Monday, November 12, 2007

M&A - Points to Refresh Weston's Book Ch.6 Theories of Mergers

Ch.6 Theories of Mergers and Tender Offers

You may not fully understand these brief points if you have not studied the text.

The theories and models are covered under the following classifications.

A. Theories explaining why mergers occur.
B. Theories of valuation effects of mergers and acquisitions
C. Theoretical predictions of the pattern of gains in takeovers.
D. Models of Merger Process
E. Models of Bidding Process

Theories or models under the classifications

A. Theories explaining why mergers occur.
- 1. Size and returns to scale
- 2. Transaction costs and mergers

B. Theories of valuation effects of mergers and acquisitions
- 1. Theories that posit that value increases
------ a. Transaction cost efficiency - Coase
-------b. Synergy
-------c. Disciplinary
- 2. Theories that posit that value reduces
-------a. Agency costs of free cash flows - Jensen
-------b. Management entrenchment - Shleifer and Vishny
- 3. Theories that argue that value is neutral
-------a. Hubris ----------Roll
C. Theoretical predictions of the pattern of gains in takeovers.

D. Models of Merger Process
---Negotiation - When is it done in public domain?

E. Models of Bidding Process

- 1. How to avoid winner's curse
- 2. Effects of Bidding costs
- 3. Role of toehold.
- 4. Whether to pay in cash or in stock

From the seller's perspective
- 5. How to react to initial bid?
- 6. Is it beneficial to accept termination fee in the MOU?
- 7. Should it seek competing bids and go for auction?

Various theories and models in little more detail

Economies of scale — Mergers allow a reorganization of production processes so that plant scale may be increased to obtain economies of scale.

Economies of scope
Organization capital
Organization reputation
Human capital resources
Generic managerial capabilities
Industry-specific managerial capabilities
Nonmanagerial human capital

Models of the Takeover Process

Economic — competition vs. market power
Auction types — Dutch, English
Forms of games
Types of equilibria — pooling, separating, sequential
Types of bids — one, multiple
Bidding theory — preemptive; successive bids


Total gains for both target and acquirer

Positive, if the following are present in the transaction

Efficiency improvement
Increased market power

Zero if

Winner's curse
Acquiring firm overpays

Negative, if

Agency problems
Mistakes or bad fit

Gains to target — all empirical studies show gains are positive

Gains to acquirer
----Positive — efficiency, synergy, or market power
----Negative — overpaying, hubris, agency problems, or mistakes

Sources of Value Increases from M&As

Efficiency increases

Unequal managerial capabilities
Better growth opportunities
Critical mass
Better utilization of fixed investments

Operating synergy

Economies of scale
Economies of scope
Vertical integration economies
Managerial economies

Diversification motives - Why firms diversify?

Demand for diversification by managers/employees because they make firm-specific investments
Diversification for preservation of organization capital
Diversification for preservation of reputational capital

Diversification and financial synergy

Diversification can increase corporate debt capacity, decrease present value of future tax liabilities
Diversification can decrease cash flow variability following merger of firms with imperfectly correlated cash flow streams

Diversification discount - A Problem

Studies find that the average diversified firm has been worth less than a portfolio of comparable single-segment firms

External capital markets allocate resources more efficiently than internal capital markets
Rivalry between segments may result in subsidies to underperforming divisions within a firm
Managers of multiple activities are not well informed about each segment
Securities analysts may be less likely to follow multiple segment firms
Performance of managers of segments cannot be adequately evaluated without external market measures

Financial synergies

Complementarities between merging firms in matching the availability of investment opportunities and internal cash flows
Lower cost of internal financing — redeployment of capital from acquiring to acquired firm's industry
Increase in debt capacity which provides for greater tax savings
Economies of scale in flotation of new issues and lower transaction costs of financing

Circumstances favoring merger over internal growth
Lack of opportunities for internal growth
Lack of managerial capabilities and other resources
Potential excess capacity in industry
Timing may be important — mergers can achieve growth and development of new areas more quickly
Other firms may be competing for investments in traditional product lines

Strategic realignments

Acquire new management skills
Less time to acquire requisite capabilities for new growth opportunities or to meet new competitive threats

The q-ratio
Ratio of the market value of the firm's securities to the replacement costs of its assets
High q-ratio reflects superior management
Depressed stock prices or high replacement costs of assets cause low q-ratios
Undervaluation theory
Acquiring firm (A) seeks to add capacity; implies (A) has marginal q-ratio > 1
More efficient for (A) to acquire other firms in industry that have q-ratios < 1 than building a new facility

Still more points are to be posted

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