2. Theories
Merger theories are the outcomes of academic and
institutional research broadly propound the following.
1. Value increasing efficient market school
a) Synergies arise and increase value of the firm
b) Allocative synergies or collusive synergies
2. Value decreasing agency school
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3. Theories
A. Synergy
1. Efficiency Theory (Operational Synergy) : Value creation through operational synergies.
2. Financial Synergies : Cost of capital, capital restructure, Tax Benefits and Q Ratio
3. Corporate Control (Managerial Synergy) : Net gains through managerial synergies.
4. Market Power (Market Synergy) : Customers transfer wealth.
B. Agency Cost
5. Entrenchment : Agency cost declines
6. Empire Building : Agency cost increases
C. Bounded Rationality
7. Hubris Theory : Net losses through over paying.
8. Managerial Discretion : Net losses due to valuation mistakes.
D. Diversification
9. Inefficient Managerial theory
10. Pure Diversification
11. Strategic Realignment : Legal and technological factors
12. Information Signaling
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4. A. SYNERGY
When two companies merge together, it creates
synergies creating value to the firm and its owners.
1) Operational Synergies: Economies of Scale
2) Financial Synergies : Cost of capital
3) Managerial Synergies : Scope & Style of Management
4) Market Synergies : Customers
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5. 1) Operating synergy
Refers to efficiencies in production, supply chain, R&D and
Technology. Improved operational efficiency through economies
of scale and scope by acquiring a customers ,suppliers ,and
competitors. Accordingly the synergies can be classified as
follows
1) Economies of scale
2) Economies of scope
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6. Economies of Scale
1. it means reduction of average cost with increase In volume or
production. Because of fixed overhead expenses such as steel
,pharmaceutical, chemical and aircraft manufacturing .
2. In that merging of company in same line of business such as horizontal
Merger it eliminates duplication and concentrate a great volume of
activity in a available facility . In vertical mergers com expands forward
towards the customer or backward towards the source of raw material
(suppliers).
3. By acquiring com control over the distribution and purchasing bring in
economies of scale .
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7. Economies of Scope
• Using a physical asset in its physical production or
services.
• Deploying specific skill set of its manpower
currently employed in its physical production or
services.
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8. 2) Financial synergy
Financial synergies refer to lower cost of capital, tax
benefits, low transactions costs and reduced corporate
risk.
According to financial synergies theory, when the cash
flow rate of the acquirer is greater than that of the
acquired firm, capital is relocated to the acquired firm
and its investment opportunities improve.
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9. Types of Financial Synergies
1) Reduction of corporate risk: Reduction of corporate risk is increasing the
risk capacity of the overall firm, which means the ability of the firm to
bear more risk. Meaning that by increasing the risk capacity the
shareholders will invest more in the company and the firm will gain
benefits such as coinsurance effects.
2) Establishment of internal capital market: Establishing internal capital
gains means that the firm will decrease its financing costs and will increase
financial flexibility which results in the company having higher liquidity and
the ability to pay its creditors easily.
3) Tax advantages: Reducing the tax liabilities of the firm using the losses in
one business to offset profits in the other business referred to as “profit
accounting”.
4) Financial economies of scale: Financial economies of scale reducing
transaction cost in issuing debt and equity securities.
Source: Research Gate
https://www.researchgate.net/publication/275225228_Financial_synergy_in_mergers_and_acquisitions_Evide
nce_from_Saudi_Arabia [accessed Jan 27 2018].
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10. Q-ratio
• It is the ratio of share value to replacement value of
asset.
• Mergers happen when market value of the target firm is
less than replacement cost of its asset
• High interest rates can depress share value below book
value.
• High inflation may raise replacement cost above the book
value of assets.
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11. 3) Managerial Synergy
• This theory works when there exists a managerial
difference between Acquiring Company (A) Target
Company (T).
• If the management of A is more efficient than the
management of a T, then post merger the efficiency
of T is lifted to the level of efficiency of A .
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12. Contd…
• Efficiency is increased by merger.
• This is more relevant to same industry or horizontal
merger .
• It may be social gain as well as private gain.
• Level of efficiency in the economy will be increased.
• It is also called managerial synergy or managerial
efficiency.
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13. 4) Market Synergies / Market Power
Acquirer becomes stronger and power full through market
synergies in terms of customers, market participants and
price control
• Customer Base: Acquired firms value increases as all the
customers of target firm shifts to acquired firm with their
brand loyalty, product satisfaction and Service satisfaction.
• Market Participants: Increase in the size of the firm is expected to
result in market share . The decrease in the number of firm will
increase recognized interdependence.
• Price control: Mainly mergers are undertaken to improve ability to
set and maintain prices above competitive level.
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14. B. Agency Cost Theories
It refers to the cost of managers in terms of their
pays n perks when their objective is maximize
their personal value rather than meeting
organizational goals and securing shareholders
interests.
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15. 5) Entrenchment
• It is to reinforce job positions
• Agency cost decline if the ownership within the company
increases as managers are responsible for a larger cost of
these shares.
• On the other hand, given ownership to a manager within
a company may translate into greater voting power
which makes the manager's work place more secure.
Hence, they gain protection against takeover threats and
the current managerial market.
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17. 6) Empire Building Managerialism
Mergers become a threat for the firms due to managerial inefficiency or
agency problem. It happens with the contradiction of share holders goals as
there exists a managerial and owners differentials.
This happens when managers hold little equity and shareholders are too
dispersed to take action against non-value maximization behavior, insiders
may deploy corporate actions to obtain personal benefits, such as shirking
and perquisite consumption. When ownership and control is divided within a
company, agency cost arise.
• Objective is to increase the size for pay through size of the firm.
• Managers may increase the size of the firm through mergers in the beliefs
that their compensation is determined by size.
• In practice management compensation is determined by profitability
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18. 7) Hubris Hypothesis
• This is more applicable for competitive tender offers for
target acquisition. The hypothesis is that the acquiring
firm over estimates the value of the target to win the bid.
• The urge to win the game often results in the winners
curse. (Hubris Hypothesis)
• Potential benefits and economic gains for the managers
are the personal motives to look for acquisition of firms.
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19. 8) Managerial Discretion
• Net losses due to valuation mistakes
• Over confidence or bias arising at the functional level
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20. 9) Inefficient Management Theory
• This is similar to the concept of managerial efficiency but it is
different in that inefficient management .
• Basis for mergers between firms when unrelated business i.e.,
conglomerate merger.
• The management in control is not able to manage asset
efficiently ,mergers with another firm can provide the necessary
supply of managerial capabilities.
• In this replacement of incompetent managers were the sole
motive for mergers and also manager of the target company will
be replaced
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21. 10) Pure Diversification
Diversification through mergers is demanded by
managers and employees for internal growth due to
lack of internal resources or capabilities required.
Preserving organizational goals and acquiring new
capabilities is the motive. It is not beneficial for the
investors as it may or may not result in value addition.
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22. 11) Strategic Realignment
• It is a way to quickly adjust to the changes in external
environment importantly legal and technological. It is more
important when a company has burning desire to grow and
the growth rate would be slow if it does internally.
• Technical changes create new products, industries and
markets. Technology is encourages mergers in a less expensive
manner and faster way to acquire new technology.
• The owner should specialize in knowing how to bridge the gap
in current offering or to enter new business.
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23. 12) Information and Signaling
The announcement of mergers negotiation or a bid
offer may convey information or signals to market
participants that future cash flows are likely to increase
and further it will increase future values.
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