* GKN says to quickly return up to 700 mln stg to shareholders
* Comes after Dana sweetens cash element of offer for auto unit
* GKN wants its investors to reject hostile bid from Melrose (Adds analyst, Melrose statement, background)
By Kate Holton and Sarah Young
LONDON, March 26 (Reuters) - GKN promised on Monday a quick cash handout for shareholders if they back a sweetened offer for its auto business, raising the stakes in its battle to fend off a hostile bid for the entire company.
In one of Britain's most tightly fought corporate battles for years, shareholders have until 1200 GMT on Thursday to accept the hostile bid from turnaround specialist Melrose , or GKN's plan to split off its auto unit and combine it with U.S. group Dana, leaving GKN focused on aerospace.
Melrose's bid has so far split GKN shareholders, with two of the largest publicly coming out on opposite sides. Analysts predict the deal will go down to the wire.
On Monday, Dana increased the cash portion of its bid for GKN's Driveline auto business by $140 million. The bid values Driveline at $6.1 billion, including debt.
In response, GKN said it would return up to 700 million pounds in cash to shareholders as soon as practicable, as part of an already announced 2.5 billion pound cash return programme from the Driveline sale and the planned divestment of its powder metallurgy unit.
That compares with Melrose's offer of 81 pence in cash for each GKN share plus 1.69 new Melrose shares, which would hand shareholders 1.4 billion pounds and 60 percent of the enlarged Melrose - a bid worth 7.8 billion pounds in total.
Should they back GKN management's plan, GKN shareholders would end up with 47.25 percent of the enlarged Dana group, which would be listed in both the U.S. and London.
Peel Hunt analyst Harry Philips said the sweetened bid from Dana showed Driveline had been undervalued, the deal hurriedly made, and clarity was needed on the promised returns.
"This (the quick 700 million pound payout) was not part of the original proposition, so this represents a change in calibration and we think that GKN needs to redefine the make up of the 2.5 billion pound return proposition," he said.
A mainstay of Britain's engineering sector, GKN makes parts for the U.S. aviation industry, such as the Boeing 737 jet and Black Hawk helicopter, as well as components for Volkswagen and Ford cars.
Illustrating the bitter nature of the takeover battle, it featured on the front page of Britain's Daily Mail newspaper on Monday: "Don't let Vultures destroy a British colossus", it said, noting some shareholders did not have a long-term interest in the company that helped make Spitfire fighter aircraft in World War Two.
A source close to the bid battle said short-term merger arbitrage funds could own 20-25 percent of GKN shares.
While the hostile bid has prompted criticism from politicians - concerned that after improving GKN, Melrose could break it up and sell parts to foreign buyers - the decision now rests with shareholders.
Elliott Advisors, which has a 3.8 percent interest, making it one of GKN's biggest shareholders, on Friday backed Melrose's deal, saying it did not trust GKN management to deliver the "profound" cultural shift needed to meet new targets while driving through two major asset sales.
Columbia Threadneedle, with a 3.4 percent stake according to Reuters data, has said it will reject Melrose's offer.
GKN said that following Dana's improved offer for its auto business it would receive $1.77 billion in cash after deducting $1.0 billion for the transfer of a pension deficit to the combined Dana-GKN Driveline group.
"We believe that the true value of GKN is over 5 pounds per share and that Melrose's final offer fundamentally undervalues your company and should be rejected," Chairman Mike Turner told shareholders.
The offer from Melrose values GKN at 451 pence per share in cash and shares, based on Melrose's share price on Monday. GKN's stock was trading at 431.5 pence at 1200 GMT.
In a separate statement, GKN was forced to retract comments made to Sunday newspapers in which it said it thought investors would back its plan. It said the comments had not been verified.
Melrose, prevented under UK rules from improving its offer as it has said its current bid is final, dismissed the sweetened Dana deal as "a tweak" and criticised GKN's management for making claims over shareholder support.
"The last-minute attempts of claiming shareholder support that then had to be retracted is a sign of desperation," Melrose's Chairman Christopher Miller said.
"We urge shareholders to cast their votes for a proven Melrose team with an outstanding track record and a plan to revitalise GKN."
($1 = 0.7050 pounds)
Reporting by Kate Holton and Sarah Young; Editing by Guy Faulconbridge and Mark Potter