session 2

Question 1

usual source of “synergies”

Answer 1

Benefits of size

Question 2

synergies

Answer 2

Economies of scale: Average costs decline with larger size: Lower required investment in inventory: Large firms more able to implement specialization: Improved capacity utilization
Economies of scope – firm can produce additional products due to experience with existing products.

Question 3

Transaction costs:

Answer 3

Technological factors do not guarantee a merger will enhance profit: Specialization gains suggest reasons mergers should not occur: If supplier can produce input more cheaply, will not profit a firm to merge

Question 4

Coase framework:

Answer 4

in the absence of transaction costs, an efficient or optimal economic result occurs regardless of who owns the property rights: Firm must decide between internal or external production: Transaction costs within and outside firm determine decision on firm size and merge

Question 5

Theoretical perspectives related to MA transaction.

Answer 5

Value creating theories, value destructive theories, value neutral theories

Question 6

value increasing theories

Answer 6

Value increasing theories highlight the mechanisms through which M&As create net benefits for stakeholders. The primary value increasing theories are transaction cost efficiency and synergy creation.

Question 7

coase framework (simply)

Answer 7

The coase framework states that firms merge when internalising certain transactions is more cost efficient than relying on the external market. This allows M&As to optimise transaction costs by balancing internal operations and external market interactions. The outcome of this theory is that cost savings will enhance profitability and shareholder value. Synergies are created when the combined firm achieves greater value than the sum of the separate entities. These synergies can span either economy of scale of economies of scope

Question 8

scale economies

Answer 8

Economies of scale arise when larger firms reduce average costs by spreading fixed costs over a greater output.

Question 9

scope economies

Answer 9

Economies of scope arise when firms lower costs or increase revenue by sharing resources across multiple products or markets

Question 10

synergies

Answer 10

Synergies can also arise when mergers combine distinct strengths or when more effective management and operational practices are introduced. These theories also view takeovers as disciplinary, stating they serve as a corporate governance mechanism by replacing inefficient management.

Question 11

value reducing theories

Answer 11

Value reducing theories aim to explain why some M&As fail to achieve their intended goals and result in negative outcomes. These theories include agency costs of free cash flow and managerial entrenchment

Question 12

agency cost of free cash

Answer 12

The agency cost of free cash flow posits that when firms generate excess free cash flow (FCF) (cash left after funding positive NPV projects), managers may use it efficiently. Managers may pursue acquisitions to grow their influence, power or personal benefits, rather than focussing on shareholder returns.

Question 13

empirical study of agency cost of free cash flow

Answer 13

This was exemplified by Jensen (1986) empirical study which showed that firms with free cash flows were prone to value-destroying acquisitions.

Question 14

The managerial entrenchment theory

Answer 14

The managerial entrenchment theory suggests managers undertake acquisitions to entrench themselves in the company by making it harder for the shareholders or the board to replace them. It reduces value as managers may overpay for acquisitions to increase their importance or build an “empire”, creating inefficiencies and eroding shareholder value. Acquisitions driven by entrenchment motives often lead to poor integration and financial underperformance.

Question 15

value-neutral theories

Answer 15

Finally, value neutral theories suggest that mergers and acquisitions don’t create nor destroy value for the combined entity. Instead, the perceived value changes from a result of external factors such as managerial behaviour

Question 16

Value neural theories

Answer 16

Hubris Hypothesis and winners curse

Question 17

Hubris theory,

Answer 17

Rolls (1986) hubris theory, suggests that managers often pursue mergers based on overconfidence in their ability to generate synergies or improve the target firms performance. This managerial hubris leads to overpayment for the target company, negating any potential gains from the merger. The merger occurs not because it creates value but because managers believe their leadership can create favourable results

Question 18

Winners curse

Answer 18

Similarly, the winners curse, which describes competitive bidding scenarios where the winning bidder often overestimates the value of the target firm, leading to overpayment. This was exemplified by Roll (1986) found that many M&As driven by managerial hubris fail to create significant shareholder value.

Question 19

empirical evidence around gains for Target ( efficiency/synergy)

Answer 19

shareholders of target companies often experience significant positive returns upon announcement of the takeover bid, reflecting the premium offered by the acquirer.
These premiums reflect the expected value from synergies and the competition among potential acquirers

Question 20

empirical evidence around gains for Bidders ( efficiency/synergy)

Answer 20

The impact on acquiring firms is more varied. Some studies report modest positive returns especially when the acquisition is strategic, well excecuted and pays a reasonable price.

Question 21

empirical evidence around combined gains ( efficiency/synergy)

Answer 21

create net positive gains, with the combined value of both firms increasing due to synergies outweighing costs of the merger; including the premium and integration expenses.

Positive combined returns are the hallmark of successful M&A under this theory

Question 22

empirical study for value increasing theories

Answer 22

Andrade (2001)
- analysed MA activity
- to provide an overview into MA performance
- they measured stock price reactions and long-term performance measures
- observed that combined firm value typically increased around the announcement period due to anticipated synergies.
-Bidders earned small positive returns, while targets gained substantial premiums

Question 23

empirical study for value increasing theories (2)

Answer 23

Bradley et al (1988)
- aim: to determine if MA transactions create net wealth gains and how they are shared between target and bidder.
- measured stock price reactions around announcement dates
- found combined positive gains for bidders and targets with target shareholders receiving most of the benefits.
-They also found that combined gains were more pronounced in horizontal mergers, suggesting synergies drove the value creation.
Harford (2005) produced similar findings stating that combined returns were most positive in consolidated industries.

Question 24

empirical evidence around gains for Target (agency costs/ entrenchment)

Answer 24

despite potential issues, target firm shareholders typically still gain due to acquisition premiums paid to gain control.

These premiums may be inflated, or poorly justified- reflecting overvaluation, or managerial overconfidence rather than genuine synergies

Question 25

empirical evidence around gains for Bidder (agency costs/ entrenchment)

Answer 25

some research indicates mergers can be value-decreasing for firms.
Drivers of these losses include:
- overpayment; bidders overestimate value of synergies or targets intrinsic value

Question 26

empirical evidence around combined gains (agency costs/ entrenchment)

Answer 26

Costs associated with the merger, can outweigh the benefits and lead to a net decrease in combined value.

Poorly executed deals, cultural mismatches and excessive premiums offset potential gains which offsets any potential benefits.

Question 27

empirical evidence around gains (agency costs/ entrenchment)

Answer 27

Roll (1989)
- aim was to explore whether overconfidence in managers leads to overpayment and value destruction
- found many deals resulted in negative combined gains due to bidders overestimating synergies and overpaying
- negative effects were more common in large deals or when bidding firms were cash rich suggesting poor allocation of resources

Question 28

empirical evidence around gains (agency costs/ entrenchment)

Answer 28

Moeller et al (2005)
- aim to investigate wealth destruction in large acquisitions and assess bidder return patterns
- measured abnormal stock returns
- found large deals, acquirers lost significant amount over study period
- smaller acquisitions were more likely to yield neutral or positive gains

Question 29

gains for Target (value-neutral)

Answer 29

positive gains to shareholders due to premiums.

Due to overconfidence- premiums may exceed those that are rational due to bidders overestimation of synergies

Question 30

gains for Bidder (value-neutral)

Answer 30

negative returns to the bidder

Question 31

combined gains (value-neutral)

Answer 31

overall effect on combined firms value is minimal indicating merger doesn’t significantly impact total wealth of shareholders.

overpayment would offset potential synergies. Combined returns often align with the realisation that the premium paid was excessive and the synergies were overestimated.

Question 32

empirical evidence (value-neutral theory)

Answer 32

Firth (1980)
-examined UK takeovers using event studies on stock price reactions
- target shareholders experienced significant gains due to premiums
- bidders’ shareholders experienced losses
- overall no significant net value was created , supporting net neutral theory.

Question 33

empirical evidence (value neutral theory)

Answer 33

Jensen and Ruback (1983)
- reviewed empirical evidence on the market for corporate control to assess whether MA creates wealth or redistributes it
- target shareholders typically gained 20-30% premiums
- acquirers experience small positive to negative returns
- combined gains: minimal or zero- suggesting MA redistributes wealth rather than creating it.
aligns with value neutral theory

Question 34

why do we calculate combined returns?

Answer 34

To assess the overall value created (or destroyed) by the transaction for both the bidder and the target firms.
- provides clearer picture of whether the merger benefits all stakeholders collectively- beyond individual gains or lossess of bidder or target.

Question 35

returns and wealth transfer

Answer 35

Combined returns can separate value creation from value redistribution
- if target shareholders gain but bidder shareholders lose - the deal may reflect a transfer of wealth rather than value creation
- if combined returns are zero- no new value created- welath is redistributed

Question 36

theoretical motivations of MA

Answer 36

economic, strategic, managerial, finance and organisational perspectives

• These factors form a framework for understanding why firms pursue merger and the potential benefits they aim to achieve.

Question 37

economic

Answer 37

mergers are driven by the desire to reduce costs and increase market power. Firms achieve economies of scale, scope and learning

Question 38

economies of scale

Answer 38

Firms achieve economies of scale by merging, and lowering per-unit costs through increased production and operational efficiencies, these apply to single-product firms.

Question 39

economies of scope

Answer 39

Firms can achieve economies of scope when a firm gain efficiency from producing a wider variety of products. This makes it cheaper to produce a range of products together than to produce each one of them on its own. These apply to multiproduct firms.

Question 40

economies of learning

Answer 40

Economies of learning refer to reduction of costs through the learning process, throughout time saving costs of learning increases. With the size of the firm correlating to the ability to reap the benefits of scale, scope and learning.

Question 41

market power

Answer 41

Additionally, mergers often aim to enhance market power by reducing competition. Horizontal mergers, such as those in the airline industry, enable firms to dominate specific routes, leading to higher pricing power and improved profitability.

Question 42

SCP model in economic perspective

Answer 42

The Structure-Conduct-Performance (SCP) model explains how firms reshape market structures through mergers to gain competitive advantages.

Question 43

Transaction cost economies (Coase, 1937)

Answer 43

posits that firms merge when internalizing transactions is more cost-effective than relying on external markets. Vertical mergers, for instance, eliminate the need for external contracting, improving coordination and reducing transaction costs.

Question 44

Strategic motives

Answer 44

often play a pivotal role in M&As, particularly when firms seek to enhance their competitive positioning. Acquiring advanced technologies or unique capabilities is a key driver of mergers. For example, large technology firms frequently acquire startups to stay at the forefront of innovation. Mergers also facilitate market diversification, allowing firms to enter new geographic regions or industries, thereby reducing dependence on a single revenue stream. Disney’s acquisitions of Marvel and Lucasfilm are prime examples of strategic diversification, which expanded its portfolio and audience reach

Question 45

Resource based view

Answer 45

The Resource-Based View (RBV) underscores the importance of acquiring complementary resources to strengthen competitive advantages.

Question 46

Dynamic capabilities framework

Answer 46

Additionally, the dynamic capabilities framework (Teece, 1997) highlights how M&As enable firms to adapt to changing environments, ensuring long-term growth and innovation.

Question 47

Managerial

Answer 47

managerial motivations, including both value-creating and value-destroying factors. On the positive side, disciplinary takeovers serve as a corporate governance mechanism to replace inefficient management in underperforming firms. Hostile takeovers in the U.S. frequently target firms with weak governance, aligning corporate strategies with shareholder interests.

Question 48

managerial motives- value destruction

Answer 48

However, managerial motives can also lead to value destruction. Empire building, where managers pursue acquisitions to grow the size of the firm, often prioritizes personal benefits over shareholder value

Question 49

agency theory

Answer 49

Agency theory (Jensen & Meckling, 1976) explains how misaligned incentives may drive managers to undertake suboptimal M&A transactions.

Question 50

market for corporate control

Answer 50

market for corporate control (Manne, 1965) highlights how M&As can transfer control to more efficient operators, but these outcomes depend heavily on managerial intent.

Question 51

organisational perspective

Answer 51

focuses on the integration of corporate cultures, operational alignment, and decision-making processes. Mergers enable firms to achieve improved coordination by unifying goals and streamlining operations. Vertical mergers, for instance, enhance communication and efficiency between production and distribution teams.
However, successful integration requires compatibility between organizational cultures. Behavioral theories emphasize the importance of cultural fit in post-merger integration. Misalignment can lead to inefficiencies, employee dissatisfaction, and reduced productivity, which may offset potential benefits.

Question 52

financial

Answer 52

Mergers also offer financial benefits, particularly in terms of tax savings and access to capital. Leveraged acquisitions often take advantage of tax benefits such as interest deductibility on debt, which enhances post-tax cash flows. Additionally, larger merged firms typically have better access to capital markets, reducing their cost of borrowing and increasing financial flexibility.
Financial synergies further optimize the capital structure of the combined entity, creating long-term value for shareholders. For instance, merging firms can consolidate debt or equity positions to achieve a more efficient financial framework.
In highly competitive markets, M&As are driven by the need to counter threats and strengthen market position. Firms merge to respond to competitive pressures such as new entrants, disruptive technologies, or shifts in consumer preferences. For example, telecommunications mergers often aim to consolidate resources and remain relevant in rapidly evolving markets.