6 Large firms Flashcards
Three characteristics of large firms
250+ employees
degree of market power
power and growth linked to M&As
Size of large firms in UK
large firms constitute 0.2% of all firms
but >50% of total employment and turnover of private firms
Advantages of large firms
•Benefits from economies of scale where average costs (AC) fall with increases in output - productive efficiency
- purchasing, financial, technical, managerial, marketing economies of scale
•Schumpeterian economists argue that large firms are engines of economic progress, because monopoly profits achieved by large firms provide the means to fund research and development, after WWII experience
Disadvantages of small firms
•Large firms (with large market power) have the power to set high prices and otherwise to act against the consumer interest
-monopoly price is higher than both marginal and average costs leading to a loss of allocative efficiency and a failure of the market
lack of competition reduces incentive to invest in new ideas and to control costs, and ‘X’ inefficiencies will mean that there will be no real cost savings compared to a competitive market
Measures of concentration
- N-firm concentration ratio: Simplest measure. The share of the largest n-firms in a market in terms of sales, turnover and employment.
- Herfindahl-Hirschman index (HH). This looks at the share of all firms in a market, giving greater weight to those firms with the largest market share
- It is calculated by squaring the market share of each firm competing in a market, and then summing the resulting numbers
- max = 10,000
- min = near zero
What is a merger?
Refers to the union of two firms with the mutual agreement of management in both firms. Usually carried out by exchanging shares
What is an acquisition?
Occurs when one firm (A) makes an offer to the shareholders of another firm (B) to buy their shares and acquire control over the said firm (B). Usually the identity of the purchased firm disappears
Disadvantages of mergers
• Mergers have often been found to yield few efficiency gains and to lower profitability
‒ Ravenscraft and Scherer (1987) studied 6000 US mergers and found that 2/3 of them achieved lower profits than prior to the merger.
• Most mergers tend not to recover the cost of the deal and lead to a loss of wealth for the shareholders of the acquiring firm (Douma and Schreuder, 2008, pp.310-12)
‒ KMPG (1999) find that only 17% of mergers resulted in shareholder value creation, 53% of mergers resulted in a loss of shareholder value.
• Other costs:
‒ Higher prices for consumers
‒ Job losses for employees (e.g. Cadbury-Kraft merger)
‒ Lower investment (as cost of mergers reduces funds for organic growth)
Rationale of M&A
➢ ‘Value discrepancy’ hypothesis suggests that one firm will bid for another firm if it places a greater value on the firm than that placed by its current owners.
‒ If Firm B is valued at VA by Firm A and VB by Firm B then a takeover of Firm B will only take place if VA > VB + cost of acquisition.
Why do differences in valuation appear?
- From different expectations of future profitability and such differences are particularly evident where market conditions are changing rapidly due to for example technological innovations. Bidder’s confidence in ‘unlocking’ value in target firm will initiate takeover.
- Low Valuation ratio: Market value of a company, as represented by its share price, may be low compared to ‘book value’ value of its assets.
Managerial motives for m&a
Managers may have interests in increasing firm size, example….
- Salaries, power, status and job security may all be positively linked to firm size (total revenue)
- Merger activity offers a quick route to firm growth and will be the focus of growth-oriented managers and their pursuit of mergers may come at the expense of profit, i.e. interest of owners (agency problem)
Three arms of UK mergers policy
Office of Fair Trading (OFT) which judges whether mergers will lead to a substantial ‘lessening of competition’. Mergers investigated if:
‒ either the firm being taken over has a UK turnover in excess of £70M
‒ or the merged firms together account for at least 25% of the industry’s UK supply.
Competition Commission- OFT can refer mergers to CC. Assesses mergers according to their impact on competition. CC reserves right to prohibit mergers.
Secretary of State makes decision only in a limited number of cases (e.g. those relating to newspaper transfers and other ‘public interest’ cases)
