Abstract
A company can grow by taking over the assets or facilities of another. The various methods by which one firm obtains or “marries into” the business, assets, or facilities of another company are mergers, combinations, or acquisitions. These terms are not used rigidly. In general, however, a merger signifies that one firm obtains another by issuing its stock in exchange for the shares belonging to owners of the acquired firm, or buys another firm with cash. Company X gives some of its shares to Company Y shareholders for the outstanding Y stock. When the transaction is complete, Company X owns Company Y because it has all (or almost all) of the Y stock. Company Y’s former stockholders are now stockholders in Company X. In a combination, a new corporation is formed from two or more companies who wish to combine. The shares of the new company are exchanged for those of the original companies. The difference between a combination and a merger lies more in legal distinctions than in any discernible differences in the economic or financial result. In practice, the terms merger and combination are often used interchangeably. The study of merger profitability is as old as corporate finance itself. Arthur S. Dewing (1921, 1953) reported on the relative unsuccessfulness of mergers for the 1893–1902 time period; and Livermore (1935) reported very mixed merger results for the 1901–1932 time period. Mandelker (1974) put forth the Perfectly Competitive Acquisitions Market (PCAM) hypothesis in which competition equates returns on assets of similar risk, such that acquiring firms should pay premiums to the extent that no excess returns are realized to their stockholders. The PCAM holds that only the acquired firms’ stockholders earn excess returns. Jensen and Ruback (1983) reported that acquired firms profited handsomely, while acquiring firms lost little money such that wealth was enhanced. Recent evidence by Jarrell, Brickley, and Netter (1988), Ravencraft and Scherer (1989), and Alberts and Varaiya (1989) finds little gain to the acquiring firm and significant merger premiums paid for the acquired firms.
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Notes
- 1.
Although mergers, combinations, and acquisitions are exciting events of great interest to the financial community, they do not represent the most common method through which even individual companies grow. Most firm growth is direct growth, which takes place quietly and is financed either by internal sources or floating new securities. A study of 74 large companies showed that of their growth from 1900 to 1948, 75% was direct growth and only 25% was accounted for by mergers. See J. F. Weston, The Role of Mergers in the Growth of Large Firm, University of California Press, 1953.
- 2.
A firm which either by the exchange of securities or purchase of shares controls subsidiary companies is called a holding company. The holding company differs from a parent company in that the parent company has production functions of its own to perform, whereas a holding company exists mainly to control or coordinate its subsidiaries.
- 3.
Thus, the Standard Oil of New Jersey, the United States Steel Corporation, and the original Bethlehem Steel Corporation, although they owned many subsidiaries, were not usually thought of as holding companies.
- 4.
In the 1930s, investors in holding companies suffered heavy losses, and this fact, plus the exposure of legislative and operating scandals involving some promoters of holding companies, led to the passage by Congress of the Public Utility Company Act of 1935. Some of the major provisions of this legislation are:
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1.
Holding companies were prohibited over the third level-one operating company and two holding companies. That is, a holding company structure could go up to the grandfather level but not beyond. This “great-grandfather death clause” was designed to restrict the excessive leverage possible in the holding company’s structure.
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2.
Holding company systems were to be consolidated and simplified to develop some aspect of geographical contiguity. If the holding company is to serve an economic function, the location of its operating companies should have some geographical logic.
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3.
“Upstream” loans were made illegal. An upstream loan is made from a lower-level company to a higher one. A holding company that serves a function should help to finance its operating companies and not the other way around. The request for an upstream loan could not be resisted by a captive operating company even though the purpose of the loan was to bail the holding company out of a financial difficulty, and its net effect might be to deplete the assets of the operating company without necessarily rescuing the holding company.
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4.
Service and construction companies organized by the holding company system to work for operating companies were required to be nonprofit. In the usual case, there is no felt need to regulate intercompany prices because the resulting profits are only a shift of earnings among the various companies. However, in the public utility fields, excessive service charges or construction costs could affect the rate base and thus may be borne eventually by the consumers.
These rules and other provisions of the Public Utility Company Act of 1935 aroused considerable antagonism in the business community.
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1.
- 5.
A firm which is able to reduce the prices paid to its suppliers shows no true example of external economies. The result is merely a backward shifting of costs.
- 6.
Bethlehem Steel is now in bankruptcy and no longer an independent company.
- 7.
This problem is described in more detail in chapter “Management-Stockholder Relations: Is Optimal Behavior All That Is Necessary?”.
- 8.
The minimum θ consistent with the profitability constraint, that the merged firm’s price must be at least as great as the acquiring firm’s price, is given by
\( {\displaystyle \begin{array}{c}\uptheta =\frac{{\mathrm{P}}_{\mathrm{A}}\left[\mathrm{AER}\left({\mathrm{S}}_{\mathrm{B}}\right)+{\mathrm{S}}_{\mathrm{A}}\right]}{{\mathrm{E}}_{\mathrm{A}}+{\mathrm{E}}_{\mathrm{B}}}\\ {}=\frac{\$160\left[.375\left(1,000,000\right)+2,000,000\right]}{\$20,000,000+5,000,000}\\ {}=15.2.\end{array}} \)
Notice the minimum θ consistent with the acquiring firm’s profitability constraint equals the weighted average price-earnings multiple for the merging firms.
If firm A paid firm B’s stockholders $70 per share for their stock, the actual exchange ratio would be.4375 and the merger premium would be 40%. The minimum θ consistent with merger profitability would be
\( {\displaystyle \begin{array}{c}\uptheta =\frac{\$160\left[(.4375)1,000,000+2,000,000\right]}{\$25,000,000}\\ {}=15.6.\end{array}} \)
If firm A is willing to pay firm B’s stockholders a 40% merger premium, the market must allow the merged firm to maintain at least a 15.6 price-earnings multiple for the merger to profit the acquiring firm’s stockholders.
- 9.
Harris et al. (1982) found that acquired firms had significantly lower price-earnings multiplier than acquiring firms.
- 10.
Sometimes the subsidiary interest is a branch, a by-product operation, or plant and is not independently incorporated. If so, an initial step of incorporation would have to be taken before the subsidiary can be relinquished.
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Guerard, J.B., Saxena, A., Gultekin, M. (2021). Mergers and Acquisitions. In: Quantitative Corporate Finance. Springer, Cham. https://doi.org/10.1007/978-3-030-43547-9_18
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