CHAPTER 2: REVIEW OF LITERATURE

2.1 Global Literature

Mergers and acquisitions activity impacts various diverse groups such as

corporate management, shareholders & investors, investment bankers,

regulators, stock markets, customers, government and taxation authorities, and

society at large. It has therefore received considerable attention from

researchers across the world.

There have been numerous studies on mergers and acquisitions worldwide, in

the last five decades, and several theories have been proposed and tested for

empirical validation. Research studies have analysed the economic impact of

mergers and acquisitions on industry consolidation, returns to shareholders

following mergers and acquisitions, and the post-merger performance of

companies. Several measures have been postulated for analysing the success

of mergers, in terms of whether or not a merged company achieves the

expected performance. Such measures have included both short-term and

long-term impacts of merger announcements, effects on shareholder returns

following mergers, post-merger performance of merging companies etc.

A number of research studies have been done in the developed countries of

USA and Europe, and some in Asia. These studies have focused on different

aspects of mergers and acquisitions, viz.

29
 (a) The rationale of Mergers and Acquisitions [1, 2],

(b) Allocational and redistributional role of Mergers and Acquisitions [3],

(c) Effect of takeovers on shareholders' wealth [4, 5, 62],

(d) Evaluation of corporate financial performance following mergers [6, 7, 11,

12] and

(e) Comparison of pre- and post-merger financial performance of companies

engaged in mergers [8, 9 and 10].

The research that has been so far done globally on M&As, can be categorised

into two broad areas: (i) Wealth effects of mergers and (ii) Impact of mergers

on long-term firm financial / operating performance

2.1.1 Studies on Wealth effects of mergers

Valuation theories state that a firm’s value is the sum total of the discounted

value of firm’ s cash flows generated by the assets already in place plus the

discounted value of the expected future cash flows to be generated from the

potential investment projects. Stock prices of today not only reflect the firm’ s

current earning capacity but also reflect investor’ s expectations of future

operating and investment performance.

The efficient market hypothesis states that asset prices in financial markets

should reflect all available information; as a consequence, prices should always

be consistent with ‘fundamentals’. Any changes in “fundamentals” as caused by

announcements of mergers / acquisitions that alter the existing characteristics

of the firms involved, will therefore get reflected in the market’s repricing of the

30
underlying securities (equity shares) of the firms; the stock market is “efficient”

in the sense that stock prices adjust very rapidly to new information. These

“abnormal changes” in stock prices are analysed in Event Studies. An event

study is therefore an analysis of whether there was a statistically significant

reaction in financial markets to the occurrence of a given type of event that is

hypothesized to affect public firms' market values.

Past event studies have focused on the impact of merger announcements and

subsequent events, on the stock prices of both firms involved. The market

reactions to acquisition / merger announcements have been analysed for

periods ranging from 3 months to 5 years, before and after the announcement

date of the merger/ acquisition. In these studies, which use the residual

analysis / event studies methodology, the significance of Cumulative Average

Abnormal Returns (CAARs)1 to target firms and returns to bidder firms is

usually tested for statistical significance. Such studies have analysed abnormal

stock returns earned by shareholders of acquired and acquiring firms, after the

acquisition / merger announcement, and the completion of the merger process.

Abnormal stock returns generally reflect the value that a transaction potentially

creates for shareholders. It is accepted as a measure that indicates likelihood

of the success of the acquisition / merger. The various residual analysis

techniques used in event studies 2 have been reviewed by Halpern and Weston

1
The expected returns on equity shares is calculated in accordance with the Capital Asset
Pricing Model (CAPM), and the actual returns are calculated from the stock prices, and the
difference between these two returns is termed as the abnormal returns. When such returns
are cumulated over a period of time and averaged , they are termed as Cumulative Average
Abnormal Returns (CAAR)
2
Event studies examine the effects of the merger / acquisition announcement on the stock
market valuations of target / bidder firms around the time the deal / agreement is announced. A
common method is to calculate cumulative abnormal returns, i.e., the increase in stock price
over that which the capital asset pricing model, would predict excluding the merger / acquisition

31
[13, 14]. Other event studies have looked at returns to shareholders in terms

of growth in market capitalisation relative to industry peers during the post-

acquisition period

Event studies globally have generally found that target firm share prices have

increased following merger announcements, whereas acquirer firm share

prices stayed about the same or declined. Generally, target firm share prices

are expected by researchers, to go up in anticipation of successful offers that

will involve payment of premiums to shareholders who tender their shares to

the acquirer. Bidder firms’ share prices are generally expected to stay flat on

average or decline, because the market is assumed to judge the future gains

from a merger cautiously, and the assumption that achievement of the

anticipated benefits by acquirer firms has always been viewed skeptically by

investors. However, some event studies have also noted that where

acquisitions were expected by investors to bring in gains for acquirer firms

beyond the price paid for acquisition, the share prices of acquiring firms have

also gone up.

2.1.1.1 Studies in USA

Joseph P.H. Fan and Vidhan K. Goyal, [15] used industry commodity flows

information to measure vertical relations for completed mergers of all firms on

NYSE, Amex and NASDAQ from 1962 to 1996 in the USA. The study

addressed the following questions concerning the wealth effects of mergers of

different types:

 Do vertical mergers create value?

32
  How do the wealth effects of vertical mergers compare with those of

horizontal and/or diversifying mergers?

 Are the wealth effects in cross-industry, but vertically related firms different

from those in cross-industry, but vertically unrelated firms?

The sample firms were classified as cross-industry, diversifying, pure vertical,

mixed vertical-horizontal, and pure horizontal mergers. The study examined the

cross-sectional variation in the wealth effects of mergers by merger type, and if

there was a time-series relation between vertical merger activity and wealth

effects. Standard event study methodology was adopted, to compute daily

returns over a 255-day estimation period that ended 46 days before the initial

merger announcement.

The study found that vertical mergers generated positive wealth effects that

were significantly larger compared with those for diversifying mergers; and that

the wealth effects in vertical mergers were comparable to those in pure

horizontal mergers. Even in a sub sample of mergers between bidders and

targets in different industries, the study found that vertically related mergers

generated significantly greater positive wealth effects compared to vertically

unrelated mergers.

G. William Schwert [16] found from a study of 1,814 merger announcements,

that from the time of the announcement to the time of delisting (or 126 days

later, whichever came first), Cumulative Abnormal Return on target stock rose

by 10.1%. The rise was called as a "mark-up." The study reported an average

33
rise of 133% in the target firm's stock price that occurred due to

preannouncement rumours, and the change was called a "run-up." The study

also found that mark-ups and run-ups were not correlated, and concluded that

run-ups tended to inflate the premium paid by bidder firms. (For pre-rumour

target firm shareholders, however, the results were found to be good - an

average total rise of +23.4 %).

Michael Bradley, Anand Desai and Han Kim [17] found that stock market

responses to announcements of completed mergers had brought positive stock

returns (cumulative average return of +7.43%) to shareholders of both the

bidding and target firms. The study analysed 236 tender offers that were

successfully completed between 1963 and 1984 in the US and estimated the

magnitude of the synergistic gains, using the revaluation of the combined

wealth of target-firm and squiring-firm shareholders as a basis. The study

examined the factors that determine the division of those gains between the

stockholders of the two firms and documented how the division and the total

gains created have changed with the changing environment of the tender offer

process.

The study also found that target stockholders have captured the lion’s share of

the gains from tender offers, and their share of the gains has increased

significantly since the passage of the Williams Amendment in 1968. Acquiring

firms, on the other hand, had realized a significant positive gain only during the

unregulated period 1963-1968 and in fact, suffered a significant loss during the

sub-period, 1981-1984. The study also found that the total percentage

34
synergistic gains from tender offers have remained remarkably constant over

time.

Sayan Chatterjee [18] compared three broad classes of resources that

contribute to creation of value in mergers: cost of capital related (resulting in

financial synergy), cost of production related (resulting in operational synergy),

and price related (resulting in collusive synergy). The sample comprised of 157

merger cases that occurred during the period 1969 – 72 in the USA. Using an

event study spanning a window of 200 days prior to the announcement date of

the proposed merger to 50 days after the announcement, the study analysed

the wealth gain/loss to the rivals of the target firms, and compared them with

those of the merged entities.

The study adopted the following methodology, for selecting a suitable sample of

merging firms:

(a) Elimination of collusive synergies: by restricting the sample to related non-

horizontal mergers (firms which contain both operational and financial

synergies), for comparing with a sample of unrelated mergers (likely to have

only financial synergy)

(b) Elimination of speculative gains: to maintain consistency in comparing

CAARs of individual acquisitions, only merger proposals were considered,

and tender offers were excluded, so as to eliminate effect of any speculative

gains that could occur due to presence of risk arbitrageurs

(c) Emphasizing financial synergies: Financial synergy could be realised only if

the target firm is big enough to absorb the capital infusion by acquiring firm.

Hence relatively large acquiring firms compared to the targets were chosen

35
 in the unrelated sample, assuming that the potential financial synergy

arising out of the merger can be fully exploited.

(d) Standardization of gains: To standardize the wealth gain to the same asset

base for each of the samples, if the absolute size of any one target varied

significantly from the rest of the sample, such case was eliminated from the

sample, instead of trying to control for any differential impact of absolute

size.

The study concluded that relative size does appear to be an indicator of

financial synergy and if financial synergy can be fully exploited (large relative

size of acquiring firm), then the merger-related gains appeared to be greater

than those that depended primarily on operational synergies. Further, the study

suggested that horizontal mergers outperformed the other two types of

mergers, in terms of stock price returns to shareholders

Tim Loughran and Anand Vijh [5] studied the long-term effects of 947

acquisitions conducted between 1970 and 1989 and found a relationship

between the post-acquisition returns and the mode of acquisition and form of

payment. The study found that during a five-year period following the

acquisition, on average, firms that completed stock mergers earned

significantly negative excess returns of -25.0 percent whereas firms that

completed cash tender offers earned significantly positive excess returns of

61.7 percent. Over the combined pre-acquisition and post-acquisition period,

target shareholders who held on to the acquirer stock (received as payment in

stock mergers) did not earn significantly positive excess returns. The study

suggested that firms that pay in stock tend to have overvalued shares, whereas

36
firms that pay in cash tend to have undervalued shares; and that during the

post-merger period, the true valuation of the merging / acquiring companies

would emerge, causing the differences in returns.

Franks, Harris, and Titman [19] investigated share-price performance following

corporate takeovers, using a sample that included 399 U.S. takeovers

consummated in the 1975–1984 period. The study used multifactor

benchmarks from the portfolio evaluation literature to overcome some of the

known mean-variance inefficiencies of more traditional single-factor

benchmarks. The study concluded that previous findings of poor performance

after takeover were likely due to benchmark errors rather than mis-pricing at

the time of the takeover

Agrawal, Anup and Jaffe, Jeffrey [20] reviewed the literature on long-run stock

returns following acquisitions, and concluded that long-run performance was

negative following mergers, though performance was non-negative (and

perhaps even positive) following tender offers. However, the study felt that

effects of both methodology and chance might modify such conclusion. The

study did not find evidence to support the conjecture that under-performance

was specifically due to a slow adjustment to merger news.

Mercer Management Consulting and Business Week [21] did a joint study of

post-merger performance of acquiring firms, by tracking post-merger share

price returns for 150 deals of the size $500 million-plus from 1990 to 1995.

Using a large sample and comparing total return three months before the

37
merger announcements with returns up to 36 months afterward, the analysis

used the S&P industry indexes to filter out, as much as possible, other external

events affecting acquirers' returns. Stock returns were compared for 248

acquiring companies (that had acquired 1045 companies from January 1990

through July 1995) with those of 96 non-acquirers (companies that made zero

purchases during the period).

The study found that acquiring firms in the 1990’s (where most of the deals

were done ostensibly for business reasons) had performed better, than they did

after 1980’s transactions, a high proportion of which were financially driven. But

most of the '90s deals still had not worked - about half of the 150 deals were

found to have destroyed shareholder wealth, while another third contributed

only marginally to shareholder wealth. Only 17% of the total deals had created

substantial returns for the acquiring companies; 33% created only marginal

returns, 20% eroded some returns, and 30% substantially eroded shareholder

returns (as measured by total returns to shareholders relative to industry peers

over a three-year period).

The study also found that the non-acquirer firms had done better than the

acquiring firms. While 69% of the companies that made no acquisitions larger

than $5 million outperformed their respective Standard & Poor's industry

indices, only 58% of the acquiring firms had produced superior returns. Further,

the more experienced the acquiring firm was, the better were the returns: 72%

of companies that completed six or more deals valued over $5 million each

38
yielded returns above the industry average, compared with 54% of companies

that had done between one to five transactions.

Anup Agrawal, Jaffrey F. Jaffe, Gershon N. Mandelkar [6], re-examined the

issue of post-merger underperformance by acquiring firms. They concluded

that the results of prior empirical research are inconclusive, due to

methodological problems, and that the anomaly of negative returns to acquirers

remained unresolved. The performance of acquiring firms over a 5-year post-

merger period was again tested using a sample of 937 mergers and 227 tender

offers between 1955 and 1987, between NYSE acquirers and NYSE / AMEX

target firms. The study hypothesised that the long-run performance of the

acquiring firm would reflect that part of the net present value of the merger that

was not captured by the announcement period return. The study used two

alternate methodologies and control groups, to adjust for beta risk and market

capitalisation. Results were further sub-divided by time-periods and by

conglomerate and non-conglomerate acquisitions

The results of the study indicated that the stocks of acquiring firms performed

poorly after mergers, and that stockholders of acquiring firms suffered a

statistically significant loss of about 10% over the 5-year post-merger period,

which was validated by various specifications. Also, neither the firm size effect

nor beta estimation problems seemed to be the cause of negative post-merger

returns. The study also did not find any conclusive evidence that the negative

returns were caused by a slow adjustment of the market to the merger event.

However, the study observed that effects of both methodology and chance may

39
modify the conclusion. Two explanations of under-performance (speed of price-

adjustment and EPS myopia) were seen as not supported by the data, while

two other explanations (method of payment and performance extrapolation)

seemed to receive greater support from the data analysed

Raghavendra Rau and Theo Vermaelen [22] investigated bidders’

underperformance (if any) in the long run after the acquisition, as found by

earlier studies, and the determinants of such underperformance. The sample

included bidding firms in mergers and tender offers announced and completed

between January 1980 and December 1991 (3169 mergers and 348 tender

offers). The study found that after adjusting for both firm size and book-to-

market ratio, on average, acquirers in mergers underperformed equally-

weighted control portfolios with similar sizes and book-to-market ratios, by a

statistically significant 4% over a period of three years after the merger

completion date. On the other hand, acquirers in tender offers were found to

have earned a statistically significant positive abnormal return of 9%, on

average.

To measure abnormal performance, the study used the common technique of

computing cumulative abnormal returns relative to a size- and book-to-market-

based benchmark. The study used a methodology that was said to be robust

to counter criticisms of standard long-horizon event study tests – by forming ten

size deciles of every month based on market capitalization of NYSE and AMEX

firms. The deciles were further segregated into quintiles using book-to-market

ratios. Portfolio returns were calculated for every month by averaging the

40
monthly returns for these 50 portfolios. The returns were then used as

benchmarks to calculate abnormal performance for each firm relative to its size

and book-to-market benchmark (as the difference between its monthly return

and that of its control portfolio) every month for 36 months after the merger

completion date. CAARs were calculated by averaging across all acquirer firms

every month, and then summing the averages over time.

The study showed that bidders in mergers under performed, while bidders in

tender offers over performed in the three years after the acquisition. However,

the long-term underperformance of acquiring firms in mergers was not uniform

across firms: it was predominantly caused by poor post-acquisition

performance of low book value-to-market value glamour acquirers, who

performed much worse than other stocks, and earned significant negative bias-

adjusted abnormal returns of 17% in mergers. In contrast to value bidders,

glamour bidders in both 100% cash-financed and 100% equity-financed

mergers were seen to have significantly underperformed after the merger.

The fact that glamour bidders in tender offers performed significantly worse

than value bidders, suggested that companies with low book-to-market ratios

tend to make relatively poor acquisition decisions, in general. The study

interpreted this finding as evidence that both the market and the management

over-extrapolate the bidder’s past performance (as reflected in the bidder’s

book-to-market ratio) when they assess the desirability of an acquisition.

41
Lubatkin [11] reviewed the findings of previous studies that had investigated

either directly or indirectly the question, “Do mergers provide real benefits to

the acquiring firm?”. The review suggested that acquiring firms might benefit

from merging because of technical, pecuniary and diversification synergies.

The review also pointed out that in general, only mergers completed by

infrequently merging firms tended to be included in the samples of CAPM

merger studies, in order to protect against any bias associated with the

possible influence of other mergers completed by the same acquiring firms. It

was suggested that the clean data screening procedure used to protect against

this multiple merger bias, therefore, may inadvertently introduce a sampling

bias by systematically excluding mergers completed by more experienced

acquiring firms. Further, if there was a positive relationship between merger

performance and experience, then this sampling bias might explain the low

return observed for acquiring firms in prior merger studies. Lubatkin therefore

suggested using a large sample size for such studies, to test explicitly the

relationship between experience and performance in the acquisition market, by

relaxing the clean data screen and forming groups of mergers relatively

homogeneous to the acquiring firms’ experience level. Lubatkin also suggested

that a small acquisition may play a role in promoting a capability linked to

enhancing acquisition performance, namely acquisition experience.

According to Lubatkin, the motivations for mergers and acquisitions can be

theorized into seven main areas:

 Monopoly Theory: Gaining market power

42
  Efficiency Theory: Operating synergies, financial synergies and

management synergies.

 Valuation Theory: Bidder managers have better information about the

target's financial performance than the stock market.

 Empire Building Theory: Planned and executed by managers who

maximise their own utility instead of their shareholders value.

 Process Theory: Managers have only limited information and base

decisions on imperfect information.

 Raider Theory: Managers creating wealth transfers from the stockholders

of the companies they bid for.

 Disturbance Theory: Merger waves are caused by economic disturbances

Alexandra Reed and Fred Weston [2] reviewed short-term impact studies and

long-term performance studies to analyse whether deals improved post-

merger performance. The review suggested that the overall impact of mergers

on short-term share value was positive, but the result seemed skewed toward

those who are "leaving" the deal – i.e., target shareholders who sell to the

bidder - and away from those who are "staying" in the deal – i.e., the

shareholders of the company that will remain after the merger. The research

on the longer-term effects of mergers however suggested impairment of value

(measured by share price and other indicators) for a variety of identifiable

reasons, including inexperience, lack of strategic purpose, use of overvalued

stock as a payment mode, and poor post-merger integration.

43
2.1.1.2 Studies in Europe

Mara Faccio, John J. McConnell and David Stolin [23] documented an average

announcement period return of +1.05% for the stocks of the acquiring firms, in

a large study comprising a sample of 4,579 acquisitions announced between

January 1997 and December 2000 by firms in 13 Western European countries.

The study concluded that returns are not significantly lower for companies that

were exposed to various sources of agency conflicts - suggesting that to the

extent that synergies do not depend on ownership structure, acquisitions are

not a vehicle through which controlling shareholders increase their private

benefits of control at the expense of minority shareholders. The study also

showed that controlling shareholders on average did not enjoy a larger

increase in wealth than that implied by the bidder’s announcement return.

Further, for a sub–sample of announcements comparing the change in

wealth for the controlling shareholder to the change in wealth implied by the

bidder’s stock price reaction, it was found that the wealth of the controlling

families did not increase more than what was implied by their investment in the

bidder.

Bhattacharya, Daouk, Jorgenson, and Kehr [24] examined if it was possible to

have a stock market where a firm's stock price does not react to firm-specific

news announcements. Their study suggested that there could be four

scenarios in which such phenomenon may occur:

 First, the stock market may be informationally inefficient, which implies that

stock prices are not linked to firm values. In such a stock market, stock

44
 prices will not change when new information about firm value is released

through corporate announcements.

 Second, it is possible that firms in an economy do not make value-relevant

news announcements. Even if stock markets in this fictional economy are

informationally efficient, prices are left with no announcement stimuli

against which to respond.

 Third, though a stock market may be efficient, and the news may be value-

relevant, the news provided may be completely anticipated. In such a

market, announcement days bring no surprise.

 Fourth, insider trading prohibitions may not exist in a stock market or, if they

exist, are not enforced. In such stock market, the superior information of

insiders may have been incorporated in stock prices through their trades

prior to the announcement, in which case the public announcement would

be news to everyone except the traders.

The study suggested that if an event is defined as a point in time at which a

great deal of information is incorporated into stock prices, then any of the

above four reasons could explain why a corporate news announcement may

not really be an event. This calls into question whether event studies represent

the best way to capture impact of mergers and acquisitions on acquiring firms’

performance, as implied by stock price changes on merger announcements

The evidence suggested however, that it cannot explain some important and

worrying features of asset market behaviour [25, 26]. Most importantly for the

wider goal of efficient resource allocation, financial market prices appear at

45
times to be subject to substantial misalignments, which can persist for

extended periods of time

After reviewing nearly 20 years of research on corporate acquisitions, Jensen

and Ruback [27] observed that: “research studies have reached the point of

diminishing returns from efforts that focused solely on effects of stock prices

(during acquisitions). Further research would have to be done on examining

other organisational, technological, legal aspects of the environment: the

relationship between these other factors and stock prices would continue to be

of continuing importance to future research”

2.1.1.3 Summary of results from Event Studies

Empirical evidence in the form of event studies on US companies [17, 18 & 20]

pointed out that the target firms’ valuations increased substantially in takeovers,

and that stock market responses to announcements of completed mergers had

brought positive stock returns to shareholders of both the bidding and target

firms (combined). The studies also found that target stockholders have

captured the lion’s share of the gains from tender offers.

Some event studies have found negative returns to bidders on acquisition

announcement [28], while others have found evidence of negative effect of

diversification on shareholders’ wealth [29]. The post–outcome negative

abnormal returns suggested that changes in stock prices during takeovers

overestimated the future efficiency gains from mergers.

46
In summary, research based on event studies on the effect of mergers, had

showed impairment of value (measured by share price and other indicators) for

acquiring firms, for a variety of identifiable reasons, including inexperience, lack

of strategic purpose, use of overvalued stock as a payment mode, and poor

post-merger integration. The research also suggested that companies avoiding

these traps performed better than their peer firms - both acquiring and non-

acquiring merging firms

2.1.2 Limitations of research through event studies

2.1.2.1 Limitations of short-term event studies

Generally, short-term event studies on mergers have concluded that acquiring

firm shareholders had loss of market value post the acquisitions, as indicated

by share price movements. Such studies however, have some limitations:

 Much of the research had examined returns surrounding announcement

dates of on mergers and acquisitions, in order to infer the wealth effects of

mergers. This approach implicitly assumed that markets are efficient, since

returns in later periods following the merger completion were ignored.

Concluding that mergers have caused poor returns, based on stock market

reactions to merger announcements, is yet to be accepted as the best

method to measure the success of mergers.

 Secondly, considering the financial motivations for acquisitions, the

combined firm should be expected to generate cash flows with a present

value in excess of the sum of the market values of the bidding and target

firms. But the abnormal returns estimated in event studies do not identify

which components of the present value of net cash flows have changed.

47
 Some event studies which have demonstrated abnormal returns through

higher stock prices to takeover participants, have not distinguished between

these alternative sources of gains, and thus could not reach definitive

conclusions on the effects of mergers on operating performance of the

acquiring firms

 When abnormal returns are computed using market model, there could

be estimation bias because expected returns are set according to capital

asset pricing model (CAPM), and this assumes stationarity of the risk-free

rate and systematic risk. In a cross-section of acquisitions, risk-free rate

and systematic risk of acquiring firms could be higher / lower before the

completion date, and lower / higher afterwards. Pre-acquisition estimates of

the market model could therefore be biased upward or downward, causing

bias in the outcomes of event studies.

For many years, the traditional wisdom was that the announcement-period

stock price reaction fully captures the information effects of mergers. However,

several long-term event studies measuring negative abnormal returns over the

three to five years following merger completion cast doubt on the interpretation

of traditional short-window event study findings. According to these studies,

investors systematically fail to assess quickly the full impact of corporate

announcements, with the implication that inferences based on announcement-

period event windows are flawed, particularly those attempting to document the

wealth effect of the event. In fact, some authors found that the long-term

negative drift in acquiring firm stock prices overwhelmed the positive combined

stock price reaction at announcement, making the net wealth effect negative

48
2.1.2.2 Limitations of long-term event studies

There are also some methodological concerns with long-term event studies,

particularly the calculation of the point estimates and the assumptions required

to assess statistical significance. The basic concern stems from all tests of

long-term abnormal performance being joint tests of stock market efficiency

and a model of market equilibrium. The model of expected returns becomes

increasingly important as the holding period is lengthened, becoming crucial for

multi-year horizons. Three-year expected returns can easily range from 30

percent to 65 percent, depending on the model used, making it very difficult to

determine whether for example, an abnormal return of 15 percent is statistically

significant. If long-term expected returns can only be roughly estimated, then

estimates of long-term abnormal returns are necessarily imprecise.

The most dramatic long-term abnormal performance comes from certain sub-

samples of acquiring firms. For example, Loughran and Vijh [5] calculated long-

term abnormal returns for acquiring firms using stock financing and for those

paying with cash over the period 1970-1989. They found that acquiring firms

using stock financing had abnormal returns of 224.2 percent over the five-year

period after the merger, whereas the abnormal return was 18.5 percent for cash

mergers.

An additional statistical concern with many long-term event studies is that the

test statistics assume that abnormal returns are independent across firms.

However, major corporate actions like mergers are not random events, and

thus event samples are unlikely to consist of independent observations.

49
Mergers could also cluster through time by industry. This clustering leads to

positive cross-correlation of abnormal returns, which in turn means that test

statistics that assume independence are severely overstated.

2.1.3 Studies on Impact of mergers on long-term firm performance

Studies on the long-term impact of mergers have measured the failure or

success of mergers according to various financial criteria. Some of the key

determinants considered for failure or success of acquiring companies are

growth and profitability ratios, returns ratios, cash flows, and market share

estimates relative to industry peers during the post-acquisition period.

2.1.3.1 Studies in USA

Meeks and Meeks [30] studied the use of profitability measures as indicators of

Post-Merger Efficiency. They concluded that the ratios, profit to sales (NPM),

share holders’ return on equity capital (ROE), and return on Total Net Assets

can cause a bias in the results of such studies, due to differences in accounting

practices

Healy, Palepu and Ruback, [7] examined post-acquisition performance for the

50 largest U.S. mergers between 1979 and 1984, by analysing the post-merger

cash flow performance of acquiring and target firms. The study used post-

merger cash flow measures to test directly for changes in operating

50
performance that result from mergers, to control for the impact of the financing

of the acquisition and the method of accounting for the transaction. Abnormal

industry-adjusted performance of the target and bidding firms was used as a

benchmark to evaluate post-merger performance. The study further examined

the relation between the cash flow measures of post-merger performance and

stock market measures used in earlier studies.

The study concluded that operating performance of merging firms improved

significantly following acquisitions, since they had increases in post-merger

operating cash flow returns in comparison with their industries, in the five years

following mergers. However, no evidence was found that the improvement in

post-merger cash flows was achieved at the expense of the merging firms’

long-term viability, since the sample firms maintained their capital expenditure

and R&D rates in relation to their industries. The results indicated that the cash

flow improvements did not come from policies that could impede the long-

term viability of the merging firms. The increase in industry-adjusted

operating returns was due to an increase in asset turnover, rather than an

increase in operating margins.

The study also found no evidence that transaction characteristics such as (a)

the method of financing, (b) whether the merger is hostile or friendly, or (c) the

size of the target firm could explain cross-sectional variation in post-merger

performance. Other results in the same study showed a statistically and

economically significant relation between the measure of post-merger

performance improvements and the market’s revaluation of the merging

51
firms’ equity at the merger announcement. The abnormal announcement

returns suggested that the stock price gains at the merger announcement

were related to expectations of subsequent cash flow improvements for the

acquiring firms. The study also found that strategic takeovers generated

substantial gains for acquirers, while takeovers for financial reasons barely

broke even.

Aloke Ghosh [11] observed that conclusions about improvements in operating

performance based on an intercept model from a regression framework, as

used by Healy and the team, or a simple comparison of post- and pre-

acquisition industry-adjusted cash flows are likely to be biased. The bias was

suggested to depend on various econometric problems like (a) measurement

errors, (b) whether merging firms outperformed industry-median firms, and (c) whether

superior performance arises because of permanent or temporary factors . Using a

sample of large acquisitions between 1981 and 1995, the study compared the

post- and pre-acquisition performance (over three years each) of merging firms

relative to matched firms (based on pre-acquisition performance and size of

merging firms), to determine whether operating cash flow performance

improved following acquisitions. Pro-forma performance was computed by

aggregating performance data of target and acquiring firms for pre-acquisition

years.

The study found that merging firms’ post-acquisition operating cash flow

performance had increased significantly, but that merging firms had

systematically outperformed industry-median firms over pre-acquisition years,

52
which suggested that estimates of improvements in cash flow from a regression

model are likely to be biased. Once the superior pre-acquisition performance

was accounted for, the study did not find evidence of improvements in the

operating performance of acquiring firms following acquisitions. In particular,

merging firms’ post-acquisition operating cash flow did not increase relative to

control firms matched on performance and size from pre-event years.

Malcolm Salter and Wolf Weinhold [3] studied a sample of 36 companies and

compared their operating returns with those of other stocks listed on the New

York Stock Exchange (NYSE). The study found that the average return on

equity (ROE) for the sample of merging firms was 44% lower than average

NYSE-listed firm levels, and their average return on assets (ROA) was 75%

lower than average NYSE-listed firm levels. The results suggested that

acquiring firms under-performed other listed companies. The study however

did not consider firm characteristics or business similarities between sample

and control firms

Weston and Mansinghka [12] analysed the effects of the conglomerate merger

wave of the 1960s. The study compared the profitability of a sample of 63

conglomerates with that of a randomly selected control sample of industrials,

and a combined industrial and non-industrial sample. The ratios used for the

study were Operating Profit Margin3 (EBIAT / Total Assets), Gross Profit Margin

(EBIT / Total Assets), Net Income / Net worth 4, and Debt / Net worth. The ratios

3
EBIAT = Earnings Before Interest, Amortization and Taxes and EBIT = Earnings Before
Interest and Taxes
4
Net worth was calculated by two methods, first including and then excluding preferred stock

53
of the same sample and control firms for the years 1958 and 1968 were

compared using “f-statistic”.

The study found that for the year 1958, the earnings rates of the companies in

control group (industrial and non-industrial combined) were significantly higher

than the earnings rates of the conglomerate firms. By 1968, there were no

significant differences observed in performance between the two groups. The

improvement in earnings performance of the conglomerate firms was explained

as evidence for successful achievement of defensive diversification. The study

thus suggested that the conglomerate firms in the 1950s were diversifying

defensively to avoid (1) sales and profit instability, (2) adverse growth

developments, (3) adverse competitive shifts, (4) technological obsolescence,

and (5) increased uncertainties associated with their industries.

Heron and Lie [31] investigated the relation between method of payment in

acquisitions, earnings management and operating performance using a sample

of 859 acquisitions between 1985 and 1997 in the USA. The study investigated

potential pre-event earnings management and post-event changes in operating

performance, by analysing the following issues:

(a) Whether managers of bidding firms managed their earnings prior to the

acquisition in an attempt to temporarily inflate the firm’s stock price and

reduce the total cost of the acquisition

(b) Whether industry and economic-wide conditions played a role in the change

of operating performance

54
 (c) Whether performance was comparable to firms in a similar industry with

similar pre-event performance

After adjusting for the above factors, the study found that even though

acquiring firms exhibited superior operating performance relative to their

industry counterparts prior to acquisitions, there was no evidence of earnings

management. Subsequent to acquisitions, it was found that acquiring firms

continued to exhibit operating performance levels in excess of their respective

industries, and significantly outperformed control firms with similar pre-event

operating performance. There was also no evidence that the method of

payment conveyed any information about the acquirer’s future operating

performance.

From the results obtained, the study opined that a potential explanation for the

weak relation between stock returns and operating performance subsequent to

acquisitions was that investors systematically develop erroneous expectations

of near-term earnings performance subsequent to acquisitions that correlate

with the method of payment. For example, although operating performance

following all types of acquisitions in the study tended to improve relative to

benchmarks, investors may have expected even greater improvements

following stock acquisitions or smaller improvements following cash

acquisitions. The study examined such possibility by estimating the abnormal

stock price reactions to quarterly earnings announcements over the three years

subsequent to the completion of the acquisitions. There was no evidence that

investors were more pleasantly surprised at the announcements of quarterly

earnings following cash acquisitions than those following stock acquisitions.

55
The study also suggested that investors could also be overly optimistic about

long-term future growth opportunities before announcements of stock

acquisitions. Although the subsequent operating performance might not

materially change, stock prices will change as investors revise their

expectations of longer-term growth opportunities. For example, the stock prices

could reflect an overly optimistic (pessimistic) view of future growth

opportunities at the announcements of stock (cash) acquisitions. But the study

found no difference in the pre-acquisition discretionary accruals or post-

acquisition changes in operating performance across payment categories.

Consequently, the study concluded that method of payment does not appear to

provide information regarding the firms’ future operating performance. Instead,

the improvements in operating performance subsequent to acquisitions were

significantly greater when firms with higher market-to-book value ratios

acquired firms with low market-to-book value ratios, and when the acquirer and

target belonged to the same industry. The study found little evidence to support

for the notion that firms that conduct stock acquisitions disappoint their

investors when they announce quarterly earnings after their acquisitions.

Another finding of the study was a more dramatic increase in debt ratios around

cash acquisitions than around stock acquisitions, which, in turn, may contribute

to the higher announcement and post-acquisition returns for cash acquisitions –

suggesting that the trends in stock returns were due to differential changes in

capital structure rather than operating performance.

56
2.1.3.2 Studies in Europe

Geoffrey Meeks [32] explored the gains from mergers, for a sample of 233

transactions in the United Kingdom between 1964 and 1971. The study tested

the change in profitability following the merger, by comparing the change in

return on assets (ROA)5 with the change in ROA for the industry. The analysis

revealed a decline in ROA for acquirers following the transaction, with

performance dropping to further lower levels, five years after the merger. For

nearly two-thirds of acquirers, performance was below the standard of the

industry. The study concluded that the mergers in the sample suffered a “mild

decline in profitability”.

Marina Martynova, Sjoerd Oosting and Luc Renneboog investigated the long-

term profitability of corporate takeovers [33], of which both the acquiring and

target companies were from Continental Europe or the UK, and in which at

least one of the participants was a publicly traded company. The study

employed four different measures of operating performance: (1) EBITDA 6, (2)

EBITDA minus changes in working capital, (3) EBITDA / book value of assets

and (4) (EBITDA minus changes in working capital) / sales.

The study found that both acquiring and target companies significantly

outperformed the median peers in their industry prior to the takeovers, but the

raw profitability of the combined firm decreased significantly following the

5
Meeks defines return on assets as pre-tax profits (after depreciation, but before tax) divided
by the average of beginning and ending assets for the year. The key metric was R change = RAfter -
RBefore where RAfter and RBefore were measures of performance relative to the weighted average of
returns of the buyer’s and target’s industries.
6
• EBITDA = Earnings Before Interest, Taxes, Depreciation and Amortization

57
takeover. However, the decrease became insignificant after controlling for the

performance of the peer companies based on industry, size and pre-event

performance. None of the takeover characteristics (such as means of payment,

geographical scope, and industry-relatedness) explained the post-acquisition

operating performance. The study found an economically significant difference

in the long-term performance of hostile versus friendly takeovers, and of tender

offers versus negotiated deals: the performance deteriorated following hostile

bids and tender offers. The acquirer’s leverage prior takeover seems to have

had no impact on the post-merger performance of the combined firm, whereas

the acquirer’s cash holdings were negatively related to performance. This

suggested that companies with excessive cash holdings suffer from free cash

flow problems and are more likely to make poor acquisitions. Acquisitions of

relatively large targets seem to have resulted in better profitability of the

combined firm subsequent to the takeover, whereas acquisitions of a small

target lead to a profitability decline.

Magnus Bild, Paul Guest, Andy Cosh and Mikael Runsten [34] studied value

creation in takeovers by UK firms completed during 1985-96. The study used a

methodology of employing the residual income approach to valuation, and

comparing the present value of the acquirer’s future earnings before the

acquisition, with those that actually result following takeover. The study also

accounted for the cost of the acquisition, the acquirer’s cost of capital, and the

earnings which are created beyond the sample period. The study found that by

using the traditional accounting method, acquisitions resulted in a significant

improvement in profitability. However, the residual income approach revealed

58
that on average, acquisitions destroyed roughly 30 percent of the acquirer’s

pre-acquisition value.

Manthos Vogiatzogloy, Michail Pazarskis, Petros Christodoulou and George

Drogalas [35] empirically examined the impact of mergers and acquisitions on

the operating performance of firms in Greece, using a sample of 50 Greek

companies listed at the Athens Stock Exchange (ASE), that executed at least

one merger or acquisition in the period from 1998 to 2002. Selected accounting

variables (financial characteristics) were used 7 to measure operating

performance and compare pre- and post-merger firm performance for three

years before and after merger, while the year of merger event was omitted from

comparisons. T-statistic was used to test the pre-merger and post-merger

averages for statistical significance.

The analysis showed that for the firms in the sample, post-merger gross profit

margin decreased slightly, while the Liquidity ratios - quick ratio and current

ratio did not show a decrease in their values. Solvency ratios - net worth/total

assets, and total debt/net worth also decreased slightly in values. The study

also found that earnings before taxes/net worth, and returns on assets

decreased in value after mergers, which was equivalent to a decrease of the

profitability of the sample companies from a merger/acquisition event.

Mueller [36] edited a collection of studies of M&A profitability across seven

nations (Belgium, German, France, Netherlands, Sweden, U.K., and U.S.) All
7
Financial variables included Profitability (Earnings before taxes/Net worth), Returns on assets,
Gross profit margin, Liquidity (Quick ratio), Current ratio, Solvency (Net worth/Total assets and
Total Debt/ Net worth)

59
the studies had applied standard tests and data criteria and therefore afforded

a cross-border comparison of results across parts of Europe and the U.S. The

research tested theories about mergers and consequent changes in size, risk,

leverage and profitability. Profitability was measured by the studies in three

ways: (a) profit divided by equity; (b) profit divided by assets, and (c) profit

divided by sales. The changes in profitability for acquirer firms (measured as

the difference between the post-acquisition performance, and the average

profitability for five years before the transaction) were compared to similar

measures for two benchmark groups: (i) firms matched on the basis of size and

industry and who had made no acquisitions, and (ii) a general sample of firms

that neither made acquisitions nor were acquired during the observation period.

From the comparative studies, Mueller observed that acquirers were

significantly larger than targets, that acquirers had been growing faster than

their peers and their target firms, and that they were more highly leveraged

than target firms and peer firms. In profitability, the acquirers had showed no

significant differences—the specific data for the U.S. were generally found to

be representative of the findings across many nations. The main observation

from the findings was that acquirers reported worse returns in the years after

acquisition than their non-acquiring counterparts—but not significantly so. No

consistent pattern of either improved or deteriorated profitability could therefore

be claimed across the seven countries. Mergers appeared to have but modest

effects, up or down, on the profitability of the merging firms in the three to five

years following merger. Any economic efficiency gains from the mergers

appeared to be small, judging from the statistics.

60
Richard Schoenberg investigated [37] the comparability of four common

measures of acquisition performance for a sample of British cross-border

horizontal acquisitions. The measures were:

(i) 21-day cumulative abnormal returns (using 3 month beta prior to the merger

to estimate expected returns vs. actual returns);

(ii) Managers’ subjective assessments over three to five years following

acquisitions (using postal questionnaire to get performance scores, on criteria

like return on investment, asset utilization, earnings per share etc.);

(iii) Divestment data (whether acquired firm was divested either 6, 9 or 13 years

after the acquisition); and

(iv) Expert informants’ subjective assessments (using press commentary

reports)

The study found that

 Independently, each of the four measures suggested a mean acquisition

success rate of between 44–56%, for the acquiring firms

 Some positive relationship was observed between managers’ and expert

informants’ subjective assessments

 No significant correlation was seen between the performance data

generated by the alternative metrics. In particular, ex-ante capital market

reactions to an acquisition announcement exhibited little relation to

corporate managers’ ex-post assessment.

The observations reflected the information asymmetry that can exist between

investors and company management, particularly regarding implementation

aspects. Based on this, the study recommended that future acquisition studies

61
should consider employing multiple performance measures in order to gain a

holistic view of the outcome, and that there was still scope to identify, refine and

improve the metrics for measuring acquisition performance.

Keith, Hastenburg and Joran Ven [38] reviewed research literature on mergers,

to examine the dilemma: if most mergers are considered failure for the

acquiring firms, why do firms still pursue mergers as a strategic option?

Suggesting that prior researchers have been using incorrect measures of

merger performance, the study employed a new methodology for measuring

merger performance, based on reasoning that (i) managers have multiple

motives, (ii) they use “key success factors”, and (iii) they evaluate mergers

using various performance measures.

The methodology involved the survey of top financial managers of publicly

traded Dutch firms involved in mergers in 1994, on the importance of 17 merger

motives in the merger deals done by their firms. The survey showed that the

most important factor was “economic motives”, followed by “strategic and

personal motives”, thus supporting previous findings that indicated that

economic motives tend to be the driving force behind most mergers. However,

the study found that both strategic and personal motives were important,

suggesting that multiple motives exist for mergers, and that some of them are

more important than others.

The study suggested that a better performance measure of an acquisition was

not the economic measure of profitability or shareholder value, but the

62
achievement or non-achievement of the original objectives of the merger. The

reason managers perceive mergers as being successful, while economic

measures continue to show disappointing results, was because managers are

measuring success against a set of pre determined criteria (key success

factors) that they had set at the outset of the merger.

Responses to a survey questionnaire from same firms showed that mergers

were extremely successful, and that firms were able to achieve (i) an increase

in market power, (ii) an increase in sales, (Iii) creation of additional shareholder

wealth, (iv) increase in profitability and (v) marketing economies of scale in

most of the mergers. A correlation analysis between motives and performance

showed that for 12 out of the 17 motives, managers indicated a high degree of

achievement. The study concluded that if a single performance measure (like

profitability or ROI) was used, mergers would be termed as failure, while using

multiple performance measures or motives would show them as successful, for

achieving the set objectives. The study therefore strongly recommended the

use of multiple measures for understanding the benefits of mergers.

Dickerson, Gibson and Tsakalotos [39] investigated the impact of acquisitions

on company performance using a large panel of UK-quoted companies

observed during 1948 - 1977. The results of the study indicated that in both the

short-run and the long-run, acquisitions had a negative net impact on company

profitability as measured by the rate of return on assets; acquisitions had a

detrimental impact on company performance, and company growth through

acquisitions yielded a lower rate of return than growth through internal

63
investment. The results were consistent with other studies based on the

American experience, which suggested that takeovers did not lead to enhanced

performance as measured by profitability; the results also indicated that there

was a negative long-term effect of acquisition on profitability of the UK firms

2.1.3.3 Studies in Asia

Divesh Sharma and Jonathan Ho [40] examined the operating performance of

acquiring Australian firms during the period 1986 to 1991, by comparing post-

acquisition control-adjusted performance (for 3 years after merger) with the pre-

acquisition control-adjusted performance (for 3 years before merger), using

earnings and cash flow information. The study also tested whether there were

any significant differences in post-acquisition operating performance between

conglomerate and non-conglomerate acquisitions, and for firms using different

methods of acquisition financing.

The study found that, based on analysis of four accrual and four cash flow

performance measures, corporate acquisitions did not lead to significant post-

acquisition improvements in corporate operating performance. The study also

found that the type of acquisition (conglomerate versus non-conglomerate) and

the form of acquisition financing (cash, share or a combination) did not

significantly influence post-acquisition performance. Similarly, the size of the

acquisition and the payment of a premium (goodwill) also did not seem to

influence post-acquisition performance.

64
Timothy A. Kruse, Hun Y. Park, Kwangwoo Park, and Kazunori Suzuki

examined the long-term operating performance of Japanese companies [41]

using a sample of 56 mergers of manufacturing firms traded on the Tokyo Stock

Exchange, in the period 1969 to 1997. The study focused on the effect of

diversification, the existence of pre-existing relationships, and the changes in

employment surrounding the mergers.

The study analysed the cash-flow performance in the five-year period following

mergers, by comparing the performance of newly merged companies to a pre-

merger aggregate of the acquiring and target firms. A sample of control firms

was constructed, to adjust for changes in performance attributable to industry

or economy-wide factors. The performance metrics used were pre-tax

operating cash flow divided by market value of assets (operating return), and

the pre-tax operating cash flow divided by sales (operating margin).

The study found evidence of improvements in operating performance for the

entire sample, and also that the pre- and post-merger performance was highly

correlated. The study concluded that control firm adjusted long-term operating

performance following mergers in case of Japanese firms was positive but

insignificant, and there was a high correlation between pre- and post-merger

performance. Long-term performance was significantly greater following

diversifying mergers, and was especially marked among diversifying firms that

acquired their sales or trading company affiliates. The results were consistent

across different measures of diversification and time frames

65
Increases in employment surrounding the mergers were positively related to

post-merger performance, particularly among diversifying mergers and those

mergers that were completed before the end of the equity bubble in 1989. In

contrast, increases in employment were not found to be related to post-merger

performance among mergers that occurred in the 1990s. The results of the

analysis suggested that a key motivation of consolidation in Japan was to

benefit from expanding the scope of business of the acquiring company. In

addition, the study also inferred that rescue mergers involving distressed

targets had not lead to inferior long-term performance of the acquiring firms.

Abdul Rahman and Limmack [42] examined financial performance of a sample

of 94 Malaysian companies that made acquisitions during 1988-92, using

operating cash flow returns8 and found that financial performance improved

significantly following acquisitions; improvement was driven both by an

increase in asset productivity and by higher levels of operating cash flow

generated per unit of sales. Increases in capital expenditure in post-acquisition

period suggested that companies had not sacrificed long-term investments for

the sake of short-term profitability

2.1.4 Limitations of post-merger profitability studies

For interpreting the findings of operating performance studies, selecting an

appropriate expected performance benchmark in the absence of a merger is

crucial. The tendency for merger activity to cluster through time by industry, as

8
Measure used was the ratio of operating cash flow to book values of operating assets of the
companies

66
seen from past studies, means that a short sample period will contain

observations from only a few industries, making it difficult to generalize from

these samples. Also, if there is a common shock that induces merger activity at

a particular point in time, there is no reason for it to be limited to just one

industry or to affect all firms in an industry. Therefore, controlling for industry

may not be sufficient to account for all cross-sectional correlation. A sample

spanning a longer time period allows for statistical techniques that are better

able to account for cross-sectional dependence.

2.1.5 Other Studies on mergers

John Kusewitt [43] investigated seven common factors of acquisition strategy

and their relationships, both individually and collectively, to long-term financial

performance of the firm. The factors were:

i. Relative size of acquired firm to acquirer

ii. Acquisition rate

iii. Industry commonality between acquirer and acquired firm

iv. Acquisition timing relative to the market cycle

v. Type of consideration (cash or securities) used in payment

vi. Acquired firm’s profitability just prior to acquisition

vii. Price paid

The sample comprised of 138 active acquiring firms that made 3500

acquisitions during 1967-1976 period. The study tested whether there are

common factors of acquisition strategy which are generally applicable and

67
which are fundamental considerations in the successful implementation of a

programme of external growth.

The study found that all factors considered, except price paid were significantly

related to the performance, and that they together accounted for most of the

post-merger financial performance attributable to the acquisition programme.

The six key acquisition variables, on the average largely determined the

success of acquisition strategy, suggesting that those variables need to be paid

attention to, for improving the effectiveness of an acquisition programme. The

study also suggested that both excessively small and excessively large

acquisitions should be avoided to benefit from acquisitions.

Kitching (44) analysed results of corporate mergers in USA, two to seven years

after the event, to find what distinguished successful cases from failures. The

study was based on field interviews with 25 top-level executives from 22

companies in different industries, on their experience in acquiring and

managing a total of 181 companies during 1960-65. The interviews focused on

(i) Top manager’s qualitative assessment of the success or failure of the

acquisition programme measured against the original strategy and

(ii) Financial results actually obtained versus forecasts made before the

merger (where they existed), and on the ease and dollar payoff of the

synergy achieved

The study found that

(i) Nearly half of the mergers were of conglomerate type, and they also

accounted for a large percentage of failures (see table 6 below);

68
 Table 6

Which types of acquisition have the highest incidence of failure?

Acquisition Type % of total % of failures

Vertical Integration 3 0
Horizontal 25 11
Concentric marketing 13 26
Concentric technology 14 21
Conglomerate 45 42
Source: John Kitching, Why do Mergers Miscarry, Harvard Business Review, Nov- Dec 1967,

Vol.45, pp 84-101

(ii) Size mismatch (acquired companies sales were less than 2% of acquiring

company’s sales before merger) occurred in 81% of the acquisitions

considered failures

(iii) In terms of dollar payoff from synergy, production & technology were at the

bottom of the list of dollar producers through synergy; marketing showed

up better; and finance had the biggest payoff (see table 7 below)

Table 7

Which functions produce the biggest payoff from synergy after acquisitions?

69
 Type of merger Finance Marketing Technology Production

(including R&D)
Conglomerate 100 58 20 32
Concentric technology 100 72 72 27
Concentric marketing 100 100 57 72
Horizontal 96 100 41 29
All categories 100 74 33 36
Source: John Kitching, Why do Mergers Miscarry, Harvard Business Review, Nov- Dec 1967,

Vol.45, pp 84-101
Note: Executives scored dollar payoff of synergy as high / medium / low / none for each

acquisition case. Table shows relative payoff values for each function, with 100 representing the

score for the highest rated function.

The findings suggested that size differences between the bidder and target

firms also influence acquisition performance, and that relatively large

acquisitions would have a greater combination potential, especially in the case

of related acquisitions. When the acquiring firm is substantially larger than the

target, combination potential could be limited by size constraints. When the

target firm was relatively small, the human integration needs of the target firm

were seen to be commonly overlooked by the acquirer, and such acquisitions

may not receive sufficient managerial attention to realise the projected

synergies.

Paul Healy, Krishna Palepu and Richard Ruback [5] examined cash flow return

performance9 of acquiring companies (measured for each of the five years

before takeover: years -5 to -1; and in five subsequent years: years 1 to 5)

involved in 50 acquisitions during 1979-1984, and found that acquirers did not

generate any additional cash flows beyond those required to recover the

9
Operating cash flows were defined as sales minus cost of goods sold, administrative &
selling expenses, plus depreciation and good will expenses. Assets were measured by market
value of equity plus book value of debt.

70
premium paid. However, while the takeovers were break-even investments on

average, the profitability of the individual transactions varied widely.

The sample firms were categorised into two types: (i) friendly transactions that

typically involved stock payment for firms in overlapping businesses, called

“strategic” takeovers, and (ii) hostile transactions that generally involved cash

payments for firms in unrelated businesses, called as “financial” takeovers. The

results showed that strategic takeovers generated substantial gains for

acquirers: financial transactions broke even, at best. Results also showed that

the premiums in strategic takeovers were lower than in financial deals, and that

the synergies were higher, indicating that strategic acquirers were able to pay

less to get more

2.1.6 Summary of Global Research

Mergers have been one of the most researched areas in finance, yet some

basic issues still remain unresolved. While most empirical research on mergers

so far had focused on daily stock returns surrounding announcement dates, a

few studies have looked at long-run performance of acquiring firms after

mergers. Differences in conclusions could be seen in studies using the event

study methodology, both on the short and longer-term effects of mergers on

shareholder wealth. Most studies in USA have shown an impairment of

shareholder value (measured by share price and other indicators) for a variety

of identifiable reasons, including inexperience, lack of strategic purpose, use of

71
overvalued stock as a payment mode, and poor post-merger integration.

Similar studies in other countries in Europe and Asia are however, inconclusive.

Extensive work has however been not done in terms of evaluation of post-

merger performance, in developed and developing countries, as compared to

short term impact studies. Studies done on operating performance of acquiring

firms thus far in developed countries have concluded that the acquiring firms

experienced decline in operating performance. However, studies in Europe and

Asia, and a few studies in USA too, have shown contrary results.

2.2 Indian Literature

Ajay Pandey [46] studied the short-term impact of merger announcements on

the stocks of both firms involved in 14 large takeover related open offers during

1997 to March 2001 in India, using even study methodology, and found

significant announcement returns of more than 10% (Cumulative Average

72
Excess Returns) associated with the tender offers. The estimation period used

for the event study was –51 days to –150 days (0 being the open offer

announcement day).

The study observed that the post-announcement stock returns for target firms

undergoing change of control in India were very different from the empirical

evidence in the context of developed countries. The study found that the target

firm valuations had increased in the run-up to the open offer announcement.

However, unlike the reported results in developed countries, substantial part of

the gains were seen to have been wiped out subsequently - indicating that

valuation gains associated with takeovers in large part reflected private value of

control, expected to be high in Indian context. The fact that only one large open

offer in the sample was associated with an attempted unsuccessful hostile

takeover bid suggested that, given relatively large insiders’ shareholdings,

takeovers as governance mechanisms are not likely to be effective, and private

value of control may be the driver in the market for corporate control.

Surjit Kaur [47] examined various aspects pertaining to mergers and

acquisitions in India, after the Takeover Code came into effect in 1997. The

study attempted to test the usefulness of some select financial ratios 10 to

predict corporate takeovers in India, using a sample of 37 target companies, for

which open offers were made during 1997- 98 to 2000-01 to gain management

control. Multivariate discriminant analysis method was used to classify firms

into targets and non-targets.

10
The financial ratios used were: Operating Margin (Earnings Before Interest and Tax/ Sales), Return on
Capital Employed (ROCE), Debt- Equity Ratio(D/E), Assets Turnover Ratio(S/TA), Current Ratio(CA/CL),
Cash Flow to Sales (CF/S), Enterprise Value / Earnings Before Interest Tax Depreciation and Amortisation
(EV/EBITDA), Market Price to Book Value (MP/BV))

73
The model was able to discriminate the target firms correctly to the tune of 62

per cent, and reasons for the low discriminating power of the model were

attributed to measurement error, specification bias, and other technical

reasons. The study suggested that the model might be used for screening

potential companies for takeovers rather than as a decision-making tool, and

that this could help in reducing the number of companies considered for

possible takeover, to a manageable size.

The study also compared the pre and post-takeover performance for a sample

of 20 companies, using the same set of eight financial ratios, for a period of

three years each immediately preceding and succeeding the takeover attempt,

and tested for statistical significance using t-test. The study found that two

profitability ratios used viz. EBIT/Sales and ROCE declined significantly in the

post-takeover period. Since the assets turnover ratio also showed a decline,

the study concluded that both profitability and efficiency of the companies

declined in post-takeover period. However, a ‘t’ test applied to each of the eight

ratios indicated that the change in post-takeover performance was statistically

not significant. The study concluded that the financial performance of the target

companies did not improve significantly in the post-acquisition period.

Beena [48] analysed the role of mergers in the private corporate manufacturing

sector during 1990-91 to 1994-95 in India, the characteristics of the mergers in

terms of management & economic rationale, the role of acquisitions in the

growth of assets of acquiring firms, and the sources of financing for their

growth. The study suggested that acceleration of the merger movement in the

74
early 1990s in India was accompanied by the dominance of mergers between

firms belonging to same business group or business house with similar product

lines. Also, while there was an increase in product or asset concentration

measured on a firm-wise basis, it did not contribute to an increase in market

concentration, as measured by relative product market shares of business

groups. Also, mergers seemed to have contributed significantly to asset-growth

in only one fifth of the sample firms. The firms in the sample had also mobilised

large amount of resources through capital markets, to finance their expansion

during 1989-90 to 1994-95.

The study noted signs that mergers between unrelated firms, as also the

participation of foreign-controlled firms in mergers in India, were increasing

since 1992-93. The study concluded that the merger wave in the early 1990s

was used as a means of internal restructuring to improve operating efficiency,

rather than to further product market share or asset growth.

Beena [49] also analysed the performance of acquiring firms in the

manufacturing sector in India, during 1995-2000, after classifying the acquiring

firms into two categories - Indian owned and foreign owned. The sample

consisted of 115 cases of mergers and acquisitions (84 Indian owned and 31

foreign-owned acquiring firms), which was said to have accounted for about 22

per cent of the total number of mergers and acquisitions that occurred in the

Indian manufacturing sector during 1995-2000.

Table 8
Trends of M&As during 1990 to 2000
Year Non-Mfg Mfg Total

75
 Source: P. L. Beena, Towards understanding the merger wave in the Indian corporate sector – a
comparative perspective, working paper, February 2004. Figures in brackets represent the number of
MNE related deals

The study used some select financial ratios 11 to test whether there was any

significant difference between the performance of acquiring firms in pre and

post-merger phases, and as compared to the average performance of the

industry as a whole (Product-groups were considered as a proxy to industry).

Statistical significance of the mean difference between pre and post-merger

phases was tested by using t-statistics. The study did not find any evidence of

improvement in the chosen financial ratios of the acquiring firms in the sample

during the post-merger period, as compared to the pre-merger period, while

they were relatively better when compared to the overall manufacturing

average. Further, the foreign-owned acquiring firms seemed to have performed

relatively better when compared to Indian-owned acquiring firms.

Nagesh Kumar [50] studied the M&A activity in the Indian corporate sector

associated with foreign multinational enterprises (MNEs) and their Indian

affiliates, for the period 1993 to 2000. The study examined the industrial

composition of the deals as well as their motives, and the patterns of foreign

direct investment (FDI) into India, through cross-border M & As. The study

observed that in contrast to nearly all of FDI inflows to India that was in the

form of green-field projects during early 1990s, a substantial proportion of FDI

inflows since 1996 in India had occurred in the form of acquisition of existing

11
The financial ratios used were Price - Cost Margin (Profit After Tax / Net Sales), Rate of
return (Profit Before Tax /Total Capital Employed), Shareholders’ Profit (Profit After Tax /Net
Worth), Dividend per equity (Dividend Per Share / Earnings Per Share), Debt-equity ratio,
Export intensity (Export/Gross sales), R&D intensity (R&D expenditure/Gross sales) and
Capacity utilization (Net Sales/Total Assets).

76
enterprises in the country. In addition, the deals relating to MNEs were

predominantly of horizontal type rather than vertical in nature, and two-fifths of

the deals involved buying out the local partners in joint ventures, or raising the

equity stake.

Extending the scope of operations or consolidation of market share was the

motive in about a fifth of the cases, while ten per cent of the

deals involved mergers of foreign affiliates, following the merger

of their parents, or as a part of group restructuring. Bulk of the

observed deals also involved acquisition of relatively smaller

and often closely held enterprises that evaded public attention

and regulatory scrutiny.

Rakesh Basant [51] analysed the corporate response to economic reforms in

India, by exploring changes in some key corporate strategies through an

analytical description of available evidence. The strategies studied included

corporate restructuring, alliances, technology development, manufacturing

capacity expansion, and other aspects of non-price competition. The study

concluded that industrial concerns in India have been consolidating their

activities after 1991 to retain competitiveness, but research and development

has suffered. Quality up-gradation was seen as a priority for firms, but product

differentiation strategy was preferred to improvement in marketing and

distribution, and export orientation was seen to be limited for firms in the

sample.

77
The study observed that the number of mergers and acquisitions between

Indian firms had increased substantially post the initiation of economic reforms.

The study also found that 50 percent of all mergers during 1990-97 were

horizontal in nature, 16 percent were vertical in nature, and the remaining were

conglomerate mergers, as shown in the table 9 below:

Table 9

Distribution of Mergers and Acquisitions in India by various categories, 1991-

97

Type Mergers Acquisitions

Horizontal 134 (53.2%) 107 (73.8%)
Vertical backward 31 (12.3%) 3 (2.1%)
Vertical forward 8 (3.2%) 2 (1.4%)
Conglomerate related 26 (10.3%) 11 (7.6%)
Conglomerate unrelated 53 (21.3%) 22 (15.2%)
All 252 (100%) 145 (100%)

Source: Basant Rakesh, Corporate Response to Economic Reforms, Economic and Political Weekly,
March 2000, pp 813-822
The study also found that of those mergers, 60 percent were by private Indian

corporates, as shown in the table below:

Table 10

Distribution of Mergers and Acquisitions in India during 1991-97

by identity of Active Company

Identity Mergers Acquisitions

Private Indian 221 (87.7%) 88 (60.7%)
Private Foreign 19 (7.5%) 47(32.4%)
Non-resident Indian 1 (0.4%) 6 (4.1%)
Joint Venture between Indian and foreign 4 (1.6%) 2 (1.4%)
Others 7 (2.8%) 2 (1.4%)
All 252 (100%) 145 (100%)

78
Source: Basant Rakesh, Corporate Response to Economic Reforms, Economic and Political Weekly,
March 2000, pp 813-822

Sudha Swaminathan [52] observed from a study of a sample of five mergers

(small and large) that took place during 1995-96, that four out of the five

acquiring firms managed to improve operating and financial synergies

(measured through certain Financial Ratios12 for three years after the merger).

Of all the contributing factors, the net profit margin seemed to have significantly

improved post-merger, since the asset turnover did not change significantly

post the merger. The study inferred that shareholder value improved for the

mergers of smaller companies that seemed more focused, while mergers of

large companies that seemed to have joined hands to create bigger entities

seemed to have eroded shareholder value. In a further study of the same

mergers [53] by EVA analysis, only two of the five mergers were found to have

enhanced shareholders’ wealth.

Pawaskar [54] analysed the pre-merger and post-merger operating

performance of acquiring firms, for a sample of 36 mergers over the period

1992 to 1995. Analysing a set of financial variables that included ratios of

profitability, growth, leverage, liquidity and tax provisions 13, the study found that

the acquiring firms performed better than industry in terms of profitability. The

study found that the mergers led to financial synergies and a one-time growth

of 43% in asset base for the acquiring firms, in the merger year. The growth in

sales and operating income for the acquiring firms in the merger year was

found to be 39% and 185% respectively

12
Ratios used were Net Profit Margin (PAT/Sales), Operating Profit Margin, Return on Capital
Employed, Cost of Production / Sales, Debt-equity Ratio and Operating Cash Flow.
13
Ratios used were: Operating Return on Assets (PBIDT/ Net Assets), Growth Rate (average
growth rate in total assets), Leverage (Total Debt /(Total Debt + Equity Capital)), Tax Provision (
Tax / Operating Profit) and Liquidity ((Current Assets – Inventory) / Current Liabilities)

79
However, the average annual growth rate of assets over the three years prior to

merger and the three post-merger years was found to be same, at around 16%,

implying that mergers did not contribute to the acquiring firm’s growth rate in

subsequent years. Regression analysis showed that there was no increase in

the post-merger profits compared to main competitors of the acquiring firms.

Comparison of performance of each of the firms involved in the merger with a

competing firm that was not involved in merger showed that if no merger had

taken place the post-merger period profitability would have improved further.

The study concluded that the firm performance had not improved due to

mergers for the sample firms, and that mergers had created significant

advantages only in terms of the debt position of the acquirer. The study also

inferred that the type of merger - horizontal or BIFR- revival or those between

group companies & subsidiaries - did not significantly affect the post-merger

performance.

The study also observed that both the merging firms (acquirer and acquired)

were at the lower end in terms of size, growth, tax and liquidity of their industry.

The firms however performed better than their industry in terms of profitability.

Most of the mergers were also between group companies or subsidiary firms,

suggesting it was more a part of the restructuring activities by the firms in

response to changes in industrial policy, but the restructuring had not improved

the profitability of firms in the post-merger period. Several of the acquired firms

80
in the sample were also much smaller in size of operations, relative to the

acquiring firm.

Justin Paul [55] analysed the merger between Bank of Madura and ICICI Bank,

for indications of synergy in the Indian banking industry and the strategic

factors to be considered while taking merger or acquisition decisions. The study

examined various issues relevant to the merger, like reasons for the merger,

financial performance, estimation of the stock swap ratio for shareholders of

both the banks, and the share price trends before and after the merger related

developments. The study also assessed the suitability of the merger between

the 57 year old Bank of Madura that had a traditional focus on mass banking

strategies based on social objectives, and ICICI Bank, a six year old ‘new age’

organisation, which had been emphasising parameters like profitability and the

interests of shareholders.

The study found that the final swap ratio was 1:2 in favour of Bank of Madura,

but if the valuation had been done on basis of the market price of the shares,

the balance sheets and the NPAs of both the banks, the swap ratio could have

been derived more in favour of ICICI Bank. Strategic considerations such as

ICICI’s desire to acquire a good bank from South India where they did not have

a strong presence and geographical advantage had influenced the merger

decision. Bank of Madura was motivated for the merger by considerations of

financial consolidation and increase of shareholder value. The synergies

expected from the merger were increased financial capability, branch network,

customer base, rural reach and better technology. Also, while ICICI bank

81
shares had declined in price at the time of and after the merger

announcements, Bank of Madura shares had seen a rise in anticipation of a

favourable swap ratio, in the run-up to the merger finalisation. However,

managing human resources and rural branches was suggested to be a

potential challenge given the differing work cultures in the two organizations.

Mishra and Rashmi Goel [56] analysed the merger of Reliance Industries

Limited (RIL) with its group company, Reliance Petroleum Limited (RPL). Since

it was widely perceived as being beneficial to both the companies due to

expected cost advantages and growth prospects, the study was undertaken to

investigate if the expectations were translated into shareholder value creation.

Using the share price movements around the announcement date of the

merger, the study examined whether shareholders of the two firms had gained

or lost due to the merger. Cumulative excess returns (CER) were computed for

the period of -20 days to +20 days, i.e. from 20 days before the merger to 20

days after the merger announcement date, separately for RIL and RPL. CER

was also estimated for the two firms (combined), using both market value and

book value of equity capital as weightages.

The study showed that positive excess returns had accrued to shareholders of

RPL (acquired company), and negative excess returns to shareholders of RIL

(acquiring company). Despite the deal appearing to be favourable to

shareholders of RIL, they had lost in value, and the shareholders of RPL had

gained from the deal. For the combined firm, average cumulative loss of returns

was observed, as measured by both market value and book value of capital.

82
The study concluded that the RIL-RPL merger was apparently not driven by

any synergy gains, as indicated by the negative combined returns. Instead, it

seemed to indicate that the deal was undertaken by the managers of RIL to

maximise the utility of RPL business at the expense of RIL shareholders.

Harbir Singh and Prashant Kale [57] studied the returns to acquiring firm

shareholders in India in two different periods of 1992-97 and 1998-2002, by

measuring stock returns on acquisition announcements, for the acquiring firms.

The study observed that during 1992-97, shareholders of acquiring firms had

earned mean abnormal returns of about 5% in 60 percent of the cases, on

acquisition announcements. No differences were however found between

related and unrelated acquisitions. The study also found that during 1998-2002,

similar announcements by acquiring firms had given their shareholders,

positive but much lower abnormal returns: the abnormal returns were more

favourable for related acquisitions (3.5%) than unrelated acquisitions (1%).

From the findings the researchers inferred that in the period of 1992-97, the

Indian M&A market was not well developed and hence target firms were

apparently acquired at very low premiums by acquirers. The acquisitions made

after 1998 were more expensive, and so more efforts had to be put in by the

acquiring firms to extract value out of the acquisitions, as reflected by the

response of the stock market.

Manish Agarwal and Harminder Singh (58) empirically investigated the

existence of insider trading prior to merger announcements in India, by

examining the daily stock price movements and volume traded of 42 target

companies during the period of 1996-1999. The study examined the pattern of

83
stock prices and trading volume of the sample companies, and estimated

average residuals (AR) and Cumulative Average Residuals (CAR), for 150 & 10

trading days prior to the announcement, on the announcement date, and 15

days after the announcement date.

Based on the analysis the study concluded that in case of companies belonging

to the same business group, there existed evidence for the presence of insider

trading activity, during the month immediately preceding the merger

announcement date. Further, the evidence seemed to become more

perceptible during the ten-day period immediately preceding the merger

announcement. The results also suggested that non-group companies did not

show significant abnormal returns immediately prior to merger announcement,

and the immediate response in terms of abnormal returns was also

insignificant. The study therefore concluded that same group merger

companies in the sample showed presence of trading based on non-public

information, which however did not seem to exist for non-group merger

companies.

Rajesh Kumar and Prabina Rajib [59] analysed the financial characteristics of

53 firms involved in multiple (more than three) mergers between 1993 and

2002, using control groups based on industry sector and sales in the earliest

year of initiation of merger activity. The study found that the average sales,

profits and cash flow for a period of ten years were higher for the merging firms

as compared to a control group matched by industry and size. Also, low

financial leverage and unused debt capacity appeared to be motives for firms to

use multiple mergers as a strategic business tool. Capital structure seemed to

84
be an especially important variable in the decision of firms to become a multiple

acquirer, as also maximizing the size and increasing the efficiency in producing

sales per value of assets. The study also concluded that firms whose main

shareholder power was not strong were more likely to be involved in multiple

mergers.

Pitabas Mohanty [60] observed that firms that have gone for related mergers

(or acquisitions) have performed better than companies that have gone for

unrelated mergers (or acquisitions), and that Cumulative Abnormal Returns

(CARs) on merger announcements increased in the case of target firms while

those of the bidder firm had fallen.

2.2.1 Summary of research on mergers and acquisitions in India

Mergers and acquisitions, being a new phenomenon in India, have received

more attention of researchers during the last decade. Review of the existing

research literature on mergers and acquisitions in India shows that the

research coverage has been sporadic, and focused on a few high-profile

samples of mergers & acquisitions and some samples from manufacturing

sector in India, over a limited period of time. Research done so far had covered

various aspects like

85
 (a) Rationale for mergers and acquisitions, distribution of acquisitions by

industry, and the issues of controlling foreign investments through the

acquisition of Indian companies by foreign corporates

(b) Effects of merger and takeover announcements, on stock prices of

acquiring and acquired firms

(c) Usability of financial ratios as predictors of mergers and acquisitions

(d) Government regulation, competition policy, issues pertaining to corporate

governance and interests of shareholders in the context of acquisitions

(e) Impact of mergers in terms of contribution of M&As in Foreign Direct

Investments (FDI) in India

(e) Issues in corporate governance due to mergers and acquisitions, and

effectiveness of SEBI’s take-over code in regulating acquisitions in India

(f) Investigation into likely presence of insider trading prior to the merger

announcements

(g) Analysis of motives behind merger activities of firms involved in multiple

mergers

2.3 Research Gaps identified

Research studies in India on mergers and acquisitions have looked at issues

like motivations for mergers, returns to stock holders on merger

announcements, insider trading, corporate governance, foreign investments

through acquisition route, government policy and regulation – however, very

few studies have analysed impact of mergers on operating performance of

acquiring firms, and research in that area has been sporadic, and limited to

analysis of individual cases, for limited periods of time and for small samples of

contemporary firms. Empirical testing of corporate performance following

86
mergers of Indian companies has been quite limited so far; and therefore

provides scope for additional research in the area. Scope for additional

research includes study of post-merger operating performance for different

types of mergers, for longer time periods, for different industries, for different

sizes of merging and merged firms, and for variations over different time-

periods in history, etc. There has also been no prior research on stock price

returns in the long run following mergers / acquisitions, for merging firms in

India

87