Week 8 Flashcards
Why firms choose to merge or acquire
– Improving target’s management / stand-alone performance
– Access Economies of Scale or Scope
- Cheaper production with higher output OR
- Cheaper production by producing related products and splitting fixed costs across them
– Reduce Price Competition
Strategies that reflect potential Economies of Scale / Scope
Roll-up’ strategy
in a fragmented market with lots of small firms, combination could help economise on costs such as marketing, purchasing etc
Strategies that reflect potential Economies of Scale / Scope
Accelerate Market Access for Target’s Product – Large pharmaceuticals frequently acquire smaller specialised pharmaceuticals, as the acquirer is often better able to market the small firm’s product (they already have a large distribution network)
Strategies that reflect potential Economies of Scale / Scope
Remove Excess Capacity From Industry – in mature industries excess production capacity commonly develops. It is not in any individual firm’s interest to reduce capacity, but if 2 or more firms combine they may find it easier to shut down some productive facilities
e.g. 5 factories become 4
describe one benefit of econocmies of scale
– Access complementary resources / skills / capacity more cheaply than they can be bought/developed in-house
Describe the benefit for target in the case of mergers and acquisitions
Provide Low-Cost Finance to Financially Constrained Target
where the target is a young, high-growth company, an acquirer with superior information regarding the target may be able to buy such a firm ‘cheaply’ because other investor’s required return is inflated by information asymmetry.
Managerial Motivations for M&As
Empire building:
Managers may perceive a personal benefit to managing a larger corporation…even if it is less profitable
Managerial Motivations for M&As
Compensation
Manager’s compensation contracts are frequently re-written after large acquisitions, manager may believe that this will work in their favour
Effect of form of payment on target shareholders
Tax effects
Cash received by target shareholders triggers capital gain (loss) recognition, while receiving shares of the acquiring firm defers recognition of gain (loss).
Effect of form of payment on target shareholders
– Transaction costs
Incurred when target shareholders sell shares received under consideration for their shares in the target
- If the bidder offers cash, target shareholders won’t face these costs
- Not significant for investors planning to hold acquirer’s shares following the acquisition
Acquisition Financing and Form of Payment
Effect on Shareholders of Acquirer
Capital structure effects
If debt financing (or surplus cash) is used, analysis should be conducted to see if the resulting increase in financial leverage is excessive
– Examine Debt / Equity and Coverage ratios pre / post acquisition, including off balance sheet items like operating leases
• What happens to cost of capital?
Acquisition Financing and Form of Payment
Effect on Shareholders of Acquirer
Information problems make funding via new equity issue difficult
• Hard to raise new equity to finance an acquisition as market may interpret the equity raising as a signal that the acquirer is currently overvalued (there is a lot empirical evidence that firms issue equity when managers believe the firm’s stock is overvalued)
Acquisition Financing and Form of Payment
Effect on Shareholders of Acquirer
Control and the form of payment
• Using equity to finance M&A dilutes the ownership and control of the acquiring firm.
Another consideration facing an analyst/investor is assessing the likelihood that the merger will be successfully completed.
– Other potential acquirers
• Others may offer a higher bid.
– Target management entrenchment
• Target management may fear losing their jobs.
