Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

VIII. Topics in Corporate

Finance

25. Mergers and
    Acquisitions

© The McGraw−Hill^875

Companies, 2002

The word beachheadhas been used in describing the process of entering a new in-
dustry to exploit perceived opportunities. The beachhead is used to spawn new oppor-
tunities based on “intangible” relationships. One example is Procter & Gamble’s initial
acquisition of the Charmin Paper Company as a beachhead that allowed Procter &
Gamble to develop a highly interrelated cluster of paper products—disposable diapers,
paper towels, feminine hygiene products, and bathroom tissue.^5

Market Power One firm may acquire another to increase its market share and market
power. In such mergers, profits can be enhanced through higher prices and reduced
competition for customers. Of course, mergers that substantially reduce competition in
the market may be challenged by the U.S. Department of Justice or the Federal Trade
Commission on antitrust grounds.

Cost Reductions

One of the most basic reasons to merge is that a combined firm may operate more effi-
ciently than two separate firms. A firm can achieve greater operating efficiency in sev-
eral different ways through a merger or an acquisition.

Economies of Scale Economies of scale relate to the average cost per unit of pro-
ducing goods and services. If the per-unit cost of production falls as the level of pro-
duction increases, then an economy of scale exists:

Frequently, the phrase spreading overheadis used in connection with economies of
scale. This expression refers to the sharing of central facilities such as corporate head-
quarters, top management, and computer services.

Economies of Vertical Integration Operating economies can be gained from vertical
combinations as well as from horizontal combinations. The main purpose of vertical ac-
quisitions is to make it easier to coordinate closely related operating activities. Benefits
from vertical integration are probably the reason that most forest product firms that cut
timber also own sawmills and hauling equipment. Economies of vertical integration may
explain why some airline companies have purchased hotels and car rental companies.

Cost ($)

Size

Economies of

scale

Optimal size

Minimum cost

Diseconomies

of scale

CHAPTER 25 Mergers and Acquisitions 851

(^5) This example comes from Michael Porter, Competitive Advantage(New York: Free Press, 1985).