The Theory of Corporate Finance - Assignment Example

The Theory of Corporate Finance Horizontal Merger is explained as the merger between two or more competent companies. It is believed that horizontal merger will create negative impact on the competitive situation in the market, 'they frequently run afoul of regulatory officials' (Yang, 2005). The degree of concentration is on rise due to the horizontal mergers. Considering an example of Staples Inc., a retailer of office supplies acquired Office Depot i.e. giant retailer of office supplies as well. It was believed that the merger will reduce the number of superstore competitors, as Staples will be the only product available in the market. The company's pricing data revealed that the Staples planned to establish their monopoly, and wanted to increase the prices of their product 13% after the merger. The merger was therefore criticized and blocked by the trading regulatory organizations, this saved 'consumers an estimated $1.1 billion over five years' (Yang, 2005), which otherwise would have been spent towards high prices. The acquisition and merger of the supplier with the reseller is regarded as vertical merger. In the case of vertical merger, both the parties are involved in buyer-seller relationship. The acquisition of the Medico Container Services by Merck is regarded as vertical merger. The regulatory authorities have appreciated exercises of vertical mergers. It is expected that consumers are also able to benefit from the vertical mergers, because such activities i.e. the integration of the supply chain, increase the efficiencies, the prices stabilize and quality of the services also improve. The merger of the Time Warner Inc. and Turner Corp., which are entirely different entertainment networks, has improved the services of the entertainment giants greatly. The regulatory authorities expressed their concerns that Time Warner after merger will be reluctant to offer and sell its video programs to other competitors of the cable TV companies, and Turner Corp. will have extra benefit through such bargains of merger, and Turner Corp. will be offered programming right at discriminatory rates, therefore both the companies will establish their monopolies against other competitors including Direct Broadcast Satellite and new wireless cable technologies. The regulatory authority also feared that the merger will affect competition in the production of video programming; the merger will allow Time-Turner to refuse the services of transmission by competitors. The regulatory authority therefore approved the merger as it was likely to improve the services, but ' Direct Broadcast Satellite and new wireless cable technologies' (Yang, 2005). The Corporate Diversification has been discussed in detail by the financial economists, the analysts are of the opinion that corporate diversification has lesser degree of favorable impact in judging the benefits of diversification for different reasons. The primary reason is that 'any diversification possibilities that corporations might have, will, in a perfect capital market, already have been exhausted through shareholders’ individual portfolio choices' (Yang, 2005). The secondary reason is that the diversification discount i.e. the diversified corporations have the privilege to trade at discounted rates as compare to their non-diversified counterparts. It has been therefore concluded that corporate diversification is neutral, but has the potential to damage strategy. Surprisingly, the corporate diversification has been strong practice, 'At face value, diversification can be explained by the fact that when pooling income streams that are less than perfectly positively correlated, the resulting income stream is less volatile than were the constituent income streams' (Yang, 2005). The dilution of the risk factor therefore has the potential to be beneficial. The critics of the corporate diversification are of the opinion that any reduction that can be achieved through diversification, by any of the firm, 'can be replicated by the individual shareholders through an appropriately chosen portfolio'. The shareholders are expected to achieve more through cheap and economical diversification, as compare to the firm. It is believed that diversification reduced the exposure of the shareholders towards risk, therefore diversification is beneficial for the shareholders, 'the view of diversification as a means to decrease the exposure to the risk of shareholders is unnecessarily narrow in that corporate diversification and the resulting decrease in risk factor could increase the combined entity’s debt capacity' (Montgomery, 1994). The major concern towards the debt capacity motive has been that it has suffered from drawbacks of the similar nature based on pure risk reduction motive. However, in perfectly functioning capital markets, the access to the credit for the firms is constrained and limited by the value of the project, therefore 'under the same conditions where the diversification neutrality result has bite, increasing debt capacity through diversification should not be a concern in the first place' (Yang, 2005). The important feature of the merger and acquisition features has been its resemblance with the business cycle, the merger and acquisition activities are positively related to the industrial output, business incorporations and further based on the reduction in interest rates. It has been examined that merger activity is positively related to easing of financing constraints. The increase in the merger activity is also based on the increase in the in collateral values. Economists have proposed that reorganization possibilities due to the advent of technology have created focus of the corporate towards merger and acquisition of corporate. Furthermore, overvaluation is also responsible for the increase in the merger activity. In certain cases the economy which has poorly capitalized firms, seek assistance through financial intermediaries to that funds for particular project can be increased. The merger or acquisition of unrelated firm is also expected to boost the debt capacity of the corporate. 'This means that the equilibrium extent of merger activity is a function of the amount of funds available from financial intermediaries. In equilibrium, when intermediary capital is plentiful, more firms will become active in the economy, many of them becoming so by forming conglomerates' (Montgomery, 1994). In recent past American companies experienced full-blown merger mania, for last decade, every year has experienced greater level of merger and acquisition activities. Although the market has experienced the negative fallout of the merger activities, the companies and shareholders have suffered tremendous economical blow than expected, however the current corporate sector has completely ignored such facts and has planned further mergers in the years to come, the conglomerate deals of the 1960s and 1970s which was responsible for the emergence of the non-profitable companies including ITT Corp. and Litton Industries 'have been thoroughly discredited, and most of these behemoths have been broken up' (Tirole, 2005). In October 1989, the bankers fail to raise the funds for the 'ill-conceived buyout' of UAL Corp., the deal later collapsed and was responsible for causing severe blow to the stock market. The successful experience of the mergers started when Chemical Bank Corp. and Manufactures Hanover Corp. planned to merger their finances and services, in 1991 both the corporate agreed to join in a $2.3 billion stock swap, the merger was responsible for the establishment of the second largest banking company in America, after the merger the corporate was able to produce $650 million in annual expense savings by the end of 1994. Once the merger exercises turned profitable, it was regarded that, 'this was to be the era of strategic deals, friendly, intelligent, and relatively debt-free transactions done mostly as stock swaps, which were supposed to enrich share holders by producing synergies in which two plus two equals five or more' (Montgomery, 1994). The diversification of the stock portfolio is responsible for the reduction in the risk, as it minimizes the potential loss from any single stock. The observation is applicable in cases of mergers and acquisition, if the 'companies treated the businesses they acquire as investors treat stocks' (Montgomery, 1994), the failure to do so will lead towards the increase in the threshold of risk factor, in some of the cases the diversification of the business is considered to be risky activity. It is because the companies diversify on marginal basis, it is impossible for any of the corporate to diversify broadly and offer the sought-for security. In contrast with the mutual funds, 'Mutual funds trade hundreds of stocks in many unrelated industries, with very little of the total portfolio in any single stock. By contrast, when a company expands into a new area, its portfolio consists of two stocks, typically 90 percent in the core operation and 10 percent in the new businesses’ (Tirole, 2005). The diversification in majority of the cases is responsible for lower return and maximal risk factor. Researchers have observed that there is possibility of higher failure rates and lower returns for unrelated acquisitions than for related acquisitions. When the company acquires businesses in their own industry, it is observed that lowest failure rates and highest returns phenomenon occur. The reason why the diversification into unrelated business is considered to be risky is that the corporate is unfamiliar about the industry itself, and therefore the corporate is likely to overlook critical risk factors during due diligence. The corporate is expected to pay more towards the acquisition of strange industry, and will experience trouble to monitor the performance of the new acquisition. It is therefore important that the company conduct the process of due diligence in comprehensive and thorough manner, and the entire proceedings should be flawless. Often the company has appointed non-technical and irrelevant people to monitor the task force, and different departments after the mergers, such appointments will affect the performance and growth of the business, and therefore the shareholder's investment is expected to be at stake. Diversification is popular and common practice in the American market. The responsibility of the manager is to increase the wealth of the shareholders, and therefore if the diversification efforts are consistent it is expected that the shareholders will be able to benefit. It is expected that the diversification of the firms is responsible for the growth of sales i.e. to be considered less vulnerable to the business conditions, therefore the diluting volatility will support and enhance the performance and initiatives of the management, and it is expected that ultimately the shareholder will enjoy the benefits of such efforts. Diversification is responsible for the diminishing the volatility of the profits, and therefore the expected profit remain consistent. Diversification also have an impact size of the firms, the size of the firm is expected to increase after it diversify through acquisition of other firms, and it is believed that such acquisitions offer hidden payoffs to the top management on the basis of the company's size and magnitude. It is not always necessary that the diversification is profitable for the shareholder. There is no difference 'between the diversification of the portfolio of shares and diversification by the firms, and the shareholders’ (Tirole, 2005) investment is at risk. Considering the example of developing countries, the steel company has diversified its operation into telecommunication, and therefore there is equivalent portfolio of shares in telecommunication and steel company separately. Therefore the diversification carried through portfolio is proper course to lower the volatility in a diversified firm, 'this alternative is readily available to the owners directly, and hence managers do not add value by doing firm-diversification if the only gain is a reduction in the risk factor of profits and sales'. The firm diversification is not responsible for the addition of value, rather it reduce the value, the reason because merger activities are considered to be expensive, and therefore it require great deal of managerial efforts for the execution of an exercise centered at entrance into a new industry, also 'buying out an existing company in the target industry but assimilating the taken-over company is still an onerous and time consuming task where failures are not uncommon' (Tirole, 2005). It is argued that the degree of diversification is the measure for the size of benefits likely to be achieved by the shareholders. The small benefit is achieved by the shareholder involved in the diversified project; therefore such investors are poorly inclined towards IPO of such diversified firms. The reduction in the likelihood of an IPO is linked with the increase in the degree of diversification, therefore IPO is mainly preferred by such investors who are strange to diversified companies, and as such investors have the potential to make profit from diversification of their portfolios. The firm is likely to go public if the stakeholders are diversified, and possess equal shares. The banks are likely to avail the opportunity for the increasing the value of deposits insurance, therefore, 'an acquisition policy designed to maximize the value of deposit insurance may be shareholder-wealth maximizing if an increase in the value of deposit insurance increase shareholder wealth'. It was believed that the possibility that banks seek to become larger to increase the probability is possible provided that the FDIC will cover 100 percent of the bank's deposits, the "deposit insurance put-option-enhancing" hypothesis predicts the pursuance of the growth under social suboptimal conditions, the mergers of banks equity also improve the pursuance of growth in terms of increase in salary, perquisites, and personal prestige. The deposit-insurance hypothesis is based on the assumption that the 'acquirers would be willing to pay more for riskier, more profitable organizations whose returns are highly correlated with the acquirer's returns'. The managerial-interest hypothesis is constant and consistent, and has no relationship with purchase price and exposed risk. It is expected that corporate in particular banks through maximizing risk fail to maximize the shareholder wealth; it is because the regulatory will defy any such risk exposure associated with funding of shareholders, and also in the case of failure the expected loss will be greater than the deposit insurance. Therefore the wealth of the shareholder can be increased through mergers that diversify earnings. The earnings diversification hypothesis is based on the fact that higher levels of cash flow for the same level of total risk can be achieved through acquiring banks i.e. seek earnings diversification, 'the reductions in business risk are offset by increases in financial risk'. The analysts are of the opinion that acquisition of firms can offset the reduction in equity value, which can be achieved through issuance of additional debt; such measures diminish the probability level of bankruptcy to the previous level, there have been strong evidence that leverage is increased as a result of mergers and acquisitions between the non-financial firms. It has been observed that banks acquired by bank holding companies have reduced their capital ratios after acquisitions, and reduction has been incorporated at significant level, 'the increased leverage increases the tax shield due to debt and, hence, after-tax net cash flow' (Tirole, 2005). The acquired banks reduce their holdings of low-risk securities to a greater level, and also improve their holdings of loans, this correspondingly increase the earnings. Question#3 The revenue enhancement and cost cuttings are the major reason behind mergers and acquisition activities. The exploitation of the potential costs and revenue is achieved through merger activities, in 1996, the merger of Chase Manhattan and Chemical Bank created largest banking organization in U.S.A, the assets of the company after merger stood at $ 300 billion, it was reported that the merger was responsible for the annual savings of more than $1.5 billion, which was achieved through 'consolidation of certain operations and elimination of redundant costs' (Tirole, 2005) which was based on the removal of 12,000 positions from combined staff of 75,000. The merger was responsible for expansion of the operations, and the corporate had its branches in more than 39 states of American, and was present in another 5 countries across the world. The Ban cone purchased First Chicago in 1998 for $30 billion; the acquisition was responsible for the annual cost savings of more than $930 million, additional $275million was saved through integration of credit card and other retail and commercial services. The Firstar acquired Bancorp for $18.7 billion in late 2000, it was expected that the merger will reduce the expenses by $206 million on annual basis. The acquisition of Summit Bancorp by Fleet Financial's for $7 billion in 2001 was responsible for the annual savings of $275 million. It is expected that acquisition of the bank is likely to increase the revenues in the growing market. The merger of J.P-Morgan and Chase Manhattan in 2000, and the establishment of J.P-Morgan-Chase was responsible for cost savings of $1.5 billion; the merger was performed to increase the revenue growth. The merger combined 'J.P. Morgan's greater array of products with Chase's broad client base, the merger added substantially to many businesses such as equity underwriting, equity derivatives, and asset management', which previously both the firms failed to launch in a comprehensive manner individually, both the corporate mutually were able to develop their own presence through deals, and were able to achieve presence in Europe, 'where investment and corporate banking were fast growing businesses' (Tirole, 2005). The assets and liability portfolio of the institution offer different credit, interest rate, and liquidity risk characteristics which is based on the stability of the acquisition of the bank's revenue stream. Considering the example of real estate, in 1980's the real estate value of the Southeast American region declined, and was lower than the worth of the Northeast. Therefore the availability of the geographically diversified real estate portfolio produced a stable revenue stream. The revenue enhancement can be achieved through adoption of investment and expansion activities in areas that offer mediocre level of opportunities less compare with the fully competitive avenue. It is therefore important the merger should not involve 'a federal government assisted purchase of a failing bank' (Tirole, 2005). Mergers of banks holding companies are included, and bans which are subsidiaries of common banks holding tock are not included. It is important that minimum $250 million in book value of total assets prior to merger should be possessed by the merging banks. It is also important that the book value of the target bank's assets must be at least 10 percent of the bidder bank's assets. The bidder should be barred from participation in any other merger activity, it is also important that the bidder bank should have minimum single industry match bank. The size of the banking organization can be increased to improve the value of the deposit insurance. The increase in the variance of the returns of the acquired bank is another parameter to increase the value of deposit insurance. It is important to estimate the differences in the operating performance and the ratios of certain parameters in pre- and post-merger context. Following are the performance indicators, which should be thoroughly reviewed and estimated to predict the impact of the merger and acquisition activities, in particular the financial companies, the parameters were forwarded by Cornett and Tehranian, the overall performance is measured through profitability indicators, the bank's ability to achieve the regulated capital standards and its success in attracting the loans and deposits is based on the measurement of Capital Adequacy Indicators, the changes and reforms in the bank's quality of loan can be judged through Asset Quality Indicators measure. The bank's ability to improve and increase its revenue, expenses related to pay and measurement of employee productivity is based on the Operating Efficiency Indicators Measure. Changes in the composition of the bank’s; loan portfolio, and its return can be assessed by Loan Composition Indicators Measure. The changes and activities in the generation of income, excluding the lending activities at the bank should be monitored by Non-interest Income Indicators Measure. The changes in the off-balance sheet activities of the bank should be based on Off-Balance-Sheet Indicators Measure. Similarly parameters including Liquidity Risk Indicators Measure and Growth Indicators Measure assist in the evaluation of changes in the bank's cash position and the bank's change in assets and deposits respectively. The organization after its merger might have lower risk level, prior to portfolio changes, it is because diversification is based on 'less-than-perfectly correlated returns at the two banks and because the target is low risk' (Tirole, 2005). The returns of acquirer and the target, and its covariance can be determined through respective returns on assets during the last four years prior to merger. The variance of the earnings of the target is also based on the variance of return. The non-diversification of the owners of the target banks is inversely related to the variance of the target. The estimate for the Change in Net Cash Flow is dependent upon the ability of the acquirer to minimize the 'costs of producing the combined organization's existing product mix by achieving economies of scale'. The managers of the target banks may be inferior to me managers of the acquiring banks in producing shareholder value. The superiority of the managers of the acquiring banks is based on lower costs and increased revenues. The ratio of the efficiency of the acquire to its book value of equity based on the assumption that stock market worth more or less than its book value, provided 'if the bank's managers are better or worse than normal'. There is a possibility that prospective target bank might improve its value to an acquirer, under such market condition, the size of the market, and the expected market growth, and degree of concentration are the crucial factors. Market concentration is responsible for the reduction in the probability of horizontal acquisition, and is also considered to be insignificant factor for the determination of market extension mergers. The avoidance of such factors is responsible for the ' bias results weakly against the earnings diversification hypothesis' (Amel-Rhoades, 1989) References 1. Montgomery, C. A. Corporate Diversification. Journal of Economic Perspectives. 1994. pp. 165 2. Tirole, J. The Theory of Corporate Finance. Princeton University Press. 2005 3. Yang, L. What Has Motivated Diversification: Evidence from Corporate Governance? 2005. Read More