MOTIVES FOR MERGERS and MERGER THEORY-

HOW VALUE IS ADDED

a. Efficiency Arguments
1. Differential Managerial Efficiency
Management of a more efficient acquiring firm can bring up the
level of efficiency of the acquired firm, providing both social and private gain.
Implies that firms in similar industries would be potential acquirers. Acquiring
firms management complements the management of the acquired firm
through its e!perience in the industry. E!cess managerial talent by the
acquiring firm can be put to use in the acquired firm "managerial synergy#.
$his talent may be applied by direct entry into a new mar%et. &ew entry may
be e!pensive if the firm with e!cess managerial capacity does not have other
non'managerial organi(ational capital relevant to that mar%et. )uch capital
can be acquired through toehold acquisition
*roblem+ Implies very few large firms and little speciali(ation.
,. Inefficient management.
In the case of totally inept management, mergers serve as a means of
providing discipline to the managerial mar%ets where the only way to get rid
of inept management is through ta%ing over the company.
*roblems+
1# -hy arent managers replaced after mergers.
,# -hy cant acquired firms be operated as subsidiaries..
/. 0perating synergies
Economies of scale allow large firms to operate more efficiently than
smaller firms due to indivisibility of resource inputs.
Management and financial functions may also generate economies of scale.
1ertical integration may also generate economies through more efficient co'
ordination of the production process.
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2. 3inancial )ynergies.
Internal funds allow a less costly and more efficient means to finance
e!pansion that reliance on e!ternal funds. $his would allow cash'rich firms to
provide financing for cash'poor companies. It might also allow for economies
of scale in the financing of pro4ects.
$he debt capacity of a combined company may e!ceed the debt
capacity of its components because the variability of cash flow is reduced.
5. *ure diversification.
3or shareholders, diversification at the shareholder level is equivalent
to diversification at the firm level, but should be cheaper, since acquisition
costs are much less. 3or managers, firm diversification is much preferable
since human capital is concentrated in a specific firm and depends on the
fortunes of that firm. 6y diversifying, managers gain more 4ob security and
perhaps the firm gains lower labor costs.
3irm diversification also allows protection of firm'specific information
and the firms reputation capital against firm liquidation.
Debt capacity can be raised by diversification.
7. )trategic realignment
8hange can be effected more quic%ly by entry into a new product or
mar%et through merger than through direct entry. -here values are
ephemeral, it may pay to acquire rather than to build.
*roblem+
$he price for timely acquisition may fully reflect value.
9. :ndervaluation
$he mar%et may not fully reflect the true value of a potential
acquisition, which may be %nown by competitors and managers in the
industry with access to privileged information.
,
Assets may be acquired more cheaply in the aftermar%et than by
building. $he allows assets to be acquired whenever mar%et values are lees
than their replacement cost.
$obins q ; mar%et value<replacement cost
A q value less than one implies negative &*1 pro4ects or assets that
are worth less than their cost.
*roblem+
bringing up value of assets still requires greater efficiency by the
acquirer.
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b. Agency probe!"# !anager$a$"!# and %ree ca"& %o'
0verview+
Agency problems in relationships arise whenever the two parties do not have
e!actly the same ob4ective function. $hen, benefits to one of the parties can
come at the e!pense of another party. In the conte!t of the differences
between ob4ectives of management and shareholders, agency problems can
lead to inefficiencies, which inefficiencies may be resolve by means of the
mar%ets discipline of managers through ta%eovers or the threat of ta%eovers.
E!amples+
Manager<employees vs. stoc%holder<owners
Managerial per%s are paid for by shareholders
Inefficiency is a form of managerial per%.
)toc%holders vs. bondholders
Application of option pricing theory to stoc% valuation
1. Mergers as a solution to agency problems
If managers have created inefficiencies, then the stoc% price will not be
as high as possible had such inefficiencies not e!isted. $he presence of
inefficiencies opens the opportunity for an outsider to buy assets at a
discount, resolve the inefficiencies, and bring the assets up to full value.
,. Mergers as an outcome of managerialism
Managers may have incentives to ma!imi(e the si(e of assets managed
rather than ma!imi(ing shareholder wealth if their incomes or economic
power is more related to the si(e of their managerial scope. $hey are incented
to add assets for their own purposes rather than to ma%e shareholders better
off. $he discipline of a merger would strip inefficient or un'needed assets and
reduce the firm to its proper si(e.
/. 8onflicts over the distribution of cash flows
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Managers and shareholders may have different ob4ectives represented
in preferences for use of the firms internally generated cash, with managers
wanting the firm to become larger while shareholders would prefer to obtain
cash through dividends or share repurchases.
2. $he rationale for the use of debt.
Interest and principal payments provide discipline for managers in
running a tighter ship to assure that cash is available for fi!ed financial
charges. 3inancing associated with =everaged buyouts or management
buyouts can impose such discipline.
*roblem+ a merger is not a necessary condition for imposition of debt
discipline. It can be implemented independently of mergers. In *hillips
*etroleum e!ample, the leveraged re'financing serves a very effective
ta%eover defense, not to ma%e the ta%eover more costly, but to add value
without a ta%eover.
5. $he 3ree 8ash 3low problem.
Agency problems are heightened when management has financial
fle!ibility at its disposal in the form of the ability to generate cash from
operations or in pools of liquid assets built up. 6uildup of free cash flow in a#
current assets b# pension fund c# borrowing capability can be used by
managers to benefit themselves directly "higher salary# or indirectly "poor
investments# at the e!pense of shareholders.
3irms with good investment opportunities have greater need for
financial slac% "free cash flow# and are less li%ely to waste free cash. 3irms
with poor investment opportunities may be inclined to invest anyway simply
because ample cash is available.
E!ample+ 8ash'rich oil companies with poor investment opportunities being
the sub4ect of and the sub4ect of ta%eover battles in the 1>?@s. $a%eovers
prevented oil companies from wasting cash in negative &*1 investment
because of managerialism.
Empirical Evidence on 3ree 8ash 3low problems
Investments "Mc8onnell and Muscarella#
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Aegular Dividends "=ang and =it(enberger, Denis, Denis, and )arin#
)pecial Dividends "Bowe, Be, and CaoD Eombola and =iu#
)toc% Aepurchases "*orter, Aoenfeldt and )icherman#
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c. In%or!a($on and "$gna$ng arg)!en("
6asic 8oncept+
Information is not shared equally between parties in a transaction.
)ellers and 4ob applicants %now more about the item offered or s%ills
available than buyers or employers. Managers %now more abut the condition
of the firm than investors or the managers of an acquiring firm.
*ooling Equilibrium
-hen individual characteristics are un%nown then group characteristics
are assigned rather than individual characteristics.
E!ample+
All used cars are classified as FlemonsG.
Eraduates of prestigious universities are considered smarter and
harder'wor%ing
Aesolution
8ostless signaling is worth what it costs. 8ostly signaling is difficult to
signal falsely.
Empirical Aesearch +
)toc% offerings "Asquith and Mullins, 6rous#
Aegular dividend increases and decreases "asymmetry#
)toc% repurchases "8omment and Harrell, Hain#
Investment Announcements "Mc8onnell and Muscarella, Hohn and
Mishra#
Divestment Announcements "6lac%well, Marr, and )pivey, Eombola
and $setse%os#.
1. Information implications of merger activity.
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Investors learn information about a company when it goes in play as a
ta%eover target. Its value is revised upward. $he revision may be due to a
combination of two e!planations.
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E!planation J1. ' F)itting on a gold mineG
$he target shares and assets may be undervalued because of their
higher value for an alternative owner who may place assets at a higher and
better use. If one outsider can add value, then other potential new owners
may also add value.
E!planation J, ' KCic% in the pantsK
-hen managers learn of the potential for the discipline of a merger,
they institute pre'emptive steps to initiate the discipline by themselves.
,. )ignaling implications
$he form of mergers can be used to glean information about bidders
and targets. A bidder that uses common stoc% rather than cash may signal that
the bidders own stoc% may be overvalued, or it may signal that the bidder is
unsure of the target value and wishes target shareholders to share in the ris%
of potential mis'estimation of the targets value.
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d. Mar*e( +o'er con"$dera($on"
1. Mar%et )hare
Any merger will increase mar%et share, but mar%et share may not be
translated into higher profits and higher share value.
*roblem+ =egal problems associated with Fundue concentrationG in an
industry. 0ld guidelines implied concentration when the four largest firms
accounted for 2@ percent or more of sales. Berfindahl inde! ta%es into
account the relative share of all firms in the industry as
B ; (%of industry#
,
where & is the number of firms at any percentage of industry sales.
,. Monopoly and monopsony power.
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e. Wea(& Red$"(r$b)($on
1. )hareholders versus bondholders.
Mergers are often, but not necessarily, accompanied by opportunities
to change capital structure in a manner that disciplines management.
)ubstitution of debt for equity applies such discipline, but also provides
shareholders with an opportunity to transfer bondholder wealth to themselves.
=osses by bondholders will increase the wealth of shareholders, even with no
change in the value of assets.
1iewing the equity as an option on underlying firm assets produces the
same implications.
)ale of assets to generate cash also undercuts the value of bonds since
fewer assets reduces the cash flow available for paying interest and principal.
E!amples+
In the CCA ta%eover of AHA assets sales of L5 billion and sale of 4un%
bonds that produced a net loss after interest of L>97 million.
In *hillips *etroleum defense against ta%eover, the leveraged
refinancing hurt the value of e!isting bonds. Equity was reduced from L7.7
billion in 1>?2 to L1.7 billion in 1>?5, while long'term debt increased from
L,.? billion in 1>?2 to L7.5 billion in 1>?5. "&otice that ta%eover was averted
by management pre'emption of ta%eover strategies#.
,. )hareholders versus other sta%eholders.
A. Employees
In a merger, the acquiring firm and its new management may not feel
as responsible for the welfare of employees or other stoc%holders. $he result
can be much of the FefficienciesG of mergers.
E!ample+ Acquisition of $-A by Icahn produced cost savings of L,@@
million per year by means of wage reductions forced on employees.
It can be argued whether this is the result of a Fbreach of trustG or an
end to regulation.
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6. Eovernment
Ereater leverage and reduced ta! payments may transfer wealth from
society to shareholders.
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II. $he 3ree Aider *roblem
)ource of the problem+
1. 0utside acquirer pays a premium that incorporates much of the
benefits of the merger
,. All of ris% is borne by acquirer
/. Most of benefits of the merger are en4oyed by inside stoc%holders'
yet they do nothing to add value to the firm.
2. Merger can fail because original shareholders have no incentive to
tender
Aesolving the problem+
$ransferring merger benefits from acquired'firm shareholders to
acquiring firm.
1. Dilutive activity
,. $wo'tier offer
1,