Introduction to Corporate Finance

21: Mergers, Acquisitions and Corporate Control

Another cautionary consideration about growth is related to managerial agency costs. Managers

can increase their power, prestige and even pay by increasing the size of the empire they oversee.

Consequently, a recommendation by a divisional manager, or even a CEO, to pursue a project that they

claim is central to a company’s growth strategy must be tempered by the realisation that the manager

may benefit personally from the transaction, and thus have personal incentive to increase company size

more than is optimal.

The important question is whether the acquisition increases the company’s value. This will be the

case if the value of the acquired assets to the acquiring company is greater than the price paid to purchase

those assets. In other words, growth acquisitions make sense when they produce positive NPV.

Synergies

Michael Eisner, the former CEO of Disney, provided perhaps the best definition of synergy with his view

of the value created by his company’s 1995 merger with Capital Cities/ABC: ‘1 + 1 = 4.’ That is, synergies

occur when combining two entities produces extra value, so the combination is worth more than the sum

of the two separate entities. Synergies sound good. After all, who wouldn’t like to create value? However,

synergies are very difficult to measure and even harder to obtain. The synergies expected to result from the

Disney–Capital Cities/ABC combination were never realised in full. In fact, perhaps ‘1 + 1 = 1.5’ in this case.

synergy

A reduction in costs or

increase in revenues that

results from a merger

finance in practice

WHERE MERGERS GO WRONG

In a 2004 study entitled Where Mergers Go

Wrong,^7 McKinsey documented that on average,

acquirers in mergers pay sellers almost all of the

value created by the merger. This takes the form

of a premium that usually ranges from 10 to 35%

of the target company’s preannouncement value.

This occurs because the average acquirer in the

study substantially overestimated the synergies that

would result from a merger.

McKinsey found that revenue synergies are

greatly overestimated, with fewer than one-fourth

of merger synergies meeting incremental revenue

expectations. In addition, few companies account

for the revenue ‘dis-synergies’ that befall merging

companies. These could be temporary business

disruptions resulting from consolidations, employee

turnover and the like. In contrast, two-thirds of

mergers achieve within 10% of projected cost savings,

which are often related to layoffs and branch closings.

The study recommends that companies should

take care to maintain customer relationships during

the transitional period. When formulating merger

plans, assumptions of synergies and market growth

should be challenged, and double checked against

overall industry and economic growth. Managers

would do well to apply external benchmarks as

sanity checks when formulating cost savings and

growth assumptions.

7 See Scott A. Christofferson, Robert S. McNish and Diane L. Sias, ‘Where Mergers Go Wrong’, McKinsey Quarterly (May 2004).

Synergies can occur through cost reductions and revenue enhancements. Combining two companies can

reduce costs for several reasons. One is economies of scale, which result when relative operating costs are

reduced because of an increase in size that allows for the reduction or elimination of overlapping resources.

A simple example is provided by IKEA, an organisation that can sell products cheaply because its huge

buying power and global presence gives it economies of scale – units are cheaper because IKEA buys so

many of them.

economies of scale

Relative operating costs

are reduced for merged

companies because of an

increase in size that allows for

the reduction or elimination of

overlapping resources