- CFA Exams
- 2023 Level I
- Topic 4. Corporate Issuers
- Learning Module 18. Mergers and Acquisitions
- Subject 2. Motives for Merger
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Subject 2. Motives for Merger PDF Download
We now consider motives for mergers. There are possible reasons why two firms may be worth more together than apart. An acquisition adds value only if it generates additional economic rents - providing a further competitive edge that is not easily reproduced.
Motives for mergers include the following:
This is the most common motivation for a merger. A larger firm may be able to reduce its per unit cost by using excess capacity, spreading fixed costs across more units or sharing central services such as office management, accounting, financial control, etc.
Control over suppliers "may" reduce costs, but over integration can cause the opposite effect. Many companies now outsource the provision of many services and various types of production.
Mergers can also create revenue-synergies by cross-selling at distribution level or customer level.
External growth through M&A activity is easier to achieve than growth caused by making investments internally (e.g., organic growth). This is especially common in a mature industry. It is also less risky than entering an unfamiliar market and establishing the resources internally.
Increasing Market Power
If two firms in the same line of business are merged it is called horizontal integration. Greater pricing power from reduced competition and higher market share should result in higher margins and operating income.
If firms that have supplier-customer linkage are combined it is called vertical integration. A vertical merger involves companies at different stages of production. The buyer expands back toward the source of raw materials or forward in the direction of the ultimate consumer. An example is a car manufacturer purchasing a tire company. Control over suppliers may reduce costs.
Acquiring Unique Capabilities and Resources
Merging may results in each firm filling in the "missing pieces" of their firm with pieces from the other firm. For example, a small firm may have a unique product but lack the engineering and sales organization required to produce and market it on a large scale. It's probably cheaper and quicker to merge with a firm that already has engineering and sales talent, than developing the talent from scratch.
It is often argued that by merging across different industries (conglomerate merger) the shareholders can enjoy the benefit of reduced risk. The shareholders get all the diversification they want at a much lower cost and more efficiently than by buying shares in the two companies separately. However, corporate diversification does not affect value in perfect markets as long as investors' diversification opportunities are unrestricted. Investors should not pay a premium for diversification since they can do it themselves.
When a company with a high price-earnings ratio (P/E) merges with a low P/E company, the combined firm can enjoy higher earnings per share. This looks like a neat trick, if you can pull it off. The problem is that the company with the lower P/E probably has a lower P/E because it has lower growth or less reliable earnings. The market will value the combined firm at a P/E lower than that of the high P/E firm, because the combined firm has lower growth or less reliable earnings. Bootstrappers assume inefficient markets and investors, who can't see beyond their nose!
Notice that because Muck and Slurry has relatively poor growth prospects, its stock sells at a lower price-earnings ratio than World Enterprise. We assume that the merger produces no economic benefits, and so the firms should be worth exactly the same together as apart.
Since World Enterprise stock is selling for double the price of Muck and Slurry stock, World Enterprise can acquire the 100,000 Muck and Slurry shares for 50,000 of its own shares. Thus World Enterprise will have 150,000 shares outstanding after the merger.
Total earnings double as a result of the merger, but the number of shares increases only 50%. Earnings per share rise from $2.00 to $2.67. This is called a bootstrap effect because there is no real gain created by the merger and no increase in the two firms combined market value. Since the stock price is unchanged, the price earnings ratio falls.
Therefore, before the merger $1 invested in World Enterprise bought 5 cents of current earnings and rapid growth prospects. On the other hand, $1 invested in Muck and Slurry bought 10 cents of current earnings but slower growth prospects. If the total market value is not altered by the merger, then $1 invested in the merged firm gives 0.067 cents of immediate earnings but slower growth, and the Muck and Slurry shareholders get lower immediate earnings but faster growth. Neither side gains or loses provided everybody understands the deal.
Financial manipulators sometimes try to ensure that the market does not understand the deal. Suppose that investors are fooled by the exuberance of the president of the World Enterprise and by plans to introduce modern management techniques into the Earth Sciences Division (formerly known as Muck and Slurry). They could easily mistake the 33 percent post-merger increase in earnings per share for real growth. If they do, the price of World Enterprise stock rises and the shareholders of both companies receive something for nothing.
Managers' Personal Incentives
- Empire building: Some top managers' interests seem to lie in making their firms the largest and most dominant firms in their industry or even in the entire market.
- Managerial ego: It is clear that some acquisitions, especially when there are multiple bidders for the same firm, become tests of machismo for the managers involved. Neither side wants to lose the battle, even though winning might cost their stockholders billions of dollars.
- Compensation and side-benefits: In some cases, mergers and acquisitions can result in the rewriting of management compensation contracts. If the potential private gains to the managers from the transaction are large, it might blind them to the costs created for their own stockholders.
Tax benefits can arise either from the acquisition taking advantage of tax laws or from the use of net operating losses to shelter income. Thus, a profitable firm that acquires a money-losing firm may be able to use the net operating losses of the latter to reduce its tax burden. Alternatively, a firm that is able to increase its depreciation charges after an acquisition will save in taxes and increase its value.
Unlocking Hidden Value
Some firms are not managed optimally and others often believe they can run them better than the current managers. Acquiring poorly managed firms and removing incumbent management, or at least changing existing management policy or practices, should make these firms more valuable, allowing the acquirer to claim the increase in value. This value increase is often termed the value of control.
The breakup value is the value of a company if each of its parts were independent, publicly traded entities. Companies often consider the breakup value of targets when evaluating a possible takeover.
A combination of a firm with excess cash, or cash slack, (and limited project opportunities) and a firm with high-return projects (and limited cash) can yield a payoff in terms of higher value for the combined firm.
Cross-border mergers can be used to achieve many international business goals, such as exploiting market imperfections, overcoming adverse government policy, technology transfer, product differentiation, and following clients.
Learning Outcome Statementsb. explain common motivations behind M&A activity;
c. explain bootstrapping of EPS and calculate a company's post-merger EPS;
CFA® 2023 Level I Curriculum, Volume 3, Module 18
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