Economics and Finance of Business - Literature review Example

If managers are rational, mergers should always lead to an increase in shareholder value and Introduction Mergers and acquisitions are among the most used corporate strategies by businesses in the world. Andrade (2004) explains that mergers and acquisitions are used to grow business corporations to the desired sizes. It, generally, involves two or more companies combining and then offering the target company’s shareholders some shares in the acquiring company. The targeted company’s shareholders then surrender their stake in the target company (De Long, 2003). Mergers and acquisitions enable the combination of many business entities without necessarily creating a new business entity (Rizzo, 2010). The shareholders’ value after the merger or acquisition is usually higher than that of the individual companies, at least in theory (Gaughan, 2005). All mergers and acquisitions are based on reasons that are intended to benefit all the parties privy to the exercise. Sharma (2009) asserts that the rationale for undertaking mergers and acquisitions is, ultimately, to increase the value for the shareholders. Rational managers, therefore, intend that the incentives amassed be aligned with shareholder’s wants which are to grow their wealth. Rizzo (2010) adds that if managers are rational then an increase in shareholder value should be certain. Formal approval by the top level managers, communication of the decision to the shareholders and employee as well as adequately documenting the transaction were seen as the ultimate show of objectivity by managers and, in the process, making clear the rationale behind the manager’s decision. This paper first investigates the rationale behind mergers and acquisitions. The paper then delves into the issue of whether mergers always guarantee an increase in shareholder value if rational decisions are made by showing when exactly can value for shareholders be increased. Lastly, the paper gives some explanation for value destruction in a merger or acquisition. The rationale for mergers and acquisitions The rationale for mergers and acquisitions is, ultimately, to increase the shareholder value of both set of shareholders involved in the transaction. Mergers and acquisitions are based on the net present value gains model (Miller, 2008). A firm conducts an analysis of the expected cash flows and profits it expects from the transaction. The NPV model is also crucial in determining the period it would take a firm to recover the invested capital (Harding and Rovit, 2004). The major ones are by increasing the market share and penetration of the entity, by accessing new markets, by diversifying the products or services on offer, by controlling the chain of supply, and by enjoying cost efficiencies (Arnold, 2009). These benefits are meant to create synergies which, in turn, increase the shareholder value. There are, generally, three forms of synergies targeted by managers in order to increase the shareholders’ value; operating synergies, financial synergies and managerial synergies. These synergies, essentially, lead to economies of scale benefits, increased competitive power and reduction in transaction costs. The major operational synergies include revenue enhancement as the new entity is able to sell to new markets and, in the process, increase the volume of its sales (McLaney, 2003). The other operational benefit is having a greater market share and penetration than when each of the entities was operating individually. Managers also achieve cost reduction as an operating synergy in that larger companies are able to enjoy economies of scale in their productions (Sharma, 2009). The major financial synergies include managers being able to diversify the products on offer (Ross, Westerfield and Jordan, 2007). Through diversification, risk is reduced. According to Arnold (2009), when risk is reduced the company is able to take out more loans at lower interests rates since its perceived debt capacity has increased. The third synergy is the managerial synergy. This is achieved when the two management teams combined to form a highly efficient unified team (Bruner and Perella, 2004). Figure 2 is a summary of the rationale behind acquisition of firms worldwide in a study conducted by KPMG in 2011. Figure 1: The rationale behind acquisition in their order of ranking (Source: KPMG 2011) All the aforementioned incentives, in one way or the other, are geared towards directly benefiting the shareholders. However, mergers can also be rational without its incentives necessarily being aligned with shareholders’ expectations (Balls, 2014). For instance, there are mergers and acquisitions that are being undertaken to improve a company’s status or power in the industry. In the end, the company benefits from the transaction but the shareholders’ may not, though their value increases nevertheless. Shareholders’ value A study conducted by KPMG in 2011 found out that, actually, 83% of the mergers and acquisitions in the world do not lead to an increase in shareholders’ value (KPMG, 2011). The study further noted that, in contrast, those corporate decisions have led to the decline in shareholders’ value in 55% of the cases (Ferris and Pettitt, 2013). Studies have also concluded that the shareholders of the targeted partner are the ones that experience the increase in value (Lejoux and Elson, 2010). The same could not be said of the shareholders of the acquiring company. Mourdoukoutas (2011) observed that the share prices of the target company tend to increase in value around the time the intent for the merger or acquisition is made public until the day the deal is finalised and sometimes even beyond. The target shares increase in value by 15.5% but most of the acquirers’ share value tend to slightly decrease in value mostly by -1.0% (Sharma, 2009). Figure 3 shows the trend over the past one and a half decade indicating who between the acquirer and the target benefits the most from mergers and acquisitions. As can be observed from this analysis conducted by KPMG, it is clear that the sellers are the major beneficiaries. Only about a third of all transactions result to the enhancement of the shareholders value for the acquiring company. Figure 2: Enhancement of shareholder value trends (Source: KPMG 2011) Therefore, it is safe to refute the presumption that provided the decision by managers is rational there is the guarantee that the shareholders’ value is bound to increase. The following situations are the ones that are likely to increase the shareholders’ value. Situations that add value The decisions to merge or acquire another company are major decisions that require a lot of capital commitment. These decisions ought to be rational and right so as to maximise the shareholders’ worth. There are, thus, many situation where a merger or acquisitions may be prove rational in the sense that it increases value. Studies indicate that the shareholder value is likely to appreciate if the acquirer managers purchase a foreign target as opposed to purchasing a domestic one (Rizzo, 2010). This is because many investors perceive that as mega external growth and limitless possibilities for its market abound. The value is also likely to increase if the acquiring company managers pay for the merger or acquisition in terms of cash as opposed to securities or a combination of the two (Ferris and Pettitt, 2013). The shareholders have the perception that their investment is likely to pay more dividends. The third situation where value is enhanced is where a company makes only one acquisition. This is because it creates a statement of purpose; that the company actually wants to expand and not just merging or acquiring for the sake of it (Balls, 2014). Some of the single mergers that have panned out very successful include Exxon and Mobil merger in 1998 and Vodafone acquisition of Mannesmann in 1999. A good example of a company that went on an acquisition spree that proved costly in the end is that of Cisco Systems which undertook seventy acquisitions in the 1990s (Ferris and Pettitt, 2013). The other opportune time for managers make merger or acquisition arrangements that increase the shareholder value is when the target is in a downturn as opposed to an upturn (Berj and De Marzo, 2014). Rizzo (2010) observes that one of the mistakes that Cisco did when merging with Net Speed, New Port Network Solutions, Growth Networks and many others is that it undertook the corporate strategies when its targets were experiencing favourable conditions in the market. Despite all these circumstances that present opportune moments for making the merger and acquisition deals, it is a general trend that the acquirer shareholder value depreciate first at least in the first 60 days. From there, some increase in value while others do not recover. Figure 4 shows a summary of the average performance of acquiring firms in the first 60 days after the merger or acquisition. As can be observed, even if the shareholder value increases, it is not by more than 2%. Figure 3: Acquirer shareholder value in the first 60 days (Source: Sharma, 2009) Evidence of performance improvement and distribution of benefits As has already been established, the target company’s shareholders usually benefit more from the transaction than the acquirer company’s shareholders. Most of the mergers and acquisition transactions involve the target company shareholders being issued common shares in the acquiring company (Balls, 2014). A good example of a merger transaction that was successful and shows evidence of improvements post-merger is that of Exxon Mobil. Exxon and Mobil merged in 1999 with Exxon acquiring Mobil (Rizzo, 2010). Both companies, at the time of the merger, had healthy financial accounts but were driven towards the merger to leverage the potential synergies. Before the merger, Exxon had a return on asset (ROA) ratio of 6.75% while Mobil had 3.95%. After the merger, Exxon Mobil had a ROA ratio of 10.01% after one trading period. Exxon’s return on equity was 14.57% while Mobil had 9.05% (Ferris and Pettitt, 2013). The combined ROE rose to 19.67%. Additionally, pre-merger, both companies had healthy gross profit margins which improved immensely after the merger. Exxon had a pre-merger gross profit margin of 38.7% while Mobil nearly equaled that with 38.52% (Miller, 2008). The combined profit margin after the merger for the first trading period was 43.6% (Ferris and Pettitt, 2013). All the aspects of the new venture were better than when they were operating singularly. KPMG (2011) established that the performance of the resultant firm was way better than when they were operating separately. The only thing that recorded a decrease was the working capital and it is solely because the company had to undertake divestitures after the completion of the merger transaction. In the end, the combined entity realized operating synergies, capital productivity improvements and technology synergies. Operating synergies were realized in terms of improved sales efficiency, economies of scale, and reduction of the unit costs. As a result of the complementary nature of the two companies, the annual pre-taxes profits also increased. In terms of capital productivity, the combination of the two managements ensured that the new company used the best managerial practices available (Balls, 2014). In terms of technology, both companies’ proprietary technologies were combined and leveraged. Distribution of benefits Most of the companies distribute benefits in form of the common shares of the acquiring company (Rizzo, 2010). In this instance, Mobil shareholders were given Exxon common shares. For every common share a Mobil shareholder gave up, they were given 1.32015 Exxon shares (Miller, 2008). Therefore, Mobil common shareholders benefited by having Exxon pay a premium prices for their shares. In the end of the transaction, Exxon had paid a 26.2% premium amounting to US $15.4 million which was distributed among Mobil shareholders as benefits alongside retaining their shares in the combined company (KPMG, 2011). Shareholders Value Destruction The main reason cited for shareholders’ value destruction is overestimation of the target’s value by the acquirer (Lumby and Jones, 2003). This overestimation of the target company value is usually preceded by overestimation of the synergies expected from that merger or acquisition (De Long, 2003). This overestimation of either the market potential or the growth potential of the target leads to the acquirer paying more for less. The other destroyer of shareholders’ value is overbidding and overpayment by managers (Sharma, 2009). This arises especially when there are many acquirers competing for a single target. The competition places the target at a higher bargaining level and enables it to ask for more offer price (Gaughan, 2005). The acquirer ends up paying a premium. The last factor is failure by the managers of the acquirer to successfully integrate the target after the merger or acquisition has taken place (Miller, 2008). In conclusion, mergers and acquisitions are, thus, essential tools and effective corporate strategies for growing business entities. They, on their own, however, do not guarantee an increase in shareholder value. If rational decisions are made and the necessary factors that are likely to enhance or subdue the shareholder value are taken into consideration during decision making then better decisions can be made. If viable decisions are made, the new entity would be able to realize operating synergies, financial synergies and managerial synergies which eventually lead to a successful business venture that maximizes its shareholders’ value. References Andrade, G., 2004. Investigating the role of mergers. Journal of Corporate Finance, 36(1), pp. 83-104. Arnold, G., 2009. 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London: McGraw Hill. Sharma, V., 2009. Do bank managers create shareholders’ value? An event study analysis. Minneapolisfed.org, [Online] Available at:< http://www.minneapolisfed.org/mea/contest/2010papers/sharma.pdf> [Accessed 17th March 2014] Van Horne, J., and Wachowicz, J., 2009. Fundamentals of financial management (13th Ed). London: Pearson Education/ FT Prentice Hall. Read More