ONLINE CHAPTERSacquiring shares and in undervaluing the target company’s shares. There are well-known examples
of such market mispricing seeming to occur, such as AOL’s famous acquisition of Time Warner
in December 1999, when, during the height of the Internet boom, AOL’s shares were priced at a
stratospheric $191.00 per share (the price fell to $72 within one year). However, it seems to us
that such market mispricings are fairly rare, and should not often be the motivation behind a major
corporate event such as an acquisition.Diversification
A diversifying or conglomerate merger occurs when a company acquires assets or an entire company that
operates in another industry. For example, in 2008–09, Philips Electronics (maker of TVs and stereos)
purchased a medical device company because senior management thought health care had greater
growth potential.^10 Obvious questions arise from such acquisitions. Does Philips have a comparative
advantage in running a medical device company? Can this deal create new value (synergies), or are the
underlying businesses too disparate? Will Philips’ senior management possibly get distracted as they
attempt to run a medical device company, potentially hurting the electronics division? To provide insight
into the answers to these questions, we next list several possible advantages of conglomerate form, most
of which also have qualifications and possible disadvantages.
Consider two companies, Y and C, one of which operates in an industry that does well in boom times
(such as yacht building) and another that does well during recessions (such as coupon distribution).
Combining the two companies in a diversifying merger will produce more stable cash flows because as Y
goes up, C goes down, and vice-versa. We learned in Chapter 6 that portfolio diversification is valuable
to investors because it enables them to reduce risk for the same expected rate of return. Even so, is
there any advantage to having a company that implements the diversification for investors? Given that
investors can already hold individual companies Y and C in their diversified portfolio, they will not pay
more for the combined company that offers just portfolio diversification. There would need to be some
other advantage to combining the companies to justify paying a premium for the combined company.
Related to this point, diversifying mergers are sometimes said to reduce risk. Diversification can
reduce the variance of cash flows, and yet if share returns are priced by the CAPM (see Chapter 7), then
reducing variance alone may not improve share performance.^11 The CAPM tells us that conglomeration
would need to reduce systematic risk (beta risk) or the cost of capital, while at the same time not hurting
growth potential, to improve share performance.
Now, let’s think about the taxes owed if A and B were separate companies. To keep things simple,
assume that each company had exactly $0 in taxable income each of the past few years. Assume this year
is 2015 (an odd year) and company A earns $10 million and pays $3.5 million in taxes (35% tax rate).10 An example of a conglomerate run amuck is Ling–Temco–Vought (LTV). Ling had an electrical contracting business, then bought two others,
next bought Temco Aircraft, then bought Chance Vought Aerospace, then added the wire and cable company Okonite and bought Wilson,
the sports equipment company – which was also involved in meat packing and pharmaceuticals. Ling later spun each of these Wilson
divisions into separate companies traded on the American Stock Exchange; they soon acquired the trader nicknames ‘Golfball’, ‘Meatball’
and ‘Goofball’, respectively. Ling then added Greatamerica, Post’s holding company for Braniff International Airways and National Car Rental,
as well as J&L Steel, and it then acquired a series of resorts in Mexico and Colorado. By 1969, LTV had purchased 33 companies, employed
29,000 workers, offered 15,000 separate products and services, and was one of the 40 largest industrial corporations. In the end, after
numerous divestitures, what was left of LTV filed for bankruptcy in 2000?
11 If corporate diversification reduces the volatility of taxable income, it can reduce expected taxes paid and hence increase firm value. Consider
a firm that has two divisions, A and B. Division A earns $10 million in taxable income in odd years and loses $10 million in even years.
Division B does the reverse (loses $10 million in taxable income in odd years and earns positive $10 million in even years). The conglomerate
therefore earns exactly zero dollars every year, and never pays taxes.thinking cap
questionWhat are more important
(reliable), revenue or expense
synergies?