Education Course Notes
[Session 5 & 6]
Chapter 7 Acquisitions and Mergers versus Other Growth
Strategies
LEARNING OBJECTIVES
1.
2.
3.
4.
5.
Discuss the arguments for and against the use of acquisitions and mergers as a method
of corporate expansion.
Evaluate the corporate and competitive nature of a given acquisition proposal.
Advise upon the criteria for choosing an appropriate target for acquisition.
Compare the various explanations for the high failure rate of acquisitions in enhancing
shareholder value.
Evaluate, from a given context, the potential for synergy separately classified as:
(a) revenue synergy
(b) cost synergy
(c) financial synergy
Acquisitions & Mergers
versus Other Growth
Strategies
Mergers &
Acquisitions Corporate
Expansion
Evaluating Corporate
& Competitive
Nature of a Given
Acquisition Proposal
Developing an
Acquisition
Strategy
Criteria for
Choosing an
Appropriate
Target
Creating
Synergies
Explaining High
Failure Rate of
Acquisition
Advantages of
Mergers as an
Expansion
Strategies
Acquire
Undervalued
Firms
Revenue
Synergies
Agency
Theory
Disadvantages of
Mergers as an
Expansion
Strategies
Diversify to
Reduce Risk
Cost
Synergy
Errors in Valuing
a Target Firm
Financial
Synergy
Lack of Goal
Congruence
Types of
Mergers
Failure to
Integrate
Effectively
Inability to
Manage Change
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1.
Mergers and Acquisitions as a Method of Corporate Expansion
1.1
Introduction
1.1.1 Companies may decide to increase the scale of their operations through a strategy of
internal organic growth by investing money to purchase or create assets and product
lines internally.
1.1.2 Alternatively, companies may decide to grow by buying other companies in the
market thus acquiring ready made tangible and intangible assets and product lines.
1.2
Advantages of mergers as an expansion strategy
(Jun 14)
1.2.1 As an expansion strategy mergers are thought to provide a quicker way of acquiring
productive capacity and intangible assets and accessing overseas markets.
1.2.2 There are four main advantages that have been put forward in the literature and these
are summarized below:
(a)
Speed
The acquisition of another company is a quicker way of implementing a
business plan, as the company acquires another organization that is already in
operation. An acquisition also allows a company to reach a certain optimal
level of production much quicker than through organic growth. Acquisition as
a strategy for expansion is particularly suitable for management with rather
short time horizons.
(b)
Lower cost
An acquisition may be a cheaper way of acquiring productive capacity than
through organic growth. An acquisition can take place for instance through an
exchange of shares which does not have an impact on the financial resources
of the firm.
(c)
Acquisition of intangible assets
A firm through an acquisition will acquire not only tangible assets but also
intangible assets, such as brand recognition, reputation, customer loyalty and
intellectual property which are more difficult to achieve with organic growth.
(d)
Access to overseas markets
When a company wants to expand its operations in an overseas market,
acquiring a local firm may be the only option of breaking into the overseas
market.
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1.3
[Session 5 & 6]
Disadvantages of mergers as an expansion strategy
1.3.1 An expansion strategy through acquisition is associated with exposure to a higher
level of business and financial risk.
1.3.2 The risks associated with expansion through acquisitions are:
(a)
(b)
(c)
(d)
Exposure to business risk
Acquisitions normally represent large investments by the bidding company
and account for a large proportion of their financial resources. If the acquired
company does not perform as well as it was envisaged, then the effect on the
acquiring firm may be catastrophic.
Exposure to financial risk
During the acquisition process, the acquiring firm may have less than
complete information on the target company, and there may exist aspects that
have been kept hidden from outsiders.
Acquisition premium
When a company acquires another company, it normally pays a premium over
its present market value. This premium is normally justified by the
management of the bidding company as necessary for the benefits that will
accrue from the acquisition. However, too large a premium may render the
acquisition unprofitable.
Managerial competence
When a firm is acquired, which is large relative to the acquiring firm, the
management of the acquiring firm may not have the experience or ability to
deal with operations on the new larger scale, even if the acquired company
retains its own management.
(e)
Integration problems
Most acquisitions are beset with problems of integration as each company has
its own culture, history and ways of operation.
1.4
Types of mergers
1.4.1 Mergers and acquisitions can be classified in terms of the company that is acquired or
merged with, as horizontal, vertical or conglomerate. Each type of merger represents a
different way of expansion with different benefits and risks.
1.4.2 Horizontal mergers
A horizontal merger is one in which one company acquires another company in the
same line of business. A horizontal merger happens between firms which were
formerly competitors and who produce products that are considered substitutes by
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their buyers. The main impact of a horizontal merger is therefore to reduce
competition in the market in which both firms operate. These firms are also likely to
purchase the same or substitute products in the input market. A horizontal merger is
said to achieve horizontal integration.
Example 1 – Horizontal merger
The airline industry provides good examples of horizontal mergers. In December 2013
American Airways and US Airways merged to create the world’s biggest airline, American
Airlines. The deal brought American Airways out of the state of bankruptcy that it had been
in since 2011. Since 2005 mergers have reduced the numbers of US’s major airlines from
nine to four.
Such mergers made it easier for the individual airlines to gain access to routes that would
otherwise have been expensive and difficult to obtain.
1.4.3 Vertical mergers
Vertical mergers are mergers between firms that operate at different stages of the
same production chain, or between firms that produce complementary goods
such as a newspaper acquiring a paper manufacturer. Vertical mergers are either
backward when the firm merges with a supplier or forward when the firm merges
with a customer.
1.4.4 Conglomerate mergers
Conglomerate mergers are mergers which are neither vertical nor horizontal. In a
conglomerate merger a company acquires another company in an unrelated line of
business, for example a newspaper company acquiring an airline.
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2.
Evaluating the Corporate and Competitive Nature of a Given
Acquisition Proposal
2.1
Expansion by organic growth or by acquisition should only be undertaken if it leads
to an increase in the wealth of the shareholders.
This happens when the merger or acquisition creates synergies which either increase
revenues or reduce costs, or when the management of the acquiring company can
manage the assets of the target company better than the incumbent management, thus
2.2
creating additional value for the new owners over and above the current market
value of the company.
2.3
We look at some of the aspects that will have an impact on the competitive position of
the firm and its profitability in a given acquisition proposal.
Aspects
Market power
Impact on competitive position




The impact on market power is one of the most important
aspects of an acquisition.
By acquiring another firm, in a horizontal merger, the
competition in the industry is reduced and the company may be
able to charge higher prices for its products.
Competition regulation however may prevent this type of
acquisition.
To the extent that both companies purchase for the same
suppliers, the merged company will have greater bargaining
power when it deals with its suppliers.
Barriers to entry

The possibility of creating barriers to entry through vertical
acquisitions of production inputs.
Supply chain
security

A third aspect that has an impact on the competitive position of
a firm is the acquisition of a firm which has an important role
in the supply chain.

Companies acquire suppliers to ensure that there is no
disruption in the supply of the inputs that will threaten the
ability of the company to produce, sell and retain its
competitive position. Although the risk of disruption can be
eliminated by long-term contracts, acquisition is still
considered an important option.

The merged company will be bigger in size than the individual
companies and it will have a larger scale of operations.
Economies of scale
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

economies of scale from a reduction in the cost per unit
resulting from increased production, realized through
operational efficiencies.
Economies of scale can be accomplished because as production
increases, the cost of producing each additional unit falls.

Scope economies or changes in product mix are another
potential way in which mergers might help improve the
performance of the acquiring company.

Economies of scope occur when it is more economical to
produce two or more products jointly in a single production
unit than to produce the products in separate specializing firms.
debt 
The final aspect in an acquisition proposal has to do with the
Economies of scope
Tax
and
benefits
The larger scale of operations may give rise to what is called
existence of financial synergies which take the form of
diversification, tax and debt benefit synergies.
3.
Developing an Acquisition Strategy
3.1
Introduction
3.1.1 The main reasons behind a strategy for acquiring a target firm includes the target
being undervalued or to diversify operations in order to reduce risk.
3.1.2 Here, we are going to look at a number of different motives for acquisition in this
section. A coherent acquisition strategy should be based on one of these motives.
3.2
Acquire undervalued firms
3.2.1 This is one of the main reasons for firms becoming targets for acquisition. If a
predator recognises that a firm has been undervalued by the market it can take
advantage of this discrepancy by purchasing the firm at a ‘bargain’ price. The
difference between the real value of the target firm and the price paid can then be seen
as a ‘surplus’.
3.2.2 For this strategy to work, the predator firm must be able to fulfil three things.
(a)
Find firms that are undervalued
This might seem to be an obvious point but in practice it is not easy to have
such superior knowledge ahead of other predators. The predator would either
have to have access to better information than that available to other market
players, or have superior analytical tools to those used by competitors.
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3.3
[Session 5 & 6]
(b)
Access to necessary funds
Traditionally, larger firms tend to have better access to capital markets and
internal funds than smaller firms. A history of success in identifying and
acquiring undervalued firms will also make funds more accessible and future
acquisitions easier.
(c)
Skills in executing the acquisition
Diversify to reduce risk
3.3.1 Firm-specific risk (unsystematic risk) can be reduced by holding a diversified
portfolio. This is another potential acquisition strategy. Predator firms’ managers
believe that they may reduce earnings volatility and risk – and increase potential
value – by acquiring firms in other industries.
4.
Criteria for Choosing an Appropriate Target for Acquisition
4.1
The criteria that should be used to assess whether a target is appropriate will depend
on the motive for the acquisition. The main criteria that are consistent with the
underlying motive are:
Criteria
Explanation
Benefit for acquiring 
undervalued
company
The target firm should trade at a price below the estimated
value of the company when acquired. This is true of companies
which have assets that are not exploited.
Diversification

The target firm should be in a business which is different from
the acquiring firm's business and the correlation in earnings
should be low.
Operating synergy

The target firm should have the characteristics that create the
operating synergy. Thus the target firm should be in the same
business in order to create cost savings through economies of
scale. Or it should be able to create a higher growth rate
through increased monopoly power.

The target company should have large claims to be set off
against taxes and not sufficient profits. The acquisition of the
target firm should provide a tax benefit to acquirer.
debt 
This happens when the target firm is unable to borrow money
or is forced to pay high rates. The target firm should have
capital structure such that its acquisition will reduce bankruptcy
Tax savings
Increase
capacity
the
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risk and will result in increasing its debt capacity.
Disposal
slack
of
Access
to
resources
Control
of
cash 
This is where a cash rich company seeks a development target.
The target company should have great projects but no funds.
This happens when for example the target company has some
exclusive right to product or use of asset but no funds to start
activities.
cash 
A company with a number of cash intensive projects or
products in their pipeline, or heavy investment in R&D might
seek a company that has significant cash resources or highly
cash generative product lines to support their own needs.
the 
In this case the objective is to find a target firm which is badly
company

Access
to
technology
key 

managed and whose stock has underperformed the market.
The management of an existing company is not able to fully
utilize the potential of the assets of the company and the
bidding company feels that it has greater expertise or better
management methods.
Some companies do not invest significantly in R&D but
acquire their enabling technologies by acquisition.
Pharmaceutical companies who take over smaller biotechs in
order to get hold of the technology are a good example of this
type of strategy.
5.
Creating Synergies
(Jun 13)
5.1
Revenue synergies
5.1.1 Revenue synergy exists when the acquisition of the target company will result in
higher revenues for the acquiring company, higher return on equity or a longer
period of growth. Revenue synergies arise from:
(a)
Increased market power
Firms may merge to increase market power in order to be able to exercise
some control over the price of the product. Horizontal mergers may enable the
firm to obtain a degree of monopoly power, which could increase its
profitability by pushing up the price of goods because customers have few
alternatives.
(b)
Economies of vertical integration
Some acquisitions involve buying out other companies in the same production
chain, e.g. a manufacturer buying out a raw material supplier or a retailer. This
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can increase profits by “cutting out the middle man”, improved control of raw
materials needed for production, or by avoiding disputes with what were
previously suppliers or customers.
(c)
5.2
Complementary resources
It is sometimes argued that by combining the strengths of two companies a
synergistic result can be obtained. For example, combining a company
specializing in R&D with a company strong in the marketing area could lead
to gains.
Cost synergy
5.2.1 A cost synergy results primarily from the existence of economies of scale. As the
level of operation increases, the marginal cost falls and this will be manifested in
greater operating margins for the combined entity. The resulting costs from economies
of scale are normally estimated to be substantial.
5.3
Financial synergy
5.3.1 Sources of financial synergy include;
(a)
Elimination of inefficiency
If the acquired company in a takeover is badly managed its performance and
hence its value can be improved by the elimination of inefficiencies.
Improvements could be obtained in the areas of production, marketing and
finance.
(b)
Tax shields/accumulated tax losses
Another possible financial synergy exists when one company in an acquisition
or merger is able to use tax shields or accumulated tax losses, which would
have been unavailable to the other company.
(c)
Surplus cash (cash slack)
When a firm with significant excess cash acquires a firm, with great projects
but insufficient capital, the combination can create value. Managers may reject
profitable investment opportunities if they have to raise new capital to finance
them. It may therefore make sense for a company with excess cash and no
investment opportunities to take over a cash-poor firm with good investment
opportunities, or vice versa.
(d)
Debt capacity
By combining two firms, each of which has little or no capacity to carry debt,
it is possible to create a firm that may have the capacity to borrow money and
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create value. Diversification will lead to an increase in debt capacity and an
increase in the value of the firm. When two firms in different businesses merge,
the combined firm will have less variable earnings, and may be able to borrow
more (have a higher debt ratio) than the individual firms.
6.
Explaining High Failure Rate of Acquisitions in Enhancing
Shareholder Value
(Jun 14)
6.1
Agency theory
6.1.1 Agency theory suggests that takeovers are primarily motivated by the self-interest
of the acquirer's management.
6.1.2 The implication of agency theory is that, because the target firm knows that a bid is in
the interest of the management rather than the shareholders of the acquiring firm, it
sees this bid opportunity to extract some of the value that would have gone to
acquiring firm management. How much value the target firm can extract depends on
the bargaining power they have.
6.2
Errors in valuing a target firm
6.2.1 Managers of the bidding firm may advise their company to bid too much as they do
not know how to value an essentially recursive problem. A risk-changing acquisition
cannot be valued without revaluing your own company on the presupposition that the
acquisition has gone ahead. The value of an acquisition cannot be measured
independently. As a result the merger fails as the subsequent performance cannot
compensate for the high price paid.
6.3
Lack of goal congruence
6.3.1 This may apply not only to the acquired entity but, more dangerously, to the acquirer,
whereby disputes over the treatment of the acquired entity might well take away the
benefits of an otherwise excellent acquisition.
6.4
Failure to integrate effectively
6.4.1 An acquirer needs to have a workable and clear plan of the extent to which the
acquired company is to be integrated, and the amount of autonomy to be granted.
6.4.2 At best, the plan should be negotiated with the acquired entity’s management and staff,
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but its essential requirements should be fairly but firmly carried out.
6.4.3 The plan must address such problems as differences in management styles,
incompatibilities in data information systems, and continued opposition to the
acquisition by some of the acquired entity’s staff.
6.5
Inability to manage change
6.5.1 Many acquisitions fail mainly because the acquirer is unable or unwilling reasonably
to adjust its own activities to help ensure a smooth takeover.
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