Note: No statistical data was available for the amount of expenditure spent in the UK for mergers and acquisitions occurring in the UK by overseas companies between the years of 1969 to 1985.
2.1 Synergy
Arnold (2005) explains synergy is the idea that underlies that the value of the combined company which should be greater than the value of the sum of the companies, whose operations formed the merged entity. He argues the increased value comes about because of an increase to revenue and/or a reduction in costs. He goes on to say that occasionally it is the ability to share sources of supply or production activities that helps to improve the corporate position of the company.
Lumby and Jones (2004) both argue that if a company wishes to acquire another company, the buying company hope not to acquire the assets of the target company but also to gain from costs savings, economies of scale, and other benefits. They collectively refer these additional benefits arising from the acquisition as “synergy” – where the sum of the whole company is greater than the sum of the individual parts. Both declare the value of a synergy can be defined as the difference between the actual value of the combined company, VAB and the market values of the individual companies, VA and VB:
Value of Synergy = VAB - [VA + VB]
Watson and Head (2004) make a case that synergy occurs when the assets and/or operations of two companies complement each other, in order for the sum of their separate outputs to be lower than their combined value. They believe this can be achieved by acquiring a company which can provide a service to its operations which it cannot provide for itself, it may be able to realise cost savings.
Damodaran (2006) declares that if synergy is perceived to exist in a merger or acquisition, the market value of the combined company must be greater than the sum of values of the bidding and target firms, both operating independently from each other before the merger occurred, in order for synergy to be created.
VAB > VA + VB
Where:
VAB = The value of the company created by the merger and acquisition.
VA = Value of company A, operating independently.
VB = Value of company B, operating independently.
Investopedia (2005) declares that in most cases, acquirers always pay a substantial premium on the stock market value of the companies they purchase, and the main reason for doing so, is that it will help the buying company to gain synergy. It argues that a merger does benefit shareholders when the purchasing company’s post-acquisition share price increases by the value of its potential synergy, and the justification for doing so always boils down to the notion of synergy. It goes on to say regardless of what the target company’s pre-merger valuation, the purchasing company will always pay a premium above the market price. It points out that for sellers, the premium represents the company’s future prospects while for buyers, the premium represents part of the post-merger synergy that they expect can be achieved. The equation below declares whether a particular merger or acquisition makes sense and what minimum synergy is required, in order for the merger or acquisition to be successful.
Pre-merger value of both companies + synergy = Pre-merger stock price
Post-merger number of shares
Minimum required synergy =
(Pre-merger stock price X Post-merger number of shares) –
Pre-merger value of both companies
2.2 Market Power
Arnold (2005) believes one of the most important forces driving mergers and acquisitions today, is an attempt by companies to increase their market power. He argues this can be achieved by the merged company having a higher share of the market, where it will have some degree of control over price and will allow the combined company to increase the price of goods and services sold because customers have fewer alternatives sources of supply. He states that market power can also be created from downstream mergers which are often formed in order to ensure a market for the acquirer’s product and to shut out competing firms, and also from upstream mergers where barriers of entry are raised or formed which are designed to place competitors at a cost advantage. He makes a case that conglomerate mergers and acquisitions can enhance power by forcing suppliers to buy products from its different divisions under the threat that it will stop buying from them if they won’t comply.
Watson and Head (2004) both argue that an organisation can gain market power through horizontal integration by its ability to earn monopoly profits due to fewer competition, and through vertical integration by having more influence in the raw materials or distribution markets.
McLaney (2003) believes that when the bidder and target are in competition for revenue and market share in the industry they compete in, a merger between the two companies will enable the combined company to have a larger market share for their merged assets. He goes on to explain that their combined strength in the marketplace might enable prices to be raised without loss of their combined turnover, which will result an increase in their market revenue.
2.3 Economies of scale
Arnold (2005) argues companies can gain from economies of companies through a merger by using its larger size which often leads to lower cost per unit of output. He states the other areas where costs savings can be achieved in a merged entity - advertising, distribution, administration, research and development, and purchasing. He believes that managers and executives benefit from mergers and acquisitions by improving their work at a larger firm with a prepared programme of training and access to a wider range of knowledgeable and experienced colleagues. He believes a combined merged company can also achieve economies of scale financially as well by being able to sell off surplus building, machinery, and making surplus workers redundant in order to cut overcapacity.
Damodaran (2006) points out a combined company’s debt capacity can increase as a result, because their earnings and cash flows may become more stable and predictable, thus allowing the merged company to borrow more than they could have as individual entities, and hence they realise economies of scale from the merger.
Watson and Head (2004) both claim economies of scale that is created, is similar to synergy benefits and occur because the scale of operations is larger after a merger or acquisition. They believe it is likely to arise from horizontal integration but may also arise in vertical integration in areas such as production, distribution, marketing, management, and finance. Also, they go on to say the combined company will be able to gain from suppliers by having the ability to enjoy bulk-buying discounts following an acquisition or merger because of its larger scale of its operations and its larger purchasing power.
Investopedia (2006) states one of the first areas executives look at following a merger or acquisition is to achieve cost saving by cutting staff levels. It states money will be saved from reducing the number of staff members from different departments of the company. It goes on to say a larger company when placing orders can save more in costs as they have a greater ability to negotiate price with their suppliers due to their larger purchasing power.
McLaney (2005) believes economies of scale can arise from a wide range of areas following a merger or acquisition where combining the administration of the two companies may lead to savings in the associated costs. He also argues economies of scale can be achieves in the costs of raising finance where the effect is that it would decrease total cash outflows.
Sloman and Sutcliffe (2001) believe once a company has merged successfully with another company, the different areas of the company might be more effectively coordinated which will help reduce unnecessary production costs and may involve a process of “rationalisation.” According to both of them, this means the newly merged company will have to reorganise itself in order to eliminate any duplication of activities and to cut out waste. This will involve the combined company selling off surplus buildings, machinery and other assets (such as unprofitable subsidiaries) while at the same time cutting staff in various departments. Both argue that in most cases neither the buildings nor the employees are being used as intensively as they could be, and in the case of retailers, once a merger or acquisition is completed, a number of branches can be closed, to leave one rather than two owned by the merged company in a particular location, which will help reduce their cost levels.
2.4 Entry to new markets
Arnold (2005) believes the best method for a company to enter a particular market and the fastest way of establishing itself in that market may be through the purchase of an existing well-known participant in that product or geographical market. He argues that to enter into a new market from scratch, it will need to develop the necessary skills and market strength through internal efforts alone, which may mean it will take many years for the company in the particular market to establish itself and to reach a required size to become an effective competitor. As a result of following this method, he points during the growth period; large losses may well be incurred. Also, he goes on to declare that creating a new participant in a particular market could generate over-supply and excessive competition, producing the danger of a price war and thus eliminating profits.
Watson and Head (2004) believe companies may want to expand into new geographical and business areas in order to meet their strategic objectives. They argue organic or internal growth may be to be too slow or too costly for the company and so acquisition is the best efficient route to expansion. They go on to say this is particularly true of the retail trade, where starting operations from scratch is both costly and time consuming, where the costs involved will result from purchasing, refurbishing premises, hiring, raining personnel, and building up market share.
2.5 Tax advantages
Damodaran (2006) declares tax benefits can arise when the acquiring company takes advantage of tax laws or from the use of net operating losses to shelter their income. Hence he argues a profitable company which acquires a lost making company may be able to use its net operating losses to reduce its total tax burden. Alternatively, he makes a point that a company can increase its depreciation charges after an acquisition where it will help the merged entity to save in taxes and increase its market value.
Watson and Head (2004) both believe mergers and acquisitions may be beneficial for a company that pays a large sum of tax to take over a company that doesn’t pay a large amount of tax, so it can realise tax allowable benefits. They argue it can also apply to companies who make insufficient profits against which it can set off its capital allowances and interest.
Arnold (2005) declares that in some countries, notably the USA, if a company makes a loss in a particular year, it will be able to carry forward these losses so that it can reduce taxable profit in a future year. He also points that more importantly for a company that has undergone a merger, the past losses of an acquired subsidiary can be used to reduce present profits of the parent company and thus lower its tax liabilities, which helps to gives companies an incentive to buy other companies which have accumulated tax losses.
Lumby and Jones (2003) declare there are two potential sources of tax synergy. The first potential source is the possibility of a purchasing company with a large tax liability to reduce it by acquiring a company which is either making tax losses, or which is making insufficient profits to gain all the tax relief that is available on interest payments and capital allowances. While the second potential source, they point that by allowing the enlarged company to borrow more through an increase in debt capacity and so thus obtain more interest tax relief.
2.6 Risk diversification
Damodaran (2006) does argue diversification reduces an investor’s exposure to a company’s risk level. He points out that by purchasing companies in other businesses that will help it to diversify, executives of the acquiring company argue they can reduce earnings volatility and spread risks.
Besanko, Dranove, Shanley, Schaefer (2001) all believe company shareholders may benefit from diversification if its directors are able to identify other firms that are undervalued by the stock market.
Arnold (2005) argues one of the primary reasons for conglomerate mergers is that the overall income of the holding company will be less volatile and more stable, if the cash flows come from a broad diversity of products and markets. He does see a positive in the diversification of unrelated income streams that would improve the situation for the company shareholders where they would obtain a reduction in risk without a decrease in return. He goes on to say that diversification will appeal to the lender as a result of greater stability; hence the merged company will be charged lower interest rates at the time of borrowing. He believes as a result of reduced earnings volatility, a company would avoid defaulting on interest payments on borrowing as there is likelihood of the company producing negative returns is very small.
Lumby and Jones (2004) believe another frequently given reason for an acquisition or merger is that it will help diversify a company’s existing business and hence reduce a company’s risk level.
