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Though the terms are used loosely to describe a variety of activities, in every case the end result is that two companies become a single enterprise, in fact if not in name.
Whether by amalgamation or by takeover, the end result may be achieved by:
(a) transfer of assets; or
(b) transfer of shares
The two methods are summarised below.
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TRANSFER OF ASSETS |
TRANSFER OF SHARES |
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TAKEOVER (B TAKES OVER A) |
B acquires trade and assets from A for cash. A is then liquidated, and the proceeds received by the old shareholders of A |
B acquires shares in A from A’s shareholders in exchange for cash. A, as a subsidiary of B, may subsequently transfer its trade and assets to its new parent company B |
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MERGER (X and Y merge to form Z) |
Z acquires trade and assets from both X and Y in return for shares in Z. X and Y are then liquidated and the shares in Z distributed in specie to the shareholders of X and Y. |
Z acquires shares in X and Y in return for its own shares. X and Y as subsidiaries of Z may subsequently transfer their trade and assets to their new parent company (Z). |
Other names that are used are Acquisition (Takeover) or Merger (Amalgamation).
The ultimate justification of any policy is that it leads to an increase in value, ie, it increases shareholder wealth. As in capital budgeting where projects should be accepted if they have a positive NPV, in a similar way mergers should be pursued if they increase the wealth of shareholders
Suppose firm A (the acquirer) has a market value of £2m and it buys firm B, market value £2m, at its. current market price.
If the resultant new firm AB has a market value in excess of £4m then the merger can be counted as a success, if less it will be a failure. Essentially, for a successful merger we should be looking for a situation where:
Market value of the combined companies (AB) > Market value of A + Market value of B
If this situation occurs we have experienced synergy, that is, the whole is worth more than the sum of the parts. This is often expressed as:
2+2=5
It is important to note that synergy is not automatic. In an efficient stock market A and B will be correctly valued before the acquisition and we need to ask how synergy will be achieved, i.e., why any increase in value should occur.
Some sources of synergy are:
(a) operating economies;
(b) Market power;
(c) Financial gains; and
(d) Others.
We will examine each in turn.
(a) Economies of scale
Horizontal mergers (acquisition of a company in a similar line of business) are often claimed to reduce costs and therefore increase profits due to economies of scale. These can occur in the production, marketing or finance areas. Note that these gains are not automatic and diseconomies of scale may also be experienced. These benefits are sometimes also claimed for conglomerate mergers (acquisition of companies in unrelated areas of business) in financial and marketing costs.
(b) Economies of vertical integration
Some acquisitions involve buying out other companies in the same production chain, eg, a manufacturer buying out a raw material supplier or a retailer. This can increase profits by ‘cutting out the middle man’.
(c) Complementary resources
It is sometimes argued that by combining the strengths of two companies a synergistic result can be obtained. For example, combining a company specializing in research and development with a company strong in the marketing area could lead to gains.
(d) Elimination of inefficiency
If the victim company is badly managed its performance and hence its value can be improved by the elimination of inefficiencies. Improvements could be obtained in the areas of production, marketing and finance.
Several financial arguments are proposed in this area.
(a) Diversification
The argument goes that diversification normally reduces risk. If the earnings of the merged companies simply stay the same (ie, no operating economies are obtained) there could still be an increase in value of the company due to the lower risk. This argument is developed by application #2.
The following data are available for two companies
Company A Company B (i) Market value £2m £2m (ii) Earnings to perpetuity £0.2m £0.4m (iii) Rate of return 10% 20% (iv) Standard deviation of return 8% 18%
Correlation coefficient between returns of A and B = 0.3
The risk and return of the combined company may be calculated in a similar way to the analysis of a two asset portfolio (in portfolio theory).
Return (assuming no operating economies) = £0.2 + £0.4m= £0.6m
The same total earnings are available but the risk is considerably less than the weighted average of the risk of the two individual companies (18+8)/2 = 13%
Therefore the value of the combined company should be in excess of £4m and synergistic gains will have been obtained.
The major fallacy in this argument is that it is based on total risk. Well-diversified shareholders evaluate companies on the basis of systematic risk, which, in one of the conclusions of CAPM, cannot be eliminated by diversification.
Assume, for example, that the following additional data were available:
βA = 1
βB =3.00
Rm = 10%
Rf = 5%
The systematic risk of the combined company would simply be given by the weighted average of the two β factors:
(0.5 x 1.00) + (0.5 x 3.00) = 2.00
This gives an implied required rate of return of:
Rf+ β(Rm–Rf) = 5%+200(10%–5%)
= 15%
On total earnings to perpetuity of £0.6m this would give a combined company value of:
£0.6m/0.15 =£4m
No increase in value has occurred because no risk reduction has been obtained. The systematic risk of the combined company is simply the weighted average of the individual systematic risks.
From a shareholder’s point of view, in the absence of any operating economies, there appears to be no gain from the merger.
Note, however, that managers often concentrate on total risk, as total risk affects their job security and the diversification argument can make sense from a managerial viewpoint if not a shareholder’s.
(b) Diversification and financing
If the future cash flow streams of the two companies are not perfectly positively correlated then by combining the two companies the variability of their operating cash flow may be reduced. A more stable cash flow is more attractive to creditors and this could lead to cheaper financing.
(c) The ‘boot strap’ or PE game
It is often argued that companies with high PE ratios are in a good position to acquire other companies as they can impose their high PE ratio on the victim firm and increase its value.(see application #3)
The following data are available:
Company A Company B (i) Earnings available to shareholders £0.2m £0.4m (ii) PE ratio 10 5 (iii) Market capitalisation (i) x (ii) £2m £2m (iv) Number of shares Im Im (v) Value per share £2 £2
Assume company A decided to buy company B at market value on a share for share basis.
This would involve the issue of 1m new shares by company A. The resultant company
(assuming no synergistic effects) would look something like this:
Company AB Earnings available to ordinary shareholders £0.6m Number of shares 2m Earnings per share £0.3
The value per share will depend upon the PE ratio set by the market. Both parties would hope that the market would continue to apply A’s PE ratio to the combined company. This would lead to a share price of: EPS x PE ratio = 30px 10= £3 and a market capitalization of:
£3 per share x 2m shares = £6m
This is an overall increase in value of (over the value of the two companies prior to the merger) and would benefit both sets of shareholders.
The question we need to ask is ‘ In an efficient market why should this occur?’
The low PE ratio given to B presumably reflected its high risk or poor growth prospects. Why should the market change its mind simply because ownership has changed?
It might do so because of likely future operating economies, but not simply because A has a high PE ratio. The moral is clear – a high PE ratio in the acquiring company in itself is not the cause of any increase in value. In an efficient market increases in value will be caused by other benefits. If no other benefits are forthcoming the new PE ratio will simply be the weighted average of the individual PE ratios, i.e.:
[(Earnings of Ax PE ratio of A) + (Earnings of B x PE ratio of B)]/( Earnings of A + B)
= [(0.2m x 10) + (0.4m x 5]/(0.2m + 0.4m)
=6.667
The combined market capitalization of A and B would then be:
30p x 2m shares x6.667 = £4m - i.e., no gain to shareholders.
(d) Other financial benefits
These largely revolve around the elimination of inefficient financial management practices. Examples include:
(i) Buying low geared companies with good asset backing in order that they may be geared up to obtain the benefit of the corporation tax shield on debt.
(ii) Buying companies with accumulated tax losses in order that they may be offset against profits of the acquiring company.
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