Case Study of Acquisition of Nokia Handset by Microsoft

Case Study of Acquisition of Nokia Handset by Microsoft

CHAPTER ONE: INTRODUCTION

1.1 Background of the Study

Due to the intensified competition in the telephone industry, there rose a decline in the Nokia company’s activities. Competition led to the need for re-strategizing to ensure that the business activities of the corporation regained normalcy. In 2013, it was announced that Microsoft had sought the acquisition of Nokia to enable the continued growth of the dying world technology giant. The acquisition was meant to bring in new opportunities to the company and help resolve the company’s challenges during this hard economic time. The negotiation between Nokia and Microsoft lasted for two years, after which Microsoft acquired the company. Since then, the two companies have strived to revive the mobile phone business of Nokia through intensified sales and increased innovation to meet the changing customer demands and to beat the prevalent competition in the telecommunication industry.

Based on the agreement signed between Nokia and Microsoft, Microsoft was given the right to own all Nokia’s devices, including the Dial phones, the smartphones, and the services related to the phones. The acquisition required that the company transfer about 32,000 employees to Microsoft to facilitate its activities. The agreement allowed Microsoft to construct a data center in Tami Reller, Finland, and Mark Penn, all close to the Nokia corporate structures, to enable production efficiency.

Terms of the Agreement

Source: Domadoran website

1.1.1 Acquisition

The acquisition involves the purchase of more than 50% of another company’s shares. The acquiring company gets full control of the company as they have more than half of the company’s shares in question. Therefore, they control the overall business functioning and make most of the business decisions regarding the firm. When a firm acquires another firm, they make decisions regarding the purchase of new assets within the business without considering the shareholders’ views.  Mergers and acquisitions are shared among the medium and the small corporations. The primary purpose of entering these agreements is to enable entry into a foreign market, enable the company’s growth, reduce excess capacity, and gain much-needed technology. Often, corporations enter into acquisition because of the challenging economic environments shrouding the industries in which they operate.

The rules governing mergers and acquisitions vary across different countries. For instance, in Cuba, an external company cannot purchase more than 50% of the shares in a local company. Such legislation is essential in setting the framework for which the acquisitions are to be carried out. Several acquisitions have made headlines in the past 20 years due to the massive amounts of money invested by the acquiring companies. Due to the significant capital outlays by the acquiring companies, comprehensive market analysis has to be carried out to prevent entering into contracts that are non-viable, which may, in turn, lead to loss-making by the corporations.

Table 1: Top Acquisitions

Source: Domadoran website

1.1.2 Microsoft Company

The Microsoft Plc is an American company incorporated on the 4^th of April, 1975. The company’s founder members were Paul Allen and Bill gates for sales of BASIC interpreters of Altair 8800. The company whose headquarters is in Redmond, Washington, has grown into a global company with its operations cutting across all the continents of the world. Their main products are personal computers, consumer electronics, services related to computers, and computer software. The most significant company products include Microsoft Windows, which is part of their computer software packages of the operating systems, The Edge web browsers, and the Internet Explorer, and the Microsoft Office Suite. This software package has since become part of the day to day activities of most institutions.

The corporation also produces other products like the videogames, the X box video consoles. The company is part of the Big Five companies in the technology industry. According to the Fortune 500 ranking of 2018, Microsoft was ranked at number 30 amongst the most significant income earners in the United States. According to the United States company valuation of April 2019, the corporation had reached the trillion-dollar cap making it the third public corporation to hit the trillion cap after Amazon and Apple. The company has survived the competitive technology industry through continuous innovation. The technology industry is marred with the competition, and a product may get obsolete overnight.

The leadership of Microsoft Corporation

Microsoft corporation is managed by a board of directors who are non-shareholders as per the requirements for the public corporations. The organization is led by CEO Satya Nadella below, whom the organization is segmented into two major groups: the Engineering and the Business departments.

Figure 1: Leadership Structure of Microsoft Company

Source: Microsoft org. Inc.

1.1.3 Nokia company

Nokia Corporation is a Finnish company incorporated in 1865. The company is one of the largest employers, with an employee scope of more than 103,000 employees. The company trades in more than 100 countries in the world. In 2018, the company recorded a revenue of $28 billion. The company is listed in both the New York Stock Exchange and the Helsinki Stock Exchange markets. According to research by Fortune Global 500, the company was in 2018 rated as the 415^th largest company in the world.

The main product of the company is mobile products, mobile phones. The company since 1990 focused on the production and the distribution of mobile phones throughout the world. The telephone industry is somewhat competitive. To keep up with the competition in the telecommunication industry, the company has innovated highly beginning with the LTE networked dial phones to the current smartphones with 5G networking.

Figure 2: Leadership structure of the company

Source: Nokia org. Inc.

1.2 Statement of the problem

Acquisition in a firm by another firm may result in additional financial risks for the firm. When firms merge with other firms in the same industry or different industries, the organizations gain an additional economic advantage that helps the company to increase the share capital value of the company. Firms need to carry out a comprehensive analysis of the firm’s financial states they wish to merge with or to acquire. The acquisition of Nokia by Microsoft has been beneficial to both firms and has led to an increase in the share value of both Nokia and Microsoft company.

1.3 Research objectives

1.3.1 General Objective

This study’s general aim is to assess the post-launch acquisition of Nokia by Microsoft and ascertain whether the acquisition was a success.

1.3.2 Specific objectives

1. To identify the structural deal between Nokia and Microsoft in terms of valuation and other considerations.
2. To determine the purpose of the acquisition of Nokia by Microsoft.
3. To highlight the challenges and the issues arising from the integration of Nokia into the Microsoft business model.
4. To evaluate the potential impact of Nokia acquisition on the Share Prices of Microsoft.

1.4 Research Questions

1. What are the drivers and motivations of both Nokia and Microsoft in the M&A transaction that lead to either success or failure of the deal?
2. Is ‘Human Factor” a significant key to the success of the acquisition of Nokia by Microsoft?
3. Were the intended synergistic benefits achieved in the M&A between Microsoft and Nokia?
4. Was the Shareholder value realized for both Nokia and Microsoft?
5. What is the financial impact of the Nokia Acquisition in the share prices of Microsoft?

1.5 Aims of the Study

This study aims to provide an analysis of the purchase of Nokia and Microsoft. The research will focus on the viability of the acquisition. It will ascertain whether the intended purpose for the acquisition was met or if the purchase has not been valid. It will justify the underlying reasons behind the partnership between Microsoft and Nokia. The study will also aim at providing further recommendations on the required elements of the consolidation between the two companies.

1.6 Importance of the study

The findings from this study will be of importance to a variety of groups. The study will highlight the various elements of the acquisition process that will help both other companies and firms in the decision making process. The following are some of the areas that are expected to benefit from the findings of the study.

The study will provide the required information to future scholars to research the area. The data from this study will form a basis from which the future scholars will get information to guide them in carrying out future research. Also, the study’s recommendations will help scholars identify the gaps that need to be addressed.

The study will be relevant to the two organizations, Nokia and Microsoft companies. From the survey, Nokia and Microsoft will determine the viability of the acquisition. It will also help the companies to decide on whether to carry on with the merger or to quit is based on the calculations of the returns and risks of the acquisition.

The findings of the study will be necessary for the management of the two companies. The management requires in-depth analysis to make the different decisions affecting the organization. From the survey, they will be able to the management to get information on the financial progress of the firm resulting from the merger.

1.7 Scope of the study

This study will cover the information from the financial records of both the two companies after the acquisition to help in the calculation and computation of various elements of importance to the growth of the two organizations.

CHAPTER TWO: LITERATURE REVIEW

This section of the study will focus on the available literature concerning the acquisition of companies by other companies. The chapter will also gather the information of other researchers in the area who have researched the acquisition of Nokia by Microsoft. It will also identify the reasons why the firms decided to agree, the impact of the purchase on both firms, and the post-acquisition analysis of the firms. The literature will be based on the reasons for the acquisition and the valuation methods used in carrying out the study of the two companies. The section will also cover the “comparables” between the two companies.

2.1 Reasons for the partnership

2.1.1 Creation of value for shareholders

The main aim of carrying out business is to maximize the shareholder’s value. All companies require to meet the shareholder’s expectations to prevent disagreements that may arise between the shareholders and the company management, The agency problem. According to the Agency problem, company management must align the business strategies towards achieving the central business objective (Damodama, 2005).

The main aim of the mergers and acquisitions is often to increase the share value and to satisfy human needs. Human need satisfaction enables an increase in business profits. An increased profit margin helps increase the per-share value, which helps prevent disagreements between the shareholders and the board of directors. Nokia’s company was at its peak in 2009 when it recorded the highest sales. There, however, arose a recession in the company leading to an increased demand for strategies to help improve the value of the company. The company considered the acquisition as an effective way to regain its market share and, at the same time, increase the value of its shares. On their behalf, Microsoft needed to acquire the shareholders’ value. The company’s idea was a risky idea based on the financial position of Nokia at this time. The positive consequences resulting from the acquisition would enable Microsoft company to create value for its shareholders. Often, companies make mistakes in the valuation of the companies to be acquired, and this may, in turn, lead to negative consequences and a decline in the share value.

2.1.2 Synergy

According to Luchrman (1997), synergy describes the additional value that the individual entities get out of the combination of two different entities. It helps to create opportunities for the parties and to achieve organizational efficiency. The acquisition helps to create synergy between two organizations that join forces to work together. Through the synergy, the organizations become more independent and avoid the errors in their functionality.

Synergy is the main driver to the increase in the performance of firms in various industries. The added energy enables the firms to reach new markets and innovate more as it adds to the available capital that can be used for capital projects. Also, synergy allows the firms to be productive and thus acquire increased profits, which leads to an increased trading advantage. The businesses in the contract must be analyzed to ensure that each business’s financial position is identified. This helps in drafting the terms of the agreement. It also aids in avoiding over-ambition in the acquisition process, which in turn leads to loss-making. The firm must evaluate the financial data that are computed before the contract is initiated and the values that arise from the combination of the two companies to minimize the biases that arise from a poor valuation. In this way, the companies confirm that the financial analysis carried out before the contract was accurate and reliable.

2.2 Valuation Methods

Financial valuation is an integral part of each profit-making organization. According to Stevenson et al. (2015), “financial valuation is central to setting the business strategies.” Businesses must strategize to keep the business in shape and ensure that the corporation is not beaten by competitive forces in the ever-changing business environment. The finance department of a business carries out a periodical analysis of the industry to ensure that it moves in the right direction. This valuation is done from the company’s books of accounts, such as the income statements and balance sheets.

General managers and the financial experts also join in the business valuation to ensure that the company’s various resources are assigned to the right activities that are profitable to the business (Myers, 1995). The knowledge of the information on the firm’s valuation helps to streamline the business activities and is necessary for the resource allocation choices of the firm (Copeland et al., 1990). The firm’s assessment varies from firm to firm, depending on the suitable portfolio of the valuation approaches. At all times, the organizations should ensure that the valuation methods selected for valuation match the requirements of the different firms. The estimation should reflect the current financial position of the firms (Welch, 2004). From the assessments, the firms develop a prospect of growth, which is essential to the firms. According to the GAAP, businesses are a going concern and do not consider ending trade at any known time.

An unbiased and coherent analysis of the company’s capital structure and the changes in the capital structures should be carried out to ensure that the methods adopted for valuation are the most appropriate (Young et al., 2016). To ensure that the analysis is carried out in the most appropriate methods, the companies should use the Discounted cash-flows (DCF) and the Relative valuation method, which evaluates by multiples. According to Goedhart et al. (2005), the discounted cash flow method is the most accurate and flexible method for the organization’s valuation. It offers the firms flexibility in which the assessments can be carried out effectively and efficiently by incorporating more years in carrying out the analysis. Lie & Lie (2002) highlighted that valuation by multiples helps generate insights into specific drivers, which adds to the industry’s value. The valuation by multiples also helps to compute the value of equity while focusing on the value of debt, a comprehensive measure for the firm (Young et al., 2019).

The Discounted cash flow method of financial analysis helps to focus on the future expectations of cash flows through discounting the forecasts of the future cash flows to their present value. Discounting is carried out at a set market rate, which is the rate of risk prevailing in the market at the given time (Sigmundson, 2018). There are four methods mostly used under this broad aspect of valuation, which include the Weighted Average Cost of Capital (WAAC).  Capital Cash flows(CCF), Adjusted Present Value (APV), Free Cash Flows to the Firm(FCFF), and the Cash Flows to Equity (CFE). The Discounted Cash Flow method of valuation delivers the best valuation results compared to the other measures used in the valuation of a given firm (Goodhart et al., 2005).

On the contrary, valuation by multiples requires that the firm computes specific multiples for a given set of benchmark for companies sharing similarities. The asset values of the organizations are then calculated through the use of these set multiples. Accuracy is achieved through the application of the accurate multiples for each set of data that is being analyzed (Lie & Lie, 2002).

2.2.1 Cash Flow approaches

When carrying out a valuation based on the DCF method of valuation, the process begins by first identifying the real and the nominal future cash flows. At this stage of valuation, it is easy for the company to have valuation errors whereby the company may overestimate or underestimate the future expectations in the values of cash inflows (Damoduram, 2005). The errors in the use of the method may result from the returns on investment, the expected growth rates, and the duration of the forecasts. These rates are arrived at based on the assumption that the discounting rates will be equal throughout forecast and that the growth rates will grow at a set constant rate of perpetuity. The analysis then determines the rates at which the cash flows will be discounted. According to Kaplan and Ruback (1996), there is a high level of risk associated with the cash flows necessitating the use of a distinct discounting rate. Their rates are obtained through the calculation of the cost of capital, mostly through the use of the Capital Asset Pricing Model (CAPM).

2.2.1.1 Cost of capital

The calculation of the cost of capital is one of the essential parts of the company valuation process. There are complications in calculating the cost of capital since many companies operate in more than one industry. The cost of capital can be described as the cost of investment in a similar risk project. This cost can be derived from financial tools like hybrids, bonds, securitization, convertibles, and bad debts (Peterson, 2017). The cost of debt capital is calculated from the default risk spread and the risk-free rate. The most common method for calculating the cost of capital is the Capital Asset Pricing Model (CAPM). This method describes the relationship that exists between the beta and the value of equity in a regressional analysis of the equity returns of the corporation. The concept was developed by Sharpe (1964), Lintner (1965), and Black (1972). The profits of the organizational assets describe the sum of the risk premium and the risk-free rate.

The formula calculates CAPM;

R_i= R_f + β₁ * (R_m – R_f): Where R_i is the required rate of interest, R_f is the risk-free rate, β₁ is the firm’s risk factor, or the equivalent beta, and (R_m – R_f) is the risk premium that investors require to invest in the firm at the same level of risk.

The WACC method of financial valuation requires that the capital structure be rebalanced. This means that when the future asset values are not known with certainty, the planned debt tax shield will be uncertain. Complex capital structures and tax positions of the firms lead to errors in the valuation of the firm’s capital availability (Copeland, 2016). WACC is an out of fashion valuation method of the cost of capital.

WACC = R_e * E    + R_d * D   * (1-T_c)

E+D         E+D

Where R_e is the cost of equity, R_d is the cost of debt, E is the equity, D is the debt, and T_c is the corporate tax rate.

WACC presents advantages in the valuation process as it brings together two different sources of capital: the debt and the equity. The method then discounts the two sources of capital once. This method has lost in the valuation process due to the changes in the capital structures of companies in the present (Myres, 2018).

2.2.2 Relative valuation

Relative valuation methods provide the smallest valuation errors. This necessitates using these methods to estimate the cost of capital and ascertain the firm’s value. This method focuses on the firm’s ability to make profits relative to other firms in the same position as the firm. The evaluation method begins with finding similar values from the companies’ books to enable comparability. These transactions include earnings and sales proceeds of the business. The estimated multiple is then applied to the values of the chosen parameters. The success of this valuation method is pegged on the ability to identify the transactions showing specific characters like growth rate, risk, size, capital structure, and the firm’s liquidity. According to Goodhart et al. (2015), the most appropriate choice of comparable values and the implication of the best set of multiples is the first step to achieving the most accurate results. When the two firms to be compared are of the same size, and with the same timing of the cash flows, accuracy is attained. This step of the process should also entail defining the firm’s business divisions by using a four-digit Standard Industrial Classification (SIC) code. This code identifies and locates the segments in which each of the companies belongs in the industry. The main concern is also on the firm’s growth expectations and the Return on Capital (ROC).

The next step of using the valuation method involves the use of the set multiples. According to Lee et al. (2020), a good set of multiples is the collection that is not easily manipulated by leverage, and that explains the firm’s productive capacity. The EBITDA values are superior compared to the equity value multiples because the equity value multiples are directly affected by capital structure changes. According to Goodhart (2005), the enterprise value multiples for non-operating items such as employee stock, pensions, operating leases, and excess Cash can be adjusted. The accuracy of the valuation depends on the value of intangible assets, profitability, and firm size. The larger the firm size, the more the accuracy of the assessments (Alford, 2015). Lie & Lie (2002), pointed out that these valuations work more for the financial companies than the nonfinancial companies. For the companies high in the number of intangible assets, there should be used the nonfinancial multiples, including the subscribers, the visitors to the website, and the effect of the two on the value of the firm.

2.3 Mergers and Acquisition of Related Issues

2.3.1 Formation of Mergers and Acquisitions

Mergers and acquisitions took center stage of the world in the late 20^th century. Businesses that have opted for total takeovers have never got the expected results for the engagements. The time limit and the asymmetry in the information available on firms make the acquisition process delayed and difficult to accomplish. Poor management in some companies has also played a significant role in the hindrance of the acquisitions. For success in the acquisition process, the acquiring firm must conduct a comprehensive market analysis to ensure that the strategies of the firm it wants to acquire are in line with the business strategies of the firm. In this way, the firms buy only those companies with the same policy as it has to ease the process of integrating the company into the acquiring company (Very & Schweiger, 2001). The process begins with identifying the company’s potential target firms, after which the company carries out an analysis to enable the selection of the best company from the recognized companies. The process then enters the negotiation period when the two firms agree on the merger or the acquisition terms. The process ends in post-acquisition integration (Stewart et al., 2019).

2.3.1.1 Types of Mergers and Acquisitions

According to Loughran and Vijh (2017), “a firm can be acquired by another company or by an outside investor and its managers. The formation of M&A is driven; it will directly affect the method of payment and the post-acquisition outcome.” In some ways, another company’s acquisition can be termed as a tender offer, a merger, acquisition of assets, and consolidation. The acquisition is referred to as a merger when the target company is integrated into the acquiring company, giving both the shareholders the ability to intervene in the process of acquisition. A tender offer is a situation where the acquisition depends on the approval or non-approval of the stockholders; for instance, if the shareholders of the target company accept the tender offered, then the purchase goes through. The acquiring firm gains control of the target firm. In case of a consolidation, both the firms come together to form a new firm different from the two firms. This type of acquisition requires the participation of the shareholders from both the acquiring and the target companies. The purchase of assets acquisition is realized when the acquiring firm buys the assets of the target firm. This type of acquisition requires only the consent of the shareholders of the target company. The acquisition can also occur when the company’s management decides to buy the company from the shareholders, Management Buyout. Also, external investors can choose to acquire the firm, Leveraged buyout, these types of acquisition take the form of tender offers which turns the companies into private companies in case the acquisition holds (Davies, 2019).

According to Jemison and Sitkin (2017), “Leveraged buyouts (private equity) markets are learning to bust and boom cycles due to the hostile piecing and the laid back credit market conditions.” Such acquisitions are undertaken through the use of debt financing. The challenge is the person in possession of the debt. According to Acharya et al. (2007), private financial institutions have entered the banking industry, adding on to the funds provided by the banks, therefore, creating problems for those who financed the leverage buyout debts. The acquiring firms have modified their capital requirements and required more information about the exposure to risk associated with debt finances.

According to Loughran & Vijh (2017), there is a need to distinguish between friendly takeovers and aggressive takeovers. They highlighted that mergers are usually friendly takeovers. Tender offers, on the other hand, are hostile and stringent in the process of acquisition. The integration speed is vital in determining the assimilation process of the target firm into the acquiring firm. Faster acquisitions enable more straightforward cultural assimilation of the target firms by the acquiring firms. It was also noted that the acquisition of a firm with a similar firm or a firm in the same industry materialized faster. The acquisition also led to several advantages as the acquiring firms needed not to change the target firm (Barkema & Vermeulen, 2015).

2.3.2 Synergies

Synergy denotes the increase in the value that a firm derives from combining with another firm. The combination of two or more companies helps gather power; for instance, the economic power to help increase the market penetration of firms (Damodaran, 2005). Value creation is vital to the company as it averts the agency crisis that may arise between the management and its shareholders. The synergies are in the lines of management, finance, marketing, and the complete control of the company. Before entering into acquisitions, the acquiring company carries out a market valuation analysis in which the company revalues the target company to ascertain the fact that it meets the set minimum standards of the acquiring company. Also, the two companies’ strategies must match to ensure that the acquisition leads to the creation of synergy. The purchase of the companies leads to a new managerial aspect into both the acquiring and the target companies, which in turn leads to the creation of value. Firms analyze the target firms to ensure that the firms have an additional benefit to offer before getting into acquisition agreements. The acquisitions must distinctly give details of whether such purchases are controlled value-oriented or control non-value-oriented. This helps to identify the course of action to be taken in the analysis of the target company.

This research focuses on the creation of synergies resulting from mergers and acquisitions (M&A). The main focus of the paper necessitates the analysis of the importance of synergies and the process in which the synergies can be created.

2.3.2.1 Synergy creation

According to Sirower & Sahni (2006), synergies are created by the reduction in the costs of operations of the firms entering into collaborative agreements with other firms, and the enhancements in revenue resulting from the diversification of the scope of the firm’s activities due to the mergers and the acquisitions. Damodaran (2005) posits that the synergies that are the increase in the value of firms result from the rise in the expected cash flows of the firms while at the same time reducing the cost of capital that the firm uses to meet such improvements in the cash inflows. It is often easier for companies to reduce costs than to increase revenue. The decrease of the expenses is carried out through cutting down the costs of various business activities that result in minimal profits. However, the achievement of increased firm values requires improved strategic decision-making and the firm’s processes in question (Li et al., 2020). The businesses must strategize on prospects of future growth regarding the returns on capital resulting from the M&A to derive synergy from an acquisition.

2.3.2.2 Types of synergies

According to Damodaran (2005), synergies are grouped into three sub-groupings: the Dubious synergies, Financial synergies, and the Operating synergies. Operating synergies require that the two firms’ agreement in the acquisition process increases the value of the two firms’ already existing assets. The development in the asset value leads to an increase in the consolidated company’s pricing power, a combination of distinct skills, economies of scale, and higher growth potential of the firms in question. Financial synergies are concerned with the financial aspects of the firms that enter into the M&A agreement. These economic aspects include the increase in the firm’s debt capacity through the use of additional Cash in the new opportunities, referred to as the Cash slack. Reduction of the earnings variance is another essential aspect; diversification of the firm’s financial potential, which is mainly determined by the firm’s corporate governance and the size. And the tax benefits resulting from the deductions and the accumulations of losses over a while. On the other hand, dubious synergies are a type of synergy in which the markets for the two companies entering into an M&A agreement respond positively to the announcements of such contracts. These synergies often take the form of fast-growing enterprises and the purchase of accretive units with a higher EPS in the post-acquisition stage of the M&A.

2.3.2.3 Valuation of synergies

According to Domadaran (2005), synergy valuation is unanimous among different analysts. These evaluations are carried out through the use of methods such as the DCF method, which helps in the computation of the excess value created by the firms. The DCF method’s evidence is hard to trace and to evaluate. Kaplan & Weisbach (2015), stated that a majority of synergies seem to have the potential of giving so much value to the firms at the beginning of the acquisitions. However, only a small portion of the synergies translate t value creation in the long run because of the intervention of the operation of both the target and the acquiring firms that collide with each other, and the excessive prices paid by the acquiring firms as part of the agreement with the target firm. Synergies also fail to deliver because of the market’s view of the M&A. Markets are often taken by surprise in the M&A acquisition process and need to adjust quickly regardless of the new prices of the two companies (Kiymaz & Kilic, 2004). According to Damodaran (2005), firms can increase the possibility of M&A success by using three critical realities. These realities include the fact that the M&A between firms of similar sizes is likely to fail compared to M&A between firms of different sizes, such as a Small firm merging with a large firm. The second fact is that the cost reduction mergers and acquisitions are more likely to add to the firm’s value than the growth synergies. The third truth is that the acquisition involving a private business is more likely to add to the firm’s value than the acquisition of public companies. Public corporations fail to deliver because of government intervention witnessed in such firms (Shivdasani & Zak, 2017).

2.3.3 Cross-Border M&A and the emerging markets

Cross-border M&A is the result of merging and acquisition of companies in more than one country. These mergers are carried out to increase the market scope of the business and spread the firm’s risk over a larger geographical area. According to Very and Shweiger (2012), the partnerships between companies with their headquarters in different countries amount to cross border partnerships. The main concern of these M&A is the firm’s entry process into the other country and the future expectations of success after entering the new states. The world has grown into a global village in which firms operate from all corners of the world. The rise in the number of companies going global can be attributed to the market saturation and the intensified competition in the various industries leading to the search for new ventures and opportunities in the unutilized markets where the competition is low. Firms have opted to move to Africa and North Asia to expand their markets as these markets still have opportunities to be utilized by the firms (Zenner et al., 2018). According to Very and Schweiger (2012), the cross border partnerships between firms have contributed to more than 25% of the total M&A in the past 20 years.

2.3.3.1 Reasons for forming Global M&A

The increase in the number of global M&As can be attributed to geographical diversification, globalization, and the tax benefits that accrue to firms entering such agreements. Globalization is the process by which firms diversify their scope of operations to more than the country of origin. The company goes beyond its state to invest in countries referred to as the host country. Such factors may influence the formation of cross border M&A because of the rules governing the entry into some of the nations. Some laws do not allow companies to enter into countries unless through the mergers, necessitating the formation of alliances to enable entry into the nations. The transition from one state to another may also be hard for the companies, therefore, making it to consider the formation of mergers with pre-established companies in the host country to aid in the entry into the new markets. The competition that has grown in most of the industries in different parts of the world has presented the need for global diversification of firms. Most markets have been saturated by firms offering the same products, leading to a decline in the proceeds from operating in such markets. Such factors have led to firms seeking global ventures to get to the underutilized markets and to add to the firm’s net profit. In terms of the tax advantages, the global firms work on consolidated financial books of accounts. Such consolidations have enabled firms to have a collective joint power in terms of the tax expense that the firms are required to pay out (Bruner, 2014). Besides these long term advantages resulting from cross country M&A, the firms also get involved in these agreements for short term strategies such as the high-relative valuation, currency benefits, and the sovereign wealth fund creation. The cross country M&As help improve the firms’ relative-valuation by increasing the firms’ buying potential in times of upward growth in the value of the stock. The market forces lead to changes in currency values concerning other currencies. Some companies are motivated to move to the international business scope when the money for the target countries are low to help the firms utilize decreased currency values. For instance, a firm may opt to invest in the USA at times when the US dollar becomes cheap. The firms may also move to other markets to reduce domestic competition in their countries of origin. The cost of acquiring foreign corporations is high relative to buying local companies (Bruner, 2014).

2.3.3.2 Implication of cross country M&A

The cross border M&As have many consequences that must be identified and analyzed before the firm can make decisions of making such engagements. Such implications include tax laws, currency values, foreign exchange risks, and political risks. Different countries have different rules regarding companies’ taxation across the world (Koller et al., 2015). These laws define the efficiency of operating in various countries. For instance, most states tax foreign companies heavily to encourage the local company’s participation. Such laws lead to a decrease in the synergy creation resulting from operating in these countries. Currency valuation is a significant implication of cross border operations. The firms have to take into consideration factors such as the value of the currency of the country in which they wish to trade by looking at the inflation trends in the country (James & Koller, 2000). Cross country firms carry out their financial reporting in the home country currency, making it necessary to convert the proceeds from the host country into home currency. The costs realized from the exchange of money are referred to as the costs of conversion (Koller et al., 2015). These costs are essential in determining the amounts of profits that firms accrue from the countries in which they operate. Political stability and protection of the companies operating in a given country are essential aspects that must be considered before making investments into the host countries. Some countries are in states of political distress, which may lead to the destruction of the company property, resulting in losses. In some countries, the governments interfere with the business operations, making it hard for the international firms to survive in those markets; for instance, Cuba seized all the private companies leading to the Coca-cola company’s exit from the Cuban Market. These factors have to be considered before making investment decisions that may lead to losses by the firm.

The foreign markets’ analysis should consider the risk assessment, cost of capital, cash flows, and the inflation in the host countries. The evaluation can then be carried out through the use of weighted averages method. According to Frost and Kester (2005), the evaluation can be carried out through discounting the projected cash flows in the host market in the host country’s currency before the firm can convert the values using the spot rate to determine the expected cash flows in the country. The firm will use the interest rate parity theory to obtain the forward exchange rate and the foreign exchange rate.

2.3.3.3 Reasons why cross country M&As fails

Notably, not all the cross country M&As become successful in the countries in which the firms decide to invest. According to Burner (2004), about 20% of the global M&As succeed. Factors leading to the failure in the cross country M&As are divided into two broad categories that include the long-term and the short-term factors. The short term factors include the fluctuation in the currency value as a result of inflation in the host country. The market forces of demand and supply lead to changes in the value of the currency relative to other currencies. An unfavorable change in the currency of a given country can have negative implications on the firm due to the rise in the spot exchange rates and, in turn, leading to loss-making by the firm. The long term factors may include the protectionist policies of the host governments. Some governments shield their local firms from competing with foreign companies by providing them with tax caps and raising the taxes paid by international companies. These factors go a long way in determining the survival of a firm in a host country. Some countries also have barriers to entry into their economies, leading the companies to fail in seeking such ventures. The costs of entry into some countries are high leading to the use of so much capital by the acquiring firm, thus limiting the development process after the acquisition has passed. The corporations have a responsibility to analyze the factors in the host countries keenly before choosing which country to invest in to prevent loss-making that may result from operations in the given country.

2.3.3.4 Importance of cross border acquisitions

According to Zenner et al. (2008), “Cross border M&A should be viewed as a key element of the stockholders’ value.” The main objective of firms is to add to the value of the shareholders of the firm. The corporate managers are responsible for increasing the value of the company’s shares and thus add value to the shareholders’ stock value. The foreign investments help add to the firm’s value through the provision of new markets to explore, thus increasing shareholder value. Zenner and Shivdasani (2004) pointed out that acquiring firms in the cross country engagements outperform domestic firms because of the firms’ lower execution risks and immediate market access. Acquiring firms in the cross border M&A use Cash as the mode of transaction in the acquisition process. The firms also prefer total takeovers compared to the asset financed deals. According to Zenner et al. (2008), the large acquiring companies allow the smaller companies acquired to continue with their operations to help the firm grow its shareholders’ value in case the growth is limited in the domestic market. It facilitates growth by purchasing the firm at a high cash price. According to Kiymaz and Kilik (2014), cross border M&A has benefits to both the acquiring and the target companies. The success and failure of the M&A are measured through the costs and benefits that each firm accrues from the acquisition process. Very and Schweiger (2011) highlighted that the evaluation after the acquisition enables the firms to choose whether to continue with the business or of abandoning the venture. If firms decide to continue with the investment, they must overcome the market forces that are pulling back the M & A by coming up with new strategies that can survive in the host market. The evaluation for strategy reformulation is done by integrating the host country’s cultures into the business strategies and collecting reliable data on the land. The firm also refers to the past factors leading to failure to streamline the business processes and to evade future failures in the business.

2.3.4 Methods of payment

Transactions involving mergers and acquisitions are financed depending on whether the target firm is within or outside the country (Zenner et al., 2008). The domestic and cross-border M&A is financed by using stock, cash, a combination of cash and stock. The mergers and acquisitions can also be financed through the initiation of payouts based on the expectations of the contract’s future performance, earn-out contract. When the payment is made based on the expected future returns, the payment is made according to the greatest value obtained from the analysis, thereby providing a large amount of cash or stock for the firm’s positive performance. The target company earns a good amount from the venture while the acquiring company invests in a highly risky venture to get increased returns (Burner, 2014).  According to Longhran and Vijh (2017), several mergers are financed using stock.

On the other hand, the acquiring companies’ tender offers are financed using cash since they are inflexible and need the cash factor to influence the target company into accepting the offers. The different markets are not concerned about the mode of payment used in the acquisition of the firms. According to Savor and Lu (2019), most of the acquiring firms prefer cash payment for the contracts compared to the stock means of payment. Sirower and Sahni (2016) posit that the use of cash payments in the payment for the mergers and acquisitions may lead to value loss for the target firm. According to Zenner et al. (2018), uncertainty in the future returns of the company leads to the use of stock as a means of payment for the acquisition of the company.

2.3.4.1 Factors affecting the choice of the payment method

The payment for the mergers and acquisition often demand the investment of huge amounts of capital by the acquiring firms. The decisions on the M & A payment mode have to be scrutinized to ensure that it has no negative implications on the firm’s performance and that the amount of cash or stock payable matches the returns that the company generates from the M&A. The acquiring firm must evaluate both itself and the target company to check whether the valuation for each company portrays the true value (Savor & Lu, 2019). Managers will make payments for the M&A based on the valuation of the stock. According to Savor and Lu (2019), the acquiring company’s management will prefer to pay in stock if the company’s stock is overvalued to enable the company to obtain an effective discount. In cases where the management feels that the company’s stock is undervalued, they will prefer cash payments for the M&A. The payment process also follows in the effects of the payment both on the rating by other agencies and the capital structure of the acquiring firm.

In cash transactions, the acquiring shareholders take the full risks of the entire M&A process. However, in the stock transactions, the risks associated with the M&A processes are shared between the acquiring shareholders and the target shareholders. Based on this insight, the shareholders of the acquiring company will opt for stock payments for the different M&A ventures. According to Bruner (2014), cash payments made by the acquiring firms are an indication that the corporation has total belief in the M&A process, the firm enjoys the proceeds from the M&A in the post-acquisition period of the merger. Firms also consider the tax implications in making payments for the M&A. Cash payments attract direct tax. The acquiring corporation has to meet the tax expenses when the payment is made in cash. For the stock transactions, the tax is deferred to a future date based on the return that the firm gets from the venture. According to Zenner et al. (2018), cash transactions add to the debt of the acquiring firm. The currency issued by the firm should match the currency of the target company’s cash flows to ensure that the new debt is located near the cash flows and supported assets.

2.3.5 Post-acquisition Review

Damodaran (2018) posits that the returns from the M&A are shared based on the contribution of each of the firms in the venture. The firms that contribute more to the M&A process get more returns from the process. On the other hand, the firms that contribute less to the project get minimal returns. Sirower and Sahni (2016) stated that the effort of the firms is not the only necessity in the determination of the returns of the firms from the venture. The returns are obtained through am analysis of whether the acquiring firms have outperformed the expectations of the shareholders and the bids of the other firms in the industry. Cash transactions are high risk high profitable transactions compared to the stock financed ventures. According to Kiymaz and Kilik (2014), the target companies in the M&A process attract positive wealth gains. The acquiring company gets negligible effects when the performance of the M&A is at its best.  It can, therefore, be concluded that the target shareholders are the biggest gainers in the M&A process (Sirower & Sahni, 2016).

According to Damodaran (2005), more than 50% of the acquiring companies often have negative returns. The shareholders of the different firms are skeptical of the fact that the acquiring company can integrate the target business into its operations in a manner that amounts to stability in the performance of firms. The set standards prove hard to meet for the acquiring firm. When the acquisition price is high, and the prospects of growth are low, then the M&A is riskier to the shareholder’s value and leads to an inferior stock performance for the entire acquiring corporation.

The long-run effects of the M&A are shared between the target and the acquiring shareholders. According to Loughran and Vijh (1997), stock transactions for the M&A presents a disadvantage to the target shareholders in the long run. The returns from the M&A are based on the method of M&A used by the firms. The mergers, with a tendency of stock financing, lead to negative abnormal returns relative to the size of the firms entering the M&A. For instance, the larger the size of the acquiring firm, the higher the loss for the target firm. Tender to offers are normally cash financed and have a positive, exceeding return. The acquirers of these ventures are the biggest losers (Savor & Lu, 2019).

The uncertainty in the process M&A process requires a serious analysis of the risks that the shareholders are likely to undergo when the firms enter into the contract. Sirower and Sahni (2006) came up with a ratio to assist in the analysis of the firm’s risk relative to synergy creation.

Shareholders Value at Risk (SVAR) = Premium paid for the acquisition.

The market value of acquiring firm before the M&A

The management has the responsibility of carrying out a realistic analysis of the M & A’s process to ensure that the shareholders’ value is created, a major aim for profitable businesses. According to Shivdasani and Zak (2017), the management should incorporate the Equity methodology to realize the most optimal valuation results.

CHAPTER THREE: RESEARCH DESIGN AND METHODOLOGY