Mergers are undertaken if it is believed two or more companies which are merging will be greater together than sum of its parts. The math of a merger is “1+1=3” or “2+2=5”. Specific motives for mergers for strategic and financial reasons include the following:
Tax advantages – Tax advantages in mergers will differ from one location to another. In US it can be utilized if the acquiring firm or target company has a tax loss carry-forward. Tax loss carry-forward refers to the ability to deduct past losses from the taxable income. This advantage is available in mergers but not for holding companies. To decrease the attractiveness of this motive, the US and many other countries limit the amount of tax loss carry-forward that can be deducted annually from the taxable income of merged companies.
For example, assume the acquiring company is a profitable company and the target company is a loss maker which incurred losses in the past two years. When the merger is completed, the operating results of a merged company, which probably will have the identity of the acquiring company, will be reported on a consolidated basis.
This means the acquiring company will be able to deduct past losses of the target company from the consolidated taxable income, within limits. Merged firms will continue deducting the tax loss carry-forward (within limits) until it is recovered completely over a duration of up to 20 years.
Increases liquidity for owners – If the acquiring firm is a large company and target company is a small organization then the target company’s shareholders may find it very appealing that after merger their shares’ liquidity and marketability will likely be considerably better.
Gaining access to funds – The acquiring company may have high financial leverage (a lot of debt) thereby making access to additional external debt financing very limited. Therefore, one of the motives of the acquiring company to undertake the merger is to merge with a company which has a healthy liquidity position with low or non-existent financial leverage (very little or no debt).
Growth – This is one of the most common motives for mergers. It may be cheaper and less risky for the acquiring company to merge with another provider in a similar line of business than to expand operations internally. It is also much faster to grow by acquisition.
Sometimes an organization may have a window of opportunity that will be closing fast and the only way the organization can take advantage of this opportunity is by acquiring a company with competencies and resources necessary to take advantage of the opportunity. Additional benefits of growth motivated mergers are that a competitor or potential future competitor is eliminated.
Diversification – Diversification is an external growth strategy and sometimes serves as a motive for a merger. For example, if an organization operates in a volatile industry, it may decide to undertake a merger to hedge itself against fluctuations in its own market. Another example can be when an acquiring company pursues a target company which is located in different state or country. This is called a geographical diversification.
Related diversification seems to have a better track record. It refers to expanding in the current market or entering new markets and adding related new products and services to the product or service line of the acquiring company.
Diversification usually does not deliver value to the shareholders because they can diversify their portfolio on their own at much lower cost. Therefore, diversification on its own is unlikely to be sufficient motive for a merger.
Synergistic benefits – Synergy occurs when the whole is greater than sum of its parts. For example, in terms of math it could be represented as “1+1=3” or as “2+2=5”. Within the context of mergers, synergy means the performance of firms after a merger (in certain areas and overall) will be better than the sum of their performances before the merger. For example, a larger merged company may be able to order larger quantities from suppliers and obtain greater discounts due to the size of the order.
In the context of mergers, there can be two types of synergy. The first type of synergy results in economies of scale, which refers to decreased costs. Another type of synergyresults in increased revenues such as cross-selling.
As per the above, economies of scale are derived from synergy. For example, merging businesses in the same business line will allow elimination of some of the duplicated overhead costs. A new business will not need two human resources and public relations departments. Instead, the best employees will be kept and the rest of personnel and unused office space will be reallocated or no longer used.
Cross-selling is another benefit derived from synergy. If some of the products and services of merged companies differ then cross-selling those products and services to the other firm’s customer base can be a cost effective way to increase sales. Being able to effectively meet more of the customers’ needs may also increase customer loyalty due to higher customer satisfaction which can occur by effectively providing customers with a broader spectrum of products and services which meet customers’ needs.
Synergy benefits with regard to an increase in revenue are usually more difficult to achieve than synergy benefits with regard to decreasing costs. Management also needs to be careful to ensure that potential synergy benefits are not overestimated as this may result in overpayment for the target company.
Protection against a hostile takeover – Defensive acquisition is one of the hostile takeover defense strategies that may be undertaken by target of the hostile takeover to make itself less attractive to the acquiring company. In such a situation, the target company will acquire another company as a defensive acquisition and finance such an acquisition through adding substantial debt. Due to the increased debt of the target company, the acquiring company, which planned the hostile takeover, will likely lose interest in acquiring the now highly leveraged target company. Before a defensive acquisition is undertaken, it is important to make sure that such action is better for shareholders’ wealth than a merger with the acquiring company which started off the whole process by proposing a hostile takeover.
Acquisition of required managerial skills, assets or technology – The target company may have managerial skills, assets and/or technology that the acquiring company needs to improve its performance, profits, revenue, cut costs, reduce productivity etc. This can become a motive for merger.
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