Foundations of Financial Management: An Analysis (Part 77)

Before you speak, listen. Before you write, think. Before you spend, earn. Before you invest, investigate. Before you criticize, wait. Before you pray, forgive. Before you quit, try. Before you retire, save. Before you die, give.

William A. Ward

External Growth through Mergers

(Part A)

by

Charles Lamson

In the last few posts of this analysis, we examine the motives for business combinations; the establishment of negotiated terms of exchange, with the associated accounting implications; and the stock market effect of mergers (including unfriendly takeovers).

Motives for Business Combinations

A business combination may take the form of either a merger or a consolidation. A merger is defined as a combination of two or more companies in which the resulting firm maintains the identity of the acquiring company. In a consolidation two or more companies are combined to form a new entity. A consolidation might be utilized when the firms are of equal size and market power. For purposes of our discussion, the primary emphasis will be on mergers, though virtually all of the principles presented could apply to consolidations as well.

Financial Motives

The motives for mergers and consolidations are both financial and nonfinancial in nature. We examine the financial motives first. A merger allows the acquiring firm to enjoy a potentially desirable portfolio effect by achieving risk reduction while perhaps maintaining the firm's rate of return. If two firms that benefit from opposite phases of the business cycle combine, their variability in performance may be reduced. Risk-averse investors may then discount the future performance of the merged firm at a lower rate and thus assign it a higher valuation than was assigned to the separate firms. The same point can be made in regard to multinational mergers. Through merger, a firm that has holdings in diverse economic and political climates can enjoy some reduction in the risks that derive from foreign exchange translation, government politics, military takeovers, and localized recessions.

While the portfolio diversification effect of a merger is intellectually appealing with each firm becoming a mini-mutual fund onto itself, the practicalities of the situation can become quite complicated. No doubt one of the major forces of the merger wave of the mid-to-late 1960s was the desire of the conglomerates for diversification. The lessons we have learned from the LTVs, the Littons, and others is that too much diversification can restrain the operating capabilities of the firm (Block & Hirt, p. 586).

As one form of evidence on the lack of success of some of these earlier mergers, the ratio of divestitures (selling off subsidiary business interests or investments) to new acquisitions was only 11 percent in 1967, but it rose to over 50 percent generations later. As examples, Sears spent the early 1990s shedding itself of its Allstate Insurance Division and also Dean Witter, its entry into the stock brokerage business. Eastman Kodak sold off its chemical holdings during the same time period. The stock market reaction to divestitures may actually be positive when it can be shown that management is freeing itself from an unwanted or unprofitable division.

A second financial motive is the improved financing posture that a merger can create as a result of expansion. Larger firms may enjoy greater access to financial markets and thus be in a better position to raise debt and equity capital. Such firms may also be able to attract larger and more prestigious investment bankers to handle future financing.

Greater financing capability may also be inherent in the merger itself. This is likely to be the case if the acquired firm has a strong cash position or low debt-equity ratio that can be used to expand borrowing by the acquiring company.

A financial motive is the tax loss carryforward that might be available in a merger if one of the firms has previously sustained a tax loss. 

In the example below, we assume Firm A acquires Firm B, which has a $220,000 tax loss carryforward. We look at Firm A's financial position before and after the merger. The assumption is that the firm has a 40 percent tax rate.

The tax shield value of a carryforward to Firm A is equal to the loss involved times the tax rate ($220,000 * 40 percent = $88,000). Based on the carry forward, the company can reduce its total taxes from $120,000 to $32,000, and thus it could pay $88,000 for the carryforward alone (this is on a nondiscounted basis). 

As would be expected, income available to stockholders also has gone up by $88,000 ($268,000 - $180,000 = $88,000). Of course Firm B's anticipated operating gains and losses for future years must also be considered in analyzing the deal.

Nonfinancial Motives

The nonfinancial motives for mergers and consolidations include the desire to expand management and marketing capabilities as well as the acquisition of new products.

While mergers may be directed toward either a horizontal integration (that is, the acquisition of competitors) or vertical integration (the acquisition of buyers or sellers of goods and services to the company), antitrust policy generally precludes the elimination of competition. For this reason mergers are often with companies in allied but not directly related fields. The pure conglomerate merger of industries in totally unrelated Industries is still undertaken, but less frequently than in the past.

Perhaps the greatest management motive for merger is the possible synergistic effect. Synergy is said to occur when the whole is greater than the sum of the parts. This "2 + 2 = 5" effect may be the result of eliminating overlapping functions in production and marketing as well as meshing together various engineering capabilities. In terms of planning related to mergers, there is often a tendency to overestimate the possible synergistic benefits that might accrue.

Motives of Selling Stockholders

Existing stockholders can sell shares in a company's initial public offering or in a follow-on offering. Existing stockholders who sell shares through initial purchasers in unregistered offerings exempt from registration under Rule 144A and Regulation S are also referred to as selling stockholders (westlaw.com).

Most of our discussion has revolved around the motives of the acquiring firm that initiates a merger. Likewise the selling stockholders may be motivated by a desire to receive the acquiring company's stock which may have greater acceptability or activity in the marketplace than the stock they hold. Also when cash is offered instead of stock, this gives the selling stockholders an opportunity to diversify their holdings into many new Investments. As will be discussed in the next post, the selling stockholders generally receive an attractive price for their stock that may well exceed its current market or book value.

In addition, officers of the selling company may receive attractive post-merger management contracts as well as directorships in the acquiring firm. In some circumstances they may be allowed to operate the company as a highly autonomous subsidiary after the merger (though this is probably the exception). 

A final motive of the selling stockholders may simply be the bias against smaller businesses that has developed in this country and around the world. Real clout in the financial markets may dictate being part of a larger organization. These motives should not be taken as evidence that all or even most officers or directors of smaller firms wish to sell out---a matter that we shall examine further when we discuss negotiated offers versus takeover attempts. 

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 584-589*

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