822 Part Ten Mergers, Corporate Control, and Governance
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Of course AB would pay a lower interest rate, other things being equal. But it does not make
sense for A and B to merge just to get that lower rate. Although AB’s shareholders do gain
from the lower rate, they lose by having to guarantee each other’s debt. In other words, they
get the lower interest rate only by giving bondholders better protection. There is no net gain.
In Section 23-2 we showed thatBond value=bond value
assuming no
chance of default−value of
shareholders’s (put)
option to defaultA merger of A and B increases bond value (or reduces the interest payments necessary to sup-
port a given bond value) only by reducing the value of stockholders’ option to default. In other
words, the value of the default option for AB’s $100 million issue is less than the combined
value of the two default options on A’s and B’s separate $50 million issues.
Now suppose that A and B each borrow $50 million and then merge. If the merger is a
surprise, it is likely to be a happy one for the bondholders. The bonds they thought were guar-
anteed by one of the two firms end up guaranteed by both. The stockholders lose in this case
because they have given bondholders better protection but have received nothing in exchange.
There is one situation in which mergers can create value by making debt safer. Consider a
firm that covets interest tax shields but is reluctant to borrow more because of worries about
financial distress. (This is the trade-off theory described in Chapter 18.) Merging decreases
the probability of financial distress, other things equal. If it allows increased borrowing, and
increased value from the interest tax shields, there can be a net gain to the merger.^8(^8) This merger rationale was first suggested by W. G. Lewellen, “A Pure Financial Rationale for the Conglomerate Merger,” Journal
of Finance 26 (May 1971), pp. 521–537. If you want to see some of the controversy and discussion that this idea led to, look at R.
C. Higgins and L. D. Schall, “Corporate Bankruptcy and Conglomerate Merger,” Journal of Finance 30 (March 1975), pp. 93–114;
and D. Galai and R. W. Masulis, “The Option Pricing Model and the Risk Factor of Stock,” Journal of Financial Economics 3
(January– March 1976), especially pp. 66–69.
31-3 Estimating Merger Gains and Costs
Suppose that you are the financial manager of firm A and you want to analyze the possible
purchase of firm B.^9 The first thing to think about is whether there is an economic gain from
the merger. There is an economic gain only if the two firms are worth more together than
apart. For example, if you think that the combined firm would be worth PVAB and that the
separate firms are worth PVA and PVB, then
Gain = PVAB − (PVA + PVB) = ΔPVAB
If this gain is positive, there is an economic justification for merger. But you also have to think
about the cost of acquiring firm B. Take the easy case in which payment is made in cash. Then
the cost of acquiring B is equal to the cash payment minus B’s value as a separate entity. Thus
Cost = cash paid − PVB
The net present value to A of a merger with B is measured by the difference between the gain
and the cost. Therefore, you should go ahead with the merger if its net present value, defined as
NPV = gain − cost
= ΔPVAB − (cash paid − PVB)
is positive.
(^9) This chapter’s definitions and interpretations of the gains and costs of merger follow those set out in S. C. Myers, “A Framework for
Evaluating Mergers,” in Modern Developments in Financial Management, ed. S. C. Myers (New York: Praeger, 1976).