Economies Of Scope And Synergies

Published Date: 02 Nov 2017

ABSTRACT

This report underlines the different types of motives, which leads to merger and Acquisition such as competitive considerations, a response to a changing environment and inefficient capital markets. This report also focuses on the outcome of the different methodologies used to analyze merger and acquisition activities by using Event method, Accounting based Method. This tells us that shareholder are benefited as well as destroyed in some cases in US, United Kingdom and Asian countries.

TABLE OF CONTENTS

ABSTRACT……………………………………………………………………….2

INTRODUCTION…………………………………………………………………4

MOTIVES OF MERGER & ACQUISITION………………………………….….4

OUTCOMES OF DIFFERENT METHODOLOGIES USED TO

ANALYZE MERGER & ACQUISITION……………………...............................7

CONCLUSION……………………………….……………………………………8

REFERENCES………………………………………………………………….....10

APPENDIX………………………………………………………………………..13

TABLE 1 :- THEORIES OF MERGER MOTIVE…………………….….13

TABLE 2 :-STEPS OF THE EVENT STUDY METHOD.........................14

TABLE 3:- DAILY ABNORMAL RETURNS AND CARs FOR SELECTED WINDOWS IN RESPONSE TO M&A………………….…...14

INTRODUCTION

Merger and Acquisition has been important part of the corporate group. ‘The significance of the phenomenon appears to be confirmed by the increased frequency of M&A since the 1970s and the M&A wave since 1995 in particular (Boateng , Uddin , 2011). According to Harford (2005), there were 35 waves from 1981 to 2000 with the average of 34 mergers per wave. Mitchell and Mulherin (1996) suggest that waves were triggered by financial perspective whereas Shleifer and Vishny (2003) and Rhodes-Kropf and Vishwanathan (2004) argues it has been due to stock prices overvaluation. This allows the company to generate more profit and expand their business empire. According to the UNCTAD (2008), the amount of Merger and Acquisition from $49.8 million in 1987 has rise to $1.63 trillion in 2007. Vasconcellos , Madura and Kish (1990) and Vasconcellos and Kish (1998) have argued to examine the macroeconomic factor for the M&A.

Economically, M&A takes place to maximize the shareholder benefits. Some observers tell that there can be any other motive as well behind M&A. This report has been articulated in three sections. Section 2 tells the motives behind the M&A. Section 3 tells the Outcomes of Different Methodology used to analyze M&A. Section 3 gives Conclusion.

MOTIVES OF MERGER & ACQUISITION

According to Friedrich Trautwein(1990) " Most Observers believe that mergers are driven by the complex pattern of motives and no single motive can be accounted for the merger"(see Table 1 Appendix 1)(e.g. Steiner, 1975; Ravenscraft and Scherer, 1987). Theories underlining the motives of Merger and Acquisition have been broadly described into three parts. Cantwell and Santangelo (2002) suggest a categorization in competitive considerations, a response to a changing environment and inefficient capital markets.

1.) Competitive considerations

A) Economies of Scope and Synergies

This theory regard that mergers are well planned and executed to meet the synergies. It can be broadly described into three parts. Firstly, Financial Synergy should lower the cost of capital, which can be done by reducing the systematic risk of a company by investing into different portfolio or by increasing the company size, which can allow the company to access the capital at a cheaper rate. However, there is no evidence of reducing the systematic risk (Rumelt, 1986) Secondly, from operational synergies by combining two separate units or knowledge transfer (Porter, 1985). Size advantage seems to exist in the market (Scherer et al., 1975). This will lower the cost of a company.

B) Free Cash Flow

Jensen's management competition model (Jensen, 1986) tells efficient use of excess cash. Managers are threatened by management teams if they pay excess cash for the merger instead to their shareholders.

C) Economies of Scale

This theory was developed to increase the market power. Horizontal and Conglomerate Merger and Acquisition, both can apply this theory. Firms can reduce their total cost by increasing their production and also giving them competitive advantage over the competitors. By acquiring other firms in the same industry, firms can increase their market share, and thus their market power (Ahammad, Glaister, 2010). Firms with high market power can consistently charge high price as they are the ‘Price-Maker’ (Alvarado, 1998).

D) Defensive Strategy

Defensive Strategy can also drive for M&A. A Company may acquire the other company to increase its size and to avoid the other companies to acquire it. There is also a possibility that firm may acquire the other firm to avoid the firm to be taken over by the third-party. This might be done to prevent the other firm becoming strong and to increase its market power (Cantwell, Santangelo, 2002).

E.) Reduction of transaction and information costs

Firms tends to pay high capital for transaction and Information. This can be reduced by doing upstream and downstream activities through M&A. This help firms to seek more control and important for activities with the value chain (Cantwell, Santangelo, 2002).

2.) Response to a changing environment

A) Regulation of the Government and Entry Mode

Regulation of any country or industry is also important while doing M&A activity. Most observer have seen that M&A takes place from the regulated market to unregulated market. M&A activity can also be done for the tax saving purpose (Cantwell, Santangelo, 2002). Foreign Direct Investment has acted as an Entry mode for the foreign Companies. Dunning (2009) tells the influence of macroeconomics on the value added activities of MNC’s in 1990.

B) Access to resources or technologies

Access or acquiring a company can also be seen in terms of technology or any other resources, which a acquiring company wants to possess, such as patent-protected technologies, better management and marketing skills (Desyllas, Hughes, 2008; Ahammad, Glaister, 2010). Cross border M&A has been seen as a prospect to acquire new skills and knowledge.

3. Inefficient capital markets

A) Removal of inefficient management

According to Hubris hypothesis, if a Merging or Acquiring company has a manager with better planning and can monitor the abilities that can benefit the target performance. This will increase the value of the acquiring firm by replacing inefficient management with the efficient one. According to Ahammad and Glaister (2010), small companies grow along with management skills. However, Cross-border M&A carries higher asymmetric information than its domestic counterparts (Seth et al., 2000). This might result in shift of the profit from shareholder the acquiring firm to the shareholder of acquired firm.(Ahammad, Glaister, 2010). It has been criticized as evasive concept (Kitching, 1967; Porter, 1987).

B) Diversification

One of the important motives which drives M&A is diversification. Every firm diversifies its products, adding new custom segments or entering into new geographic markets. Diversification also means that they are spreading their business activities. . Thus, irrespective of the business activities of the firm, they are less correlated (Chan-Olmsted, Chang, 2003). However, diversification does not mean value maximizing from a financial perspective. In interest of shareholder, the firm diversifies their portfolio and lowers their cost (Ahammad, Glaister, 2010).

C) Managerial Ego

Its underlying idea was contained in the various managerial theories of the firm (Baumol, 1959; Marris, 1964; Williamson, 1964) and explicitly formulated by Mueller (1969). The Empire-building hypothesis states that Manager aims at the growth of the firm through M&A (Seth et al., 2000). Manager tends to think about the firm, then about the shareholders. In other words, unfavorable decisions are taken at the cost of the shareholders interest. Managers increase the firms revenue by minimizing its profits, which tends for the growth of the firm.(Baumol,1959). If the firm grows beyond its optimal size, then it will lower the corporate performance and shareholder value (Hope, Thomas, 2008).

OUTCOME OF DIFFERENT METHODOLOGIES USED TO ANALYSE M&A

There are different methodologies to measure the outcome of the M&A. Most commonly used are event study and accounting based method.

1.) The Event Study

Event study was introduced by Philip Brown (1968) and Eugene Fama et al. (1969). Event studies approach observe a stock prices reaction to merger announcement and also to measure the change due to the event (Petersen, 1989). Day of the event is defined as the day of announcement of the merger. There is an assumption of rationality of the market, which means stock prices react to the information immediately (MacKinley, 1997). Three commonly used model to measure normal return i.e. the single-index model (constant mean return model), the market model and Capital asset pricing model (CAPM) (Sharpe, 1964 ; John Lintner ,1965) is used. The CAPM model and its co-variance have been used for the outcome of the mergers and acquisitions with an event window. The restriction of CAPM model is it requires risk-free return. Event studies result has been mixed due to the length of the window. Steps to conduct this study have been shown in table 2 Appendix 1.

According to Chu et. Al (2009), used the sample of 1477 in ten emerging countries and found out that the stock markets have expected positive cumulative abnormal returns in three different event windows: a two-day (0, 1) window, a three-day (-1, +1) window, and a five-day (-2, +2) window.(see table 3 , appendix-1) This tells that Short term- window gives a positive sign for the bidder. However, Shareholder wealth is negative or neutral for the US bidders (e.g., Gaughan, 2005; Hackbarth & Morellec, 2008). It has been supported by Firth (1980) and Dodds and Quek (1985) for United Kingdom.

Long term based event studies shows negative on share price of the acquiring firms. This can be supported by overvaluation of takeovers at the time of announcement, which ultimately decrease profits and destroy shareholder value (Tichy 2002).

2.) Accounting Based Methods

This methodology is used to analyze the difference between the post-merger and pre merger performance of the merging firms. Some authors have only considered the performance of acquiring company in both cases, post-merger and pre-merger.(Dickerson, Gibson, and Tsakalotos 1997): Healy, Palepu and Ruback 1997). Healy et. al (1997) used the cash flow to see the operating performance of the firm whereas Penrose (1959) assumes that firms motive is to increase its profits which can be utilized for investment in all NPV activities. Dickerson et. al(1997) states that performance can seen be through its profitability. Meeks(1997) uses rate of return of acquiring firms by allowing for the extent of accounting biases.Purchase method , Pooling of interest and return on Equity are the other methods in Accounting based Methods.

Meeks (1997) found out a small positive effect in the year of acquisition, thereafter profitability is substantially less than in the pre-merger period—sometimes over 50% less. This suggests that acquisitions have a negative effect on profitability. Ravenscraft and Scherer (1987a, b) examined the US companies and found out that 47% of the acquired company by acquiring company were sold off and remaining have negative effect on profitability. Ravenscraft and Scherer (1987b) focused on tender offer and removed accounting biases and found out that post-acquisition profit declined but not significant whereas Dickerson et. al (1997) took a large panel of UK companies and observed for a long time and found out that profits are there as found and lagged rate of return is 0.5 as found by Geroski(1998).Moreover, size of the firm is related to its profitability, debt of the firms have negative effect on profitability and higher growth leads to a higher profit. Outcomes of the Accounting Based Method has mixed effects on shareholder wealth after merger and Acquisition.

3.) Clinical Method

This approach is qualitative method in which the small sample is studied in depth, getting information from executives of the company and observers. Results shows that large percentage of the respondent said that the acquisition did not create value, whereas Bruner (1999) examined that companies where failed to merge and Lys and Vincent (1995) showed that acquisition decreased the value to the acquiring firm due to managerial overconfidence and Hubris effect. Ruback (1982) reported that the target firms have gained and acquiring firm has lost its shareholder wealth. There has been a mixed outcome in this method.

CONCLUSION

Merger and Acquisition should create shareholder wealth but in some of the cases, it has been seen that shareholder wealth has been destroyed. Hubris theory tends to destroy shareholder wealth.

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