Question

Discuss the motives for business combinations?

Answer 1

Answer

Definition:

Business combination is defined as a merger of two or more companies for mutual benefits and to join business operations. There are different reasons for different companies to join hands -some form combinations for cutting down their expenses while some want to broaden their range of products and services. There are also companies which want to beat their competitors by making alliances.

Motives behind business combinations:

The following are the motivations behind any business combinations that occurs between the companies:

SYNERGIES

This is the most common reason for a business combinations. It is expected that when two companies merge to form a new bigger company, the value of the new entity will be more than the combined value of two separate companies. Generally, there are two types of synergies that are aimed for:

COST SYNERGIES

Synergies that reduce costs through the economies of scale in various divisions of the company, viz. research and development, procurement, sales and marketing, manufacturing, distribution and general administration.

REVENUE SYNERGIES

Synergies that increase the overall revenue through expanded markets, products cross-selling and an increase in prices.

RAPID GROWTH

Generally, any company has two options to grow, viz. organic growth and external growth. Organic growth is achieved by an increase in sales by making internal investments. External growth is achieved by an increase in sales by buying external resources through mergers and acquisitions. Often, companies prefer to grow externally, especially the ones in a mature industry as the industry offers limited opportunities for growth. It is less risky to have external growth.

MARKET POWER

A horizontal merger in a small industry will definitely help in increasing the market share. An increased market share will, in turn, give the power to influence prices. In fact, monopoly is an extreme example of a horizontal merger. A vertical merger can also increase the market power by reducing the dependence on external suppliers.

UNIQUE CAPABILITIES

Not every company can have all the resources or strengths required for a successful growth. There will come a time when the company wants to acquire the competencies and resources that it lacks. This can easily be done through mergers and acquisitions in a very cost-effective way as compared to developing the capabilities internally.

DIVERSIFICATION

Diversification of the company’s total cash flows is a reason argued by managers for the mergers. However, shareholders are not convinced by this reason as they can easily diversify their investments themselves at the portfolio level. This is cheaper and less painful than the company going through the process of merging with another company to achieve synergies created by diversification.

BOOTSTRAPPING EPS

A merger deal might have a bootstrapping effect on the company’s EPS. This occurs when the acquiring company’s shares are trading at a higher P/E ratio than the P/E of the target company and the P/E does not decrease even after the merger. Such an effect increases the current EPS of the company at the expense of decreased future EPS and decreased growth prospects.

PERSONAL INCENTIVES FOR MANAGERS

The executives of a company might want the business combinations to satisfy their personal goals rather than maximize the shareholder value. A post-merger bigger company translates into more prestige and greater power for them. Even the compensation increases in a bigger company. Thus, the managers will prefer the merger to increase the size of their company.

TAX ISSUES

A company with a large taxable income will look at merging with a company with large carry forwards tax losses. By doing so, the acquiring company can lower the tax liability. A merger purely for reducing tax liabilities will not be approved by regulators, however, companies can hide this reason under other strong motivations to merge.

UNLOCKING HIDDEN VALUE

A struggling company may be bought by an acquirer to unlock its hidden value. The acquiring company may believe that by making some improvements in management and organizational structure and adding more resources, it can make the company perform better. Of course, the acquirer will pay a lower price than the market price.

INTERNATIONAL GOALS

International mergers and acquisitions have become more common and important in today’s business world. Like with mergers in one’s own country, these international deals are also motivated by the above-mentioned reasons.

• Unique products can be marketed in new markets.
• Transfer of technology to new markets.
• Exploiting market inefficiencies.
• Overcoming disadvantageous policies of the government.
• Continued support to international clients.