CU-MBA-SEM-III-Project Finance and Financial Modeling- Second draft-converted

• How to Get Only the Numeric Part from a String in Excel If you want to extract only the numeric part or only the text part from a string, you can create a custom function in VBA. You can then use this VBA function in the worksheet (just like regular Excel functions) and it will extract only the numeric or text part from the string. 301 CU IDOL SELF LEARNING MATERIAL (SLM)

Something as shown below: Below is the VBA code that will create a function to extract numeric part from a string: 'This VBA code will create a function to get the numeric part from a string Function GetNumeric(CellRef As String) Dim StringLength As Integer StringLength = Len(CellRef) For i = 1 To StringLength If IsNumeric(Mid(CellRef, i, 1)) Then Result = Result & Mid(CellRef, i, 1) Next i GetNumeric = Result End Function You need place in code in a module, and then you can use the function =GetNumeric in the worksheet. This function will take only one argument, which is the cell reference of the cell from which you want to get the numeric part. Similarly, below is the function that will get you only the text part from a string in Excel: 'This VBA code will create a function to get the text part from a string Function GetText(CellRef As String) Dim StringLength As Integer StringLength = Len(CellRef) For i = 1 To StringLength If Not (IsNumeric(Mid(CellRef, i, 1))) Then Result = Result & Mid(CellRef, i, 1) Next i GetText = Result 302 CU IDOL SELF LEARNING MATERIAL (SLM)

End Function 12.6 SUMMARY • Excel offers several functions to look up values from a table or from the arguments of the function itself. For example, you may want to look up from a tax table the marginal tax rate for a certain taxable income. You may want to look up from a table of detailed information on inventory the cost and availability of particular products. • HLOOKUP and VLOOKUP are parallel functions that work the same way. HLOOKUP searches for a value in the top row of a table or an array of values and then returns the value from a specified row in the same column of the table or array. VLOOKUP searches for a value in the leftmost column of a table and then returns a value from a specified column in the same row of the table or array. • Returns the relative position of an item in a range of contiguous cells in a row or a column that matches a specified value. Even though the function is called MATCH, as with the lookup functions, it does not need to find an exact match. • A pivot table allows you to organize, sort, manage and analyze large data sets in a dynamic way. Pivot tables are one of Excel’s most powerful data analysis tools, used extensively by financial analysts around the world. • In Financial Modeling , Macros and VBA for Excel are commonly used to develop and maintain complex financial models. They allow the finance professional to increase efficiency and accuracy as well as providing more flexibility in building models. • A macro is a collection of commands which are executed in a set order. A macro allows you to repeat operations that you would usually do manually by hand. Macros are much faster, and when written accurately and much more dependable. 12.7 KEYWORDS • HLOOKUP - searches for a value in the top row of a table or an array of values and then returns the value from a specified row in the same column of the table or array. • VLOOKUP - searches for a value in the leftmost column of a table and then returns a value from a specified column in the same row of the table or array • INDEX - Returns the value of an element in a table or an array, selected by the row and column number indexes. 303 CU IDOL SELF LEARNING MATERIAL (SLM)

• OFFSET - Returns the reference to a single cell or a range of cells that is a specified number of rows and columns from a cell or range of cells. • MACROS - A macro is a collection of commands which are executed in a set order. 12.8 LEARNING ACTIVITY 1. Take a list of expenses made by an enterprise in a year. Analyze, sort and rearrange them using the PIVOT table. ______________________________________________________________ ______________________________________________________________ 12.9 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. What is Macro? Briefly Explain 2. What Is lookup function? 3. For what purpose INDEX function is used. 4. Briefly discuss about OFFSET function. Long Questions 1. How to run a macro program. Explain 2. What is Pivot Table. How to use it for financial modelling? 3. Explain the use of VLOOKUP and HLOOKUP in financial modelling. B. Multiple Choice Questions 1. __________ function returns value of an element in a table or an array. a. MATCH b. INDEX 304 CU IDOL SELF LEARNING MATERIAL (SLM)

c. OFFSET d. MACRO 2. ____________ searches for a value in the top row of a table or an array of values and then returns the value from a specified row in the same column of the table or array. a. VLOOKUP b. HLOOKUP c. LOOKUP d. MACRO 3. A ________ allows you to organize, sort, manage and analyze large data sets in a dynamic way. a. Pivot tale b. Macro c. VLOOKUP d. HLOOKUP 4. In Financial Modelling, _______ for Excel are commonly used to develop and maintain complex financial models. a. Excel b. VB c. Macro d. Pivot Table 305 CU IDOL SELF LEARNING MATERIAL (SLM)

Answers 1) a 2) b 3) a 4) c 12.10 REFERENCES Textbooks: • Edward Yescombe, Principles of Project Finance, Yecombe Consulting Ltd., Academic Press • Michael Rees, Principles of Financial Modelling: Model Design and Best Practices Using Excel and VBA , The Wiley Finance Series) Reference Books: • Edward Bodmer, Corporate and project finance modelling, Wiley Finance Series 306 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT 13- INVESTMENT BANKING M & A Structure 13.0 Learning Objectives 13.1 What Investment Banking Is? 13.2 The Role Investment Banking Plays 13.3 How Investment Banking Differs from Traditional Banking 13.4 The Services Investment Bank Provides 13.5 How Investment Banks are Organized 13.6 How Investment Banks get Paid 13.7 The Concept of Mergers & Acquisitions 13.7.1 Introduction 13.7.2 Mergers and Acquisitions 13.8Why Companies Merge and Acquire 13.8.1 Introduction 13.8.2 Some Underlying Rationale 13.8.3 Merger Drivers 13.9Integration and Conglomeration 13.9.1 Introduction 13.9.2 Vertical Integration 13.9.3 Horizontal Integration 13.9.4 Conglomeration 13.10 The Merger and Acquisition Lifecycle 13.10.1Introduction 13.10.2Typical Lifecycle Phases 13.11 Measuring the Success of Mergers and Acquisitions 13.11.1Introduction 13.11.2Short Term Measures of Success 13.11.3Long Term Measures of Success 13.11.4Some Scenarios of Failure 13.12 Summary 13.13 Keywords 13.14 Learning Activity 13.15 Unit End Questions 13.16 References 307 CU IDOL SELF LEARNING MATERIAL (SLM)

13.0 LEARNING OBJECTIVES After studying this unit, you will be able to: • Explain the concept of Investment Banking • State the services offered by the investment banks • Outline the meaning of Mergers & Acquisitions • Why companies Merge & Acquire • How Integration and Conglomeration happens • Lifecycle of Mergers and Acquisitions • How to measure the success of mergers and acquisitions 13.1 WHAT INVESTMENT BANKING IS If you are like most people, you probably figure investment banking got its start in a towering office skyscraper in New York City. But the real story of the origin of investment banking is far less metropolitan, yet arguably even more interesting. Investment banking traces its roots to the age of kings and queens. Many of the most commonly used financial instruments trace their origins to centuries ago when bankers navigated the edicts of rulers and, believe it or not, religious leaders. If you’ re interested in the very early days of investment banking, check out the appendix for a quick history lesson. But for now, just know that investment banking is, at its very core, pretty straightforward. Investment banking is a method of controlling the flow of money. The goal of investment banking is channelling cash from investors looking for returns into the hands of entrepreneurs and business builders who are long on ideas, but short on bucks. Investment bankers raise money from investors, by selling securities, and then transfer that money to people who need cash to start businesses, build buildings, run cities, or bring other costly projects to reality. There are many aspects of investment banking that muddy this fundamental purpose. But in the end, investment bankers simply find opportunities to unlock the value of companies or ideas, create businesses, or route money from being idle to having a productive purpose. 13.2 THE ROLE INVESTMENT BANKING PLAYS Investment bankers get involved in the very early stages of funding a new project or endeavour. Investment bankers are typically contacted by people, companies, or governments who need cash to start businesses, expand factories, and build schools or bridges. Representatives from the investment banking operation then find investors or organizations like pension plans, mutual funds, and private investors who have more cash than they know what to do with (a nice problem to have) and who want a return for the use 308 CU IDOL SELF LEARNING MATERIAL (SLM)

of their funds. Investment banks also offer advice regarding what investment securities should be bought or the ones an investor may want to buy. One of the trickiest parts of understanding investment banking is that it ’ s typically a menu of financial services. Some investment banking operations may offer some services, but not others. The services offered by investment banks typically fall into one of a few buckets. One of the best ways to understand investment banks is to examine all the functions that some of the biggest investment banks perform. For example, Morgan Stanley, one of the worlds’ s largest investment banks, has its hands in several key business areas, including the following: • Capital raising: This part of the investment banking function helps companies and organizations generate money from investors. This is typically done by selling shares of stock or debt. • Financial advisory: In this role, the investment banking operation is hired to help a company or government make decisions on managing their financial resources. Advice may pertain to whether to buy another company or sell off part of the business. A common business decision tackled by this type of investment banking is whether to acquire another company or divest of a current product line. This is called mergers and acquisitions (M&A) advisory. • Corporate lending: Investment banks typically help companies and other large borrowers sell securities to raise money. But large investment banks are also frequently involved in extending loans to their customers, often short-term loans (called bridge loans ) to tide a company over while another transaction is in the works. • Sales and trading: Investment bankers are a creative and innovative lot, in the business of constructing financial instruments to be bought and sold. It ’ s natural for investment bankers to also buy and sell stocks and other financial instruments either on the behalf of their clients or using their own money. • Brokerage services: Some investment banking operations include brokerage services where they may hold clients’ assets or help them conduct trades. • Research: Investment banks not only help large institutions sell securities to investors, but also assist investors looking to buy securities. Many investment banks run research units that advise investors on whether they should buy a particular investment. The terms investments and securities are pretty much interchangeable. • Investments: Investment banks typically serve the role of a middleman, sitting between the entities that need money and those that have it. But periodically, units of investment banking operations may invest their own money in promising 309 CU IDOL SELF LEARNING MATERIAL (SLM)

companies or projects. This type of investment, often made in companies that don ’ t have investments that the public can buy, is called private equity. Investment banking operations at one firm may be engaged in some of the preceding activities, but not all. There ’ s no rule that demands investment banking operations must perform all the services described here. As investment firms grow, though, they often add functions so they ’ re more valuable to their clients and can serve as a common source for a variety of services. 13.3 HOW INVESTMENT BANKING DIFFERS FROM TRADITIONAL BANKING The critical part of the investment banking process is in the way cash is funnelled from the people who have it to the people who need it. After all, traditional banks do essentially the same thing investment banks do — get cash from people who have excess amounts into the hands of those who have productive uses for it. Traditional banks take deposits from savers with excess cash and lend the money out to borrowers. The main types of traditional banks are commercial banks (which deal primarily with businesses) and retail banks (which deal mostly with individuals). The difference between traditional banks and investment banks, though, is the way money is transferred between the people and institutions that need it and the ones who have it. Instead of collecting deposits from savers, as traditional banks do, investment bankers usually rely on selling financial instruments (such as stocks and bonds), in a process called underwriting. By selling financial instruments to investors, the investment bankers raise the money that ’ s provided to the people, companies, and governments that have productive uses for it. Because banks accept deposits from Main Street savers, those deposits are protected by the Federal Deposit Insurance Corporation (FDIC), which guarantees bank deposits. To protect itself, the FDIC along with the federal government puts very strict rules on banks to make sure they are not being reckless. On the other hand, investment banks, at least until the financial crisis of 2007 (see the appendix), were free to take bigger chances with other people’s money. Investment banks could be more creative in inventing new financial tools, which sometimes don’t work out so well. The idea is that clients of investment banks are more sophisticated and know the risks better than the average person with a bank account The meaning of the term investment bank got even more unclear after the financial crisis that erupted in 2007. Due to a severe shock to the bond market, many of the dedicated investment banks went out of business, including venerable old-line firms such as Lehman Brothers and Bear Stearns, or were bought by banks. Many of today ’ s largest investment banks are now units of banks or technically considered commercial or retail banks, although they still perform investment banking operations. Meanwhile, these banks will 310 CU IDOL SELF LEARNING MATERIAL (SLM)

often say they perform investment banking functions. The term investment bank is somewhat of a misnomer, because the major financial institutions are now technically considered banks. Now that you see that the chief role of investment banks is selling securities, the next question is: What types of securities do they sell? The primary forms of financial instruments sold by investment banks include the following: • Equity: If you have ever bought stock in a company, be it an individual firm like Microsoft or an index fund that invests in companies in the Standard & Poor ’ s (S&P) 500, you ’ve been on the investor end of an equity deal. Investment bankers help companies raise money by selling ownership stakes, or equity, in the company to outside investors. After the securities are sold by the investment bank, the owners are free to buy or sell them on the stock market. Equity is first sold as part of an equity offering called an initial public offering (IPO). • Debt capital: Some investors have no interest in owning a piece of the company, but they are more than willing to lend money to it, for a price. That ’ s the role of debt capital. Investment banks help companies borrow money by issuing bonds, or IOUs, that are sold to investors. The company must pay the prearranged rate of interest, but it doesn’t give up any ownership of the company. If a company falls onto hard times, though, the owners of the debt have a higher claim to assets than do the equity owners if a liquidation of the company is necessary. • Hybrid securities: Most of what investment banks sell can be classified as either debt or equity. But some securities take on traits of both, or are an interesting spin on both. One example is preferred shares, which give investors an income stream that’s higher than what’s paid on the regular equity. But preferred shares don ’ t come with as high a claim to assets as bonds, and this income stream can be suspended by the company if it chooses. 13.4 THE SERVICES INVESTMENT BANKS PROVIDE Investment banks do much more than just raise capital by selling investments. Although selling securities to raise money is arguably the primary function of investment banks, they also serve several other roles. All the functions of investment banks typically fall into one of two primary categories: selling or buying. • The sell side: Investment banks are best known for the part of their business that sells securities, or the sell side. This function of the investment bank is responsible for finding investors to buy the securities being sold, which raises the money needed by businesses and governments to grow and prosper. • The buy side: Investment banks may also take the role of advising the large investors who are interested in buying financial instruments. Serving in its role on 311 CU IDOL SELF LEARNING MATERIAL (SLM)

the buy side, the investment bank can offer suggestions to large institutional investors like mutual funds, pension plans, or endowments on which securities may be appropriate for it to buy in order to meet return targets. The dual role played by investment banking operations, serving both buyers and sellers of securities, raises constant worries of double dealing and conflicts of interest. Some people rightly question whether it ’ s possible for the same investment bank that makes money selling shares of an IPO, for instance, to give honest and unbiased investment advice to investors trying to decide whether they should buy or sell. The question of conflicts of interest in investment banking operations has become paramount since the financial crisis began in 2007. 13.5 HOW INVESTMENT BANKS ARE ORGANIZED Investment banks may seem like financial behemoths that have their hands in just about any matter that involves large sums of money. And to a large degree, that ’ s true. Investment banks are usually involved in some fashion when it comes to financing major projects, conducting trading in financial instruments, or developing new ways to generate capital. With that said, nearly all major investment banks divide their operations into several key areas, including the front office, middle office, and back office. When you talk to someone about investment banking, or even listen to the heads of investment banks talk, they’ll often refer to these three common parts of a traditional investment bank: • The front office: The front office is exactly what it sounds like. It ’ s not only the part of the investment bank that sells investments, but also the part that courts companies looking to do deals. Traditionally, companies that are looking to find a fast way to turbo-charge growth may think about buying another company (say, a rival with similar customers or complementary technology). From the front office, investment banks help usher along the M&A process by pairing up buyers and sellers. The front office is also the part of the investment bank that conducts trading (frenetic buying and selling of securities to take advantage of any mispricing’s — even if the holding period is for only a few seconds). This type of trading, done using complicated mathematical formulas and using the firm ’ s money (not the clients’ money), is often called proprietary trading. Many investment banks operate a business where they buy and sell securities themselves. Proprietary trading tends to be quite profitable for investment banks. Another part of the front office is the part of the business involved in conducting research on companies. The front office often employs sell side analysts, whose job it is to closely monitor companies and industries and produce reports used by large investors trying to decide whether to buy or sell particular securities 312 CU IDOL SELF LEARNING MATERIAL (SLM)

• The middle office: The middle office of an investment bank is generally out of the limelight. It ’ s the part of the bank with the job of cooking up new types of securities that can be sold to investors. Some innovations in investment banking are useful, but others can wind up putting investors and the markets in general in an unfavourable light. Some of the infamous financial instruments cooked up in the middle office of investment banks that came back to haunt the system include auction-rate securities and credit default swaps. Auction-rate securities are debt instruments that promise investors higher rates of return than are available in savings accounts. Instead of selling debt at a prearranged interest rate, the investment bank would conduct auctions, and the rate would be set by a bidding process. That’s great as long as there are willing buyers and sellers. But the auction-rate market relied on auctions, many of which weren’t successful during the financial crisis that erupted in 2007. Many investors holding the securities found they couldn’t sell them because the market had dried up, causing a huge headache for the investors and investment banks. Credit default swaps are tools that allow lenders to sell the risk that borrowers won’t be able to meet their obligations. Credit default swaps operate as a form of unregulated insurance policies. These instruments got so complicated, though, that they exacerbated the financial interdependencies between giant financial firms, worsening the financial crisis that erupted between 2007 and 2009 • The back office: The back office is the part of the investment bank that is far from the glamour of the front office. It’s primarily made up of the systems and procedures that allow investment bankers to gather the data they need to do their jobs well. The back office, for instance, maintains the computer systems used by investment bankers to gauge interest in certain securities and provides traders the ability to make short-term bets on market movements. The parts of investment banking considered more operational in nature tend to fall into the back office Investment banking operations are rarely identical between firms. Some banks and investment banks are engaged in some front-office areas, while others steer clear of them completely. There are also some peripheral areas of business some banks and investment banks include as part of their services that don’t fall in one of the traditional “offices.” One example of a service that is often grouped in investment banking is investment management. In an investment management unit, investment professionals are paid to invest money on behalf of individual clients or institutions. 313 CU IDOL SELF LEARNING MATERIAL (SLM)

13.6 HOW INVESTMENT BANKS GET PAID As you can imagine, although investment banking plays an important role in funding economic progress, there’s also lots of money to be made. Investment bankers can’t afford those fancy suits if they’re not getting paid. Investment bankers perform services for customers and collect money in a number of ways, include the following: • Commissions: Investment banks sometimes collect fees in exchange for conducting a financial transaction between a buyer and seller. One of the more common forms of commissions is often collected in the brokerage operations by some traditional banks and investment banks. For instance, Merrill Lynch, the brokerage and investment banking unit of Bank of America, charges commissions when purchasing stock for its customers. But that’s just a small example • Underwriting fees: A lucrative area of investment banking generates fees for selling securities in the primary market (the collection of buyers’ and sellers’ interest in trading brand-new securities). When a company sells stock to the public for the first time, for instance, the investment banker who handles the deal, called the underwriter, collects a fee. • Trading income: Investment banks usually handle other people’s money. But many investment banking operations also include a trading division. This unit attempts to take advantage of temporarily mispriced financial instruments. This high-risk proprietary trading is designed to generate profits for the firm. • Asset management fees: Some investment banks help their clients make decisions on how to invest their money. Investment banks generate asset management fees when they help clients decide which securities they should buy or sell. • Advisory fees: Companies often look to their investment banks for advice, especially in the cases of M&A deals. And in these cases, the investment bankers are brought in to provide in-depth, numerical analysis of a proposed deal. The companies pay substantial fees for this high-level assistance 13.7 THE CONCEPT OF MERGERS AND ACQUISITIONS 13.7.1 Introduction This section introduces the concept of mergers and acquisitions. The section assumes no prior knowledge of the subject. It should be appreciated at the outset that mergers and acquisitions are affected by a number of influences that are very much specific to the individual country where they take place. Typical regional factors with a direct impact on mergers and acquisitions include: 314 CU IDOL SELF LEARNING MATERIAL (SLM)

• Company law. • Employment law. • Community law. • Regulations and regulatory powers. • Community codes of practice and standards. • Custom and embedded practices. • Protectionism. For example, in most European countries and the US there are government controls on mergers and acquisitions where the combination of two or more companies can have an impact on the overall level of competition within a particular market. This applies particularly where the merger or acquisition would give the new company the ability to alter or fix prices in a particular sector. In the UK the Competition Commission considers proposed mergers between large companies in the same sector to determine whether there is any possibility of such price control being an outcome. Several large, proposed mergers have been blocked on these grounds in the UK over the past few years. Employment law can be a major consideration in some EU countries. There are significant differences in the level of employee rights in the various member states. Germany, for example, has much more stringent employment law than the UK. A UK company wishing to merge with a German company may find itself dealing with powerful, legally protected employee ‘commissions or representative groups. In some cases, such groups can influence government bodies and can make the difference between the proposed merger being accepted or being blocked. In considering mergers and acquisitions it is not possible to allow for the multitude of different restrictions and laws that apply in the numerous different countries where such actions take place. This text attempts to develop a generic overview of mergers and acquisitions. The main areas and sections covered are intended to provide a general overview of what is involved and how the process works. The individual regulatory and legal details are generally omitted 13.7.2 Mergers and Acquisitions A merger or an acquisition in a company sense can be defined as the combination of two or more companies into one new company or corporation. The main difference between a merger and an acquisition lies in the way in which the combination of the two companies is brought about. In a merger there is usually a process of negotiation involved between the two companies prior to the combination taking place. For example, assume that Companies A and B are existing financial institutions. Company A is a high street bank with a large commercial customer base. Company B is a building society or similar organisation specialising in providing home loans for the domestic 315 CU IDOL SELF LEARNING MATERIAL (SLM)

market. Both companies may consider that a merger would produce benefits as it would make the commercial and domestic customer bases available to the combined company. There will obviously be some complications and difficulties involved but there are also some obvious potential synergies available. For example, company B might be able to use its home loans experience to offer better deals to potential and existing mortgage customers of company A. The two companies may decide to initiate merger negotiations. If these are favourable, the outcome would be a merger of the two companies to form a new larger whole. In an acquisition the negotiation process does not necessarily take place. In an acquisition company A buys company B. Company B becomes wholly owned by company A. Company B might be totally absorbed and cease to exist as a separate entity, or company A might retain company B in its pre-acquired form. This limited absorption is often practised where it is the intention of company A to sell off company B at a profit at some later date. In acquisitions the dominant company is usually referred to as the acquirer and the lesser company is known as the acquired. The lesser company is often referred to as the target up to the point where it becomes acquired. In most cases the acquirer acquires the target by buying its shares. The acquirer buys shares from the target’s shareholders up to a point where it becomes the owner. Achieving ownership may require purchase of all of the target shares or a majority of them. Different countries have different laws and regulations on what defines target ownership. Acquisitions can be friendly or hostile. In the case of a friendly acquisition the target is willing to be acquired. The target may view the acquisition as an opportunity to develop into new areas and use the resources offered by the acquirer. This happens particularly in the case of small successful companies that wish to develop and expand but are held back by a lack of capital. The smaller company may actively seek out a larger partner willing to provide the necessary investment. In this scenario the acquisition is sometimes referred to as a friendly or agreed acquisition. Alternatively, the acquisition may be hostile. In this case the target is opposed to the acquisition. Hostile acquisitions are sometimes referred to as hostile takeovers. One tactic for avoiding a hostile takeover is for the target to seek another company with which it would rather merge or be acquired by. This third company, if it agrees, is sometimes referred to as a white knight, as it ‘comes to the rescue’ of the threatened target. In hostile takeovers the acquirer may attempt to buy large amounts of the target’s shares on the open market. The problem with this action is that the target’s share price will tend to increase in value as soon as any large-scale purchases are detected. In order to minimise share price rises, the acquirer may attempt to buy as much stock as possible in the shortest possible time, preferably as soon as the markets open. This practice 316 CU IDOL SELF LEARNING MATERIAL (SLM)

is sometimes referred to as a dawn raid, as it attempts to take the market (insofar as is possible) ‘by surprise’. In both friendly and hostile takeovers the decision on whether or not to sell shares in the target lies with the shareholders. If all or a large proportion of target shareholders agree to sell their shares, ownership will be transferred to the acquirer. Shareholders generally will agree to a merger if they are recommended to do so by the board of directors and if they stand to make a profit on the deal. The acquirer may offer either cash or its own shares in exchange for target shares. Cash transactions offer shareholders an immediate potential profit, whereas shares offer a longer-term investment. Share transactions tend to be more attractive to shareholders in a buoyant market as the value of the shares is likely to increase more rapidly than in a stagnant market. 13.8 WHY COMPANIES MERGE AND ACQUIRE 13.8.1 Introduction There are numerous reasons why one company chooses to merge with or acquire another. The literature suggests that the underlying motivation to merge is driven by a series of rationales and drivers. Rationales consist of the higher-level reasoning that represents decision conditions under which a decision to merge could be made. Drivers are mid-level specific (often operational) influences that contribute towards the justification or otherwise for a merger. As an example, company A might decide to acquire company B. The underlying rationale could be that of strategy implementation. In order to achieve one or more strategic objectives it may be necessary for company A to acquire company B because, at present, there is over-capacity in the sector in which company A and company B operate. This is an example of a strategic rationale. The underlying driver for acquiring company B is the desire to control capacity in that sector. An understanding of the various rationales and drivers behind mergers and acquisitions is very important in developing command of this text. 13.8.2 Some Underlying Rationales There are several primary rationales that determine the nature of a proposed merger or acquisition. These rationales are: • Strategic rationale. The strategic rationale makes use of the merger or acquisition in achieving a set of strategic objectives. As discussed above, a merger to secure control of capacity in the chosen sector is an example. Mergers and acquisitions are usually not central in the achievement of strategic objectives, and there are usually other alternatives available. For example, company A might want to gain a foothold in a lucrative new expanding market but lacks any experience or expertise in the area. One way of overcoming this may be to acquire a company that already 317 CU IDOL SELF LEARNING MATERIAL (SLM)

has a track record of success in the new market. The alternative might be to develop a research and development division in the new market products in an attempt to catch up and overtake the more established players. This alternative choice has obvious cost and time implications. In the past it has only really been achieved successfully where the company wishing to enter the new market already produces goods or has expertise in a related area. As an example, an established producer of electronic goods might elect to divert some of its own resources into developing a new related highly promising area such as digital telephones. A large scale example is the electronics giant Sony in taking the strategic decision to create a research and development facility in electronics games consoles in order to develop a viable competitive base in this area despite there being a relatively small number of very powerful and established competitors in the area. The strategic rationale may also be fundamentally defensive. If there are several large mergers in a particular sector, a non-merged company may be pressured into merging with another non-merged company in order to maintain its competitive position. This strategic scenario tends to happen in sectors dominated by relatively large players. In the UK, all of the major high street banks were engaged in merger activity between 1995 and 2002. In the global oil production sector, all of the major oil producers were involved in merger activity in the same period. In some cases three or more major producers merged into super companies. In both industries the merger wave was driven by a need to respond to the merger activities of competitors. • Speculative rationale. The speculative rationale arises where the acquirer views the acquired company as a commodity. The acquired company may be a player in a new and developing field. The acquiring company might want to share in the potential profitability of this field without committing itself to a major strategic realignment. One way to achieve this is to buy established companies, develop them, and then sell them for a substantial profit at a later date. This approach is clearly high risk, even if the targets are analysed and selected very carefully. A major risk, particularly in the case of small and highly specialised targets, is that a significant proportion of the highly skilled people who work for the target may leave either before, during or immediately after the merger or acquisition. If this does happen the actual (rather than apparent) value of the target could diminish significantly within a very short time. Another form of speculative rationale is where the acquirer purchases an organisation with the intention of splitting the acquired organisation into pieces and selling these, or major parts of them, for a price higher than the cost of acquisition. The speculative rationale is also high risk in that it is very vulnerable to changes in the environment. Apparently attractive 318 CU IDOL SELF LEARNING MATERIAL (SLM)

targets, purchased at inflated (premium) cost, may soon diminish significantly in value if market conditions change. • Management failure rationale. Mergers or acquisitions can sometimes be forced on a company because of management failures. Strategies may be assembled with errors in alignment, or market conditions may change significantly during the implementation timescale. The result may be that the original strategy becomes misaligned. It is no longer appropriate in taking the company where it wants to go because the company now wants to go somewhere else. Such strategy compromises can arise from a number of sources including changing customer demand and the actions of competitors. In such cases, by the time the strategy variance has been detected, the company may be so far off the new desired strategic track that it is not possible to correct it other than by merging with or acquiring another company that will assist in correcting the variance. • Financial necessity rationale. Mergers and acquisitions are sometimes required for reasons of financial necessity. A company could misalign its strategy and suddenly find that it is losing value because shareholders have lost confidence. In some cases the only way to address this problem is to merge with a more successful company or to acquire smaller more successful companies. • Political rationale. The impact of political influences is becoming increasingly significant in mergers and acquisitions. In the UK between 1997 and 2002, the government instructed the merger of a number of large government departments in order to rationalise their operations and reduce operating costs. Government policy also encouraged some large public sector organisations to consider and execute mergers. These policies resulted in the merger of several large health trusts (hospitals financed by central government but under their own management control). By 2002 several large universities were also considering merging as a result of changes in government funding policy. In Australia, some of the ‘big four’ banks embarked on an aggressive overseas acquisitions policy because legislation in Australia directly prevented them from merging with each other. 13.8.3 Merger Drivers Some typical merger drivers are considered below. • A requirement for specialist skills and/or resources. A company sometimes seeks to merge with or acquire another company because the company is keen to acquire a specific skill or resource owned by the other company. This type of merger or acquisition often occurs where a smaller company has developed high value specific skills over a number of years and where it would take an acquiring company a long time and a great deal of investment to develop these same skills. 319 CU IDOL SELF LEARNING MATERIAL (SLM)

• National and international stock markets. Variations in share prices can act as powerful drivers for mergers and acquisitions. A stock market boom tends to make acquisition activity more attractive because it becomes easier to use the acquirer’s shares as the basis for the transaction rather than cash. Alternatively a falling stock market can lead to potential targets being valued lower, and therefore they become more attractive for a cash purchase. • Globalisation drivers. Increasing globalisation, facilitated to a considerable extent by the growth and development of IT, tends to encourage mergers as the geographical separation between individual companies becomes less of an obstacle to organisations working together as single entities, both within the same countries and across international boundaries. In the UK several large high street banks have been successfully acquired by a major Australian bank • National and international consolidation. This type of driver occurs where there are compatible companies available for merger or acquisition within the same general geographical area(s). • Diversification drivers. A company may want to diversify into new areas or sectors as a means of balancing the risk profile of its portfolio. Diversification was a primary driver of many mergers and acquisitions in the 1960s, 1970s and 1980s. More recently there has been a discernible move away from diversification as a risk-management strategy. Numerous researchers and practitioners have argued that diversification and non-related acquisition does not in fact reduce the risk profile faced by an organisation. This argument is supported by the assertion that the more diversified an organisation is, the less it has developed the specific tools and techniques needed to address individual problems relating to any one of its range of business activities. • Industry and sector pressures. In the 1990s, mergers became very commonplace in some sectors. Large-scale mergers were particularly important in the oil exploration and production sector. For example, BP and Amoco merged in 1998 and Exxon Mobil and Total Petrofina merged in 1999. • Capacity reduction. The total production in a given sector may exceed or be near to demand so that the value of the product is low. In some cases it may be desirable for a company to merge with or acquire a competitor in order to secure a greater degree of control over total sector output. If company A acquires company B, company A has achieved greater control over total sector production and also has the opportunity to maintain more of its own production facilities and employees within the new company at the expense of company B. 320 CU IDOL SELF LEARNING MATERIAL (SLM)

• Vertical integration. A company may attempt to integrate vertically with (for example) a supplier of a key supply in order to reduce the risk profile associated with that supplier, and therefore ensure continuity of supply. • A drive for increased management effectiveness and efficiency. A particular company may have a deficit in management expertise in one or more key areas. Such areas may be ‘key’ because they are central to a new growth area the company is seeking to develop, or because they relate to the achievement of new strategic objectives that have just been established. • A drive to acquire a new market or customer base. A merger or acquisition can often provide a fast-track route to new and established markets. If a large high street bank merges with another bank, each bank acquires the customer base of the other bank. In some cases the acquired customer base may represent a market that was previously unavailable For example one bank may have previously specialised in business customers and the other bank in domestic customers. The new arrangement provides a more balanced customer base. • A drive to buy into a growth sector or market. Companies sometimes use mergers or acquisitions as a way to enter a desirable new market or sector, particularly if they expect that market or sector to expand in the future. 13.9 INTEGRATION AND CONGLOMERATION 13.9.1 Introduction The various merger waves that have taken place since the 1890s have generated three basic types of merger. In the literature these are referred to as follows: • Vertical integration. • Horizontal integration. • Conglomeration. Vertical integration is characterised by forward or backward integration along the supply chain. Horizontal integration is characterised by the practice of one company acquiring another company that is active in the same general areas or sectors. Conglomeration is characterised by the acquisition of unrelated companies that continue to produce in unrelated sectors. This section briefly introduces these three basic types of merger. 13.9.2 Vertical Integration Mergers and acquisitions are often used in the pursuit of vertical integration. In its simplest form, vertical integration is the process of manufacturers merging with suppliers or retailers. Major production companies obtain supplies of goods and raw materials from 321 CU IDOL SELF LEARNING MATERIAL (SLM)

a range of different suppliers. Vertical integration is basically an attempt to reduce the risk associated with suppliers. Note that vertical integration can run in both directions, as shown in below Figure. Forward integration refers to vertical integration that runs towards the customer base, whereas backward integration refers to vertical integration that runs towards the supplier base. Vertical integration offers a number of obvious advantages. Some of these advantages are listed below. • Combined processes. The production processes of most organisations carry fixed price overheads. Typical examples include human resources and IT support. Where integration allows these overhead functions to become combined, there is, theoretically, the prospect of increased support function efficiency. • Reduced risk and/or enhanced risk management. Vertical integration allows some of the risk associated with suppliers to be removed. Obvious examples are sudden supply price increased and late and/or defective deliveries. In many ways, the control of supply products and raw materials passes to the acquirer • Configuration management. The concept of configuration management is covered in the EBS text Project Management. Configuration management is primarily concerned with the efficient and effective flow of information both within and outside an organisation. Information is generally much more easily and effectively controlled within an organisation and vertical integration, therefore, acts to enhance the configuration management system operated by a given organisation. • Quality management. This is an increasingly important consideration for most organisations. A fully integrated production system provides the opportunities for an enterprise wide quality management system covering everything from raw 322 CU IDOL SELF LEARNING MATERIAL (SLM)

materials, through production to sales. As with risk management, quality management is more easily executed where supplies, production and sales are contained in-house rather than externally. • Reduced negotiation. As suppliers are acquired the necessity for complex and competitive negotiations decreases. The acquiring company is no longer required to negotiate the best deals with suppliers as the suppliers become part of the parent organisation. The obvious downside is that the acquired suppliers may lose their competitive edge as they now have a guaranteed market and no longer need to compete at the same level. • Proprietary and intellectual property protection. This can be an important consideration in sectors that are characterised by rapid change and innovation. Organisations that operate under these circumstances have to give away a certain degree of their organisational knowledge when specifying exactly what they want suppliers to produce. In some cases, such specifications can be very revealing, and an uncontained supplier could release proprietary and intellectual property to a third party. • Individualisation. Complete control of suppliers and customers can lead to a particular classification of trading known as brand. In order to achieve and maintain brand status, organisations have to achieve and maintain a close degree of control over all aspects of production and sales so that quality and image can be maintained. The evolution of a brand allows organisations to charge a premium rate for their products. Vertical integration also implies some disadvantages. By acquiring suppliers the acquirer also eliminates the direct competition that existed previously in the supply market. This can be addressed to some extent by partial vertical integration, where selected key suppliers are integrated while remaining non-key suppliers remain outsourced and open to competitive pricing. There are also brand implications in vertical integration. Some companies have successfully integrated along all sections of the production and distribution process. In fast food, for example, a company might integrate all outlets and then award outlets operation to selected and approved subcontractors through a system of controlled franchises. This practice protects the brand from the point of manufacture through distribution and right up to the point of sale to the consumer. Vertical integration is sometimes extended beyond suppliers to include customers as well. Examples of this are particularly pronounced in the interaction between the entertainment and fast food industries. It is common practice for manufacturers of fast foods and drinks to integrate with outlets such as cinemas and fast food restaurants so that only their particular brand of food or drink is offered for sale in that outlet. This practice, if 323 CU IDOL SELF LEARNING MATERIAL (SLM)

successful, more or less guarantees a steady and dependable outlet for the food or drink product concerned. 13.9.3 Horizontal Integration Mergers and acquisitions can also be used in order to achieve horizontal integration. Horizontal integration occurs where two companies engaged in essentially the same product or service merge to improve their combined value. As discussed above, horizontal integration has been widespread in the global oil production sector over the past few years. Another example is where automobile distribution companies buy other companies with distribution franchises for ranges of vehicles from other manufacturers. 13.9.4 Conglomeration Conglomeration mergers occur where the merging companies continue to operate in different sectors and industries. Conglomeration can be a useful approach in spreading business risk across a range of different areas. As conglomerates grow and expand, however, they run the risk of becoming unfocused as their senior management team may be unfamiliar with the new products, services and markets that are introduced as unrelated companies are acquired. In effect, the risks increase rather than decrease. 13.10 THE MERGER AND ACQUISITION LIFECYCLE 13.10.1 Introduction Most mergers and acquisitions progress through a clearly identifiable lifecycle. In this context, the word ‘lifecycle’ is taken to refer to the changes that take place during the life of an entity. In this context the word ‘entity’ means something that exists in its own right, and has its own existence. A merger can be regarded as consisting of two or more entities progressing through a series of identifiable changes or lifecycle points until the merger is complete. More correctly, most mergers and acquisitions do not have a clearly defined completion point. Most organisations, however, do establish a point at which the merger or acquisition is regarded as being complete. After this point the process usually receives no separate resources or funding. Any longer-term costs are simply absorbed into the overall operational expenses of the organisation. 324 CU IDOL SELF LEARNING MATERIAL (SLM)

13.10.2 Typical Lifecycle Phases Most mergers commence with an inception phase. In this phase the senior managers of an organisation initiate the process. Inception is usually followed by a feasibility stage where the underlying financial and logistic areas are considered. The merger may be initiated to improve financial performance or for numerous other reasons .Most feasibility phases include a detailed analysis of the financial characteristics of the proposed merger together with considerations of likely timescales, synergy generation and other variables. At some point during, or on completion of, the feasibility phase a firm commitment is made to proceed. At this point the organisation commits itself to the merger and allocates funding and resources as necessary. The pre-merger negotiation phase usually starts right after the commitment to proceed. In this phase the senior managers of the two organisations enter into negotiations in order to reach agreement on the structure and format of the new combined organisation. The negotiation phase often involves external professional consultants such as specialist contract lawyers. In many cases (especially in the US) specialist merger project management consultants are used as negotiation drivers and facilitators. Once the negotiations are complete, the deal itself takes the form of a detailed merger contract. The contract sets out the rights and obligations of each party (organisation) under the terms of the deal. Merger contracts can be extremely complex and are usually developed and finalised by specialist external consultants working with in- house specialists. The implementation process starts as soon as the contract is in place. Implementation includes the mechanics of actually making the merger happen. In the UK, implementation is often carried out by in-house project teams, whereas in the US there are growing numbers of external project management implementation consultants who offer integrated services that take implementation through from inception to completion. There is usually some point at which implementation is designated as being complete, at least from an independent project point of view. This point is usually followed by a longer-term phase in which the new organisation acclimatises to the new organisational structure. This phase is usually referred to as commissioning. In some cases the commissioning phase can 325 CU IDOL SELF LEARNING MATERIAL (SLM)

continue for several years. In reality, merger lifecycles can be considered in much more complex terms. In practice, in order to have sufficient control and response it is usually necessary to subdivide each lifecycle phase into relatively small components. For example, premerger negotiations might be considered in terms of several different sub- phases, each of which may be separated by control gateways. Each phase of negotiation may have to be concluded and agreed before the negotiation process can move through that gateway and on to the next phase. It is common practice to establish precise performance achievements before each gateway can be passed. It is also common for merger implementation managers to establish detailed reviews and associated reporting procedures for each phase. These procedures can be very useful in ensuring that the entire merger remains focused and on track. The above Figure shows the various specialists that are involved in each stage of the lifecycle. The early stages tend to be dominated by the strategic planners (or equivalent), who are responsible for initiating the merger and for making a strategic evaluation of the decision. Once the decision to merge is made and the commitment to proceed is given, the involvement of the strategic planners diminishes, to be replaced by an increased input from the implementation team and the various specialist consultants who may be involved. The external consultants are usually primarily involved in setting up the contracts and the remaining aspects of the deal. Their involvement diminishes when the deal is signed although they often have a long-term lesser involvement. The post-deal work is largely dominated by the integration team. These variations in responsibility involvement are summarised in below Figure. Where possible the integration team should be involved at the earliest possible time. In general terms, the greater the involvement the implementation people have in planning the 326 CU IDOL SELF LEARNING MATERIAL (SLM)

merger, the greater the impact they can have on the development of the plans and the more easily they can actually implement the plans after the deal is signed. The integration team consists largely of operational people. Their early involvement is likely to provide a clearer view of the work required to implement the merger. This clarity contributes significantly to understanding the timescales and magnitude of cost involved, and will in turn lead to more accurate estimates of the true value of the net benefits to be derived. It also militates against over-optimism on the part of the strategic planners and financial advisors. There is a risk involved in this approach in that there is always a possibility that the early negotiations may be unsuccessful and the deal could fall through. If this does happen, the work that the implementation team have put into the early merger planning may be abortive. There is generally a balance or trade-off between reducing merger risks and unknowns by involving the integration team early and accepting the risk of potentially high, abortive implementation planning costs. 13.11 MEASURING THE SUCCESS OF MERGERS AND ACQUISITIONS 13.11.1 Introduction There are numerous ways in which the relative success or failure of a merger can be defined. Success may be defined in terms of short-term measures of performance, such as an improvement in turnover during the year immediately after the merger. Alternatively, success can be considered in terms of long-term measures of performance such as a sustained increase in average share value during the 10 years after the merger. In many cases success is measured in terms of a combination of short and long-term performance. 13.11.2 Short-term Measures of Success There are several well-documented short-term effects of a merger announcement. In most cases, when the announcement is made the value of the target company shares will increase while the value of the acquiring company shares will remain static or fall. In many cases the prices of the target company shares will increase prior to the announcement because of pre-announcement rumours. The tendency for the target share price to rise has important implications for the short-term financial success of the acquisition. In many cases the typical share price behaviour discussed can result in the acquirer paying an inflated price for the target. The difference between the pre-rumour value and the merger bid value represents the inflationary premium. As a result, acquired companies are often overvalued at the time of acquisition, particularly where more than one bidder exists. Shareholders may therefore have two different views of success in the context of an acquisition. Target shareholders who sell shares to the acquirer at the premium rate make more money than they otherwise would have done in selling the shares. For target shareholders who sell, the short-term view of the acquisition may be one 327 CU IDOL SELF LEARNING MATERIAL (SLM)

of success. Shareholders who remain with the target and continue to hold shares of the merged company may have a different long-term view. 13.11.3 Long-term Measures of Success The longer-term view tends to be more complex and less clearly defined. The literature suggests that long-term performance can depend on a wide range of variables. In straightforward financial terms the long-term success of the merger appears to depend on two main areas: • Payment method; • Implementation. The merger deal itself is generally financed either by a cash deal, or by a share deal, or by a combination of the two. In a cash deal, existing shareholders sell their shares for a cash sum. In a share deal, existing shareholders receive new shares for their existing ones. In some cases the deal may use a combination of both in what is sometimes referred to as a combined deal. Generally, in a buoyant economy more deals will be done through shares as the value of these shares is likely to increase over time. However, companies paying in shares are more likely to have overvalued shares, particularly in the period immediately before the deal. After the deal, the true value of the stock becomes apparent and the value generally falls. As an alternative, companies paying in cash tend to have higher debt levels and undervalued stock. There is evidence to suggest that, in the long term, mergers paid for in shares will perform less well from a shareholder’s point of view than those paid for in cash so long as the economy remains depressed. In a buoyant economy better long-term performance can be expected from companies that have paid for the deal in shares. The other major long-term problem indicated by the literature is ineffective implementation. Numerous mergers continue the implementation process for much longer than was originally intended. In addition it is common to find that the original implementation plans are changed during the integration process as it becomes apparent that the implementation plans were not sufficiently well thought through, or that the problems associated with full integration were not fully appreciated during the planning stages. Merger implementation and integration are considered in more detail in the final four modules of this course. 13.11.4 Some Scenarios for Failure It should be clear that it can be very difficult to say clearly whether a merger or acquisition has been successful, either in the short term or in the long term. The degree of success involved depends on the point of view of the observer, the timescale being considered and determinants of success being used for evaluation. The literature contains many examples of studies carried out on merger success and failure. Some of the literature is contradictory, while other areas of the literature lack clear outcomes and conclusions. There are, however, key issues frequently quoted in the literature upon which there is 328 CU IDOL SELF LEARNING MATERIAL (SLM)

more or less common agreement. The primary reasons for a relatively unsuccessful outcome appear to be those listed below. • An inability to agree terms. In some cases, the proposed merger may never even be implemented because the senior managers in the two companies are unable to agree terms for the merger. In such cases the merger has to be classified as a failure because of the cost involved and time wasted. There have been several examples in the UK between 1995 and 2002 of potentially very large mergers that failed to materialise because the senior managers could not agree on the management and organisational structures of the proposed new organisation. An example of such a failure was the proposed UK merger between Abbey National and Bank of Scotland. • Overestimation of the true value of the target. Acquirers often pay more for the target than it is actually worth. In the short term this could result from premerger target share price rises as discussed earlier. In the longer term the problem could result from an inaccurate assessment of the value of the target, either through poor valuation and due diligence or because the sector within which the company operates is subject to potential large-scale changes. Over-optimistic assessments, particularly where there is more than one bidder, are also common. • The target being too large relative to the acquirer. The literature suggests that the difficulties associated with a merger or acquisition increase as a function of the relative size of the target. This tends to happen because the target becomes more and more difficult to absorb as it becomes relatively larger. A target equal in size to the acquirer can only be effectively absorbed in a merger of equals. • A failure to realise all identified potential synergies. The underlying rationale behind mergers and acquisitions is often influenced by the potential to generate and exploit synergies. These potential synergies may seem achievable during the planning stage, but actually realising and exploiting them can be significantly more difficult than anticipated. • External change. Mergers and acquisition logic is sometimes superseded by events. Even the best strategic planners can occasionally fail to see sudden and large scale changes in the external market. Where such changes do occur, the whole rationale behind the merger or acquisition can quickly dissipate, sometimes with disastrous results. Examples include companies that acquired dot.com targets just before the relative global collapse in this sector in the late 1990s. • An inability to implement change. A large-scale merger or acquisition generates a considerable amount of change. In a merger of equals all sections of each organisation may be subjected to change of varying degrees. Some companies are 329 CU IDOL SELF LEARNING MATERIAL (SLM)

better than others at designing and implementing change. In some cases there may be a basic inability to plan and manage change effectively. In other cases there may be a deep-rooted cultural opposition to change. • Shortcomings in the implementation and integration processes. Poor implementation frequently shows up in the literature as a primary scenario for failure. The most common reason for poor implementation is inadequate planning and control. In mergers and acquisitions generally, the most common specific cause of poor implementation is the lack of an implementation driver. Most implementation processes appear to be carried out without an overriding driving force behind them. The result is that they take longer than originally expected, and the opportunity for generating and exploiting synergies may be lost as a result. • A failure to achieve technological fit. Technological fit and the failure to achieve it are very common problem areas in mergers and acquisitions. Companies tend to develop their own technologies and technological approaches to production over a number of years, and each system tends to be highly individualistic. It can be extremely difficult to merge two entirely different technological systems. In some cases the costs of doing so fully would be prohibitively expensive. • Conflicting cultures. The incompatibility of corporate cultures is another classical scenario for failure. Cultures, like technologies, tend to evolve over a long period of time and are highly individualistic. It is very common to observe the formation of conflict when two corporate cultures are thrown together with inadequate preparation. • A weak central core in the target. Targets may be unfocused or there may be problems with the central or core elements in the company. In such cases the acquisition may turn out to be less valuable than was originally thought. Typical examples were the acquisitions of the apparent high-growth dot.com companies of the late 1990s. 13.12 SUMMARY • Investment banking is basically a process of channelling cash from investors looking for returns into the hands of entrepreneurs and business builders who are long on ideas, but short on bucks. • Investment bankers raise money from investors, by selling securities, and then transfer that money to people who need cash to start businesses, build buildings, run cities, or bring other costly projects to reality. 330 CU IDOL SELF LEARNING MATERIAL (SLM)

• The services offered by investment banks typically fall into one of a few categories like Capital raising; Financial advisory; Corporate lending; Sales and trading; Brokerage services & Research: Investments. • The primary forms of financial instruments sold by investment banks include Equity ; Debt capital & Hybrid securities: • All major investment banks divide their operations into several key areas, including the front office, middle office, and back office. • Investment bankers perform services for customers and collect money in a number of ways which include Commissions ; Underwriting fees ; Trading income ; Asset management fees & Advisory fees: • Mergers and acquisitions are affected by a number of influences that are very much specific to the individual country where they take place. Typical regional factors with a direct impact on mergers and acquisitions include Company law; Employment law; Community law; Regulations and regulatory powers; Community codes of practice and standards; Custom and embedded practices &Protectionism • A merger or an acquisition in a company sense can be defined as the combination of two or more companies into one new company or corporation • The main difference between a merger and an acquisition lies in the way in which the combination of the two companies is brought about. In a merger there is usually a process of negotiation involved between the two companies prior to the combination taking place. • In acquisitions the dominant company is usually referred to as the acquirer and the lesser company is known as the acquired. The lesser company is often referred to as the target up to the point where it becomes acquired. • There are numerous reasons why one company chooses to merge with or acquire another. The underlying motivation to merge is driven by a series of rationales and drivers. Rationales consist of the higher-level reasoning that represents decision conditions under which a decision to merge could be made. Drivers are mid-level specific (often operational) influences that contribute towards the justification or otherwise for a merger. • Conglomeration mergers occur where the merging companies continue to operate in different sectors and industries. Conglomeration can be a useful approach in spreading business risk across a range of different areas. As conglomerates grow and expand, however, they run the risk of becoming unfocused as their senior management team may be unfamiliar with the new products, services and markets that are introduced as unrelated companies are acquired. In effect, the risks increase rather than decrease. 331 CU IDOL SELF LEARNING MATERIAL (SLM)

13.13 KEYWORDS • M&A- Mergers & Acquisitions • FDIC-Federal Deposit Insurance Corporation • Underwriting • Hybrid Securities 13.14 LEARNING ACTIVITY 1. Based on the knowledge acquired after reviewing this topic, prepare a brief note on the Roles & services provided by an Investment Banking ________________________________________________________________________ ________________________________________________________________________ 13.15 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. What are the various services offered by the investment banks? 2. Differentiate investment banking from traditional banking. 3. Explain the three common parts of the traditional investment bank. 4. How does the investment banker get paid? 5. What is merger and how is it different from acquisition? Long Questions 6. What are the rationale behind mergers and acquisitions? 7. Illustrate with example how globalisation has driven mergers. 8. What are the various types of integration? 9. Explain the M&A life cycle. 10. How can the mergers and acquisitions evaluated? B. Multiple Choice Questions 1. Abbey National and Bank of Scotland merger failed due to a. Over estimation of the true value b. Inability to implement change c. Inability to agree terms d. Conflicting culture 2. Horizontal integration means 332 CU IDOL SELF LEARNING MATERIAL (SLM)

a. Two companies engaged in essentially the same product or service merge to improve their combined value b. Spread business risk across a range of different areas c. Manufacturers merging with suppliers or retailers d. Merging parent company and subsidiary company 3. What are hybrid securities a. Cash b. Securities pledged with banks c. Private equities d. Securities that have the trait of both equity and debt 4. Investment banking refers to a. Financial services b. Credit rating services c. Depository services d. Multilateral credit agencies 5. Credit default swap is a form of a. Reinsurance b. Unregulated insurance policy c. Borrowing from capital market d. Borrowing from equity market Answers 1-c, 2-a, 3-d, 4-a, 5-b 13.16 REFERENCES Textbooks: • Edward Yescombe, Principles of Project Finance, Yecombe Consulting Ltd., Academic Press • Michael Rees, Principles of Financial Modelling: Model Design and Best Practices Using Excel and VBA , The Wiley Finance Series) Reference Books: • Edward Bodmer, Corporate and project finance modelling, Wiley Finance Series 333 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT 14- VALUATION Structure 14.0 Learning Objectives 14.1 What are Credit Ratings 14.2 Why Credit Ratings are Useful 14.3 Who Uses Credit Ratings 14.4 Credit Rating Agencies 14.5 Rating Methodologies 14.5.1 Model Driven Ratings 14.5.2 Analyst Driven Ratings 14.6 How Agencies are Paid for Their Services 14.7 The ABCs of Rating Scale 14.8 Rating Issuers and Issue 14.9 Why Credit Ratings Change 14.10 How we Communicate Credit Ratings 14.11 Summary 14.12 Keywords 14.13 Learning Activity 14.14 Unit End Questions 14.15 References 14.0 LEARNING OBJECTIVES After studying this unit, you will be able to: • Explain the what Credit Ratings are • Relevance of credit rating • What are the various rating methodologies? • How the credit rating agencies get paid for their services 14.1 WHAT ARE CREDIT RATINGS Credit ratings are opinions about credit risk. Standard & Poor’s ratings express the agency’s opinion about the ability and willingness of an issuer, such as a corporation or state or city government, to meet its financial obligations in full and on time. Credit ratings can also speak to the credit quality of an individual debt issue, such as a corporate or municipal bond, and the relative likelihood that the issue may default. Ratings are provided by credit rating agencies which specialize in evaluating credit risk. In addition to international credit rating agencies, such as Standard & Poor’s Ratings Services, there are 334 CU IDOL SELF LEARNING MATERIAL (SLM)

regional and niche rating agencies that tend to specialize in a geographical region or industry. Each agency applies its own methodology in measuring creditworthiness and uses a specific rating scale to publish its ratings opinions. Typically, ratings are expressed as letter grades that range, for example, from ‘AAA’ to ‘D’ to communicate the agency’s opinion of relative level of credit risk. Credit ratings are forward looking As part of its ratings analysis, Standard & Poor’s evaluates available current and historical information and assesses the potential impact of foreseeable future events. For example, in rating a corporation as an issuer of debt, the agency may factor in anticipated ups and downs in the business cycle that may affect the corporation’s creditworthiness. While the forward looking opinions of rating agencies can be of use to investors and market participants who are making long- or short-term investment and business decisions, credit ratings are not a guarantee that an investment will pay out or that it will not default. Credit ratings do not indicate investment merit While investors may use credit ratings in making investment decisions, Standard & Poor’s ratings are not indications of investment merit. In other words, the ratings are not buy, sell, or hold recommendations, or a measure of asset value. Nor are they intended to signal the suitability of an investment. They speak to one aspect of an investment decision—credit quality—and, in some cases, may also address what investors can expect to recover in the event of default. In evaluating an investment, investors should consider, in addition to credit quality, the current make-up of their portfolios, their investment strategy and time horizon, their tolerance for risk, and an estimation of the security’s relative value in comparison to other securities they might choose. By way of analogy, while reputation for dependability may be an important consideration in buying a car, it is not the sole criterion on which drivers normally base their purchase decisions. Credit ratings are not absolute measures of default probability Since there are future events and developments that cannot be foreseen, the assignment of credit ratings is not an exact science. For this reason, Standard & Poor’s ratings opinions are not intended as guarantees of credit quality or as exact measures of the probability that a particular issuer or particular debt issue will default. Instead, ratings express relative opinions about the creditworthiness of an issuer or credit quality of an individual debt issue, from strongest to weakest, within a universe of credit risk. For example, a corporate bond that is rated ‘AA’ is viewed by the rating agency as having a higher credit quality than a corporate bond with a ‘BBB’ rating. But the ‘AA’ rating isn’t a guarantee that it will not default, only that, in the agency’s opinion, it is less likely to default than the ‘BBB’ bond. 335 CU IDOL SELF LEARNING MATERIAL (SLM)

14.2 WHY CREDIT RATINGS ARE USEFUL Credit ratings may play a useful role in enabling corporations and governments to raise money in the capital markets. Instead of taking a loan from a bank, these entities sometimes borrow money directly from investors by issuing bonds or notes. Investors purchase these debt securities, such as municipal bonds, expecting to receive interest plus the return of their principal, either when the bond matures or as periodic payments. Credit ratings may facilitate the process of issuing and purchasing bonds and other debt issues by providing an efficient, widely recognized, and long-standing measure of relative credit risk. Credit ratings are assigned to issuers and debt securities as well as bank loans. Investors and other market participants may use the ratings as a screening device to match the relative credit risk of an issuer or individual debt issue with their own risk tolerance or credit risk guidelines in making investment and business decisions. For instance, in considering the purchase of a municipal bond, an investor may check to see whether the bond’s credit rating is in keeping with the level of credit risk he or she is willing to assume. At the same time, credit ratings may be used by corporations to help them raise money for expansion and/or research and development, as well as help states, cities, and other municipalities to fund public projects Raising capital through rated securities Fig 14.1 14.3 WHO USES CREDIT RATINGS Investors Investors most often use credit ratings to help assess credit risk and to compare different issuers and debt issues when making investment decisions and managing their portfolios. Individual investors, for example, may use credit ratings in evaluating the purchase of a 336 CU IDOL SELF LEARNING MATERIAL (SLM)

municipal or corporate bond from a risk tolerance perspective. Institutional investors, including mutual funds, pension funds, banks, and insurance companies, often use credit ratings to supplement their own credit analysis of specific debt issues. In addition, institutional investors may use credit ratings to establish thresholds for credit risk and investment guidelines. A rating may be used as an indication of credit quality, but investors should consider a variety of factors, including their own analysis. Intermediaries Investment bankers help to facilitate the flow of capital from investors to issuers. They may use credit ratings to benchmark the relative credit risk of different debt issues, as well as to set the initial pricing for individual debt issues they structure and to help determine the interest rate these issues will pay. Investment bankers may look to a rating agency’s criteria when seeking to understand that rating agency’s approach toward rating different debt issues or different tiers of debt. Investment bankers may also serve as arrangers of debt issues. In this capacity, they may establish special purpose entities that package assets, such as retail mortgages and student loans, into securities or structured finance instruments, which they then market to investors. Issuers Issuers, including corporations, financial institutions, national governments, states, cities and municipalities, use credit ratings to provide independent views of their creditworthiness and the credit quality of their debt issues. Issuers may also use credit ratings to help communicate the relative credit quality of debt issues, thereby expanding the universe of investors. In addition, credit ratings may help them anticipate the interest rate to be offered on their new debt issues. As a general rule, the more creditworthy an issuer or an issue is, the lower the interest rate the issuer would typically have to pay to attract investors. The reverse is also true: an issuer with lower creditworthiness will typically pay a higher interest rate to offset the greater credit risk assumed by investors. Businesses and financial institutions Businesses and financial institutions, especially those involved in credit-sensitive transactions, may use credit ratings to assess counterparty risk, which is the potential risk that a party to an agreement may not fulfil its financial obligations. For example, in deciding whether to lend money to a particular organization or in selecting a company that will guarantee the repayment of a debt issue in the event of default, a business may wish to consider the counterparty risk. A credit rating agency’s opinion of counterparty risk can therefore help businesses analyze their credit exposure to financial firms that have agreed to assume certain financial obligations and to evaluate the viability of potential partnerships and other business relationships. 337 CU IDOL SELF LEARNING MATERIAL (SLM)

14.4 CREDIT RATING AGENCIES Some credit rating agencies, including major global agencies like Standard & Poor’s, are publishing and information companies that specialize in analyzing the credit risk of issuers and individual debt issues. They formulate and disseminate ratings opinions that are used by investors and other market participants who may consider credit risk in making their investment and business decisions. In part because rating agencies are not directly involved in capital market transactions, they have come to be viewed by both investors and issuers as impartial, independent providers of opinions on credit risk. 14.5 RATING METHODOLOGIES In forming their opinions of credit risk, rating agencies typically use analysts or mathematical models, or a combination of the two. 14.5.1 Model driven ratings. A small number of credit rating agencies focus almost exclusively on quantitative data, which they incorporate into a mathematical model. For example, an agency using this approach to assess the creditworthiness of a bank or other financial institution might evaluate that entity’s asset quality, funding, and profitability based primarily on data from the institution’s public financial statements and regulatory filings. 14.5.2 Analyst driven ratings. In rating a corporation or municipality, agencies using the analyst driven approach generally assign an analyst, often in conjunction with a team of specialists, to take the lead in evaluating the entity’s creditworthiness. Typically, analysts obtain information from published reports, as well as from interviews and discussions with the issuer’s management. They use that information and apply their analytical judgment to assess the entity’s financial condition, operating performance, policies, and risk management strategies. 338 CU IDOL SELF LEARNING MATERIAL (SLM)

Fig 14.2 14.6 HOW AGENCIES ARE PAID FOR THEIR SERVICES Agencies typically receive payment for their services either from the issuer that requests the rating or from subscribers who receive the published ratings and related credit reports. • Issuer-pay model. Under the issuer-pay model, rating agencies charge issuers a fee for providing a ratings opinion. In conducting their analysis, agencies may obtain information from issuers that might not otherwise be available to the public and factor this information into their ratings opinion. Since the rating agency does not rely solely on subscribers for fees, it can publish current ratings broadly to the public free of charge. • Subscription model. Credit rating agencies that use a subscription model charge investors and other market participants a fee for access to the agency’s ratings. Critics point out that, like the issuer-pay model, this model has the potential for conflicts of interest since the entities paying for the rating, in this case investors, may attempt to influence the ratings opinion. Critics of this model also point out that the ratings are available only to paying subscribers. These tend to be large institutional investors, leaving out smaller investors, including individual investors. In addition, rating agencies using the subscription model may have more limited access to issuers. Information from management can be helpful when providing forward looking ratings. 14.7 THE ABCS OF RATING SCALES Standard & Poor’s credit rating symbols provide a simple, efficient way to communicate creditworthiness and credit quality. Our global rating scale provides a benchmark for evaluating the relative credit risk of issuers and issues worldwide. 339 CU IDOL SELF LEARNING MATERIAL (SLM)

Table 4.1 Investment- and speculative-grade debt: The term “investment-grade” historically referred to bonds and other debt securities that bank regulators and market participants viewed as suitable investments for financial institutions. Now the term is broadly used to describe issuers and issues with relatively high levels of creditworthiness and credit quality. In contrast, the term “non-investment-grade,” or “speculative-grade,” generally refers to debt securities where the issuer currently has the ability to repay but faces significant uncertainties, such as adverse business or financial circumstances that could affect credit risk. In Standard & Poor’s long-term rating scale, issuers and debt issues that receive a rating of ‘BBB-’ or above are generally considered by regulators and market participants to be “investment grade,” while those that receive a rating lower than ‘BBB-’ are generally considered to be “speculative-grade.” 340 CU IDOL SELF LEARNING MATERIAL (SLM)

14.8 RATING ISSUERS AND ISSUES Credit rating agencies assign ratings to issuers, such as corporations and governments, as well as to specific debt issues, such as bonds, notes, and other debt securities. Rating an issuer To assess the creditworthiness of an issuer, Standard & Poor’s evaluates the issuer’s ability and willingness to repay its obligations in accordance with the terms of those obligations. To form its ratings opinions, Standard & Poor’s reviews a broad range of financial and business attributes that may influence the issuer’s prompt repayment. The specific risk factors that are analyzed depend in part on the type of issuer. For example, the credit analysis of a corporate issuer typically considers many financial and non- financial factors, including key performance indicators, economic, regulatory, and geopolitical influences, management and corporate governance attributes, and competitive position. In rating a sovereign or national government, the analysis may concentrate on fiscal and economic performance, monetary stability and the effectiveness of the government’s institutions. For high-grade credit ratings, Standard & Poor’s considers the anticipated ups and downs of the business cycle, including industry-specific and broad economic factors. The length and effects of business cycles can vary greatly, however, making their impact on credit quality difficult to predict with precision. In the case of higher risk, more volatile speculative-grade ratings, Standard & Poor’s factors in greater vulnerability to down business cycles. Rating an issue In rating an individual debt issue, such as a corporate or municipal bond, Standard & Poor’s typically uses, among other things, information from the issuer and other sources to evaluate the credit quality of the issue and the likelihood of default. In the case of bonds issued by corporations or municipalities, rating agencies typically begin with an evaluation of the creditworthiness of the issuer before assessing the credit quality of a specific debt issue. In analyzing debt issues, for example, Standard & Poor’s analysts evaluate, among other things: • The terms and conditions of the debt security and, if relevant, its legal structure. • The relative seniority of the issue with regard to the issuer’s other debt issues and priority of repayment in the event of default. • The existence of external support or credit enhancements, such as letters of credit, guarantees, insurance, and collateral. These protections can provide a cushion that limits the potential credit risks associated with a particular issue. 341 CU IDOL SELF LEARNING MATERIAL (SLM)

Fig 14.3 Recovery of investment after default Credit rating agencies may also assess recovery, which is the likelihood that investors will recoup the unpaid portion of their principal in the event of default. Some agencies incorporate recovery as a rating factor in evaluating the credit quality of an issue, particularly in the case of non-investment grade debt. Other agencies, such as Standard & Poor’s, issue recovery ratings in addition to rating specific debt issues. Standard & Poor’s may also consider recovery ratings in adjusting the credit rating of a debt issue up or down in relation to the credit rating assigned to the issuer. Rating structured finance instruments A structured finance instrument is a particular type of debt issue created through a process known as securitization. In essence, securitization involves pooling individual financial assets, such as mortgage or auto loans, and creating, or structuring, separate debt securities that are sold to investors to fund the purchase of these assets. The creation of structured finance instruments, such as residential mortgage-backed securities (RMBS), asset-backed securities (ABS), and collateralized debt obligations (CDOs), typically involves three parties: an originator, an arranger, and a special purpose entity, or SPE, that issues the securities. 342 CU IDOL SELF LEARNING MATERIAL (SLM)

Fig 14.4 • The originator is generally a bank, lender, or a financial intermediary who either makes loans to individuals or other borrowers, or purchases the loans from other originators. • The arranger, which may also be the originator, typically an investment bank or other financial services company, securitizes the underlying loans as marketable debt instruments. • The special purpose entity (SPE), generally created by the arranger, finances the purchase of the underlying assets by selling debt instruments to investors. The investors are repaid with the cash flow from the underlying loans or other assets owned by the SPE. Stratifying a pool of undifferentiated risk into multiple classes of bonds with varying levels of seniority is called “trancing”. Investors who purchase the senior tranche, which generally has the highest quality debt from a credit perspective and the lowest interest rate, are the first to be repaid from the cash flow of the underlying assets. Holders of the next- lower tranche, which typically pays a somewhat higher interest rate, are paid second, and so forth. Investors who purchase the lowest tranche generally have the potential to earn the highest interest rate, but they also tend to assume the highest risk. In forming its opinion of a structured finance instrument, Standard & Poor’s evaluates, among other things, the potential risks posed by the instrument’s legal structure and the 343 CU IDOL SELF LEARNING MATERIAL (SLM)

credit quality of the assets the SPE holds. Standard & Poor’s also considers the anticipated cash flow of these underlying assets and any credit enhancements that provide protection against default. Surveillance: Tracking credit quality Agencies typically track developments that might affect the credit risk of an issuer or individual debt issue for which an agency has provided a ratings opinion. In the case of Standard & Poor’s, the goal of this surveillance is to keep the rating current by identifying issues that may result in either an upgrade or a downgrade. In conducting its surveillance, Standard & Poor’s may consider many factors, including, for example, changes in the business climate or credit markets, new technology or competition that may hurt an issuer’s earnings or projected revenues, issuer performance, and regulatory changes. The frequency and extent of surveillance typically depends on specific risk considerations for an individual issuer or issue, or an entire group of rated entities or debt issues. In its surveillance of a corporate issuer’s ratings, for example, Standard & Poor’s may schedule periodic meetings with a company to allow management to: • Apprise agency analysts of any changes in the company’s plans. • Discuss new developments that may affect prior expectations of credit risk. • Identify and evaluate other factors or assumptions that may affect the agency’s opinion of the issuer’s creditworthiness. As a result of its surveillance analysis, an agency may adjust the credit rating of an issuer or issue to signify its view of a higher or lower level of relative credit risk. 14.9 WHY CREDIT RATINGS CHANGE The reasons for ratings adjustments vary, and may be broadly related to overall shifts in the economy or business environment or more narrowly focused on circumstances affecting a specific industry, entity, or individual debt issue. In some cases, changes in the business climate can affect the credit risk of a wide array of issuers and securities. For instance, new competition or technology, beyond what might have been expected and factored into the ratings, may hurt a company’s expected earnings performance, which could lead to one or more rating downgrades over time. Growing or shrinking debt burdens, hefty capital spending requirements, and regulatory changes may also trigger ratings changes. While some risk factors tend to affect all issuers—an example would be growing inflation that affects interest rate levels and the cost of capital—other risk factors may pertain only to a narrow group of issuers and debt issues. For instance, the creditworthiness of a state 344 CU IDOL SELF LEARNING MATERIAL (SLM)

or municipality may be impacted by population shifts or lower incomes of taxpayers, which reduce tax receipts and ability to repay debt. When ratings change Credit rating adjustments may play a role in how the market perceives a particular issuer or individual debt issue. Sometimes, for example, a downgrade by a rating agency may change the market’s perception of the credit risk of a debt security which, combined with other factors, may lead to a change in the price of that security. Market prices continually fluctuate as investors reach their own conclusions about the security’s shifting credit quality and investment merit. While ratings changes may affect investor perception, credit ratings constitute just one of many factors that the marketplace should consider when evaluating debt securities. Agency studies of defaults and ratings changes To measure the performance of its credit ratings, Standard & Poor’s conducts studies to track default rates and transitions, which is how much a rating has changed, up or down, over a certain period of time. Agencies use these studies to refine and evolve their analytic methods in forming their ratings opinions. Transition rates can also be helpful to investors and credit professionals because they show the relative stability and volatility of credit ratings. For example, investors who are obligated to purchase only highly rated securities and are looking for some indication of stability may review the history of rating transitions and defaults as part of their investment research. 14.10 HOW WE COMMUNICATE CREDIT RATINGS Standard & Poor’s makes its credit ratings, criteria, and research available in a number of ways, including: • Press releases • Web sites 14.11 SUMMARY • Credit ratings are opinions about credit risk assessed by an agency, about an issuer like city or state government or corporation regarding the ability &willingness to meet their financial obligations in full and on time. • Credit ratings can also speak to the credit quality of an individual debt issue, such as a corporate or municipal bond, and the relative likelihood that the issue may default. 345 CU IDOL SELF LEARNING MATERIAL (SLM)

• Ratings are provided by credit rating agencies which specialize in evaluating credit risk. In addition to international credit rating agencies, such as Standard & Poor’s Ratings Services, there are regional and niche rating agencies that tend to specialize in a geographical region or industry. • Each agency applies its own methodology in measuring creditworthiness and uses a specific rating scale to publish its ratings opinions. Typically, ratings are expressed as letter grades that range, for example, from ‘AAA’ to ‘D’ to communicate the agency’s opinion of relative level of credit risk. • In rating a corporation as an issuer of debt, the agency may factor in anticipated ups and downs in the business cycle that may affect the corporation’s creditworthiness. While the forward looking opinions of rating agencies can be of use to investors and market participants who are making long- or short-term investment and business decisions, credit ratings are not a guarantee that an investment will pay out or that it will not default. • The Credit ratings are not buy, sell, or hold recommendations, or a measure of asset value. Nor are they intended to signal the suitability of an investment. They speak to one aspect of an investment decision—credit quality—and, in some cases, may also address what investors can expect to recover in the event of default. • The Credit ratings opinions are not intended as guarantees of credit quality or as exact measures of the probability that a particular issuer or particular debt issue will default. Instead, ratings express relative opinions about the creditworthiness of an issuer or credit quality of an individual debt issue, from strongest to weakest, within a universe of credit risk. • Credit ratings may play a useful role in enabling corporations and governments to raise money in the capital markets. Instead of taking a loan from a bank, these entities sometimes borrow money directly from investors by issuing bonds or notes. Investors purchase these debt securities, such as municipal bonds, expecting to receive interest plus the return of their principal, either when the bond matures or as periodic payments. • Credit Ratings are used by Investors ; Intermediaries ; Issuers and Businesses and financial institutions • In forming their opinions of credit risk, rating agencies typically use analysts or mathematical models, or a combination of the two like Model driven ratings & Analyst driven ratings. • Credit Ratings change and may be broadly related to overall shifts in the economy or business environment or more narrowly focused on circumstances affecting a specific industry, entity, or individual debt issue. • Market prices continually fluctuate as investors reach their own conclusions about the security’s shifting credit quality and investment merit. While ratings changes may 346 CU IDOL SELF LEARNING MATERIAL (SLM)

affect investor perception, credit ratings constitute just one of many factors that the marketplace should consider when evaluating debt securities. 14.12 KEYWORDS • S&P- Standard and Poor • SPE- Special Purpose Entity • RMBS-Residential Mortgage-Backed Securities • ABS-Asset Based Securities • CDO-Collateralized Debt Obligation 14.13 LEARNING ACTIVITY 1. Prepare a list of Public sector & Private Sector Banks along with their present Credit Ratings & make a brief note of what you have understood from the Credit Ratings of the above ________________________________________________________________________ ________________________________________________________________________ 14.14 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. What are credit ratings? 2. Why do you think the credit ratings are useful? 3. Which stake holders benefit out of credit ratings? 4. What are the various credit rating methodologies? 5. Write short notes on analyst driven ratings. Long Questions 1. How are the credit rating agencies paid for their servicers? 2. Explain ABCs of rating scale. 3. What is Rating an Issuer? 4. Differentiate rating an issuer and rating an issue. 5. Why credit ratings change? B. Multiple Choice Questions 1. Tranching refers to a. Forming opinion of a structured finance instrument 347 CU IDOL SELF LEARNING MATERIAL (SLM)

b. Stratifying a pool of undifferentiated risk into multiple classes of bonds with varying levels of seniority c. Tracking developments that might affect the credit risk of an issuer d. Appraise agency analysts of any changes in the company’s plans. 2. Investment Grade AA means a. Extremely strong capacity to meet financial commitments b. Very strong capacity to meet financial commitments c. Highest speculative grade by market participants d. Highly vulnerable 3. Speculative Grade BB means a. Extremely strong capacity to meet financial commitments b. Very strong capacity to meet financial commitments c. Highest speculative grade by market participants d. Less vulnerable in the near term 4. Model driven ratings are based on a. Quantitative data b. Qualitative data c. Speculation d. History Answer 1-b, 2-b, 3-d, 4-a 14.15 REFERENCES Textbooks: • Edward Yescombe, Principles of Project Finance, Yecombe Consulting Ltd., Academic Press • Michael Rees, Principles of Financial Modelling: Model Design and Best Practices Using Excel and VBA , The Wiley Finance Series) Reference Books: • Edward Bodmer, Corporate and project finance modelling, Wiley Finance Series 348 CU IDOL SELF LEARNING MATERIAL (SLM)