* Melrose raises equity part of bid, offer now 10 pct higher
* GKN rejects Melrose's sweetened offer
* GKN had agreed deal to spin off car parts business (Updates with GKN rejection, Aviva Investors comment)
LONDON, March 12 (Reuters) - Melrose Industries increased its hostile offer for GKN by around 10 percent to 8.1 billion pounds ($11.2 billion), trying to win over investors after the British engineering firm struck a rival deal of its own last week.
GKN's board unanimously rejected the new bid on Monday saying it continued to fundamentally undervalue the company.
But Melrose declared its sweetened offer as "final", meaning it cannot improve the terms further under British takeover rules. As a result, GKN shareholders must choose between the bid and the engineer's own turnaround plan.
Under the revised offer, GKN investors would receive 81 pence in cash for each GKN share plus 1.69 new Melrose shares. The previous offer made in January was 1.49 new Melrose shares plus 81 pence cash.
GKN shares fell 2.2 percent to 425.5 pence by 1556 GMT, compared to the 467 pence per share initial value of Melrose's final offer.
Shares in Melrose, a UK-based industrial turnaround specialist, fell 5.1 percent to 213.2 pence, dragging down the value of the bid to 441.3 pence.
GKN, which makes parts for car companies and aircraft manufacturers, cited the impact of Melrose's share price fall on the value of the bid as a reason for spurning the offer.
However, Aviva Investors, which holds stakes in both companies, said GKN shareholders should back Melrose's sweetened bid.
"We believe the interests of shareholders in both companies are best served by accepting Melroses raised bid," David Cumming, Aviva Investors' chief investment officer for equities, said.
The asset management arm of Aviva owns almost 1.2 percent of GKN and 5.4 percent of Melrose.
As part of its defence, GKN struck a $6.1 billion deal on Friday to merge its automotive business with U.S. company Dana Incorporated, offering GKN shareholders a 47.25 percent stake in the enlarged, U.S.-listed group.
GKN has also pledged to return 2.5 billion pounds to investors in the next three years following the Dana deal and an earlier pledge to sell its powder metallurgy business.
The engineering group said on Monday it believed it would be worth 503 pence a share given its plans for improving the company.
But Aviva's Cumming described GKN's plan as a "reactive review of its business structure" and said Aviva Investors favoured Melrose's "proposed measured execution of value."
A hedge fund investor, who has built a stake in GKN since the engineering company disclosed Melroses bid in January, also said the new offer was high enough for Melrose to win.
"It was a little bit better than we thought," he told Reuters.
Melrose argued on Monday that GKN's Dana deal was "ill-thought-through" and would face regulatory hurdles.
GKN said in its latest defence, also published on Monday, that shareholders would be invested in a more profitable GKN Aerospace following the sale of Driveline and powder metallurgy, plus have holdings in the merged GKN-Dana company.
The engineering firm, which can trace its roots back to 1759, is attractive to buyers because of its involvement with growing aircraft programmes such as the A350 and the A320, and in cars, where it has been growing market share and supplies manufacturers including Fiat Chrysler and VW Group.
But it was left vulnerable to predators after two profit warnings late last year, caused by problems at its U.S. aerospace business.
Melrose's potential takeover of GKN has prompted worries from British politicians about UK jobs being lost and the country's engineering know-how ending up in foreign hands.
GKN employs around 6,000 people in Britain -- about 10 percent of its workforce.
Politicians were also concerned that Melrose could break up GKN and sell parts to foreign buyers, potentially compromising British and U.S. national security because of GKN's work on defence programmes -- the company makes components for the Eurofighter Typhoon combat jet.
Melrose told lawmakers earlier in March that it would consider making binding commitments about the future of GKN should its bid succeed.
The deadline for GKN shareholders to accept Melrose's offer is March 29. ($1 = 0.7213 pounds)
(Editing by Kate Holton, Keith Weir and Jane Merriman)