Terms of Combination

A.
Merger

Creating
Value

Synergy
Growth
Increasing market power
Acquiring unique capabilities or
resources
Unlocking hidden value

Cross-Border
Mergers

Exploiting market imperfections

Overcoming adverse government policy
Technology transfer
Product differentiation
Following clients

Dubious
Motives

Diversification
Bootstrapping earnings
Managers personal incentives
Tax considerations

Motives for Merger

Creating value (that is, mergers with these motives have the potential to add
value):
Synergy (Note: 1 + 1 > 2)
Economies of scale
Cross-product selling
Growth
External growth (may be less risky than organic growth)
Increasing market power
Horizontal or vertical integration to increase strength in the
industry
Note: Regulatory authorities in some countries may limit this as
a benefit (e.g., FTC in the United States).
Acquiring unique capabilities or resources
Resources include patents, technology, trademarks, or raw
materials
Unlocking hidden value
Improve management, reorganize structure, breakups, or
liquidations
Cross-border mergers:

Exploiting market imperfections

Cheaper labor in one market
Lower-cost raw materials
Overcoming adverse government policy
Circumvent tariffs
Circumvent barriers to trade
Technology transfer
Facilitate entry into a countrys market
Gain access to new technology or resources
Product differentiation
Enhance product line
Expand into a countrys market
Buy reputation for entry into a market
Following clients
Make sure that the business of clients do not go to another
company once the client expands to another country.
Dubious motives:
Diversification
Investors can diversify in their own portfolios, so there is
generally no value to companies to diversify.
Bootstrapping earnings (see Example 10-3)
Occurs if the acquirers shares trade at a higher P/E than the
targets
Managers personal incentives
Compensation (often tied to size of the firm/earningspart of
managerialism theories)
Decrease their personal employment risk
Tax considerations
Most jurisdictions do not allow buying tax losses.

Example: Bootstrapping earnings

Bootstrapping earnings is the increase in earnings per share as a result of
a merger, combined with the markets use of the pre-merger P/E to value postmerger EPS.
Assumptions:

Exchange ratio: One share of Company One for two shares of Company Two

Market applies pre-merger P/E of Company One to post-merger earnings.

Earnings
Number
shares

of

Company One
$ 100 million
100 million

Company Two
$50 million
50 million

Company One
Post-Acquisition
$150 million
125 million

Earnings
per
$1
$1
$1.20
share
P/E
20
10
20
Price per share
$20
$10
$24
Market value of
$2,000 million
$500 million
$3,000 million
stock
In this example, we first assume that the market is imperfect and incorrectly
applies the pre-merger P/E of Company One to the merged company.
The correct valuation, assuming no synergistic effects not reflected in the
pre-merger values of the company, uses a weighted P/E, in which the weights
are the contributions to earnings:

WeightedP/E=

$50
20) + (
10 )=16.67
( $100
$150
$150

Earnings
Number
of
shares
Earnings
per
share
P/E
Price per share
Market value of
stock

Company One
$ 100 million
100 million

Company Two
$50 million
50 million

Company One
Post-Acquisition
$150 million
125 million

$1

$1

$1.20

20
$20
$2,000 million

10
$10
$500 million

16.67
$20
$3,000 million

Motives and the Industrys Life Cycle

The motives for a merger are influenced, in part, by the industrys stage in its
life cycle.

Factors include

Need for capital (e.g., startups may merge with larger firms to have
access to capital).

Need for resources (e.g., need for raw materials in a competitive

market).

Degree of competition and the number of competitors (e.g., survival

for a mature company with few growth opportunities).

Growth opportunities (organic vs. external)for example, mature

companies may seek out external growth as organic opportunities
wane.

Opportunities for synergy (e.g., mature companies may need to merge

to gain economics of scale to produce growth).

Mergers and the Industry Life Cycle

Industry Life
Cycle Stage
Pioneering
development

Industry
Description

Motives for Merger

Industry

exhibits
substantial
development
costs and has
low, but slowly
increasing,
sales growth.

Rapid
accelerating
growth

Mature growth

Stabilization and
market maturity

Younger, smaller

companies may sell

themselves to larger
companies in mature
or declining
industries and look
for ways to enter into
a new growth
industry.
Young companies
may look to merge
with companies that
allow them to pool
management and
capital resources.

Conglomerat
e
Horizontal

Explosive growth in
sales may require
large capital
requirements to
expand existing
capacity.

Conglomerat
e
Horizontal

Industry
exhibits high
profit margins
caused by few
participants in
the market.

Industry
experiences a
drop in the
entry of new
competitors,
but growth
potential
remains.

Mergers may be
undertaken to
achieve economies
of scale, savings,
and operational
efficiencies.

Horizontal
Vertical

Industry faces
increasing
competition
and capacity
constraints.

Mergers may be

undertaken to
achieve economies
of scale in research,
production, and
marketing to match
the low cost and
price performance of
other companies
(domestic and
foreign).
Large companies
may acquire smaller
companies to
improve
management and
provide a broader
financial base.

Horizontal

Horizontal
Vertical

Deceleration of
growth and
decline

Types of
Mergers

Industry faces
overcapacity
and eroding

Horizontal mergers
may be undertaken
to ensure survival.