/20, 5/20, 3/20, 4/20, 3/20] [5, 4, 3, 2, 1] T = 3.25 Y 1 = [3/20, 3/20, 5/20, 4/20, 5/20] [5, 4, 3, 2, 1] T = 2.75 Y 2 = [2/20, 3/20, 6/20, 3/20, 6/20] [5, 4, 3, 2, 1] T = 2.6 Y 3 = [4/20, 3/20, 3/20, 5/20, 5/20] [5, 4, 3, 2, 1] T = 2.8 Z 1 = [3/20, 3/20, 5/20, 5/20, 4/20] [5, 4, 3, 2, 1] T = 2.8 Z 2 = [2/20, 2/20, 8/20, 5/20, 3/20] [5, 4, 3, 2, 1] T = 2.75 Z 3 = [3/20, 2/20, 5/20, 6/20, 4/20] [5, 4, 3, 2, 1] T = 2.7 A X = [a X1, a X2, a X3 ] = [0.25, 0.35, 0.4] A Y = a Y1, a Y2, a Y3 ] = [0.45, 0.25, 0.3] A Z = [a Z1, a Z2, a Z3 ] = [0.35, 0.35, 0.3] One index Table 1: the assessment form of M & A financial risk in Beverage Company Two index The level of assessment 5 High-risk 4 Higher risk 3 General 2 Lower risk 1 Low risk risks Objective Financial risk 2 5 5 6 2 business valuation risk 40% 25% Profit forecast risk 8 5 2 3 2 35% discount 5 5 3 4 3 coefficient risk40% Financing Capital 3 3 5 4 5 risk 30% structure risk 45% Financing costs risk 25% 2 3 6 3 6 Financial 4 3 3 5 5 leverage risk 30% Integration Financial 3 3 5 5 4 risk 30% organization risk 35% Capital operation risk 30% 2 2 8 5 3 Profitability 3 2 5 6 4 risk 35% Resulting from (2)(3)(4): 219

X = A X [X 1, X 1, X 3 ] T = [0.25, 0.35, 0.4] [2.95, 3.7, 3.25] T = 3.3325 Y = A Y [Y 1, Y 1, Y 3 ] T = [0.45, 0.25, 0.3] [2.75, 2.6, 2.8] T = 2.7275 Z = Az [Z 1, Z 1, Z 3 ] T = [0.35, 0.35, 0.3] [2.8, 2.75, 2.7] T = 2.7525 R = [X, Y, Z] T = [3.3325, 2.7275, 2.7572] T, A = [ax, ay, az] = [0.4, 0.3, 0.3] B = A R = [0.4, 0.3, 0.3] [3.3325, 2.7275, 2.7572] T = 2.98 We can conclude that the level of the financial risk in M & A is 2.98, a general risk by the measurement model. Judged by two indicators of vector, we can further analyze that financing risk and the integration risk is a general risk in the M & A activity, and the target price risk is higher 3.33 than the general business risk. Leading to the high risk factors is the choice of profit forecasting and the discount factor. Meanwhile, although the financial risk is general, the process can be seen from the analysis that the size of the indicators which to determine their capital structure is larger than the other two medium risk of a rational risk. Comprehensive analysis of the results referred above, businesses can be targeted in this acquisition to determine which constituents to take effective measures to avoid risks. 5 Causes of the Financial Risk 5.1 Difficult to assess the enterprise value After determining the target company, the mergers are most concerned with a reasonable estimating the value of business transactions as the upset price, which is the basis of M & A. Target company's valuation depends on the time and their future cash flow forecast. Valuation depends on the acquisition of enterprises with the quality of information, and information quality in turn depends on the following factors: the target company is listed or unlisted companies; M & A is a good or a hostile takeover, ready acquisition time, and the time between target company audits to acquisitions. In other words, the value risk of target enterprise depends on the size of information asymmetry. Because our audit report submitted supposititious, inadequate information and serious symmetry information which makes the acquisition of business assets on the target companies to judge the value and profitability are difficult to be accurate, may be accepted in the pricing enterprise value of the purchase price above the target, leading to acquisition of enterprises to pay more money or more equity transactions. M & A may result in high debt ratio and the target company can not bring expected profits and financial distress. 5.2 Risk of strategic choice If the blind expansion of the field operates, especially in some non-related new areas, M&A could lead to uneconomic areas. This risk mainly: on the one hand, as market competition intensifies, companies must pay high cost to the industry. Enterprises are not familiar with, nothing to do with the existing business to expand new areas, to bear the technical, business, management, market uncertainties, which will bring great risks. On the other hand, M&A would undermine the development of the original core business, competition and ability to resist risks by mixing an excess of money into non-related business. If the main business make with the risk, and this time not developed new business, or too small, it may endanger the survival of enterprises. 5.3 Financing risks in M&A In M & A process, companies need to raise funds in full and on time, to ensure the smooth progress of mergers and acquisitions. If the merger is only temporary hold which would require a significant number of short-term capitals to achieve their goals. It can choose the lower cost of capital means the short-term borrowing, but the burden of heavy debt service. If be arranged properly, the enterprise will fall into financial crisis. If the buyer is to long-held target company, you need to pay a large sum of money to buy the target company and to maintain the operation of the target company. In this process, a large number of long-term debt, pay a lot of liquidity, may significantly alter the original capital structure of enterprises, and the existence of long-term liabilities may be a series of restrictions on borrowings provisions, restrictions and conduct normal operations of enterprises, and even the operation of the enterprise funds which are more restricted, so that cash flow problems. 220

5.4 Low mobility of corporate assets After the merger, the company may be due to the heavy debt burden, lack of short-term financing, resulting in payment difficulties. When companies take the cash acquisition, the company first considered the mobility of assets, current assets and liquid assets. The higher the quality, the liquidity is stronger; the more companies can smooth, speedy access to acquisition financing. It also demonstrates that corporate mergers and acquisitions taking up a lot of liquidity resources, which reduces the changes in the external environment company's rapid response and adjustment capacity, increasing business risks. 6 Conclusion In short, M&A as an important means of capital operation has the development of enterprises of great significance. It also brings a range of issues. In M & A process, in order to reduce risk, reduce or avoid adverse effects, mergers and acquisitions business should choose a good ideal target company, carefully assess the target company's value, and target companies in the whole process, creating the optimal capital structure of the target company and increasing the value of the company. 6.1 Setting reasonable value of the target company As the acquisition of information asymmetry is to generate both the target enterprise risk assessment of the root causes, so mergers and acquisitions should avoid hostile takeover, the target companies should be detailed review and evaluation before the mergers and acquisitions. Investment bank should be hired on the M & A business development strategy, that conduct a comprehensive analysis to the target company's future free cash flow to make reasonable predictions based on the comprehensive planning, target validation and target company's industry environment, business, financial condition and operating capabilities. On this basis, the valuation is closer to the true value of target companies. Meanwhile, the value of different assessment methods to assess the same target company may have different acquisition prices. 6.2 Reduce financing costs M & A Enterprises in determining the funding requirements for the future, they should proceed with financing. Financing methods and the size of the payment should make with the way of acquisitions, while the choice of payment methods are cash, stock and mixed, including cash payment financing most. M & A business can be combined with the mobility, diluted earnings per share, price instability, changes in ownership structure, raising the tax situation of target companies, on the choice of payment method for structural design, arrange for cash payment, debt and equity methods of various combinations to meet the acquisition needs. 6.3 Enhancing the acquirer's risk prevention The authority agency should be employed to conduct a comprehensive audit of the target company. Bearing bonds are not used to acquire the target company, but to joint ventures. This way can avoid the liability. The evasion of bank debts in M&A require local governments from the overall interests, strictly in accordance with state law dealing with mergers and acquisitions in the banking debt. Banks should handle relations with local governments and enterprises, using legal to safeguard the banking interests. The Government encourages evasion of bank debts through mergers and acquisitions, the bank can set the high-risk areas in the district to stop lending to enterprises in the region. References [1]. Gerry Tohnson [United Kingdom]. Corporate Strategy Guide, Beijing: China Press, 1998. [2]. Zvi Bodie, Robert C Morton. Finance, Beijing: China Renmin University Press, 2000. 221

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