Chapter 7: Merger and Acquisition Strategies 219In this respect, one observer said that “the added huge bonus for Cap Gemini is that it
gives them, in one move, a great presence and foothold in the U.S. market, which has
always been a challenge for them as a Europe-centric provider. This boosts their presence
and revenue in the largest market for global sourcing and gives them a credible offering
for the U.S. market.”^55 Even with these positives, the firms will have to work diligently to
avoid problems during the integration process.
Commonly, firms are willing to pay a premium to acquire a company they believe will
increase their ability to earn above-average returns. Determining the precise premium
that is appropriate to pay is challenging. While the acquirer can estimate the value of
anticipated synergies, it is just that—an estimate. Only after working to integrate the firms
and then engaging in competitive actions in the marketplace will the absolute value of
synergies be known.
When firms overestimate the value of synergies or the value of future growth potential
associated with an acquisition, the premium they pay may prove to be too large. Excessive
premiums can have dilutive effects on the newly formed firm’s short- and long-term earn-
ing potential. In November 2011, for example, Gilead Sciences paid an 89 percent premium
to acquire Pharmasset.^56 At first glance, this premium seems excessive. However, since the
acquisition was completed, Gilead’s stock price has soared. Moreover, the firm’s hepati-
tis C drug franchise, to which Gilead obtain access by acquiring Pharmasset, reached
sales of $12.4 billion in 2014 and was seen as a huge success. In this instance then, it seems
that the premium Gilead paid to acquire Pharmasset was not excessive. The managerial
challenge is to effectively examine each acquisition target for the purpose of determining
the amount of premium that is appropriate for the acquiring firm to pay.7-3c Large or Extraordinary Debt
To finance a number of acquisitions completed during the 1980s and 1990s, some com-
panies significantly increased their debt levels. Although firms today are more prudent
about the amount of debt they’ll accept to complete an acquisition, those evaluating the
possibility of an acquisition for their company need to be aware of the problem that tak-
ing on too much debt can create. In this sense, firms using an acquisition strategy want
to verify that their purchases do not create a debt load that overpowers their ability to
remain solvent and vibrant as a competitor.
A financial innovation called junk bonds supported firms’ earlier efforts to take on
large amounts of debt when completing acquisitions. Junk bonds, which are used less
frequently today and are now more commonly called high-yield bonds, are a financing
option through which risky acquisitions are financed with money (debt) that provides
a large potential return to lenders (bondholders). Because junk bonds are unsecured
obligations that are not tied to specific assets for collateral, interest rates for these high-
risk debt instruments sometimes reached between 18 and 20 percent during the 1980s.^57
Additionally, interest rates for these types of bonds tend to be quite volatile, a condition
that potentially exposes companies to greater financial risk.^58 Some prominent financial
economists viewed debt as a means to discipline managers, causing the managers to act in
the shareholders’ best interests.^59 Managers adopting this perspective are less concerned
about the amount of debt their firm assumes when acquiring other companies. However,
the perspective that debt disciplines managers is not as widely supported today as was
the case in the past.^60
Bidding wars, through which an acquiring firm overcommits to the decision to
acquire a target, can result in large or extraordinary debt. While finance theory suggests
that managers will make rational decisions when seeking to complete an acquisition,
other research suggests that rationality may not always drive the acquisition decision.
Hubris, escalation of commitment to complete a particular transaction, and self-interest