ONLINE CHAPTERS
more generally, played an important role in transforming the transportation sector from producing horse-
drawn carriages in the early 1900s to producing cars, planes and rocket engines decades later.
Managers at a particular company are less concerned about the overall economy’s efficiency than
they are about their own company’s operations. How can their company operate most effectively, often
in the face of intense competition? One strategy might involve acquiring a unit of another company, or
perhaps an entire company. For example, acquiring an oil refinery can help a chemical company obtain
sole ownership of a key input into its production process, to guarantee smooth, on-time production that
is not subject to the whims of the oil markets.
This section discusses several justifications for merger and acquisition activity. Note that in the
previous section, we discussed explanations for economy-wide trends that drive merger waves. In this
section, we dig deeper into explanations of mergers between two companies in any given year, even
during years where overall M&A activity is low.
There are three important principles that managers must keep in mind when evaluating an acquisition
opportunity. First, does it increase shareholder value? In previous chapters, we emphasised that shareholders
are the owners of the company, and therefore maximising long-run share price is a fundamental goal of
the company. Bearing this in mind, a merger should only be conducted if it increases long-run shareholder
value.^5 Second, what price is being paid for the acquisition? This is, of course, closely related to the first
principle. No matter how attractive a target, the acquiring company can destroy value if it overpays.
Finally, is an acquisition really needed to obtain the hoped-for benefit of the merger? For example, rather than
conduct an outright acquisition, can a chemical company instead arrange a strategic alliance or partnership
that allows it to access oil reliably as a key input into its production process? Acquisitions can distract
management, often cause disruption, involve fees (especially to lawyers and bankers), and can be painful
to reverse. If the sought-after outcome can be obtained in some way that is short of a full-fledged merger,
it can at times be less expensive and less risky to pursue this alternative course of action. As we explore the
common justifications for mergers and acquisitions, keep these three important principles in mind, because
we will see that not all of the given explanations make economic sense. Note that these explanations are not
mutually exclusive; that is, at times they overlap or are in other ways related to each other.21-2a EXPLAINING MERGERS AND ACQUISITIONS
Growth
A common practitioner view is that companies must grow or they will stagnate and eventually die. After
all, from the equation for value,Value = Cash flow/(r – g)
it may seem that if growth (g) increases, so does company value. Mergers are a primary way for a
company to grow, by acquiring another company’s customers or production capabilities. We note, however,
that acquiring growth at a high price can be short-sighted. Growth only increases company value if the
acquisition price does not exceed the present value of the cash flows produced by the acquired assets.^65 Notice that we refer to long-run shareholder value. When a merger is first announced, the initial stock market reaction is often negative,
which can be interpreted to indicate that the market believes that the merger will not add value, even in the long run. There may be some
cases in which it is justified to pursue an acquisition even though there is an initial negative stock market reaction. However, to pursue such a
merger, management must have a convincing argument for why the long-run benefits of a merger are positive, even though the stock market
does not recognise this initially. Of course these arguments should be scrutinised carefully.
6 One subtle point is that when evaluating a merger, the cash flows should be measured relative to the cash flows the firm would receive if no
merger were to occur. So if, for example, a company were expected to have annual cash flows of –$1 million if no merger were to occur, and
flat cash flows with the merger, then incremental cash flows as a result of the merger would be $1 million annually.