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Takeovers and mergers

Over the years, many observers have sought to identify the factors that make

mergers attractive, particularly to the bidder. Let us now consider some of these

factors and discuss each of them in the context of the overall risk reduction and cash

flow expansion mentioned above.

Elimination or reduction of competition

Where the bidder and target are in competition for the market for their output, a

merger could lead to a monopoly or at least a larger market share for the merged unit.

This strength in the marketplace might enable prices to be raised without loss of

turnover – hence an increase in cash flows. (As we shall see later in this chapter, in the

UK such a merger may well fall foul of the Competition Commission.)

Safeguarding sources of supply or sales outlets

A bidder may be attracted to a merger where the target is a supplier of some vital raw

material, which is in short supply or which the target could stop supplying, beyond

the control of the bidder. Similarly, where the target represents a major sales outlet for

the bidder, the target could cause problems for the bidder if it started to promote sales

of the product of one of the bidder’s competitors. Here a merger may not increase

annual cash flows but it may well lower the perceived risk because the cash flows of

both parts of the combined business would become more certain.

Access to the economies of scale that a larger business could yield

Economies of scale may be envisaged in a wide variety of areas. Such economies might

include:

l greater buying power leading to lower prices being paid for supplies of goods and

services;

l larger production runs, leading to savings in set-up costs and other overheads;

Bidder plc is expected to generate net positive cash flows of £1 million p.a. for ever. The

level of risk associated with these cash flows is perceived by the capital market as justify-

ing a rate of return of 15 per cent p.a. Thus the net present value of Bidder is £1 million/

0.15 =£6.67 million.

Bidder sees an opportunity to acquire the entire equity of Target plc. Forecasts indicate

that the annual net positive cash flows of the merged business would be £1.5 million for ever,

and that the required rate of return would be 12 per cent p.a. The net present value of Bidder

after the merger, should it take place, would become £1.5 million/0.12 =£12.5 million.

This would imply that it would be worth Bidder paying any amount up to £5.83 million

(i.e. £12.5 million – £6.67 million) for Target. Note that part of this amount arises from the

existing cash flows of Bidder being discounted at a lower rate than previously. This factor

would arise only where the merger had the effect of reducing risk.

It is quite feasible that £5.83 million exceeds the current market value of Target. The

reasons why this could be the case include:

lTarget’s expected cash flows being less than £0.5 million p.a., that is, the merged busi-

ness might be able to generate more expected cash flows than the sum of the expected

cash flows of the separate businesses; and

lthe possibility of the risk attaching to the combined business being less than applies to

the overall level of risk of the separate parts.

Example 14.1

Frequently, a particular merger is attractive to the bidding business for both of these

reasons.