Determination of Swap Ratio in Merger:

Case of Reliance Natural Resources Ltd.

and Reliance Power Ltd. Merger

Ravi Agarwala
Associate Professor of Finance
[email protected]
BIMTECH, India

&

Vignesh R
PGDM 2009-11
[email protected]
BIMTECH, India

Keywords: Merger, Swap ratio, Exchange ratio, DCF, Indian big company

a
Contact author.

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Electronic copy available at: http://ssrn.com/abstract=1651451

Reliance Power Ltd. – Brief Profile
eliance Power Limited (R-Power) is a largest private sector coal mining

R part of the Reliance Anil Dhirubhai

Ambani
comprises of
(ADA) group,
companies in
which
the
company in India once the captive coal
mines become operational.

telecommunications, financial services, The company as such plans to sell the bulk
media and entertainment, infrastructure of the power generated through long
and energy sectors. The energy sector term PPAs with distribution companies and
companies include Reliance Infrastructure through Case I bids. The company has
Ltd, Reliance Natural Resources Limited, also entered into long term contracts with
Reliance Energy Transmission, Reliance industrial consumers to supply power.
Energy Trading and Reliance Power
Limited. The company has won three of the four
Ultra Mega Power Projects (Sasan UMPP,
R-Power is established to develop, Krishnapatnam UMPP & Tilaiya UMPP)
construct and operate power projects awarded by the Govt of India till date. The
domestically and internationally. The UMPP is an initiative by the government to
Company on its own and through collaborate with power generation
subsidiaries has a portfolio of almost companies to set up 4,000 MW projects to
35,000 MW of power generation capacity, ease the country‟s power deficit situation.
both operational as well as under
development.

The company has over 1,000 MW of Market Price* : Rs. 174.31

operational power generation assets. The
projects under development include
No. of Equity shares : 239.68 Cr
seven coal-fired projects to be fueled by
reserves from captive mines and supplies
Debt : Nil

from India and abroad, two gas-fired P/E : 152.9

projects to be fueled primarily by reserves
from the Krishna Godavari Basin (the "KG EPS : 1.14
Basin") off the east coast of India, and
seven hydroelectric projects, six of them in * As on 13th July 2010
Arunachal Pradesh and one in
Uttarakhand. Besides these, R-Power is also considering
the development of coal bed methane
The fuel supply for the majority of the (CBM) power generation projects based
projects has been tied up. Coal linkages from CBM blocks being exposed by its
have been allocated for domestic coal affiliates. The company is also planning to
based projects. register projects with the Clean
Development Mechanism executive
The company has domestic coal reserves board for issuance of CER certificates to
of over 2 billion tonnes in India, the highest augment its revenues.
in the private sector in India. The
company is expected to become the

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Electronic copy available at: http://ssrn.com/abstract=1651451

Reliance Natural Resources Ltd. – Brief Profile
eliance Natural Resources Limited RNRL has been awarded four CBM blocks,

R (RNRL) is a part of the Reliance ADA

group, which comprises
companies in the telecommunications,
of
with an acreage of about 3,251 sq. kms,
for the exploration and production of coal
bed methane (CBM), making it the
financial services, media and second largest CBM player in India in
entertainment, infrastructure and energy terms of acreage.
sectors. Reliance Natural Resources
Limited (RNRL) is engaged in the business The Company has applied for Petroleum
of sourcing, supply and transportation of Exploration License (PEL) for all four blocks
gas, coal and liquid fuels. The company is to the Governments of the concerned
concentrating on building a strong States. The company has received the PEL
foundation for the business of fuel for two blocks (Barmer 4&5) located in
management and has already Rajasthan for which operations have
established itself as a contending player in commenced.
the Indian market.
RNRL has also been awarded an oil and
gas block with acreage of about 3,619 Sq.

Market Price* : Rs. 44.35

Kms. in the state of Mizoram under the
sixth round of the New Exploration
No. of Equity shares : 163.31 Cr
Licensing Policy (NELP–VI) for the
exploration and production of oil and gas.
Debt : 1521.6 Cr The Company has received PEL for this
block and has commenced exploration
P/E : 100.80 activities. RNRL is actively pursuing
business opportunities in the supply
EPS : 0.44 management of coal and natural gas.

* As on 13th July 2010

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Was the merger vision driven or forced?
NRL was formed in June 2005, natural gas was a national property. Post

R following the de-merger of the

Reliance Group, for the supply and
transportation of gas from RIL's oil wells to
the Supreme Court verdict, RNRL has no
locus stand in the case.

ADA group companies, including R-Power

Ltd.
June 2005 – RNRL was formed
RNRL currently possesses acreage of 7,000
sq. kms, comprising four coal bed
Inception till May 2010- Pricing war
methane blocks and one block for over the Gas supply from RIL to
exploration of oil and gas. It had also RNRL
given an application to the Petroleum
and Natural Gas Regulatory Board for
May 7, 2010 – Supreme Court
claims Natural Gas as National
laying a gas pipeline from Kakinada in
property
Andhra Pradesh to Dadri in Uttar Pradesh,
where R-Power plans to develop the May 20, 2010 – Ambani Brothers
largest gas-based power plant in the scraps non- compete agreement
world. RNRL was also planning to set up a
20-million-tonne capacity for cement June, 2010 – RNRL’s existence
using flyash from R-Power‟s coal-based questioned
power plants and enter shipping to
transport coal for R-Power‟s power plants. July 4, 2010 – RNRL – R-POWER
It was also planning to enter distribution of Merger announced
gas to retail consumers in cities, using the
share of gas available from KG D-6.
Pursuant to the Supreme Court's May 7
Since its inception there has been a judgment, both the groups on May 23 had
pricing war over the gas supply from entered into a non-compete agreement
Reliance Industries Limited (RIL) and the to reconcile their four-year-old differences
need for RNRL as a separate entity had a on gas supply.
rationale. RNRL had earlier sought 28
million standard cubic metres of gas per After the signing of the agreement, RNRL
day (mscmd) for 17 years at $2.34 per became almost a shell company with no
million British thermal units (mBtu) from RIL. major activities as it was formed for the
supply and transportation of gas from the
The brothers could not come to a various gas fields of RIL to ADAG
conclusion regarding the pricing of gas companies for power and other projects.
and they sought the help of Supreme Now that the dispute between the
Court. The court struck down its claim, brothers over gas pricing is over and they
saying the government was the owner of may not have the need of a separate
natural gas under article 27.1 of the entity for an intermediary company for
production-sharing contract with RIL on gas supply. This necessitated the need for
May 7, 2010. It also said that RNRL could a merger, a forced one, since the
not be allowed to trade natural gas, as existence of RNRL as a separate entity
was being questioned.

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Arriving at a Swap Ratio
he merger announcement by the determination, of the fairness of the

T board members of both the

companies mandates the
computation of the Share Swap Ratio or
Exchange
Extraordinary
Ratio proposed
General
in
Meeting
Shareholders and board of members
the
of

the Exchange Ratio for one share of RNRL approving the Merger. The paper tries to
or R-Power, as the case may be. identify the appropriate ratio by adopting
a set of 3 different methodologies namely,
The purpose of this Report is to provide the Discounted Cash Flow Analysis (DCF),
share holder, general public, the Conn and Nielson model (1977), and
academicians and students with elements Market price approach.
and points of references that will aid in the

The pro forma figures for the valuation

Growth potential as high as 28.47% for the rate, for the rest of the years. The rationale
three years spanning from 2011 till 2013, behind the growth assumptions include:
and 17.99% for the second stage which
spans for the next three years till 2016 and  The presence of four coal bed
a constant growth rate, which is the methane blocks with an acreage
growth rate of the economy, for the rest of about 3,251 sq km; and
of the years, has been forecasted for the  Holds oil and gas block in Mizoram
parent company based on the projects awarded under Nelp-VI with an
lined for them and with the below acerage of 3,619 sq. Kms.
mentioned resources and reserves:
The parties estimate that the new group
 Has a portfolio of almost 35,000 Mw will harness the potentials of the earlier
of power generation capacity; gas supply company to the best possible
 Has over 1,000 Mw of operational extent and add value to the group as a
power generation assets; and whole. New group‟s synergy would lead
 Has a coal reserve of over 2 billion to an increase in the EPS by 11.1% from
tonnes in India. 1.140to 1.267;

For RNRL the growth potential is seen as The study has been done post
high at 33.86% for the first stage which announcement of the merger with the
decreases to 17.18% growth for the next reference date taken as 13th July 2010
three years and then at a constant growth and the corresponding market price as
rate, which is that of the economy growth Rs.44.35 for RNRL and Rs.174.31 for R-
POWER.

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The main strategic operational guidelines are as follows

 Formation of a New Group capable of enhancement of the corporate culture

competing with the top players in the and competencies of each Group;
market and further enhancing the and
value of strong local roots, which
includes the preservation of brand  Rapid achievement of expected
identities; synergies due to the proven track
record of the management of the two
 Achievement of significant growth Groups in managing the integration
targets as a result of the proximity and process.
complementary geographic presence
in areas with high development
potential, increase in critical mass and

R-POWER and RNRL expect that the transaction will enable the New
Group to benefit from synergies resulting from:

 Optimisation of the various partnerships with leading international

infrastructures; reduction of costs operators, and further enhancements
following the adoption of a single in the level of service and quality
platform for the Group; offered to end customers ; and

 Control of administrative expenses,  Alignment of best practice within each

including benefits from the increased Group (benefiting both costs and
negotiating power of the New Group; revenues).

 Enhancement in scale of the product

companies, including through

Valuation methodology

According to standard valuation practice, configuration and future prospects of the

the fundamental precondition for two companies on an independent basis,
obtaining significant and comparable without taking any potential synergies
valuations in merger transactions is the from the merger into account.
consistency and comparability of the
methods applied according to the As stated previously, the selected
characteristics of the companies and/or methodologies – which represent
groups being valued. recognised techniques, widely used in
valuation practice - should not be
In addition, a second fundamental considered individually, but rather as
principle often adopted for merger different parts of a single valuation
valuations is the “stand alone” process. Independent use of the results
assumption. That is, a valuation obtained from each methodology,
perspective based on the current without duly considering the

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complementary relationship with other valuation methodologies have been
methodologies, will result in loss of the selected:
meaningfulness of the valuation process
itself.  Discounted Cash Flow Analysis (3
stage growth model);
On the basis of these considerations and
in view of the distinctive characteristics of  Conn and Nielson model; and
the two companies, the type of
transaction and the market sector in  Market price approach.
which they operate, the following

Discounted Cash Flow Analysis

The DCF Model defines the economic the Terminal Value (TV), calculated
value of a company as the sum of (i) the assuming a perpetual constant growth
present value of future cash flows, for a rate for the normalized cash flow beyond
set of predetermined time horizon first and the projected time horizon.
second stage and (ii) the present value of

where:

V = Economic value of the company;

CFt = Cash flow at time t;
n = Number of years of explicit forecast;
WACC = Discount rate, equal to the company‟s cost of capital; and
g = Growth rate of profits beyond the explicit forecast period.

Application of the DCF consists of the following steps

 Determination of the potentially stream which is both sustainable and

foreseen cash flows for the explicit consistent with the long-term growth
forecast time period assuming rational rate).
growth rates; Use of this method for the current
 Determination of the Weighted valuation is justified by the fact that,
Average Cost of Capital and the beyond general analytical
growth rate “g”; and motivations, it is based on medium to
 Calculation of the present value of long-term forecast data and,
cash flows for the forecast time period therefore, enables a more accurate
and of the Terminal Value valuation of the growth potential of
(representing the perpetual earnings the company concerned.

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Identification of the Cash flows potentially foreseen for the explicit forecast
period

For the purposes of this valuation, a time calculated. Income statement and
horizon of 2011-2016 has been assumed balance sheet projections for the explicit
for the cash flow forecasts, beyond which forecast period (2011-2016) are based on
the value of the banks was calculated by the consolidated financial plans of the
normalising the growth for 2011 from company.
which the Terminal Value was then

Determination of the discount rate and the perpetual growth rate

The rate used to discount cash flows Rf = Rate of return for risk free
(WACC) corresponds to the return investments. For the current
required by investors for alternative valuation, taking the reference
investments having the same risk profile. time horizon into account, a risk
free rate of 5.62% as on 13th July,
Consistent with standard valuation 2010 was assumed;
practice, this rate was calculated by
Rm-Rf = Risk premium required by the
applying the Capital Asset Pricing Model
market set at 5.5%, considered
(CAPM) which is expressed in the following
conservative and in line with
formula:
current valuation practice; and
β = Correlation coefficient between
the effective return on an individual
share and the total return for the
reference market; this measures the
volatility of a share compared to
the market portfolio.
where:
On the basis of these assumptions, the
Ke = Cost of Equity; 9.80% for RNRL and discount rate WACC used for both RNRL
7.33% for R-POWER calculated and R-POWER was 9.13% and 7.32%
using CAPM. respectively.
Kd = Cost of Debt;
D, E = Debt and the Equity of the firm; The nominal growth rate “g”, used to
calculate the Terminal Value, was
T = Tax rate; Taken as 20% for both assumed to be 5% for both of the
the companies; companies involved in the Merger.

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Summary of results

Reliance Natural Resources Ltd. Reliance Power Ltd

Value of the Firm : Rs. 7731.27 Cr Value of the Firm : Rs.31227.46 Cr

PV of Debt : Rs. 1521.6 Cr PV of Debt : -NIL-

Value per share : Rs. 38.41 Value per share : Rs. 131.98

RNRL Sensitivity Analysis R-POWER Sensitivity Analysis

Growth rate
Growth rate
WACC 4.0% 4.5% 5.0% 5.5% 6.0%
WACC 4% 4.5% 5% 5.5% 6%
7.15% 99.9 116.7 141.4 181.0 255.1
7.60% 47.86 56.06 67.41 84.16 111.3
8.10% 40.55 46.61 54.61 65.70 82.07 7.20% 98.3 114.5 138.1 175.6 244.4

8.60% 34.83 39.47 45.38 53.21 64.05 7.25% 96.7 112.4 135.0 170.5 234.5

9.10% 30.25 33.88 38.41 44.19 51.84 7.30% 95.2 110.3 132.0 165.7 225.3
9.60% 26.48 29.40 32.96 37.38 43.03 7.35% 93.7 108.3 129.1 161.1 216.9
10.1% 23.34 25.73 28.58 32.06 36.38 7.40% 92.3 106.4 126.4 156.8 209.1
10.6% 20.68 22.66 24.99 27.78 31.18 7.45% 90.9 104.5 123.7 152.7 201.7

RNRL Optimal value range R-POWER Optimal value range

Min Value : Rs. 37.38 Min Value : Rs. 112.4

Max Value : Rs. 39.47 Max Value : Rs. 161.1

Share Swap Ratio (No of RNRL shares:

No of R-POWER shares) using DCF

Min: 3.0061: 1 and Max: 4.0831: 1

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Conn and Nielson Model

Whenever a firm „A‟ acquires another firm Price earnings ratio of the combined firm
„B‟, the compensation to the shareholders when multiplied by the Earnings per share
of the acquired firm is usually paid in the of the combined firm gives the Market
form of shares of the acquiring firm. In Price per share.
other words, shares of firm A will be given
in exchange for shares of firm B. Thus, the PAB = (PEAB )( EPSAB) = PA
exchange ratio is a very important factor
in any kind of merger. Firm A will want to Earnings per share of the combined firm
keep this ratio as low as possible, while firm can be expressed as:
B will want it to be as high as possible. In
any case, both firms would ensure that
post merger, their equivalent price per EPSAB = (EA + EB ) / [SA + SB (ERA )]
share will at least equal their pre-merger
price per share. Given below is the model Substituting formula of EPS AB in above
developed by Conn and Nielson for equation we get
determining the exchange ratio. The
symbols used in this model are: - PA = PEAB (EA +EB)/[SA +SB (ER)]

ER = Exchange ratio From the above equation, we may solve

for the value of ER A as follows
P = Price per share
EPS = Earning per share
ERA=-(SA /SB )+[(EA+EB)PEAB] / PA SB
PE = Price earning multiple
E = Earnings For firm B
S =No of outstanding equity shares
AER = Actual exchange ratio After discussing the maximum exchange
ratio acceptable to the shareholders of
In addition, the acquiring, acquired and firm A above, we will now calculate the
combined firms will be referred to by minimum exchange ratio acceptable to
subscripts A, B and AB respectively. the firm B(ERB). The basic condition is –
(PAB)(ERB) >= PB
For firm A Using the equality form of above equation
and substituting P AB we get
Firm A would ensure that the wealth of its
shareholders is preserved. This implies that (PEAB)(EPSAB)(ERB)= PB
the price per share of the combined firm is
at least equal to the price per share of Substituting the value of EPS AB in the
firm A before merger: PAB >= PA above equation, and solving the equation
for ERB we get –
For the obtaining the boundary conditions
consider that PAB =PA ERB = PB SA /[(PEAB)(EA + EB) – PB SB]

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Summary of results

Synergy result

The synergy yielded a PE of 137.62 for the

combined firm i.e. an EPS of 1.26, 11%
more than the EPS of the firm (R-POWER)
taken alone.

Reliance Natural Resources Ltd. Reliance Power Ltd.

PB = Rs. 44.35 PA = Rs. 174.31

EPSB = 0.44 EPSA = 1.14

PEB = 100.80 PEA = 152.90

EB = Rs. 71.85 Cr EA = Rs. 273.24 Cr

SB = 163.31 Cr SA = 239.68 Cr

From RNRL‟s perspective From R-POWER‟s perspective

Min acceptable ratio = 3.79:1 Max allowable ratio = 4.98:1

i.e. 1 R-POWER share for 3.79 shares of i.e. 1 R-POWER share for 4.9 8shares of
RNRL. RNRL.

Share Swap Ratio (No of RNRL shares: No of R-POWER shares) using DCF

Min: 3.79: 1 and Max: 4.98: 1

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Market Price analysis

For listed companies, standard valuation For the current valuation, it was
practice suggests that market prices considered appropriate to apply this
should be observed over time intervals methodology using the following criteria:
which can be considered significant in (i) use of the arithmetic average of the
terms of providing the necessary closing prices and the weighted average
information to assess their economic of the official prices for RNRL and R-
value. The principal feature of this POWER; (ii) use of reference periods of 1
methodology is its ability to express the day, 1 month, 2 months and 3 months
relationship between the values of the prior to 13 July 2006.
companies being examined, as
perceived by the market, in relative terms.

Summary of results

Simple Average Weighted Average

Exchange Exchange
Duration RPOWER RNRL Ratio Duration RPOWER RNRL Ratio
3 months 159.976 57.4706 2.7836 3 months 165.098 59.7171 2.7647
2 months 161.905 54.7641 2.9564 2 months 169.305 59.0158 2.8688
1 month 161.905 54.7641 2.9564 1 month 174.818 62.6435 2.7907
13th July 174.31 44.35 3.9303 13th July 174.31 44.35 3.9303

Share Swap Ratio (No of RNRL shares: No of R-POWER shares) using DCF

Min: 3.79: 1 and Max: 4.98: 1

Main difficulties and limitations in valuation

The main difficulties and limitations of the management limited the ability to
valuations performed are summarized obtain specific information, above all
below: in relation to assumptions underlying
the financial projections used; and
 Use of forecast data: the analyses
 Valuation methods adopted: the
were performed using forecast data,
valuations performed reflect the limits
which by its nature contains
and particularities of each of the
uncertainty and the potential lack of
various valuation methods used.
comparability between related items;
 Access to management: the inability
to gain direct access to R-POWER

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Conclusion
Putting it all together

Minimum Maximum
DCF Analysis 3.0061 4.0831
Market Price method 2.7647 3.9303
Conn Nielson Ratio analysis 3.7863 4.9835
Average 3.1857 4.3323
Swap ratio 3.7590

Based on the comparison of results shares for 4 RNRL ordinary share - is, from a
achieved from the various valuation financial perspective, fair to RNRL
methods selected, it is considered that the shareholders, since the minimum required
Share Exchange Ratio which the Board of swap ratio for RNRL share holders is at the
Directors of R-POWER intends to propose level of 3.18 and the proposed swap ratio
to the General Meeting of Shareholders – is 1 R-POWER share for 4 shares of RNRL
that is, 1 newly issued R-POWER ordinary which is also well below 4.33 swap ratio.

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References
 About Us: Business Profile RNRL. Retrieved July  Conn, R.L. and Nielsen, J.F.(1977),„„An empirical
13, 2010, from Reliance Natural Resources Ltd.: test of the Larson-Gonedes exchange ratio
http://www.rnrl.in/buisness_profile.html; determination model ‟‟, Journal of Finance,
Vol.32, No.3, pp.749-59.; and
 About Us: Business Profile RPOWER. Retrieved
July 13, 2010, from Reliance Power Limited:  J.Fred Weston, J. A. (2002). Takeovers,
http://www.reliancepower.co.in/html/business_ Restructuring and Corporate Governance.
profile.html; Pearson Education.

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