07ma_lixjw16
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Motives and Effects of Mergers and Acquisitions
by
JUANJUAN WANG
September 2007
A dissertation presented in part consideration for
the degree of MA in Finance and Investment
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Acknowledgements
I would like to take this opportunity to express my sincere appreciation to all
those people who helped me complete this dissertation. Firstly, I do
appreciate my supervisor Ms. Lynda Taylors assistance. She gave me
valuable feedback and guidance throughout this dissertation.
In addition, I would like to send my deepest gratitude to Dr. Stephen
Praffenzellers assistance. He helped me proof-reading the majority of this
dissertation.
My sincere thank is also extended to my parents, my boyfriend and my
cousin who gave me unconditional support and encouragement all the time
during my study in the UK.
Further thanks to my parents who gave me this precious opportunity to
study in the University of Nottingham in the UK.
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Abstract
Mergers and acquisitions, nowadays, play significant roles for helping
companies achieve certain objectives and financial strategies. This
dissertation, firstly, presents three major types of motives of participating in
M & A. This part involves the motives that increase or decrease
shareholders value or has uncertain impact on shareholders value. The
motives which increase shareholders value include the synergy motive,
improvement of managerial efficiency, achievement of economies of scale or
scope, increased market power and increased revenue growth; whereas the
motives which decrease shareholders value include the agency motive,
managerial hubris and free cash flow; the diversification motive has
uncertain impact on shareholders value. Secondly, the effects of engaging
in M & A are examined based on four approaches in literature review.
Generally speaking, M & A increase shareholders value for the target
company, whereas they decrease shareholders value for the acquiring
company or the newly combined company. Lastly, this dissertation advances
quantitative research methodology- an accounting study-to measure the
changes in the financial performance of the target and the acquiring
company.
In order to control firm-specific, industry-specific, economic wide factor that
may pose impact on the post-acquisition performance of the acquiring firm,
the different financial performance indicators of the acquiring firm are
compared with those of its non-acquiring peers. Moreover, two cases-
Vodafones acquisition of Mannesmann AG and the merger between AOL and
Time Warner- are selected in order to check the literature results. The
findings present that both the target company and the acquiring company
had a healthy financial performance before mergers and acquisition, but the
acquiring firm suffered a great deal of loss after mergers and acquisitions.
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Table of Contents
Page Number
List of Tables-------------------------------------------------------------6
List of Figures------------------------------------------------------------6
Chapter 1 Introduction--------------------------------------------------8
1.1 Background of mergers and acquisitions---------------------------------8
1.1.1 Definition of mergers and acquisitions-----------------------------9
1.1.2 Types of mergers and acquisitions--------------------------------10
1.2 Objectives of the dissertation--------------------------------------------13
1.3 Research Methodology---------------------------------------------------14
1.4 Organization of the dissertation-----------------------------------------14
Chapter 2 Literature Review-------------------------------------------16
2.1 Motives of engaging in mergers and acquisitions-----------------------16
2.1.1 Motives which increase shareholders value----------------------16
2.1.2 Motives which decrease shareholders value---------------------22
2.1.3 Motive which has uncertain impact on shareholders value------25
2.2 The Effects of the motives in mergers and acquisitions: post-M & A
performance------------------------------------------------------------27
2.2.1 Empirical evidence based on accounting studies---------------27
2.2.2 Empirical evidence based on event studies----------------------31
2.2.3 Empirical evidence based on clinical studies--------------------35
2.2.4 Empirical evidence based on executives of surveys-------------35
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Chapter 3 Research methodology-------------------------------------39
3.1 Overview of an Accounting Study Research Methodology--------------39
3.2 Data Source--------------------------------------------------------------42
3.3 Limitations of this study--------------------------------------------------43
Chapter 4 Case Studies Analysis--------------------------------------44
4.1 Overview of Vodafones acquisition of Mannesmann AG---------------44
4.1.1 The historical development of Vodafone and Mannesmann AG--45
4.1.2 The motives of Vodafones acquisition of Mannesmann AG------46
4.1.3 Effects of Vodafones acquisition of Mannesmann AG: financial
performance-------------------------------------------------------48
4.1.4 Comparisons of Vodafones post-financial performance with its
industry competitors---------------------------------------------52
4.2 Overview of AOL and Time Warner merger------------------------------60
4.2.1 The historical development of AOL and Time Warner------------60
4.2.2 The motives of AOL and Time Warners merger and acquisition-61
4.2.3 Effects of AOL and Time Warners merger and acquisition: financial
performance------------------------------------------------------62
4.2.4 Comparisons of Time Warners post- financial performance with its
industry competitors---------------------------------------------63
Chapter 5 Conclusion, Limitations and Recommendations of Study
5.1 Conclusion----------------------------------------------------------------72
5.2 Limitations of this study--------------------------------------------------74
5.3 Recommendations for further study-------------------------------------75
References--------------------------------------------------------------76
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List of Tables: Table 1: The relationship between the motives of M & A and gains------26 Table 2: Comparisons among each research approach--------------------38 Table 3: Formulas of Key Financial Ratios----------------------------------40 List of Figures: Figure 1: Key figures and ratios of Mannesmann AG from 1998-2000 (in million) ----------------------------------------------------------------------48 Figure 2: Key figures and ratios of Vodafone from 1996-2000(in million)-49 Figure 3a: Key Growth of Vodafone from 2000-2005-----------------------53 Figure 3b: Key Growth of O2 from 2000-2005------------------------------54 Figure 3c: Key Growth of Deutsche Telekom from 2000-2005-------------54 Figure 4a: Profitability ratios of Vodafone from 2000-2005(%) -----------55 Figure 4b: Profitability ratios of O2 from 2000-2005(%) -------------------55 Figure 4c: Profitability ratios of Deutsche Telekom from 2000-2005(%) --56 Figure 5a: Liquidity ratios of Vodafone from 2000-2005 -------------------56 Figure 5b: Liquidity ratios of O2 from 2000-2005---------------------------57 Figure 5c: Liquidity ratios of Deutsche Telekom from 2000-2005----------57 Figure 6a: Activity ratios of Vodafone from 2000-2005 --------------------58 Figure 6b: Activity ratios of O2 from 2000-2005 ----------------------------58 Figure 6c: Activity ratios of Deutsche Telekom from 2000-2005 ----------58 Figure 7: Key figures and ratios of Time Warner from 1996-2000(in $ million) --------------------------------------------------------------------------------62 Figure 8a: Key Growth of Time Warner from 2000-2005-------------------64
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Figure 8b: Key Growth of Walt Disney from 2000-2005---------------------65 Figure 8c: Key Growth of News Corporation from 2000-2005--------------65 Figure 9a: Profitability ratios of Time Warner from 2000-2005(%) --------66 Figure 9b: Profitability ratios of Walt Disney from 2000-2005(%) ---------66 Figure 9c: Profitability ratios of News Corporation from 2000-2005(%) ---67 Figure 10a: Liquidity ratios of Time Warner from 2000-2005 --------------67 Figure 10b: Liquidity ratios of Walt Disney from 2000-2005 ---------------67 Figure 10c: Liquidity ratios of News Corporation from 2000-2005 --------68 Figure 11a: Activity ratios of Time Warner from 2000-2005----------------68 Figure 11b: Activity ratios of Walt Disney from 2000-2005 ----------------68 Figure 11c: Activity ratios of News Corporation from 2000-2005-----------68
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Chapter 1 Introduction
1.1 Background of Mergers & Acquisitions
Several decades ago, mergers and acquisitions have seldom dominated the
headlines as much as at present. Whereas, the pace and scale of mergers
and acquisitions, nowadays, are remarkable in the world. For instance,
academic research has shown substantial mergers and acquisitions
activities in a wide range of sectors, such as banking, insurance,
pharmaceuticals, electricity, oil, gas, automobile, steel etc. In the US,
corporations spent more than $1.7 trillion on mergers and acquisitions in
2000 (Brealey et al., 2006).
From the perspective of historical development of mergers and acquisitions,
they appear to follow a historic pattern with several boom periods. The first
period of mergers and acquisitions occurred at the beginning of the 20th
century and the second one took place in the 1920s. During the period from
1967 to 1969, it was a boom period for mergers and acquisitions and the
same in the 1980s and in the 1990s. Although each period was characterised
by the fluctuations in share prices, it had some differences in payment
methods and types of firms that merged or acquired (Brealey et al., 2006).
During the most recent mergers and acquisitions boom periods, managers
and investment bankers spent much time on mergers and acquisitions
transactions every day, which can be worth hundreds of millions or even
billions of dollars. For instance, in January 2000, the merger and acquisition
between Time Warner and AOL (American On line) broke a record of $181
billions of stock (www.bbc.co.uk). Therefore, not surprisingly, these
transactions always make the news. Unfortunately, according to the survey
of researchers, in many CEOs opinions, only 37 percent of mergers and
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acquisitions activities are considered to be very successful or somewhat
successful (Reeves, 2000).
Even though different companies have diverse reasons for engaging in
mergers and acquisitions, the main purpose is to create shareholders value
over and above that of the sum of two companies (Sudarsanam1995).
According to Sudarsanam (1995), the fundamental objectives of doing
mergers and acquisitions involve enhancement of shareholders wealth,
increased competitive advantages (i.e. economies of scale or scope or
increased market power), expansion of acquirers assets, sales and market
share. In short, one plus one equals three. This equation is the essence of
mergers and acquisitions. Whatever the motivating factors, the same
principle always applies (Reeves, 2000).
In a word, the hot issue of participating in mergers and acquisitions seems
to be on the rise.
1.1.1 Definition of Mergers & Acquisitions
Both the terms merger and acquisition mean a corporate combination of
two separate companies to form one company and they are often used
synonymously in practice (Chiplin & Wright, 1987), but there are slightly
different meanings between them.
In a merger activity, it usually takes place when two separate firms which
have similar size agree to form a new single company. Then both companies
stocks will cease to exist and the newly created companys stock will be
issued in its place. This kind of activity is often referred as a merger of
equals (www.investopedia.com). A typical example of a major merger is
the merger between AOL and Time Warner in 2000.
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While in the case of an acquisition, one company is purchased by another
one and then no new company is formed subsequently. From a legal point of
view, the target company ceases to exist, the acquirer occupies the business
of the target firm and the acquirer's stock continues to be traded. In addition,
the acquiring firm collects all asset and gains of the target company as well
as the liability (www.investopedia.com). An example of a major acquisition
is Manulife Financial Corporation's acquisition of John Hancock Financial
Services Inc in 2004 (www.investopedia.com).
From the degree of friendliness between the acquirer and the acquired,
there are two general types of acquisitions: friendly and hostile (Schnitzer,
1996). When the board of directors and managers of the target company
agree an acquisition from the acquiring firm, it is called a friendly acquisition.
The top managers of the target firm will keep their positions within the newly
created firm. In contrast, a hostile takeover takes place in a situation when
the acquired firm resists an acquisition from others; in this case the top
managers in the target firm may lose their jobs after the hostile takeover
(Schnitzer, 1996).
In a word, the degree of friendship among companies board of directors,
senior managers and shareholders decides whether the takeover process is
a merger or an acquisition (www.investopedia.com).
Nevertheless, the slightly different meanings between mergers and
acquisitions will not be strictly distinguished in this dissertation and both are
refer to under the term of M & A, which literally means mergers and
acquisitions.
1.1.2 Types of Mergers & Acquisitions
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From the perspective of business structure and the relationship between two
corporations, according to Gaugham (2005), there are four main categories
of M & A: horizontal, vertical, conglomerate and cross-border. Each type has
its own characteristics and nature, which are described as follows.
1.1.2.1 Horizontal Mergers & Acquisitions
Horizontal M & A describes that one company merge with or acquires
another one from the same business field. Moreover, this kind of M & A is the
most popular in the modern world (Brealey et al., 2006). For example, the
Vodafone Group (UK) acquired the German telecommunications
giant-Mannesmann AG in 2000.
Horizontal M & A may arise from the possible side effects on competition in
the same industry, in that after horizontal M & A, companies may occupy a
monopoly position by decreasing the number of firms in the same field
(Weston et al., 2004). Furthermore, horizontal M & A usually occurs between
small or immature firms and when there is no dominant leader in the same
business. They combine to achieve the goal of economies of scale in
purchasing, marketing, information systems, distribution, and senior
management (Weston et al., 2004, p.7). Consequently, the newly merged
firms are usually financed by initial public offering (IPO), but this kind of M &
A is not the best way to achieve economies of scale (Weston et al., 2004).
1.1.2.2 Vertical Mergers & Acquisitions
Vertical M & A refer to the vertical integration of two firms, which operate in
the same production line. Specifically speaking, there are two major
categories of vertical M & A, which are forward integration (i.e. the acquirer
expands forward of the ultimate consumer) and backward integration (i.e.
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the buyer expands backward to suppliers of raw materials) (Brealey et al.,
2006). Examples of this type M & A are typical in the oil industry and in the
pharmaceutical industry.
The primary reasons for companies to be vertically integrated are
technological economies such as the avoidance of reheating and
transportation costs in the case of an integrated iron and steel producer and
the reduction of transaction cost (i.e. the cost of searching for prices,
contracting, payment collecting, and advertising and also might reduce the
costs of communicating and coordinating production) (Weston et al., 2004,
p.7). Moreover, the more efficient information that flows into the firm gives
rise to the improvements of production and inventory. Vertical M & A can
also help companies avoid the uncertainty about input supply of long-term
contracts due to the difficulty of writing and executing of long-term
contracts (Weston et al., 2004).
1.1.2.3 Conglomerate Mergers & Acquisitions
Conglomerate M & A refer to a combination of two firms which do business in
diverse fields. This kind of M & A is the least popular nowadays (Brealey et al.,
2006). There are three categories of conglomerate M & A: product extension
mergers, geographic market extension mergers and the other conglomerate
mergers. The first type is also called concentric mergers, which means two
firms merger or acquire in related businesses in order to broaden the
product lines of firms. The second one occurs when two firms, which have no
overlapping businesses, merge in different geographic areas. The last kind
refers to a pure conglomerate M & A in different business field (Weston et al.,
2004; Sudarsanam 2003).
1.1.2.4 Cross-border Mergers & Acquisitions
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Cross-border M & A refer to M & A across national boundaries and involving
substantial cash flow into other countries (Sudarsanam, 1995). It seems
that cross-border M & A have an increasing trend over the past few years
due to the globalization and the development of the internet. With the
advent of globalization, companies prefer to seek a competitive area that is
worldwide in scale in order to have customers worldwide through cross-
border M & A. The typical example is the biggest cross-border M & A at the
beginning of 21st century -Vodafone (UK) acquired Mannesmann AG
(Germany) and it has a record of worth $203 billion.
However, regardless of which type of M & A, the main goal is to create the
value of the combined companies greater than the value of the two single
entities and the success relies on the synergy effect of the new company
(www.investopedia.com).
1.2 Objectives of the dissertation
The main purpose of this dissertation is, firstly, to examine motives of
participating in M & A. It asks what factors result in these activities and the
reasons why one company seeks to merge with or to acquire another one. In
this part, the role of synergy, of the agency problem, of the free cash flow, of
the increased market power, of diversification etc that influenced the
decision of managers to participate in M & A will be indicated. Moreover, the
motives are categorized into three kinds: increase or decrease shareholders
value 1 or have uncertain impact on shareholders value. Secondly, the
effects or the consequences of these motives on companies post M & A
performance will be investigated. To illustrate this point, two case studies
that happened in two different sectors and different countries (i.e.
Vodafones acquisition of Mannesmann AG and the merger between AOL and 1 Shareholders value means the increased acquirers returns or profitability in this study.
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Time Warner) at the beginning of the 21st century will be analyzed in order
to check the literature results in terms of companies financial performance.
1.3 Research Methodology
The major research methodology of this dissertation is a quantitative
approach- an accounting study2. The relevant data is mainly collected from
companies annual reports, as well as online and printed publications, such
as research papers and articles. Specifically speaking, an accounting study
is used to measure the changes of firms financial performance before and
after M & A and to see how M & A affect the companys financial performance.
This process involves the calculation of the key ratios 3 including
revenue/turnover growth rates, key profitability ratios, liquidity ratios and
activity ratios. Lastly, in order to control firm-specific, industry-specific and
economic-wide factors that might pose impact on the measurement of
companies financial performance, the comparisons among the acquiring
company and its non-acquiring peers in the same industry during the same
period will be examined.
1.4 Organization of the dissertation
The dissertation is structured as follows: the first chapter serves as an
introduction to the dissertation including background, types of M & A, the
main purpose, research methodology and organization of this dissertation.
Chapter two refers to the literature review, which gives an overview of the
theoretical literature on motives of engaging in M & A and the empirical
literature on the effects of M & A. In chapter three, the quantitative research
2 The definition and meanings of an accounting study are specifically explained in Chapter three-research methodology. 3 The formulas, meanings and explanations of the key ratios refer to chapter three-research methodology.
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methodology-an accounting study- will be overviewed. Chapter four looks at
two case studies (i.e. Vodafones acquisition of Mannesmann AG and the
merger between AOL and Time Warner) in two different sectors to study the
motives behind M & A, as well as companies historical development, effects
of motives of engaging in M & A and comparisons between the acquiring
company and its competitors in the same industry in terms of financial
aspects. The last chapter briefly reviews the major findings, presents some
limitations and suggestions of this study and concludes the dissertation.
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Chapter 2 Literature Review
2.1 Motives of engaging in M & A
Mergers and acquisitions play a significant role in the majority of companies
strategies. The motives for M & A can be defined as the acquirers corporate
and business strategy objectives, which are varied in different companies.
Empirical evidence has provided many possible motives for M & A, just as
Andrade et al. (2001) summarized as follows:
efficiency-related reasons that often involve economies of scale or other
synergies; attempts to create market power, perhaps by forming monopolies or
oligopolies; market discipline, as in the case of the removal of incompetent
target management; self-serving attempts by acquirer management to
over-expand and other agency costs; and to take advantage of opportunities
for diversification, like by exploiting internal capital markets and managing risk
for undiversified managers (p.103)
However, the appeal and frequency of M & A drive scholars not only to
investigate the motives behind M & A, but also to question that whether
these motives increase or decrease shareholders value.
In this section, the motives which are concerned with shareholders value
are examined. Different motives have different characteristics and
contribute to diverse effects on shareholders value. Thus, the motives can
be mainly categorized into three types as follows: motives which increase or
decrease shareholders value or have uncertain impact on shareholders
value.
2.1.1 Motives which increase shareholders value
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In this section, the motives which can benefit shareholders value will be
investigated. Empirical evidence concludes that these motives mainly
include the synergy effect, improvement of managerial efficiency,
achievement of economies of scale and economies of scope, increased
market power and revenue growth.
2.1.1.1 The Synergy Motive
The synergy motive is regarded as the most popular motive for M & A. It
refers to acquire or to merge with the resources of two separate firms and
thus it contributes to the value of the newly combined firm greater than that
of two separate unities (Seth et al., 2000). One important source of synergy
is from the transfer of some valuable intangible assets, such as know-how,
between targets and acquirers (Seth et al., 2000). Evaluating synergy
effects from M & A deals has become one of major tasks of managers. From
the perspective of the relationship between targets and total gains, they are
positively correlated in synergy motivated M & A. This means that the higher
the synergy, the higher the target gains as well as the acquiring firms
shareholders benefits (Berkovitch & Narayanan, 1993).
To sum up, the empirical results show that the synergy motive has a positive
effect on targets, acquirers and total gains (Berkovitch & Narayanan, 1993;
Gondhalekar & Bhagwat 2000; Bradley et al., 1983). Sudarsanam et al.
(1996) further support this view: the synergy motive creates shareholders
value for the acquirer and the acquired or the new company.
Specifically speaking, according to Chatterjee (1986), there are three types
of synergy creation: operational synergy, financial synergy and collusive
synergy.
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Operational Synergy
Operational synergy represents the achievement of production and/or
administrative efficiencies (Chatterjee, 1986). In addition, it can be
classified into revenue-enhancing operating synergy and cost-reducing
operating synergy (Gaughan, 1999). As Copeland et al. (2005, p.762)
report that the theory based on operating synergies assumes that
economies of scale and scope do exist in the industry and that prior to the
merger the firms are operating at levels of activity that fall short of achieving
the potential for economies of scale. In other words, either economies of
scale or economies of scope can lead to operational synergy. Moreover,
operational synergy can help companies realize some potential benefits
such as purchasing, training programs, common parts and the development
of larger scale manufacturing facilities (Harrison et al., 2001).
Financial Synergy
When the capital of two unrelated companies is combined and results in the
reduction of the cost of capital and a higher cash flow, that is so called
financial synergy (Fluck & Lynch, 1999; Chatterjee, 1986). Specifically
speaking, financial synergy applies into financing expensive investment
projects which are difficult to accomplish on an individual basis (Chatterjee,
1986). In addition, another type of financial synergy is to purchase a target
at bargain basement prices. When the q-ratio 4 is low, the acquirer is
considered as successful in buying the target (Copeland et al., 2005).
Compared with external financing, the lower cost of internal financing is one
major source of financial synergy (Copeland et al., 2005). Thus, the value 4 The q-ratio is defined as the ratio of the market value of the firms securities to the replacement costs of its assets (Copeland et al., 2005, p.762).
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creation of financial synergy comes from the advantage of lower cost of
internal funds and greater growth investment of excess cash flow.
Sudarsanam (2003) further points out cost of savings are one aspect of
value creation in M & A. Another source of financial synergy is from the
potential benefits of tax savings on investment income, because the debt
capacity of the new firm is greater than the sum of the two firms capacities
after M & A. The savings of transaction costs from economies of scale is also
regarded as a benefit of financial synergy (Copeland et al. 2005).
Furthermore, it is supported that financial synergy, on average, tends to be
associated with more value than do operational synergies (Chatterjee,
1986, p.120).
Collusive Synergy
Collusive synergy means the scarce resources are gathered together and
then the market power will be increased. Furthermore, researchers have
found that collusive synergy creates more value than operational synergy
and financial synergy (Chatterjee, 1986).
2.1.1.2 Achievement of Economies of Scale or Scope
Most companies pursue to save production cost through M & A, because low
costs are vital for corporations profitability and success. However,
economies of scale and economies of scope can help companies achieve that
goal.
Economies of scale refer to the average unit cost of production going down
as production increases (Brealey et al., 2006; Seth, 1990). Achieving
economies of scale is the goal not only for horizontal M & A, but also for
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conglomerate M & A. Since economies of scale in horizontal M & A and
conglomerate M & A apply to the same line of business, so the economies
come from sharing central services such as office management and
accounting, financial control, executive development and top-level
management (Brealey et al., 2006, p.874).
Economies of scope are attributed to an increase in the variety of products
leading to the declining production cost. This feature of economies of scope
is more suitable for vertical M & A in seeking vertical integration (Brealey et
al., 2006). Corporations may find it is more efficient to outsource the
provision of many services and various types of production; one method to
achieve this aim is to merge with or to acquire a supplier or a customer.
In addition, complementary resources between two firms are also the
motive for M & A. It means that smaller firms sometimes have components
that larger ones need, so the large companys acquisition of the small
company often take place (Brealey et al., 2006).
To sum up, although economies of scale and economies of scope can result
in companies value creation, firms should also be aware of diseconomies of
scale and diseconomies of scope, which may result from the diffusion of
control, the ineffectiveness of communication and the complexities of
monitoring (Sudarsanam, 2003).
2.1.1.3 Increased Market Power and Revenue Growth Motive
According to Seth (1990, p.101), market power is the ability of a market
participant or group of participants to control the price, the quantity or the
nature of the products sold, thereby generating extra-normal profits.
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As Zheer & Souder (2004) state, increased market power and increased
revenue growth are the most common objectives for firms participating in M
& A. These motives can be achieved through horizontal M & A. As Andrade et
al. (2001) state market power may be increased by forming monopolies or
oligopolies. Furthermore, increased market power can help companies
compete more effectively and revenue growth can be achieved by lowering
the prices of products which are highly price sensitive. New growth
opportunity comes from the creation of new technologies, products and
markets (Sudarsanam, 2003). As a result, the financial position of the
acquiring firm will be strengthened by increased market power and revenue
growth. Thereby the profitability of the firm will increase as well as the
shareholders value. Gaughan (2005) has expressed a similar view.
2.1.1.4 Improvement of Managerial Efficiency
In order to improve managerial efficiency, a company may prefer to merge
or to acquire a target to improve managerial efficiency by restructuring its
operations (Copeland et al., 2005). As a result, efficient management mainly
comes from the potential benefits of the combination between two firms
unequal managerial capabilities.
Generally speaking, the improvement of managerial efficiency in M & A may
be attributed to two methods (Martin & Mcconnell, 1991). On the one hand,
the market for corporate control plays a significant role in improving the
managerial efficiency of target firms, in that potential bidders may pose a
threat on managers positions and monitor their performance as well
(Jenson & Ruback, 1983). Therefore, senior top executives and managers
will improve managerial efficiency to avoid of dismissal after M & A and
minimize non-value maximizing behaviour (Manne, 1965; Alchian &
Demsetz, 1972). On the other hand, when the threat of M & A can not
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minimize managers non-value maximizing behaviour, the acquirer will
replace the management of the target company (Martin & Mcconnell, 1991).
Consequently, the improved managerial efficiency may help managers
operate the company efficiently and maximize shareholders value.
However, M & A may not be the only way to improve management efficiency,
but sometimes it may be the most practical and simple method (Brealey et
al., 2006).
2.1.2 Motives which decrease shareholders value
In contrast to the theories based on synergy effects, managerial efficiency,
economies of scale, economies of scope and increased market share, a
number of theories argue that the motives including managerial hubris,
agency problem and free cash flow theory are the potential responses to
shareholders value destruction for M & A.
2.1.2.1 Managerial Hubris
Managerial hubris, according to Seth et al. (2000), contains two major
issues: the hubris hypothesis and the managerialism hypothesis.
Managers are considered to have the incentive to create economic value and
have the ability to assess the potential value of targets (Seth et al. 2000).
However, when the management of the acquirer underestimates the value of
the target firm and usually overestimates the potential synergies, the hubris
hypothesis will take place (Berkovitch & Narayanan, 1993). A study by Roll
(1986) showed that the hubris hypothesis can be served as an explanation
of corporate M & A deals, because managers seek to acquire firms for their
own benefits, rather than for the whole companys economic gains as the
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major motive. Therefore, acquirers may pay more than the current market
price for their targets due to the hubris factor (Roll, 1986; Seyhun, 1990).
Gaugham (2005) further supports the hubris hypothesis. He states that top
executive management hubris is positively related with the size of premiums
paid. As a result, there will be zero correlation between target and total
gains, since target gains are merely a transfer of wealth from acquirers,
(Berkovitch & Narayanan, 1993, p.348).
From the perspective of managerialism hypothesis, it could be concluded
that managers prefer to carry on M & A at the expense of shareholders, in
order to maximize their own competence (Firth 1980; Caves 1989). Just as
Marris (1964)s opinion, which was cited by Seth et al. (2000), reported that
since managerial compensation is usually associated with the amount of
assets, which are under the control of managers, managers prefer a higher
growth to higher profits. Langeteig (1978) also supports the view that
managerial welfare may be one motive of M & A.
To sum up, managerial motives drive bad M & A (Morck et al., 1990) and it
has been proven that when M & A is driving by managerial hubris, (a) the
combined value of the target and bidder firms should fall slightly, (b) the
value of the bidding firm should decrease, (c) the value of the target should
increase (Roll, 1986, p. 213).
2.1.2.2 The Agency Motive
In some circumstances, the agency problem might force managers to
engage in M & A (Malatesta, 1983). With the separation of ownership and
control, the agency problem implies M & A occur when managers want to
increase their wealth at the expense of the acquirers shareholders benefits
(Berkovitch & Narayanan, 1993). However, the agency problem can
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stimulate competition among companies but it can not be eliminated by
competition, and the gains to the target shareholders increase with
competition (Berkovitch & Narayanan, 1990; 1993).
Even though the agency motive may reduce the value of the acquiring firm,
management still prefers to seek a target and then the dependence of the
firm so that their own competence can be enhanced (Shleifer & Vishny,
1989). Thus, it seems that the agency motive is the main reason for value
destruction in M & A.
In a word, in contrast to the synergy motive, when the agency motive is the
main motive in M & A the returns to the target is positive, whereas the
returns to the acquirer is more negative, thus the returns to the newly
company is negative (Gondhalekar & Bhagwat, 2000).
2.1.2.3 Free Cash Flow Theory
Free cash flow is cash flow in excess of that required to fund all projects that
have positive net present values when discounted at the relevant cost of
capital (Jenson, 1986b, p.323). When the acquiring company has
substantial free cash flow and a low growth prospect, managers would like
to concentrate on M & A in order to keep control of internal funds and
maintain their power, in that the payment of the high cash flow as dividends
or share buyback can reduce managers control and power. In addition,
managers regard a pay out of dividends or repurchasing shares as a
complete waste, whereas M & A are considered a very attractive way to
conserve corporate wealth (Shleifer & Vishny, 1991). Jenson (1986b; 1988)
argues that free cash flow is regarded as a source of value destruction for
shareholders and that the returns for the combined company are negative.
In order to strengthen his opinion, Jenson (1986b) cites the oil industry in
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the 1970s and concludes that excess free cash flow results in shareholders
value destruction.
2.1.3 Motive which has uncertain impact on shareholders value
2.1.3.1 The Diversification Motive
The diversification motive can serve as a motive of conglomerate M & A. The
reason of engaging in M & A that are driven by diversification is to reduce the
top managers employment risk, such as the risk of losing job and the risk of
losing professional reputation (Amihud & Lev, 1981). Many large firms seek
to achieve diversification by external M & A, rather than internal growth
(Thompson, 1984; Levy & Sarnat, 1970). Gorecki (1975) indicates that
diversification also has a significant effect on an industrys structural
change.
According to Berger & Ofeck (1995), diversification has an uncertain effect,
i.e. either value creation or value destruction, on shareholders value. On
the one hand, the potential benefits of diversification include greater
operating efficiency, less incentive to forego positive net present value
projects, greater debt capacity and lower taxes (Berger & Ofeck, 1995,
p.40). In addition, the value of the acquiring company is increased through
diversification in terms of economies of scale, economies of scope and
market power. However, the potential costs of diversification involve the cost
of undertaking value destructing investments, resources which are allocated
from better-performing departments to poor ones, are not sufficiently used,
and there is a conflict of interest problem among diverse managements
(Berger & Ofeck, 1995).
On the other hand, Graham et al. (2002) argue that corporate diversification
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destroys companies value. The destruction effects from diversification
resulte from overinvestment and the subsidization of failing segments
(Jensen, 1986a; Stulz, 1990). However, the benefits of the increased debt
capacity and the reduced tax payments that result from the combination of
two firms may mitigate the value loss from diversification (Lewellen, 1971).
Just as Berger & Ofeck (1995, p.59) stated, Diversification creates a further
tax advantage by allowing the losses of some segments to be offset
contemporaneously against the gains of others, rather than merely carried
forward to future tax years.
Furthermore, the opinion of Seth et al. (2000, p.391) indicates in an
integrated capital market, firm-level diversification activities to reduce risk
are generally considered non-value maximizing as individual shareholders
may duplicate the benefit from such activities at lower cost.
To sum up, as Berger & Ofeck (1995) state, there is no clear prediction about
the overall value of diversification.
Conclusion
In conclusion, with regard to the relationship between motives of M & A and
gains to the target, the acquiring company and the newly combined
company, the following table summarizes the different patterns of gains in M
& A.
Table 1: The relationship between the motives of M & A and gains
Theory Combined gains Gains to target Gains to bidder
Efficiency/Synergy positive positive Non-negative
Agency costs negative positive more negative
Hubris zero positive negative
Source: Weston et al., 2004, p.136.
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2.2 The Effects of the Motives in M & A: Post-M & A Performance
After presenting diverse kinds of motives for M & A, it is essential to assess
the effects or consequences of these motives which force managers to
engage in M & A. This can be found out by studying the post M & A
performance for acquirers and targets. According to Bruner (2002), there
are four approaches (i.e. accounting studies, event studies, survey of
executives and clinical studies) to measure post- M & A performance. The
former two are quantitative methods, while the latter two are qualitative
approaches. It is undeniable that each research approach has its own
advantages and disadvantages, which will be described at the end of this
chapter.
Although lots of researchers have studied this popular thesis, it seems that
they used diverse estimation techniques and the results may be a slightly
different. In this part, the empirical evidence about the effects-post M & A
performance, which mainly focus on the findings in the UK and in the US, will
be presented. The implications of the empirical evidence are also discussed
in each part and at the end of this chapter.
2.2.1 Empirical Evidence Based on Accounting Studies
Accounting studies examine the changes in financial performance, which are
based on pre- and post- M & A accounting data of the target and the acquirer
or the newly combined firm. More specifically, the changes of net income,
profit margin, growth rates, return on equity (ROE), and return on asset
(ROA) and liquidity of the firm are the focus of accounting studies (Bruner,
2002; Pilloff, 1996). Furthermore, the comparisons between the acquirer
and the non-acquirer based on similar size in the same industry will also be
investigated in order to illustrate whether the acquiring company
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outperforms its non-acquirer competitors (Bruner, 2002).
UK Findings
Dickerson et al. (1997) are the first researchers to study the relationship
between M & A and profitability for UK firms in the period 1948-1977. Their
findings indicated that there was no evidence that M & A brought benefits to
the acquiring companys financial performance, which was based on the
measurement of profitability. Conversely, the growth rate and profitability
was lower after M & A than that of before M & A. In addition, after controlling
other uncertain factors that might affect profitability, Dickerson et al. (1997)
observed that M & A had a negative effect on the acquirers profitability by
measuring return on assets (ROA) in both the short term and the long term
period. This finding was consistent with that of Meeks (1977), who also
found that ROA for acquiring firms decreased after M & A in the UK. However,
Dickerson et al. (1997)s paper did not investigate acquired firms nature
that may be horizontal, vertical or conglomerate, because the nature of a
firm may affect the final findings.
Firth (1980), who cited many other previous researchers results, concluded
that based on accounting studies, generally speaking, acquired companies
do not have great profitability and have low stock market ratings before M &
A, but obtain a great deal of profit after engaging in M & A. In contrast,
acquiring companies generally have average or above average profitability
prior to M & A, whereas they suffer a reduction in profitability after M & A.
This finding is very evident in the UK, whereas it is inconclusive in the US,
because some studies found there was no change in profitability for
acquiring firms after M & A; while others indicated a reduction in profitability
for acquiring firms following M & A.
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The work of Caves (1989) showed a conflict result for the effects of M & A in
financial performance through event study and accounting study
respectively. He found that in event study the target shareholders obtained
positive gains, while the bidder shareholders had zero or negative return; in
contrast, accounting studies found negative average productivity for
mergers or acquirers.
Surprisingly, Chatterjee & Meeks (1996) studied the reasons of Caves
(1989)s conflicting results and reported that the choice of accounting policy
in M & A had an impact on the reported profitability. In the UK during the
period from 1977-1990, there was no significant increase in profitability for
mergers following M & A until 1985 when some new accounting standards
were introduced. The new accounting regulations were much more
transparent for evaluating M & A and made new discretion over the valuation
of assets that might affect future profit.
US Findings
In a study of Mueller (1985), one studied the relationship between M & A and
market share for the 100 largest US companies between 1950 and 1972 by
analyzing market share data. In order to avoid some uncertain factors that
might affect market share, the market share of other non-acquired firms
were selected to be compared with those of acquired firms. The finding
showed that the acquired companies suffered substantial losses in market
share following M & A, regardless of whether they were participating in
horizontal or conglomerate M & A. However, this finding did not directly
imply decreased profitability or shareholders return, but the return on
assets (ROA) or sales may decline for the acquired companies relative to
their industry.
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From the perspective of operating performance, Healy et al. (1992)
examined the post M & A operating performance of the 50 biggest M & A in
the US during the period from 1979 to mid-1984 and the same industry
performance was used as a benchmark. The authors indicated that after M &
A, the increased asset turnover resulted in significant improvements in the
operating cash flow for acquired firms, compared with its non-acquired
peers. While the increased asset productivity was not at the expense of
long-term performance, because sample firms in this paper maintained
capital expenditure and R & D rate relative to their industries after M & A. In
addition, this finding is more evident in overlapping businesses. More
importantly, this paper came to conclude that there is a strong positive
relationship between the improvement in operating cash flow after M & A
and the abnormal stock returns at merger announcements. This means the
share price at announcement can be explained by the expected economic
gains.
It must be recognised that the above empirical evidence is limited to study
the profitability of the acquiring firm or the acquired after M & A, they do not
reveal the effects of payment on profitability. Ghosh (1997) is the first
researcher to examine the correlation between post-merger operating cash
flow and the method of payment used in M & A for the acquiring company for
315 mergers over the period from 1981 to 1995. The results showed that if
the acquiring firm paid with cash and then was compared with its industry
peers, the cash flow would increase significantly through improved asset
turnover after the M & A. In contrast, the cash flow of the acquirer decreased
significantly with stock payment. Even though stock acquisitions are a good
strategy to reduce cost, the benefits from such a strategy are less than the
loss of declined asset turnover. However, the author did not find any
evidence that the acquiring company outperforms its peers in term of cash
flow following large M & A.
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However, one of drawbacks of accounting studies is that the calculated
outcome often neglects current market value and is merely based on
historical data (Pilloff, 1996), the more specific of advantages and
disadvantages of accounting studies will be presented later.
2.2.2 Empirical Evidence Based on Event Studies
Since Fama, Fisher, Jensen and Rolls 1969 study of stock, event studies
have become the predominant methodology for determining the effects of
an event on stock return, and it has become a powerful tool that can help
companies to determine whether there are abnormal returns (Boehmer et
al., 1991; McWilliams & Siegel, 1997; MacKinlay, 1997). It is well recognized
that the reliability of an event study depends heavily on a series of strong
assumptions (Brown & Warner, 1980).
According to Bodie et al. (2005, p.381), an event study describes a
technique of empirical financial research that enables an observer to assess
the impact of a particular event on a firms stock price. For example, an
event study may infer the relationship between stock returns and dividend
changes. Bruner (2002, p.4) also points out that an event study examines
the abnormal returns 5 to shareholders in the period surrounding the
announcement of a transaction. The standard event study methodology
involves the use of Sharpes (1963) market model and capital asset pricing
model (CAPM) (Dimson & Marsh, 1986).
Even though numerous event studies show that M & A creates shareholders
value, most of gains are belonged to shareholders of targets. For instance,
Bruner (2002) points out target shareholders can earn positive market
5 The abnormal return is simply the raw return less a benchmark of what investors required that day (Bruner, 2002, p.4).
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returns, while acquiring shareholders may earn zero adjusted returns, the
combined company may earn positive adjusted returns.
The results of empirical studies of M & A impact on stock returns can be
classified in terms of short term and long term approach. The short term
approach assumes stock market efficiency that means the stock market
reaction to acquisitions when they are announced or completed provides a
reliable measure of the expected value of the acquisition. The long term
performance assessment assumes the stock market spends time to evaluate
the value implications of acquisitions and wait new information about the
progress of the merger. Besides, the probability of M & A will be analyzed
(Sudarsanam, 2003, p.71).
UK Findings
Based on event studies, Firth (1980) studied 496 targets and 434 acquirers
in the UK during the period from 1969 to 1975 and presented a conflict
result in terms of shareholders returns to acquiring firms in the UK and in
the US respectively. In the UK, he found that the share price of acquiring
firms on average declined on the announcement of takeover and the
profitability was also reduced. This phenomenon will last a few years. In
addition, there was a zero overall gain in M & A and there was no overall
improvement in profitability for merged firms, because the benefits to
acquired firms are offset by the loss to acquiring firms. In contrast, in the
US, M & A have small or zero gains for the acquiring firms shareholders.
From the perspective of total gains, M & A results in overall stock market
gains and thus the profitability of the merged firms is increased. In all, the
overall benefits are attributed to improvement of the profitability
performance of the acquired firm.
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US Findings
Langeteig (1978), who cites Mandelker (1973, 1974) and Franks, Broyles,
and Hecht (1977)s work, concludes that the combined firm earned a normal
rate of return based on capital asset pricing model. He further cited Dodd
and Ruback (1977)s research, which shows that M & A have negative but
normal gains for the acquiring companies after the date of first public
announcement. In addition, Langeteig (1978) used a three-factor
performance index to measure long term stockholders gains from M & A.
The sample size was composed of 149 mergers among NYSE firms between
1929 and 1969. He concluded that post-merger excess returns were
insignificantly different from zero and provided no support for mergers. The
acquired had an average excess return of 12.9%, while bidders return was
only 6.11%.
Moeller et al. (2004) examined a sample of 12,023 US acquisitions by public
firms between 1980 and 2001 over the event window of three days (-1, +1).
They found a link between firm size and acquisition announcement returns.
It proved that when corporations make an acquisition announcement, small
firms obtain more benefits than larger ones. In more detail, the abnormal
return associated with acquisition announcements for small firm is higher
than that for large ones by 2.24 percentage points, whereas this finding is
not true for acquisitions of public firms paid for by stock; and large
companies suffer shareholder wealth losses regardless of the payment of
acquisition.
Based on a study of 947 acquisitions during 1970-1989 in the US, Loughran
& Vijh (1997) found a relationship among the post-acquisition returns and
the mode of acquisition and form of payment. Acquirers obtain negative
excess returns of -25.0 percent when they complete M & A by stock during
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a five-year period following the acquisition, whereas acquirers obtain
positive excess returns of 61.7% when they complete M & A by cash.
Furthermore, the overall wealth gains of target shareholders from stock
mergers by combing the pre-acquisition and post-acquisition returns were
investigated. In the finance literature, it has been generally accepted that
target shareholders get benefits from all types of acquisitions. However, this
paper questiones this opinion and supportes that target shareholders who
sell out soon after the acquisition effective date gain from all acquisitions,
those who hold on to the acquirers stock received as payment find their
gains diminish over time (Loughran & Vijh, 1997, p.1789).
Most previous researchers investigated share price performance of
acquiring firms after M & A by using single factor benchmarks, while Franks
et al. (1991) are the first to use multifactor benchmarks from the portfolio
evaluation literature to do the same research, in that multifactor
benchmarks can get rid of some drawbacks, such as mean-variance, of
single factor benchmarks. As a result, based on a sample size of 399 US
takeovers between 1975 and 1981, Franks et al. (1991) conclude that target
firm shareholders had much higher cumulative abnormal returns (28.04%)
than shareholders of acquiring firms (-1.45%) over the event window6 of
(-5,5). Therefore, it seems that the poor performance following M & A may
be due to benchmark error, rather than the wrong evaluation for a target at
the announcement time of M & A.
To sum up, Based on short term stock performance, target firm shareholders
obtain significant, positive abnormal returns, while acquiring firm
shareholders earn zero or negative abnormal returns and the combined
entity seems to be slightly better off and create shareholders value. From
6 The event window is defined as the period over which the security prices of the firms involved in the event will be examined (MacKinlay, 1997, p.14).
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the perspective of long term stock performance, abnormal returns are still
negative or zero for acquiring firm shareholders and they underperformed
their non-acquiring peers three to five years after M & A. However, this
underperformance has been attributed to the smallest acquirers (Bouwman
et al., 2003).
2.2.3 Empirical Evidence Based on Clinical Studies
Clinical studies originated from anthropology, sociology and clinical methods
in the 1920s, and a clinical study is also called a case study, which is an in-
depth study by one person through field interviews with executives and
knowledgeable observers and is a form of qualitative descriptive research
(Bruner, 2002). The purpose of a case study is to seek the patterns and
causes of an activity by analyzing the history and nearly every aspect of a
case. In addition, it is observed that case studies are usually subjective
(Wagner, n.d.).
There are many case studies to discover the motives and measure effects of
motives in post M & A performance. A typical example can be referred to the
case study by Lys and Vincent (1995)s work about the AT&Ts acquisition of
NCR Corporation in 1991. This is the largest computer industry acquisition.
The profitability of AT&T after acquisition was decreased by between $3.9
billion and $6.5 billion and resulted in negative synergies of $1.3 to $3.0
billion. Therefore, one can conclude that this result is consistent with
Dickerson (1997), Firth (1980), Caves (1989)s findings.
2.2.4 Empirical Evidence Based on Surveys of Executives Studies
Surveys of executives present one study based on questions put to
executives by means of a standardized questionnaire, such as simply asking
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managers the motives of M & A or whether M & A create or destroy value for
shareholders. Then the post-merger performance can be inferred from the
questionnaire (Bruner, 2002).
One example of survey of executive studies is Ingham et al. (1992), who
surveyed 146 of UKs top 500 companies during the period from 1984-1988
on the basis of a questionnaire. However, with regard to whether the
profitability of acquiring firms increased following M & A, this study got
different findings. From the point short-term (0-3years), 77% of managers
claimed that short term profitability increased after M & A, whereas in the
long-term (over 3 years), 68% of managers indicated the profitability
increased. However, one problem should be realized in this survey. The
samples in this study involved the acquisition of private companies; while
the previous finance literature mainly concentrates on studying public
companies M & A.
Conclusion
Given the empirical evidence, it can be seen that the post- M & A
performance, just as Bouwman et al. (2003) concludes that, it depends on
various factors, such as the valuation methods (using short term or long
term stock performance or accounting methods), the investigated entity
(acquired, target or the combined firm), the type of M & A (friendly or
hostile), the method of payment (cash or stock or mixed), the type of target
(public, private or subsidiary). Generally speaking, M & A increase
shareholders value for the target company, whereas they decrease
shareholders value for the acquiring company or the newly combined
company.
However, one problem should be noted that all of the above empirical
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evidence, which uses accounting studies, is limited to evaluate one or two
aspects of financial performance, such as ROA, profit, or sales. This is
obviously not enough, because as stated earlier, the changes of net income,
profit margin, growth rates, return on equity (ROE), return on asset (ROA)
and liquidity of the firm are the focus of accounting studies (Bruner, 2002).
Therefore, in this dissertation, in chapter four-analysis and results, all of the
financial information will be analyzed in case analyses.
Finally, each approach has its own strengths and weaknesses as follows:
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Table 2: Comparisons among each research approach
Strengths
Weaknesses
Event studies
A direct measure of value created for investors A forward-looking measure of value creation. In theory stock prices are the present value of expected future cash flow.
Requires significant assumptions about the functioning of markets: efficiency, rationality, and absence of restrictions on arbitrage. Research suggests that for most stocks these are not unreasonable assumptions, on average and over the time.
Vulnerable to confounding events, which could skew the return for specific companies at specific events. Care by the researcher and law and large numbers deal with this.
Accounting Studies
Credibility: statements have been certified and accounts have been audited.
Used by investors in judging performance. An indirect measure of economic value creation.
Possibly non-comparable data for different years. Companies may change their reporting practices. Reporting principles and regulations change over time.
Backward looking. Ignores values of intangible
assets. Sensitive to inflation and deflation
because of historic cost approach. Possibly inadequate disclosure by
companies. Great latitude in reporting financial results.
Differences among companies in the accounting policies add noise.
Differences in accounting principles from one country to the next make cross-country comparison difficult.
Survey of Managers
Yields insights into value creation that may not be known in the stock market
Benefits from the intimate familiarity with the actual success of the acquisition
Gives the perspectives of managers who may or may not be shareholders, and whose estimates of value creation may or may not be focused on economic value.
Recall of historical results can be hazy, or worse, slanted to present results in the best light.
Typically surveys have a low rate of participation (2-10%) that makes them vulnerable to criticisms of generalizability.
Case studies
Objectivity and depth in reconstructing an actual experience.
Inductive research. Ideal for discovering new patterns and behaviours.
Iii-suited to hypothesis testing because the small number of observations limits the researchers ability to generalize from the cases
the research reports can be idiosyncratic making it difficult for the reader to abstract larger implications from one or several reports.
Source: Does M & A Pay? A survey of evidence for the decision maker (Bruner, 2002, p.16).
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Chapter 3 Research Methodology- an Accounting Study
As stated earlier, although there are four approaches to measure the
profitability for M & A, due to the limitations of this studythis dissertation
advances an accounting study research methodology to study the effects of
M & A on companies financial performance.
3.1 Overview of an Accounting Study Research Methodology
An accounting study 7 , which is based on the valuation of operating
performance improvements, provides an additional insight into the effects of
M & A especially for the situation when share price data is not available for
researchers. Furthermore, it directly provides the impact of M & A on the
acquiring and the acquired firm or the combined firms costs, revenues,
profits, cash flows etc. Therefore, an accounting study has become a
significant financial analysis tool in evaluating the financial performance of M
& A.
To begin with, I will overview each companys financial highlights, balance
sheet, loss and profit account in companies annual reports. From the
financial highlights and balance sheet, I will select the key figures such as
current assets, inventories, current liabilities, total assets and equity. The
important figures such as net profit, operating profit, gross profit,
turnover/revenue, and cost of sales can be obtained from profit and loss
account. The reason of choosing these key figures is that these accounting
data is necessary for calculating financial ratios which include profitability
ratios (i.e. net profit margin, gross profit margin, return on asset and return
on equity), liquidity ratios (i.e. current ratio and liquid ratio), activity ratios
7 The definition and explanation of an accounting study can refer to the effects of the motives in M & A- empirical evidence based on accounting studies in chapter three.
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(i.e. total assets turnover and inventory turnover) and key growth rates (i.e.
turnover, turnover rates and operating profit). Different financial ratios are
used to assess various aspects of the companys financial performance and
have diverse meanings.
Table 3: Formulas of Key Financial Ratios
Turnover
Changes in Turnover
Key Growth Rates
Net Profit
Net profit margin=net profit after tax / sales
Gross profit margin= gross profit /sales or =
sales less cost of sales / sales
Return on assets (ROA) = net profit before
interest/ total assets
Profitability
Ratios
Return on equity (ROE) = net profit after tax /
equity
Current ratio = current assets / current
liabilities
Liquidity ratios
Quick ratio = current assets- inventories/
current liabilities
Total asset turnover = sales / total assets
Activity ratios Inventory turnover = cost of sales / inventories
Source: Global financial accounting and reporting Walton & Aerts (2006,
p.237)
Profitability ratios are usually used to measure the companys
performance, because profitability is a major measurement of the overall
success of a company and obtaining a satisfactory profit is the significant
goal of each company.
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According to Walton & Aerts (2006), it is necessary to use margin ratios for
trend analysis and comparisons among companies. Gross profit margin
analyzes the companys operating profitability and operating efficiency.
Moreover, it shows managers ability of controlling manufacturing or
purchasing costs.
The net profit margin mainly measures the companys overall profitability
and is also referred to as return on sales. It is usually compared among
companies in the same industry or among different years to show that how
successful the management is in creating profit from a given quantity of
sales (Walton & Aerts, 2006).
ROA measures the efficiency of companies. This means it reflects how much
the company has earned on all assets. The ratio of ROE measured how
much the company has earned on the shareholders funds. It reflects the
perspective of shareholders and is also used to compare profitability among
diverse companies or from one year to another year (Walton & Aerts, 2006).
Liquidity ratios usually include current ratio and quick ratio. Current ratio
and quick ratio measure the short term liquidity problem, which is resulted
from a situation when current cash inflows do not match current cash
outflows. For example, the cash receipts from sales are unequal to the cash
payment to suppliers, employee etc. In the calculation of quick ratio, it
excludes inventory on the basis, because actually inventory is the least
liquid current asset and should not be contained in the category of quick
maturity to cash (Walton & Aerts, 2006).
Activity ratios mainly measure how efficiently the management uses the
companys assets. Total asset turnover presents how efficiently a company
utilize its total asset. Because of this characteristic, total asset turnover is
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also used to compare among different companies based on the same
industry or compare from one year to another. Inventory turnover refers to
not only the operating efficiency but also liquidity needs, so this ratio
indicates how efficient the working capital management is (Walton & Aerts,
2006).
Secondly, the major point is the changes of ratios from one year to another
or the comparisons among various companies, because absolute ratios do
not have any meanings.
Lastly, in order to control firm-specific, industry-specific and economic-wide
factors that might pose impact on the measurement of companies
profitability, the changes in profitability for the acquiring company will be
compared with its benchmark group8, which are usually the acquiring firms
top competitors on the basis of similar size and in the same industry through
similar measurement. In this dissertation, the benchmark group is
composed of the acquiring companys top two competitors. This step mainly
involves the financial ratio analysis, which is one of the important tools of
financial analysis and it can provide the easiest comparisons among
companies. Furthermore, the selected benchmark group neither made large
acquisition nor were acquired during the observation period.
3.2 Data Source
The database of this dissertation is mainly from companies annual reports
including balance sheet, profit and loss account, income statement and cash
flow statement, which are available at companies websites. The reason of
choosing these statements is that they can provide a snapshot of a firms
8 Since the target companies are most often de-listed after M & A, the post-merger, long-term data are available only for the acquirers (Sudarsanam, 1995).
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financial position and performance. The annual reports of the Mannesmann
Company are obtained by email contacting the companys top manager.
Besides, some relevant data and information are collected from online
publication, such as proxy statements, financial journals and research
papers.
3.3 Limitations of this study
Since the accounting data and the key information of each company in this
dissertation are secondary source, there maybe a possibility that the data in
annual reports might have a little bias due to the potential creative
accounting techniques9. The disadvantages of accounting studies in detail
can refer to the end of chapter two. On the other hand, even though this
dissertation analyzes the key financial ratios, there is still a possibility that
some other financial aspects that are not analyzed thoroughly. Therefore,
due to the limitations, it is appropriate for further research to compare the
results of accounting studies with those of other studies, such as event
studies, survey studies or clinical studies, because different approaches may
get diverse conclusions about the effects of M & A. For example, clinical
studies attempt to identify the organizational mechanisms and management
practices that might affect changes in productivity and performance (Kaplan
et al., 1997), whereas in accounting studies those factors are not examined.
9 Creative accounting techniques imply that companies published accounts may not be a true and fair reflection of the companies financial position (Dickerson et al., 1997, p.347).
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Chapter 4 Case studies Analysis
In order to check the results of literature review, in this chapter, two cases
that have completed M & A in 2000, namely Vodafones acquisition of
Mannesmann AG and the merger between AOL (American On Line) and Time
Warner, will be analyzed so as to investigate what motives drive these two M
& A and the effects of these activities by studying the post- M & A
performance. The reasons of choosing these two cases are as follows:
Vodafones acquisition of Mannesmann AG is the largest cross-border
acquisition in Europe on record at the beginning of the 21st century and the
merger between AOL and Time Warner showed a combination of a new
economy company and an old economy company (Weston et al., 2004,
p.20). More importantly, in order to analyze the long-term company
performance after M & A, the cases that took place in 2000 are selected.
4.1 Overview of Vodafones acquisition of Mannesmann AG
At the beginning of the 21st century, the largest cross-border hostile
acquisition in the telecommunications industry happened due to the
increased liberalization, competition and a relaxation in regulatory regimes
in many countries.
On 13 November 1999, Vodafone, as the worlds biggest mobile phone
company, launched the biggest hostile acquisition to its German rival-
Mannesmann AG, which was the Europes biggest mobile phone company. It
was also the first hostile takeover for a German company by a foreign
country (BBC, 1999). On 11 February 2000, Vodafone was finally in charge
of Mannesmann AG successfully and it cost $203 billion. Meanwhile, this is
the largest cross-border acquisition in Europe on record. Subsequent to the
acquisition, Vodafone successfully acquired two of Europes most important
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markets, Germany and Italy (Vodafone annual reports), the new company
had 42 million customers and Mannesmann AG still headquartered in
Dusseldorf, but it was delisted from Frankfurt's Xetra Dax share index (BBC,
2000).
After paying $203 billion for Mannesmann AG by stock, the total value of the
Vodafone Company on the stock market worth $365bn. As a result,
Vodafone becomes the largest company on the London stock market and the
fourth largest in the world. Just as one Vodafone spokesman said "we were
two strong businesses and together we can go from strength to
strength"(BBC, February, 2000).
4.1.1 The historical development of Vodafone and Mannesmann AG
4.1.1.1 Historical development of Vodafone
Vodafone was founded in 1984 as a subsidiary of Racal Electronics Plc. In
September 1991, it was fully demerged from Racal Electronics Plc and
became an independent company, and then its name was reverted to
Vodafone Group Plc. On 29 June 1999, the name was changed to Vodafone
AirTouch Plc because of the merger between Vodafone and Air Touch
Communication Inc., whereas the name was changed back as Vodafone
Group Plc on 28 July 2000. Vodafone undertakes its businesses in two ways.
On one hand, it uses fixed line broadband services like DSL (Digital
Subscriber Line). On the other hand, it is doing business wirelessly through
3G and HSDPA (High-Speed Download Packet Access). The Company's
ordinary shares are listed on the London Stock Exchange. On 30 June 2007,
it had 232 million customers and on 3 July 2007 it had a total market
capitalization of approximately 88 billion (www.vodafone.com).
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Vodafone, nowadays, is the world's leading mobile telecommunications
company, with a significant presence in Europe, the Middle East, Africa, Asia
Pacific and the United States through the Company's subsidiary
undertakings, joint ventures, associated undertakings and investments
(www.vodafone.com).
4.1.1.2 Historical development of Mannesmann AG
Mannesmann AG, one of Germanys oldest industrial concerns, was founded
in 1885 by the brothers Reinhard and Max Mannesmann because of their
invention of cross-rolling process, so it was originally formed to produce
seamless steel tubes. After Second World War, it was diversified to develop
hydraulics. At the beginning of the 1980s, Mannesmann had the opportunity
to access to the developing electronic markets. Since then, the company
began to develop telecommunications service sector and in 1990 it further
had the license to construct and to operate the private D2 cellular telephone
network, which was the largest mobile phone service in Germany. In order
to concentrate on developing telecommunications, the company sold off
traditional business steel tube production, and spent US$42 billion on
telecom acquisitions. In 1999, Mannesmann acquired the Orange Company
and its sales reached as high as 23.27 billion at the same time. As a result,
Mannesmann AG became a leading German telecom provider. However,
Vodafone Group plc successfully acquired 99 percent of Mannesmann AG in
February 2000 (St. James Press, 2001).
Nowadays, Mannesmann AG has become a public subsidiary of the Vodafone
Company, which is doing businesses in 25 countries on five continents (St.
James Press, 2001).
4.1.2 The motives of Vodafones acquisition of Mannesmann AG
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Firstly, with the rapid growth of telecommunications sector in early 2000,
Vodafone seek to increase market share across domestic country. Since
Vodafone had a low market share in Europe at that time, so its first target
was the European market. Consequently, it acquired a Germany company
Mannesmann AG, because Germany has the lowest penetration rate, huge
potential users and revenue growth in Europe at that time, and the most
important reason is that Mannesmann AG already had a great market share
in Europe (Byles, 2006). Secondly, the achievement of economies of scale is
also the motive of Vodafones acquisition of Mannesmann AG, because the
major goal of Vodafone is to maintain a competitive advantage as a low cost
and technological leader in the telecommunication market through the
achievement of economies of scale. This motive can be achieved by
technological complementary that the combination of fixed-line phone and
mobile phone, and existing customer relationship management between the
two companies (Vodafone annual reports). Furthermore, the revenue
synergy motive of Vodafones acquisition of Mannesmann AG can be
indicated by the low switching cost due to the low product differentiation
between the two mobile phone operators. In addition, the financial
resources, organizational resources and human resources of Vodafone
stimulate itself to seek one target to achieve that goal (Vodafone annual
reports). Finally, the diversification purpose can be reached by the
acquisition if Vodafone takes advantage of the fixed line capabilities of
Mannesmann AG (Byles, 2006). And the diversification purpose may
contribute to Vodafones economies of scope by sharing activities and
transferring core competencies. The geographic diversity and a strong
financial base also stimulate Vodafone to seek new development
opportunities, such as mergers and acquisitions (Vodafone annual reports).
The competition between the two companies is also eliminated to a certain
extent.
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4.1.3 Consequences of Vodafones acquisition of Mannesmann AG
post-merger and acquisition: Financial Performance
Figure 1: Key figures and ratios of Mannesmann AG from 1998-2000 (in million) 1998 1999 2000 Sales 13,666 14,110 13,597 Net profit 384,913 1,057,235 11,291,424 Changes in sales n/a 3.25% -3.64% Gross profit 3,158 4,246 4,334 Equity 5,417,074 22,448,748 35,233,738 Total asset 9,330,979 47,724,088 60,437,499 Retained earnings 239,195 528,618 5,645,712 Gross profit margin 23% 30.1% 31.9% ROE 71% 4.7% 32% ROA 1012% 4.67% 21.20% Total asset turnover 000146 0.000296 0.000225 Source: complied from Mannesmann AGs annual reports from 1998-2000
After analyzing the key figures of Mannesmann AG from 1998 (see figure 1),
it can be concluded that there was no increasing trend for its sales from
1998 (13,666mn) to 2000 (13,597mn). However, two other key figures
increased significantly before Vodafones acquisition. The net profit of
Mannesmann AG showed that the company has been performing
consistently well in the period before the acquisition. From net profit of
384,913mn in 1998, it increased steadily to 11,291,424mn in 2000. Thus
there was a consistent trend for retained earnings, which significantly
increased 5,406,517mn from 239,195mn in 1998 to 5,645,712mn in
2000. The substantial increased net profit is due to Mannesmann AGs
acquisition of the British telecommunications company Orange Plc at the end
of 1999, but in May 2000, Mannesmann AG sold Orange to France telecom.
These transactions largely increased Mannesmanns liquidity and
contributed to further growth and further improvement of strong market
position (Mannesmann AG Annual Reports).
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With regard to key financial ratios, gross profit margin showed an increasing
trend from 23% in 1998 to 31.9% in 2000. ROE almost increased
significantly to 32% as much as five times from 1998 to 2000, although it
decreased about 3% in 1999. This is the same situation to ROA. However,
total asset turnover declined substantially. This means Mannesmann AG
operated its profitability efficiently and managers effectively controlled the
companys purchasing costs, which can be inferred from gross profit margin,
ROA and ROE. This also implied that the company was making profit on the
total asset and shareholders equity before Vodafones acquisition.
To sum up, Mannesmann AG had a good financial position before Vodafones
acquisition in 2000. The year 2000 was a significant milestone for the future
development of Mannesmann AG. Nowadays, the development of Vodafone
determines the financial position of Mannesmann AG- as a business
segment of Vodafone.
Figure 2: Key figures and ratios of Vodafone from 1996-2000(in million) 1996 1997 1998 1999 2000
Turnover 1,402 1,749 2,471 3,360 7,873
Net profit 309.8 363.8 418.8 436.7 487
Equity 1022 770 282.5 814.6 140,833
Operating Profit
465.8 529.6 686.4 847 981
Gross Profit n/a n/a n/a 1,551 3,514
EPS (basic) 10.15p 11.89p 13.63p 20.61p 4.71p
Dividend per share
4.01p 4.81p 5.53p 6.36p 1.33p
Current asset
n/a 495.2 590.8 791.5 2517
Total asset 1572.1 1926.6 1911.5 2852.1 150,851
Current liability
n/a 1013.2 1426.4 1530 4441
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Net profit margin
22.1% 20.8% 16.95% 13% 6.19%
Gross profit margin
n/a n/a n/a 46.16% 44.63%
ROE 30.31% 47.3% 48.6% 53.61% -0.35%
ROA 29.63% 27.49% 35.91% 29.7% 0.65%
Total asset turnover
089 091 129 118 005
Current ratio n/a 0.49 0.41 0.52 0.57
Quick ratio n/a 0.47 0.39 0.49 0.52
Source: Complied from Vodafones annual reports from 1996-2000
The turnover figure of Vodafone showed that the company has been
performing consistently well in the period before the acquisition (see figure
2). From turnover 1,402mn in 1996, it increased steadily to 7,873mn in
2000. This increase included a full years turnover from the acquisition in
January 1999 when Vodafone and AirTouch had agreed to join forces to
create the worlds largest mobile telecommunications group. The turnover
increased at an average of 59%