An acquisition of a company or substantial portion of its shares is an investment. Financial managers have to appraise it to see whether return on such investment is higher than the cost of the capital for the company.
Financial managers and theorists have proposed many reasons for acquisitions and merger activity. The primary economic motives mentioned are:
Synergistic effects can arise from four sources: (1) operating economies, which result from economies of scale in management, marketing, production, or distribution due to combining operations; (2) financial economies, including lower transactions costs and better coverage by security analysts; (3) differential efficiency, which implies that the management of one firm is more
efficient and will increase the return from that the weaker firm’s assets after the acquisition or merger; and (4) increased market power due to reduced competition.
Tax considerations have stimulated a number of mergers. For example, a profitable firm in the highest tax bracket could acquire a firm with large accumulated tax losses. These losses could then be turned into immediate tax savings rather than carried forward and used in the future. Thus excess cash can be used as a way of minimizing taxes.
Purchase of Assets below Their Replacement Cost
Sometimes a firm acquires a company because the cost of replacing its assets is considerably higher than its market value. If the new management uses the assets appropriately, the market value will increase in the future.
Managers contend that diversification helps stabilize a firm’s earnings and thus benefits its owners as risk premium of the company's comes down. Stabilization of earnings is certainly beneficial to employees, suppliers, and customers; but its value is less certain from the standpoint of stockholders. Stockholders also can buy the stock of both firms? Many studies find that diversified firms are worth significantly less than the sum of their individual parts as top managements cannot provide adequate managerial expertise to diversified businesses.
Recently, takeover specialists have identified breakup value as a basis for
valuation. A company’s breakup value, is the value of the individual parts of the firm if they are sold off separately. If this value is higher than the firm’s current market value, a takeover specialist could acquire the firm at or even above its current market value, sell it off in pieces, and earn a substantial profit. Such a breakup value is mainly appearing in diversified companies.
Types of Mergers
Mergers are classified into four types:
(3) congeneric, and
A horizontal merger occurs when one firm combines with another in its same line of business.
An example of a vertical merger is a steel producer’s acquisition of one of its own suppliers, such
as an iron or coal mining firm. Congeneric means “allied in nature or action”; There is a relationship but not producers of the same product (horizontal) or firms in a producer-supplier relationship (vertical). A clothing retailer may acquire a food retailer. A conglomerate merger occurs when unrelated enterprises combine.
Vertical and horizontal mergers generally provide the greatest synergistic operating benefits
The acquiring firm performs an analysis to value the target company based on its expected cash flows and cost of capital applicable and then determines whether the target can be bought at that value or, preferably, for less than the estimated value.
The target company also makes an analysis of its cash flows and makes a valuation of them and will accept the offer if the price exceeds either its value if it continued to operate independently or the price it could receive from some other bidder.
MBA Core Management Knowledge - One Year Revision Schedule