Οικονομικό Πανεπιστήμιο Αθηνών
Τμήμα Οικονομικής Επιστήμης
Άνοιξη 2012
Χρηματοοικονομικές αγορές και εταιρική διακυβέρνηση
Lectures 4 & 5: Mergers and acquisitions.
The phrase mergers and acquisitions (abbreviated M&A) refers to the aspect of corporate
strategy, corporate finance and management dealing with the buying, selling and
combining of different companies that can aid, finance, or help a growing company in a
given industry grow rapidly without having to create another business entity.
Mergers: Independently owned firms join under the same ownership.
A merger happens when two firms agree to go forward as a single new company rather
than remain separately owned and operated.
Example: Aegean and Olympic Air
An acquisition, also known as a takeover or a buyout, is the buying of one company (the
‘target’) by another.
When one company takes over another and clearly establishes itself as the new owner,
the purchase is called an acquisition. From a legal point of view, the target company
ceases to exist, the buyer "swallows" the business and the buyer's stock continues to be
traded.
Example: Alpha Bank and Ionian Bank
Types of Mergers:
Horizontal mergers: Firms in the same line of business.
Examples.
Vertical mergers: Firms at different stages of production.
Examples.
Conglomerate merger: Companies in unrelated lines of business.
Examples.
Motives
Horizontal mergers:
Economies of scale: (AC falls as Q increases). The combined company can often reduce
its fixed costs by removing duplicate departments or operations, lowering the costs of the
company relative to the same revenue stream, thus increasing profit margins.
Economies of scope: Efficiencies primarily associated with demand-side changes, such as
increasing the scope of marketing and distribution, of different types of products.
Increased revenue or market share: This assumes that the buyer will be absorbing a major
competitor and thus increase its market power (by capturing increased market share) to
set prices.
Cross-selling: A manufacturer can acquire and sell complementary products.
Synergy: For example, managerial economies such as the increased opportunity of
managerial specialization. Another example is purchasing economies due to increased
order size and associated bulk-buying discounts.
Taxation: A profitable company can buy a loss maker to use the target's loss as their
advantage by reducing their tax liability.
Geographical or other diversification: This is designed to smooth the earnings results of a
company, which over the long term smoothens the stock price of a company, giving
conservative investors more confidence in investing in the company.
Resource transfer: resources are unevenly distributed across firms and the interaction of
target and acquiring firm resources can create value through either overcoming
information asymmetry or by combining scarce resources.
More funds.
Eliminating inefficiencies (from poor management).
Vertical mergers:
Internalize an externality problem. A common example is of such an externality is double
marginalization. Double marginalization occurs when both the upstream and downstream
firms have monopoly power, each firm reduces output from the competitive level to the
monopoly level, creating two deadweight losses. By merging the vertically integrated
firm can collect one deadweight loss by setting the upstream firm's output to the
competitive level. This increases profits and consumer surplus. A merger that creates a
vertically integrated firm can be profitable.
Economies of vertical integration (better coordination and administration). I.e. By
merging with a supplier or customer.
Complementary resources (specific skills-resources owned by small firms).
Disadvantages:
Acquiring firms' financial performance does not positively change as a function of their
acquisition activity. Therefore, additional motives for merger and acquisition that may
not add shareholder value include:
Diversification: It is possible for individual shareholders to achieve the same hedge by
diversifying their portfolios at a much lower cost than those associated with a merger.
Manager's hubris: manager's overconfidence about expected synergies from M&A which
results in overpayment for the target company.
Empire-building: Managers have larger companies to manage and hence more power.
Manager's compensation: In the past, certain executive management teams had their
payout based on the total amount of profit of the company, instead of the profit per share,
which would give the team a perverse incentive to buy companies to increase the total
profit while decreasing the profit per share (which hurts the owners of the company, the
shareholders).
Industry consolidation (too many firms, too much capacity).
Estimating gains and costs from a merger.
Recall (Lecture 2): The outcome of the takeovers. Takeovers are associated with an
increase in total value. The winners from takeovers: The target shareholders.
There is economic gain only if the two firms are worth more together than apart.
Let the manager of A who wants to purchase B.
Gain = PVAB – (PVA + PBB) = DPVAB
A, B worth more together than apart.
Cost = cash paid - PVB.
NPV (of the shareholders of A from the merger) = Gain – Cost
Example:
PVA = 200, PVB = 50, when B is bought for cash, the new firm AB has PVAB = 275
Gain = DPVAB = 25.
Let cash paid for merger (acquisition) = 65.
Cost of the merger (acquisition) is: Cost = cash paid - PVB = 65 – 50 = 15.
The 15 is gain for the shareholders of B.
The NPV to A shareholders is 10 [PVAB – cash - PVA].
The unexpected announcement: The value of B’s stock rises from 50 to 65 and the value
of A’s stock rises by 10.
Estimating cost when merger is financed by stock
If sellers receive N shares, of value PAB the cost is:
Cost = N * PAB - PVB.
Initially A has (1m) 1,000,000 shares. Market value of A is 200m.
A issues and offers 325,000 = 0.325 m shares instead of 65m in cash to the stockholders
of B. A’s share price before the deal is announced is 200. If B is worth 50m, the cost of
the merger appears to be:
Apparent cost = 0.325 * 200 – 50 = 15
However, after the announcement, A’s stock price will go up.
The new firm will have 1.325m shares outstanding, and will be worth 275m. The new
share price will be 275/1.325 = 207.55.
The true cost is:
Cost = 0.325 * 207.55 – 50 = 17.45m
Is the gain to B’s shareholders. They own 24.5% of the new firm:
0.245 * (275) – 50 = 17.45
The effects of mergers.
Horizontal merger.
(a) Cournot market structure with N firms. What happens if N-1 firms?
[price increases, total quantity decreases]
(b) One low cost firm C1 = 1, one high cost firm C2 = 4. Demand: p = 10 – Q.
Under Cournot we have: q1 = 4, q2 = 1, p = 10 - (4 + 1) = 5, prof1 = 16, prof2 = 1.
CS(Q = 5) = (10-5)2/2=25/2. Welfare =CS + prof1 + prof2 = 29.5
If merger: A multiplant monopoly. Plant 2 is shut down.
Qm = 4.5, p = 5.5, profM = 81/4, CS = (10-5.5)2/2 = 81/8, Welfare = 30.375.
Vertical merger.
Upstream firms A, B, downstream firms 1, 2.
The per unit cost for downstream firm is ci. This is the cost it pays to the upstream firm.
There is no other cost for the downstream firm.
Downstream market (2 firms) Cournot competition:
Demand p = a – q1 – q2. Cost, c1, c2 per unit.
We know: qi = (a – 2ci + cj) / 3
Q = q1 + q2 = (2a – c1 – c2) / 3 and p = a – Q = (a + c1 + c2) / 3
and profDn. = (a – 2ci + cj)2 / 9.
Upstream market: 1, and 2 firms compete ala Bertrand and sell to both A and B:
Prices = ci = 0 so q1 = q2 = a/3. We have Total profUp. = 0 and Total profDn. = 2a2/9.
Thus, before the merge the total profits (of all firms) are 2a2/9
Upstream and downstream merge: We assume A and 1 merge.
The input cost for A1 is again zero. A1 does not sell the input to B. The analysis for A is
the same (c1 = 0). However as we see below c2 is now positive.
B becomes a monopoly in the factor market. B sets c2 such that it maximizes its profits
(recall, the demand for B comes from the quantity firm 2 sells):
Max ProfB = c2 * q2 = c2 * (a – 2c2 + c1)/ 3
c2
F.O.C. 0 = a – 4c2 +c1 and c2 = a/4
We have now: c1 = 0 and c2 = a/4.
From the above we have: q1 = 5a/12, q2 = a/6, Q = 7a/12, p = 5a/12
The new firm A1 has profits:
ProfA1 = p * qA1 = (5a/12)*( 5a/12) = 25a2/144 (Recall that c1 = 0)
Firm 2 has profits:
prof2 = (p – c2)q2 = (5a/12- a/4)*( a/6)= a2/36
Thus, the quantity for the merged firm qA1 increases. The quantity for firm 2 which is q2
decreases.
The combined profits for B and 2 are less than the profits of 2 before the merge:
ProfB + prof2 = a2/24 + a2/36 = 10a2/144 < 0 + a2/9.
Total profits of all four firms increase after the merge.
ProfA1 + ProfB + prof2 = 25a2/144 + 10a2/144 > 2a2/9
Double marginalization
The upstream firm has marginal cost c < 1.
The downstream firm has cost r (this is the cost it pays to the upstream firm).
Demand function for the downstream firm is: D = 1 – p
(a) The two monopolies are separate.
The downstream firm:
Max ProfB = (p - r)(1 - p)
p
we have p = (1+r)/2 and q = (1-r)/2, and ProfB = (1-r)2/4.
The upstream firm:
Max ProfA = (r-c)((1-r)/2)
r
we have: r = (1+c)/2
If we combine the above we have: p = (3+c)/4
If the two firms integrate, we have:
Max ProfAB = (p-c)(1-p)
p
We have: p = (1+c)/2
We can show: ProfAB > ProfA + ProfB. Also, pAB < pB
References
Oz Shy, “Industrial Organization”, The MIT Press 1995, pages 173-179.