The Event Study Methodology and the Accounting Performance - Thesis Example

Conclusion In this research we have studied the cases of five mega mergers. Our objective is to analyse whether these acquisitions pronounced success. We have made an effort to judge the justifiability of merger on the ground of value creation. In this purpose we have used the two techniques. The first one is the event study methodology, for which the target variables are abnormal stock price return (ASRP), cumulative abnormal stock price return (CASRP) and the Sharpe ratio. The second one method is the accounting performance techniques, in which the target variables are return on equity (ROE), an indicator of profit, and the cash flow variables such as operating cash flow (OCF) and absolute cash flow (ACF). The definitions of the aforesaid variables are given in the research methodology. In each case of these mergers the individual companies became integrated to form a mega giant company. Though we mention these as the examples of merger actually those are the examples of acquisition. But the fact is that none of these five is a case of hostile acquisition rather all of these can be termed as friendly acquisition. While merger took place the existing shareholder of the merging companies retain their own position regarding the share they hold and the position to which they belong. Regarding the positions of the shareholders of both of the companies in the pre contract and the post contract situation here the acquisition becomes synonymous to merger. Generally the merger and acquisition takes place for various reasons: some of the reasons are beneficial for the shareholders. In these cases the major objective of the merger of each partnership was to capture the market as much as possible. If the mergers become successful enough to generate profit the shareholders premium would raise and hence the price of share and equity would rise consequently. There are two major benefits that a shareholder may enjoy. I. if the amount of dividends rise then the shareholder is benefited as he gets higher return on the same amount of money. If the premium on the share rises then the shareholder is better off. II. If the price of the share rises due to the merger then the shareholder would enjoy a capital gain. That is also a benefit that is brought about by merger. But if we consider an increase in the part of undistributed profit due to merger then we can say that the merger is not beneficial for the shareholders. . For example when a profitable company merges with a loss making company, it use the loss as a tax writes off to offset the profit, while the company is experiencing an expansion. Here the corporations that merged used to sell homogeneous products. Here the mergers have taken the form of horizontal integration. These mergers were planned and carried out to increase the share of the company in the entire financial market. Mainly the large corporations merge with each other to satisfy this objective. If the major rival firms merge they become more powerful to dominate the market. The major benefit they can reap is the increased monopoly power which is reflected through their new set of policies to operate in the market. For example we can use a hypothetical case. We consider that the penalty for default was $ 40 for being defaulter in instalment in J.P Morgan & Co; it was $35 for Chase Manhattan. So people would seek lower default charge. But if the both merge together, a single giant bank will be formed and they can raise the penalty now. In this way the monopoly power can be executed. One more popular form of merger is the merger of the companies supplying the complementary goods. Sometimes such companies merge to form an integrated company to save the cost. In our examples the corporations were the rival in early days. But as they used to sell homogeneous product they did it to capture market power. Now we should feel the inquisitiveness to learn what the economic logic of adopting merger is. By merger the companies might reap the maximum benefits from economies of scale and the economies of scope. Both of those enable the newly formed giant firm to enjoy some major advantages in the market. Economies of Scale Economies of scale are beneficial effects enjoyed by a firm along with the expansion of the output by the firm or company. When the cost per unit decreases with the increase in output, the company is supposed to enjoy the economies of scale. Economies of scale are significant for a company as the benefit of the lower cost is transferred to the consumers through the lower price. It enables the firm to capture the market share. Given the price a lower cost due to the presence of the economies of scale helps the firm to enjoy higher profit margin. There are two major types of the economies of scale: A. Internal Economies of Scale: Internal economies of scale mean the advantage obtained by the expansion of a single firm. There are different kinds of internal economies of scale:- 1. When the firm expands it needs to buy a larger amount of input. That enables it to enjoy more bargaining power in the factor market. 2. When the firm adopts large scale production plan that requires more sophisticated technology. Hence the productivity of the factors rise and the cost of production decline. In these cases of mergers while the banks merge they have to modify their networking system. In earlier times they had the isolated network. Whenever the merger is complete they required an integrated networking system with more sophisticated database management system. This transformation generally brings about a positive change in the efficiency of the employees. 3. When the firms combine to make a giant firm it is easier for it to get finance. Hence the large firms enjoy facility. Here the companies are financial intermediaries. The merger would enable them to attract people to deposit because people would think that the merger of banks would make those more efficient and the rate of return would increase. 4. Some parts of the cost are fixed in nature. Examples are advertising cost, marketing cost etc. Larger the scale of production lower will be the average cost in these accounts. In case of the banks a major service is done through providing loans. The total official cost of providing a loan does not differ much for the different amounts of loan. While the merger takes place the size of the corporation rises and hence the value of capital would also rise. That will increase the capacity of the bank in providing loan. As the transaction cost remains more or less unchanged for different amount of loans higher amount of loan refers to less average cost of lending operations. Moreover, we can consider the case of monitoring cost of providing loan. If we consider two banks one operating in Chicago and another at Dallas. Now if a person from Dallas applies for loan to the bank from Chicago the bank has a cost of monitoring the applier from Dallas. But if the both merge while the application comes the bank from Dallas would make the required investigation for providing loan. The transaction cost would be minimized. 5. With the growth of output there will be the presence of specialization in the different areas. That maximises the skills of the workers. Hence it would add efficiency in production which is reflected by declining average and marginal costs. B. External Economies of Scale: External economies refer to the fact when the expansion of the industry takes place, existing firms enjoy some benefits. But for merger the benefits reaped from external economies of scale are less. The merger of these companies provided the path of enjoying the economies of scale: both internal and external economies. The giant size of the new firm enabled them to do so. The Economies of Scope: Economies of scope means the spreading of the uses of the resources and skills over two or more products so that the company can enjoy a reduction in cost and increase in the skill. In figure 1 we show that the cost of an enterprise is halved whenever the resources are used in two commodities instead of one. If we introduce three products the cost would be reduced into one third. Figure1 The Economies of scope given in a two quadrant diagram. (Hofstrand, 2007) Now we consider the case study of the five mergers of J.P. Morgan and Chase Manhattan Corporation (J.P.Morgan Chase); J.P.Morgan Chase and Bank One; Bank of America and Fleet Boston; Wells Fargo & Co and Pacific Northwest Bancorp; and Citicorp and Travelers Group Inc. Here we have made an effort to answer the following questions which are tentative for out study. That’s why we have used some statistical tools and tables. 1. Using the combination of event study analysis and accounting performance techniques will the merger and acquisitions appear to have created value for the corporations? 2. Is the combination of event study analysis and accounting performance techniques more effective in measuring the real value than either those methods alone? In this research the researcher has used two major techniques; event study methodology and accounting performance. The analysis using event study methodology has included ‘Abnormal Stock Price Return (ASPR) and the Sharpe Ratio. The event study methodology is used to judge the justifiability of the mergers to serve the interest of the shareholders. That’s why each of the variables in this methodology is related to the share market. The measure for the accounting performance technique variable includes return on equity (ROE), operating cash flow (OCF) and absolute cash flow (ACF). These variables are related to the functioning of the corporations. We have taken both of them. If we had taken only the variables regarding the share market the result could have been misleading. On the other hand if we had used only the accounting performance we could have ignored the justifiability of the merger on the basis of the benefits that could be enjoyed by the shareholders. We have applied both of these and the period started from 2 year prior to the merger and after 2 and ½ year of the merger. Data was taken at the common interval of six months. Now we can find the result obtained from the analyses of the available data on this case history. 1. First we consider table 1 we can find that the rate of abnormal stock price returns was highest for the J.P Morgan Chase & Co and the Bank of America. So we can say that J.P Morgan Chase and Bank of America’s performance remained very brilliant in terms of market. That’s why these two the firms enjoyed abnormal stock price return (ASPR) higher than the other banks. From table 1 and 2, which show the descriptive statistics and buyer and private banks prior to the merger and after the merger respectively we come to know that the market performance was better than the individual stock performance. But for J.P. Morgan Chase & Co the individual stock performance was better than the market performance. By measuring the Sharpe Ratio we can find a general increase in the 10th to 20th time period. So the return from the same risk became higher due to the merger. This resembles the success of merger to serve the interest of the shareholders. 2. Table 3 and table 4 have represented the buyers target average measures for the variable of accounting performance techniques before and after the merger. From table 3 we find that the mean return on equity was greatest for the Bank of America at the time of announcement of merger and over time declined drastically, it was highest for J.P Morgan & Co. On the other hand that J.P Morgan &c Co experienced the highest operating cash flow. If we consider the descriptive statistics regarding the event study methodology and the accounting performance these merger pronounced success. The movements of abnormal stock price return, Sharpe ratio, return on equity, operating cash flow and absolute cash flow were satisfactory. In that sense this case of merger is successful. The results which were predicted have come true in the reality. So we can say that whenever we are taking the two major variables like accounting performance record and event study methodology to express the success of this merger in adding value the merger can be said successful. It is a method of evaluation of the performance of merger and acquisition of the firms in terms of the two techniques: (a) event study analysis and (b) accounting performance techniques. We have centred the spotlight of our focus in the two. Here we had the chance to justify the value creation by using another two crucial factors or indicators. Those are I. Profit Ratio: the ratio of profit and total asset. Higher profit ratio indicates better performance and better value created by the merger firm. II. Credit deposit ratio: the ratio of credit created and deposit maintained. If we consider a bank as a profit making body, then its main source of profit is the credit it extends to a loan seeker. The loan it extends does not fall from the sky, rather, it is the deposited money of the account holders. Now, the bank has to pay a certain rate of interest rate on the deposited money and the difference between the rate of interest it charges on the loan it extends and it provides on the deposited money may be taken as the per unit profit for the bank. It is easily understandable that if the bank does not extend loan, that is, the credit component remains a small value comparing to that of deposited amount, then most of the bank’s cash is sitting idle and to be precise the bank is not performing well, that is running a loss. So the credit deposit ratio (Credit/Deposit) is an important component while we judge the working health of the bank. However, the credit deposit ratio bears important and interesting significance for a bank. As mentioned and analysed earlier the too low credit deposit ratio (much less than 1) signifies ill health for the bank. If the ratio is greater than 1, then it also portrays the fact that the bank is living a risky life and a sudden debacle is on the cards. This follows from the fact that with a credit deposit ratio greater than 1, the bank is extending more loan than it is capable. If, suddenly, a group of account holders comes back and ask for a sudden withdrawal of funds, the bank is almost certain to fail to keep its words of pledge (in this case, the bank is left with no fund so that it can fulfil its account holders’ demand. Because of this it is very important to consider credit deposit ratio in the above analysis and otherwise the favourable outcome in terms of value addition that has gone on the merger’s way will remain as a restrictive local outcome and cannot be tagged as a universal truth. (Bagchi and Banerjee, 2005) Another important point that needs to be considered and deserves further research is concerned with the profit component of the banks. Merger and acquisition necessarily increases the size of the bank like any other corporate. However, whether the per unit profit calculated in terms of total asset has increased or not has to be considered (that is, profit/total asset). Unless we consider this indicator we cannot comment on the efficiency part as it may happen the total profit has risen whereas the per unit profit has actually fallen. Both these components or rather indicators have not been considered in our above analysis. However, what we have considered obviously portrays the fact that merger and acquisition has substantial positive impact on the value addition front for banks. Actually there is not only the advantage of economies of scale in time of expanding the size of the firm through merger. But there may be some problems also that are concerned with the larger size of the firm created by merger. The conversion into one company from a number of companies generates some problems which are called the problems or diseconomies of scale. That is the possible answer of the question - If merger is profitable for the merging companies why don’t all the companies merge? As we are here to find out the performance of the merger in terms of value created we are here avoiding the case of the diseconomies of scale for the sake of simplicity. The detailed discussion can be done while the overall performance of merger will be the centre of concentration. Then the following problems should be considered for judging the merger performance: There may be one answer that this type of merger would demolish the competitive structure in the market by creating the framework of a cartel or multi plant product monopolist. The major operational problem of a giant firm, which we call ‘Diseconomies of scale’, is due to operation of diseconomies of scale the merger may be reflected in increased inefficiency. Let us consider the U shaped average cost curve. Such type of curve exists in the reality. This shows that after a certain level if a firms keeps on raising the level of production it is sure to adopt the policy of over utilization of the capacities. That would be followed by an increasing cost along with the level of production. Hence the efficiency is hampered. (Sinclair, 1998) As we are looking through a very specified and pinpointed objective of merger we are thinking in a micro sense. We should make a cost benefit analysis when we are going to justify merger in the sense of either social optimality or social justifiability we should include the effect of merger and acquisition on the sphere of employment. We should be aware to discuss about the impact of merger and acquisition on employment. What should be the impact of merger and acquisition on employment? If the merger can raise the employment level then it can be justified on the ground of welfare. If it reduces the employment the merger is not justified according to the theory of social benefit. But our research in this particular area does not seek the social justification. The perspective of the firms on the basis of some performance is analysed here. We are now working at a micro level. In general the predictions about the impact of the labour demand or employment of merger are not unambiguous. There may be a positive or negative effect on labour demand. A merger may lead towards the contraction in output or it may generate a higher level of output and hence employment. A merger may generate a contraction in the output level of the firm as it increases the market power of the giant firm. Moreover, the economies of scale generate the efficiency in production level and hence there may be a reduction in the level of employment. The employment opportunity may decrease as a consequence of merger. On the other hand by merger a firm can enjoy a higher demand in market and hence the firm has to raise the level of output to meet the demand in market due to better product quality assured by improved research and development. That’s why it has the equal chances of creating new opportunity of employment and employment reduction: either due to the policy of output reduction to enjoy higher market power or due to the substitution of labour by capital and machineries. If merger is used as a device to secure the optimal level of employment by a firm the effect may be different regarding the difference in the institutional and structural characteristics of the existing labour market. There exists an ambiguity regarding the level of labour market adjustment cost and the chance of higher level of unemployment. But the fact is that the speed of adjustment with which the firm adjusts its employment to an unpredicted shock is inversely related to the adjustment cost. If the adjustment cost is higher the hiring of worker becomes an irreversible decision. So it is found that in the countries characterized by highly rigid labour markets there are a few numbers of firms that carry excess labour. There are a fewer firms whose adjustment is very quick to the workforce. Mergers and acquisitions are the better means to achieve a desired restructuring as the managerial team is likely to be new and that’s why they are not that much committed to uphold the past relationship with the stakeholders. The labour market of Europe is characterized by higher rigidity than America and that’s why the cases of merger and acquisition tend to reduce the excess labour in Europe than America. (Gugler and Yurtoglu, 2004) Moreover, a study on efficiency effects on the bank merger of United States that has summarised nine case studies has demonstrated that all of these mergers have been followed by a significant cost reduction in line with pre merger projections. But only four of them succeeded in achieving the desired level of cost effectiveness. The striking factor is that the largest volume of cost reduction was concerned with staff reductions and data processing systems and operation. Payroll reduction constructed over fifty percent of the total volume of cost reduction. There are few cases for which the payroll reduction accounted for nearly two third of the total cost reduction. Blaustein and Dressen (1995) have made a study over the cost reduction for merger. They have noticed that the target of the merger firms to obtain the economies of scale lead those towards the merging of services. This is concerned with the idea of retaining the best structure, shifting staffs as required and making others redundant. American bank mergers are very common examples. There are many factors which lead towards reduction in employment (e.g. - overcapacity, over costing, profit seeking activities of the bank and the decline in banking sector due to implementation of Interstate Banking Act). Moreover the network banking and the centralized system of computerized banking caused a reduction in the employment of workers in the banking sector. (Blaustein and Dressen, 1995, 31) The merger and acquisition of the banking sector is always followed by the reconstruction and development of the existing system. This wholesale reconstruction is always related to the phenomenon of massive joblessness and the incidence of growing social insecurity. The financial sector is the centre for the process. In one hand they are the agents and on the other they are the beneficiaries of this type of effects. Whenever there is a reconstruction due to merger and acquisition of the banks. The elder system is replaced by a centralized system of computerized management system. In this system the centrally controlled computerized system can easily replace the workers having traditional skills in banking method. (Regina, Kitey and Baethge, 1999, 3) The financial market indicators and the accounting performance of the banks after merger are hereby unformed. We have avoided focusing on the achievement of cost effectiveness. Of course there were some effective measures adopted to attain the maximum efficiency of the newly formed banks. We are aware of the fact that share prices can never be the only indicator of the good working of a firm. There may be perfect flow of information towards the employees and the customers. The objective of this research is not to cover the transparency of the firm. This is not a detailed analysis to measure on the ground of social justice. Merger is all over successful if it can cover all the relevant performances. Whenever the merger is followed by the adverse unemployment situation then the merger is said to be not a perfect one regarding the interest of the country. If merger creates more unemployment situation by making people jobless and by making them feel socially unsecured then the merger is not justified in the social ground. In this case study the labour market is totally kept aside. The fall in employment due to the emergence of a merger means a decline in the national income of the country. Here the realization crisis would dominate over the profit squeezing forces that create an unemployment situation decline in national income and adverse employment situation calls for the external effects. However, in our analysis we have concentrated on a partial viewpoint of the activities of the firms. A more general analysis considering all the above mentioned indicators and variables will definitely widen our scope for further research and a more general conclusion regarding the bank merger and its impact on value addition. Though the analysis that we have led on the basis of some restrictive indicators, reveals that the merger and acquisition in this very case, has been successful on the grounds that we have selected. Reference: 1. Bagchi, A. K. Banerjee, S. How Strong are the arguments for bank mergers?Economic and Political Weekly, 2005, 40(12) 2. Blaustein, E. and M. Dressen (1995) Recherche de la productivité et rentabilité dans le secteur bancaire: Théories, pratiques et conséquences sur la gestion des resources humaines (France et Etats-Unis), Sectoral Activities Programme, SAP 4.38/WP.96, Geneva, ILO 3. Regina, M. Kitay, J. and M. Baethge (eds.): From tellers to sellers: Changing employment relations in banks Cambridge, Massachusetts, the MIT Press 4. Gugler,K and B.B.Yurtoglu, 2004, The Effects of Mergers on Company Employment in the USA and Europe, Department of Economics, University of Vienna, BWZ, Bruennerstrasse 72, A-1210 5. Hanweck, G.A. and B. Shull (1999) “The bank merger movement: Efficiency, stability and competitive policy concerns”, in Antitrust Bulletin,New York 6. Hofstrand, D.(2007), “Economies of Scope”, AgMRC, available at: http://www.agmrc.org/agmrc/business/gettingstarted/econofscope.htm (accessed on May 21, 2008) 7. Sinclair, S (1998) Bank mergers and consumer protection in British Columbia, the British Columbia Task Force on Bank Mergers. Read More