Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVIII. Topics in Corporate
Finance- Mergers and
Acquisitions
(^880) © The McGraw−Hill
Companies, 2002
Diversification
Diversification is commonly mentioned as a benefit of a merger. We previously noted
that U.S. Steel included diversification as a benefit in describing its acquisition of
Marathon Oil. The problem is that diversification per se probably does not create value.
Going back to Chapter 13, recall that diversification reduces unsystematic risk. We
also saw that the value of an asset depends on its systematic risk, and systematic risk is
not directly affected by diversification. Because the unsystematic risk is not especially
important, there is no particular benefit from reducing it.
An easy way to see why diversification isn’t an important benefit of a merger is to
consider someone who owned stock in U.S. Steel and Marathon Oil. Such a stockholder
was already diversified between these two investments. The merger didn’t do anything
the stockholders couldn’t do for themselves.
More generally, stockholders can get all the diversification they want by buying
stock in different companies. As a result, they won’t pay a premium for a merged com-
pany just for the benefit of diversification.
By the way, we are not saying that U.S. Steel (now USX) made a mistake. At the time
of the merger, U.S. Steel was a cash-rich company (over 20 percent of its assets were in
the form of cash and marketable securities). It is not uncommon to see firms with sur-
plus cash articulating a “need” for diversification.
THE COST OF AN ACQUISITION
We’ve discussed some of the benefits of acquisition. We now need to discuss the cost of
a merger.^7 We learned earlier that the net incremental gain from a merger is:
VVAB(VAVB)
Also, the total value of Firm B to Firm A, VB, is:
VBVBV
The NPV of the merger is therefore:
NPVVB*Cost to Firm A of the acquisition [25.1]
To illustrate, suppose we have the following premerger information for Firm A and
Firm B:
Firm A Firm B
Price per share $ 20 $ 10
Number of shares 25 10
Total market value $500 $100
CONCEPT QUESTIONS
25.5a Why can a merger create the appearance of earnings growth?
25.5bWhy is diversification by itself not a good reason for a merger?
856 PART EIGHT Topics in Corporate Finance
(^7) For a more complete discussion of the costs of a merger and the NPV approach, see S. C. Myers, “A
Framework for Evaluating Mergers,” in Modern Developments in Financial Management,ed. S. C. Myers
(New York: Praeger Publishers, 1976).