Demerger is the business strategy wherein company transfers one or more of its business undertakings to another company. In other words, when a company splits off its existing business activities into several components, with the intent to form a new company that operates on its own or sell or dissolve the unit so separated, is called a demerger.
A demerged company is said to be one whose undertakings are transferred to the other company, and the company to which the undertakings are transferred is called the resulting company. The demerger can take place in any of the following forms:
Spin-off: It is the divestiture strategy wherein the company’s division or undertaking is separated as an independent company. Once the undertakings are spun-off, both the parent company and the resulting company act as a separate corporate entities.
Generally, the spin-off strategy is adopted when the company wants to dispose of the non-core assets or feels that the potential of the business unit can be well explored when operating under the independent management structure and possibly attracting more outside investments.
Wipro’s information technology division is the best example of spin-off, which got separated from its parent company long back in 1980’s.
Split-up: A business strategy wherein a company splits-up into one or more independent companies, such that the parent company ceases to exist. Once the company is split into separate entities, the shares of the parent company is exchanged for the shares in the new company and are distributed in the same proportion as held in the original company, depending on the situation.
The company may go for a split-up if the government mandates it, in order to curtail the monopoly practices. Also, if the company has several business lines and the management is not able to control all at the same time, may separate it to focus on the core business activity.
Reverse Merger: A merger wherein a publicly listed company is taken over by a privately held company and provides an opportunity, to the private company to go public, without going through the complex and lengthy process of getting listed on the stock exchange. In this type of amalgamation, the unlisted company acquires majority shares in the listed company. The decision of merger is taken with great planning and analysis considering all the positives and negatives.
The sole aim is to accelerate growth and build a good image in the market. It also enhances company’s profitability through economies of scale, synergy, operating economies, entry to new product lines, etc. Further, it removes financial constraints and also minimizes financial cost. However, there are certain restrictions, like high employee turnover, culture conflicts, etc. which might hit the efficiency and effectiveness.
Reason for Merger
#1. Economies of Scale:
An amalgamated company will have more resources at its command than the individual companies. This will help in increasing the scale of operations and the economies of large scale will be availed. These economies will occur because of more intensive utilisation of production facilities, distribution network, research and development facilities, etc.
These economies will be available in horizontal mergers (companies dealing in same line of products) where scope of more intensive use of resources is greater.
The economies will occur only upto a certain point of operations known as optimal point. It is a point where average costs are minimum. When production increases from this point, the cost per unit will go up.
The optimal point of production is shown with the help of a diagram also:
#2. Operating Economies:
A number of operating economies will be available with the merger of two or more companies. Duplicating facilities in accounting, purchasing, marketing, etc. will be eliminated. Operating inefficiencies of small concerns will be controlled by the superior management emerging from the amalgamation. The amalgamated companies will be in a better position to operate than the amalgamating companies individually.
Synergy refers to the greater combined value of merged firms than the sum of the values of individual units. It is something like one plus one more than two. It results from benefits other than those related to economies of scale. Operating economies are one of the various synergy benefits of merger or consolidation.
The other instances which may result into synergy benefits include, strong R &D facilities of one firm merged with better organised production facilities of another unit, enhanced managerial capabilities, the substantial financial resources of one being combined with profitable investment opportunities of the other, etc.
A company may not grow rapidly through internal expansion. Merger or amalgamation enables satisfactory and balanced growth of a company. It can cross many stages of growth at one time through amalgamation. Growth through merger or amalgamation is also cheaper and less risky.
A number of costs and risks of expansion and taking on new product lines are avoided by the acquisition of a going concern. By acquiring other companies a desired level of growth can be maintained by an enterprise.
Two or more companies operating in different lines can diversify their activities through amalgamation. Since different companies are already dealing in their respective lines there will be less risk in diversification. When a company tries to enter new lines of activities then it may face a number of problems in production, marketing etc.
When some concerns are already operating in different lines, they must have crossed many obstacles and difficulties. Amalgamation will bring together the experiences of different persons in varied activities. So amalgamation will be the best way of diversification.
#6. Utilisation of Tax Shields:
When a company with accumulated losses merges with a profit making company it is able to utilise tax shields. A company having losses will not be able to set off losses against future profits, because it is not a profit earning unit.
On the other hand if it merges with a concern earning profits then the accumulated losses of one unit will be set off against the future profits of the other unit. In this way the merger or amalgamation will enable the concern to avail tax benefits.
#7. Increase in Value:
One of the main reasons of merger or amalgamation is the increase in value of the merged company. The value of the merged company is greater than the sum of the independent values of the merged companies. For example, if X Ld. and Y Ltd. merge and form Z Ltd., the value of Z Ltd. is expected to be greater than the sum of the independent values of X Ltd. and Y Ltd.
#8. Eliminations of Competition:
The merger or amalgamation of two or more companies will eliminate competition among them. The companies will be able to save their advertising expenses thus enabling them to reduce their prices. The consumers will also benefit in the form of cheap or goods being made available to them.
#9. Better Financial Planning:
The merged companies will be able to plan their resources in a better way. The collective finances of merged companies will be more and their utilisation may be better than in the separate concerns. It may happen that one of the merging companies has short gestation period while the other has longer gestation period.
The profits of the company with short gestation period will be utilised to finance the other company. When the company with longer gestation period starts earning profits then it will improve financial position as a whole.
#10. Economic Necessity:
Economic necessity may force the merger of some units. If there are two sick units, government may force their merger to improve their financial position and overall working. A sick unit may be required to merge with a healthy unit to ensure better utilisation of resources, improve returns and better management. Rehabilitation of si.ck units is a social necessity because their closure may result in unemployment etc.