-------- Chapter 6 --------

Theories of Mergers and Tender Offers

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 Why do mergers occur?
• Economies of scale
• Transaction costs
• Mergers allow a reorganization of
production processes so that plant
scale may be increased to obtain
economies of scale

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Theories of Valuation Effects of M&A

• Value Increasing: Transaction costs

efficiency, synergy, displinary
• Value reducing: agency costs
• Value neutral: hubris – winner’s curse

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 Free-Rider Problem
• Problem of diffused, small shareholders
– Small shareholders may not expend
resources monitoring management
performance in a diffusely held corporation
– Shareholders simply free-ride on monitoring
efforts of other shareholders and share in
any resulting performance improvements of
the firm

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 Models of the Takeover
Process
• Economic — competition vs. market power
• Auction types — Dutch, English
• Forms of games
• Types of equilibria — pooling, separating,
sequential
• Types of bids — one, multiple
• Bidding theory — preemptive; successive
bids
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 Framework
• Total gains for both target and acquirer
– Positive
• Efficiency improvement
• Synergy
• Increased market power

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 – Zero
• Hubris
• Winner's curse
• Acquiring firm overpays
– Negative
• Agency problems
• Mistakes or bad fit

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• Gains to target — all empirical studies
show gains are positive
• Gains to acquirer
– Positive — efficiency, synergy, or market
power
– Negative — overpaying, hubris, agency
problems, or mistakes

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 Sources of Value Increases
from M&As
• Efficiency increases
– Unequal managerial capabilities
– Better growth opportunities
– Critical mass
– Better utilization of fixed investments

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• Operating synergy
– Economies of scale
– Economies of scope
– Vertical integration economies
– Managerial economies

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• Diversification motives
– Demand for diversification by
managers/employees because they make
firm-specific investments
– Diversification for preservation of
organization capital
– Diversification for preservation of
reputational capital

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• Financial synergies
– Complementarities between merging firms in
matching the availability of investment
opportunities and internal cash flows
– Lower cost of internal financing —
redeployment of capital from acquiring to
acquired firm's industry
– Increase in debt capacity which provides for
greater tax savings
– Economies of scale in flotation of new issues
and lower transaction costs of financing

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• Circumstances favoring merger over
internal growth
– Lack of opportunities for internal growth
• Lack of managerial capabilities and other
resources
• Potential excess capacity in industry
– Timing may be important — mergers can
achieve growth and development of new
areas more quickly
– Other firms may be competing for
investments in traditional product lines

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• Strategic realignments
– Acquire new management skills
– Less time to acquire requisite capabilities
for new growth opportunities or to meet
new competitive threats

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• The q-ratio
– Ratio of the market value of the firm's
securities to the replacement costs of its
assets
• High q-ratio reflects superior management
• Depressed stock prices or high replacement costs
of assets cause low q-ratios
– Undervaluation theory
• Acquiring firm (A) seeks to add capacity; implies
(A) has marginal q-ratio > 1
• More efficient for (A) to acquire other firms in
industry that have q-ratios < 1 than building a new
facility
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• Information
– New information generated during tender offer
process causes target firm share to be permanently
revalued upward even if offer is unsuccessful
– Two information hypotheses
• ”Sitting on a gold mine" — tender offer disseminates
information that target shares are undervalued
• ”Kick in the pants" — tender offer forces target firm
management to implement more efficient business
strategies
– Synergy explanation — upward revaluation in
unsuccessful offer merely reflects likelihood that
other bidders may surface with specialized
resources to apply to target
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• Signaling
– Information — an outside event not initiated
by the firm conveys information
– Signaling — particular actions by the firm
may convey other significant forms of
information, e.g., that management does not
tender at the premium price in a share
repurchase signals that the company's
shares are undervalued

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 Winner's Curse and Hubris
• Winner's Curse: The winning bid in a
bidding contest for an object of uncertain
value will typically pay in excess of its
true value
• One cause of the winner's curse
phenomenon in M&As is hubris, defined
as overweening pride and excessive
optimism
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 Agency Problems
• Agency problems arise when managers
own only fraction of the ownership
shares of the firm
– Managers may work less (shirk) and/or
overconsume perks
– Individual shareholders have little incentive
to monitor managers
– Dealing with agency problems give rise to
monitoring and controlling costs
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• Solutions to agency problem
– Organizational mechanisms
– Compensation arrangements tied to
performance
– Market mechanisms
• Market for managers
• External monitoring through stock market
• Takeovers — external control device of last
resort

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• Managerialism
– Mergers are a manifestation of agency
problems
– Managers are motivated to increase the size
of their firms because their compensation is
a function of firm size, sales, or total assets
– Theory may not be valid if managers'
compensation is based on profitability or
value increases

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 Free Cash Flow Hypothesis
(FCFH)
Jensen (1986, 1988)
• Free cash flows (FCF) are cash flows in
excess of the amount needed to fund all
positive net present value projects

link
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