Question

BURN PLC is a North Sea (UK) oil and gas company listed on the London Stock Exchange and financed by both debt and equity. The market value of the debt on the company’s account is £60 million and the market value of equity is £40 million. Suppose the firm has a market cost of debt of 4%; a market cost of equity of 7%; and that their corporate tax rate is 20%. GREEN PLC is a Brazilian solar energy company, listed on the Brazilian Stock Exchange, also with 60% debt and 40% equity. Suppose GREEN PLC has a market cost of debt of 6%; a market cost of equity of 15%; and that their corporate tax rate is 40%; and that BURN PLC has an equity Beta of 0.8.

1. BURN PLC is considering a merger with GREEN PLC. Assume that BURN PLC is the larger company. From the perspective of BURN PLC, discuss five advantages and disadvantages of the merger

Answer 1

Advantages of the Merger:

1. Related-sector International Diversification - Within the energy business, this merger gives BURN PLC an access to the unconventional (solar) energy sector in an emerging market. One of the most important advantages offered by mergers and acquisitions is related to a wider range of services or products which can be explored. By joining forces, the portfolio of the new business can increase even more and gain access to a larger market share. Burn Plc can reduce cyclical instability in earnings and reduce total risk of the firm.

2. Financial Synergy (Lower Financing Cost) - The borrowing costs are usually lower for the merged firm. When two firms merge, the combined company can borrow at lower interest rates than either firm could separately. This happens because now the two firms guarantee each other's.

BURN PLC	Value
Market value of the debt	60
Cost of Debt	4%
Tax rate	20%
Market value of equity	40
Cost of Equity	7%
Cost of Capital	4.72%

GREEN PLC
Market value of the debt	60
Cost of Debt	6%
Tax rate	40%
Market value of equity	40
Cost of Equity	15%
Cost of Capital	8.16%

Both the firms can retire their existing debts and issue new debt securities in the UK market (cheaper source of debt funding). This will result in economies of scale in issuing new securities, as well as there is a lower cost of debt.

3. Complementary Resources - The two firms have complementary capabilities (one in conventional Oil & Gas energy market, the other is in unconventional solar energy segment). The merger or acquisition will save time and money spent on starting the solar energy business from scratch for BURN PLC.

4. Eliminating Inefficiencies - Green Plc may be inefficiently managed, with the result that profitability is lower than it could be. To the extent that the acquirer can provide better management, an acquisition could make sense. The idea is that the external financial markets discipline management.

5. Tax advantages - Mergers and acquisitions can come with various tax advantages. Many governments offer tax cuts or reductions when a merger or acquisition is completed. In the case of a tax-loss carryforward, a company with cumulative tax losses may have little prospect of earning enough in the future to fully utilize its tax-loss carryforward. By merging with a profitable company, it may be possible for the surviving company to utilize the carryforward more effectively.

Disadvantages of the merger:

1. Investors can diversify themselves - The argument that the investors evaluate risk solely in relation to the total risk of the firm may be flawed. Diversification is much easier and cheaper for the stockholder than for the corporation. Particularly when the stock of the company is publicly traded, there is no reason to believe that investors are not able to diversify their portfolios efficiently.

2. Wealth Transfers - There may be wealth transfers from equity holders to debt holders via diversification when merger occurs. To the extent the combination lowers the relative variability of cash flows, debt holders benefit from having a more creditworthy claim. As a result, the market value of their claim should increase and the equity holders will lose value to debt holders.

3. Clash of Cultures - When two firms merge, it is more than a coming together of two names or brands – it is a real merger of people who bring along a specific corporate culture. If two firms have very different corporate cultures, conflicts can arise.

4. Management's personal agenda - Sometimes the management acquires company because management pursues personal as opposed to corporate wealth-maximizing goals. Management chases growth. Being larger bring in prestige for the management, their jobs are also more secure with risk spread out among unrelated businesses.

5. Acquisition Premium - The biggest disadvantage of mergers and acquisitions is the price at which these deals happen because there is no standardized or uniform way in which one can find out the right price as each company is unique and different from others which make calculation of right price a tricky one and chances of company overpricing the merger and acquisition deal are always there and since these decisions are irreversible in nature it can lead to problems for the company in future.