Mergers and Acquisitions represent one of the best business opportunities for any company that intends to expand rapidly as well to increase its market share; it is also one of the most delicate processes that can easily lead to bankruptcy of even the most stable companies that have solid base capital. In the current modern world of cutthroat competition, the need for companies to enter into mergers and acquisitions has become paramount as a necessity for survival. Indeed at times, these are the only options for companies if they have to remain operational, at other times the need to merge or acquire another company is undertaken as a strategic option or as a long-term investment plan (Matt, 2000).
But these are not the only reasons that drive mergers and acquisitions in the business world, the actual reasons tend to vary with the unique setups of the companies involved. Of the two options; merging and acquisitions, the acquisition is the option that offers the best benefits since it involves taking over and controlling another company by way of majority shares or full ownership. In this paper, we are going to critically explore viable financial options for General Electric Company to acquire another company, SABIC Corporation.
Background Information: General Electric Company
General Electric Company is a conglomerate of various affiliated companies based in New York that dates back to 1890. It is ranked as the second-largest company in the world with 323,000 employees working on its various affiliated subsidiaries as of 2010 based on sales volumes, capital assets, and annual revenues (Ge.com, 2010).
Indeed General Electric Company is certainly not your ordinary company but rather sort of an umbrella corporation that owns several other companies in various key sectors. As such it is therefore one of the few companies that have business operations in virtually every major sector of the country’s economy through its more than 40 affiliated business subsidiaries that are located all over the world (Ge.com, 2010).
Since its inception more than 100 years ago the company has expanded its array of business operations in all major sectors such as the power generation industry, media, information technology, real estate, insurance, and chemical manufacturing industry (Ge.com, 2010). Over recent times General electric Company has finalized several high-profile acquisitions and also disposed of some of its non-performing subsidiary companies.
Background Information: SABIC Company
The target company for this case scenario will be Saudi Basic Industries Corporation (SABIC) which is a chemical manufacturing company located in Riyadh. It is one of the top manufacturing companies in Saudi Arabia and the whole of the Middle East with generated revenues that are in the region of $40 billion mark and a workforce comprised of 33,000 personnel directly employed by the company worldwide (Sabic.com, 2010). It was ranked by Fortune Global magazine in 2008 as the topmost chemical manufacturing company in Asia and number four worldwide (Sabic.com, 2010). It has a range of several manufacturing operations that include metals and fertilizers through its various business subsidiaries that are located all over the world.
Currently, SABIC is one of the most respected companies worldwide and a leader in the manufacture of petrochemical products, fertilizers, and steel products. Specific products produced by the company include steel, butene-1, valor, Everton, ethylene, fertilizer, phenol, benzene among many others (Sabic.com, 2010). The most recent annual financial report of 2009 indicates that the company made $7billion net income generated by sales revenue of $103 billion. The current capital assets of SABIC are estimated to be valued at $297 billion (Sabic.com, 2010).
General Electric (GE) Financial Options during Acquisition
When determining the best financial option for any acquisition deal, several factors must be involved but only one key question is necessary to address. This question requires you to determine if the target company is the one that is easier to finance after the acquisition or whether it is the acquiring company, the answer to this question will determine the most appropriate financial option (Smit, 2001).
Ideally, any acquisition deal requires financing through the use of capital assets or equity and debt capital raised from the assets of the target company, sort of a leveraged buyout (Smit, 2001). For each of these methods, several options can be applied to raise the necessary capital; however, there is no right combination that can be used in all types of acquisitions. Due to the unique business environments for each company, the financial options for any acquisitions are always case-specific. In the preceding chapter, we are going to discuss the financial option that General Electric should consider in its acquisition of SABIC Company.
Internal Financing
Internal financing occurs when a company uses its profits to finance a business venture, which in this case will be SABIC acquisition. In the financial year that ended 2009, GE Company made approximately $11 billion in profits, which is far from the required acquisition capital of Sabic Corporation (Ge.com, 2010).
However, there are several other sources of internal financing which include amortization, asset swapping, retained earnings, and building reserves. Amortization is when a company depreciates its assets to reduce its capital value before tax and thereby reduce the overall deductible tax, while asset swaps involve selling a company’s assets to raise capital (Bodie, Merton, and Cleeton, 2008).
When all these options are pursued the amount of capital that can ideally be raised is considerably higher. This option of financing will be most appropriate to GE since it has a large capital base of assets worth $750 billion, a careful review of a few of these assets will ideally raise about half of the required capital through this option alone (Ge.com, 2010). Besides, because of its large capital assets, amortization will lead to significant savings after-tax that can be channeled towards required capital.
The major advantage of internal financing, in this case, will be the immediate availability of funds since there is no procedural paperwork and assessments necessary as is the case when borrowing. In addition, GE will not have to incur costs emanating from interest rates or other applicable costs that are applicable when financing from external sources.
Finally, there is no risk of influence from external parties after the acquisition since all the capital is raised internally. On the other hand, the company would be disadvantaged by losing on the tax break since internal financing does not qualify, as well as loose on immediate capital investment that would have been realized by the diverted finances This is certainly one of the viable options that would be most suitable to GE Company due to it high benefit compared to costs, however, this option alone might not enough to raise the necessary capital to acquire SABIC, which means other financial options must be explored especially so as not to strain the internal cash flow of the company.
Bond Financing
This is a contingency option that would enable the company to spread its risk vulnerability to other areas in case the acquired company turns toxic. It also eases the internal cash flow of the company since the acquisition deal in question requires large capital financing being a form of external financing (Bodie et al, 2008). In bond financing, GE will be required to float bonds, presumably at fixed rates in the market to raise desired funds that would later be paid to the bearers at a later date with interest. It is one of the most ideal options for raising funds for long-term investments since the maturity date of the bonds can be timed to coincide with when the investment is projected to have started bringing earnings, which in this case is SABIC Company.
The issuance of bonds will therefore give GE Company the time to stabilize the newly acquired company as well as to start channeling its incomes to an earmarked portfolio in preparation for the bond payments at the time of their maturity.
Another advantage is that bonds as a financial option do not provide the bearer with the privilege of owning any part of the company as is the case with stocks, for instance, thereby safeguarding the company from external manipulations. It is these features that make it a favorable financial option that should be included in raising the required capital for acquiring SABIC.
However, on the other hand, bond financing can be very risky when the maturity period is not long enough to provide the company with the necessary time to have raised the required initial capital as well as the interest after maturity. In the case of a nonperforming acquisition, this risk is even more disastrous; nevertheless, the trick here would be to issue long-term maturity bonds as long the associated interest is not prohibitive.
Reduced Dividends
Among the options that are available for raising capital finance, this option should be at the top of the list due to its lack of repayment cost and low risk (Hubbard and White, 1995). The only risk that can result from this option is shareholders’ disappointment which can lead to erosion of share value. It is very similar to retained earnings, where scheduled payments are not distributed to the company’s owners; both of these options are internal financing options that are open to any large company such as GE (Hubbard and White, 1995).
The fact that GE Company has billions of shares makes this financial option even more appealing due to its potential ability to raise a significant capital base. In reduced dividend, the company cuts back on the dividend required to be paid per share and channels this amount towards raising the acquisition capital level and is not obliged to make up for this payment in the future.
Since the company is essentially expanding through investments in the new company, shareholders are more often likely to oblige in such situations. This option is most viable where a company has substantial amounts of shares with notable dividend levels. Therefore for GE Company, this would be a viable option given that it has a total share volume of 10.69 billion and a dividend of 0.48 that are worth approximately $5 billion, when consolidated over time these earnings can become more substantial (Ge.com).
Operational Leverage
Operational leverage emanates from a company’s ability to effectively control and manage its investment decisions. Corporate finance is the term that is used to describe the financial tools that are applied to make sound financial decisions by managing the company’s financial risk; its focus is divided into two: short-term and long-term investments (Smit, 2001). Financial analysts normally apply three models during the business valuation process depending on the purpose of the process: Discounted Cash Flow Model (DCF), Relative Value Model, and Option Pricing Model.
Most often a combination of these three models is used to estimate an accurate market price, the Relative Value Model estimates business value through assessment of other similar business values while Discounted Cash Flow estimates business value by calculating projected earnings of the business in question (Pogue, 2010). The Options Pricing model is a complicated mathematical function that applies differential equations to project the company investment earnings (Pogue, 2010).
But to simplify the investment decision that companies are faced with daily, one of the most commonly applied financial principles is Capital budgeting which involves the calculation of each investment opportunity value before commitment based on its size, expected cash flow, and timing (Pogue, 2010). In practice, a company value is determined by the Discounted Cash Flow (DCF) valuation model in combination with the determination of the most appropriate opportunity to undertake the transaction which is shown by the Net Present Value index. The process of DCF analysis is done through four major steps: predicting company revenue growth, forecasting FCF, calculation of discounted rate, and fair value estimation.
Weighted Average Cost of Capital (WACC) is a variable of these models and is essentially used to check the suitability of the various mix of financing options. It is therefore a projected figure that indicates the average commitment that a company must make towards its debtors to meet its financial obligations in the future. An ideal and accurate business valuation process should scrutinize the five indicators of company stability i.e. Income Statement, Balance Sheet, Discounted Cash Flow Valuation, Ratio Analysis, and Weighted Average Cost of Capital (WACC) Calculation. The calculations for these functions can be determined in an actual acquisition deal by using the company’s annual financial data.
Conclusion
Based on the fact that the required capital level for the acquisition of SABIC Company is at least $297 billion, I would limit my financial options to the above sources that I have discussed above. One of the major sources of financial options that I have decided to forego due to its high risk is equity financing, even though it can significantly ease the internal cash flow, this is because the associated risks and cost surpass the benefits. To start with it exposes the company to the risk of external control that might jeopardize the sound management and performance of the company, this might also complicate the future earnings of the company which might be diluted and difficult to consolidate.
In any case, the Pecking Order theory states that any firm must avoid external financing options where internal financing is adequate to meet the required business initiative within a safe margin, it is, therefore, appropriate to opt for debt financing advanced at low interest to avoid equity financing (Smit, 2001). In short, any form of equity financing should be among the last resort for any company that is keen to retain its ownership and management oversight.
Even on other different financial principles, these financing options are the most valid. According to the Market Timing Theory; companies must pursue the cheapest alternative of financing despite its equity, debt, or internal options, all other factors being equal (Smit, 2001). This means that the overriding factor determinant in raising capital should be the cost of repayment and risk level, all the above methods of financing that I have advanced for GE are among the cheapest to repay in the long term since they do not pose the risk of rising interest rates or threat of external company takeover.
References
Bodie, Z. Merton, R & Cleeton, D. (2008). Financial Economics. (2nd ed). Washington, DC: Prentice Hall.
GE. (2010). Imagination at Work. Web.
Hubbard, K. & White, D. (1995). Internal Financing and Investment. Journal of Money, Credit & Banking, 3(2), 75-89.
Matt, E. (2000). Excellence in Financial Management. Washington, DC: MacGraw Hill Higher Education.
Pogue, M. (2010). Corporate Investment Decisions: Principles and Practice. Web.
Sabic. (2010). Welcome to Sabic: About Sabic. Web.
Smit, H. (2001). Acquisition Strategy as Option Games. Journal of Applied Corporate Finance, 14(2), 213-235.