Since the beginning of the era of globalisation, there have been significant changes in managerial decisions in local and multinational companies. This is due to the expansion of capital and labor markets throughout the world and a massive increase in the number of rivals which force companies to enhance their core competencies. Acquisitions which can be defined as acquiring corporate control of another firm that is called "The target company" is one of the various methods that enables businesses to enhance their value by exploiting economy of scale and synergy, and acquiring market power of corporate amalgamations. Additionally, takeovers may possibly be either hostile or friendly depending on the negotiation between the acquirer and the target company [Pike and Neal, 2006]. However, acquisitions have a variety of dimensions in different models; they tend to have highly uncertain outcomes which can cause financial distress for corporates. Thereby, businesses must be concerned with regulations and factors such as bidding processes and due diligence that have influences on business practices. This project will identify the effects of acquisitions on multinational companies and refer to a case study of business combinations.
Scope
The framework of this project is an evaluation of the impacts of takeover on business value and shareholder wealth throughout multinational companies by proving three related hypothesis. Firstly, acquisitions can enrich shareholder wealth and enhance business value. Moreover, acquisitions can contribute to economic benefits. Finally, acquisitions might deteriorate business performances.
Methodology
Related journals, articles and textbooks will be explored and studied intensively. This leads to correct perceptions in order to evaluate the impacts of acquisition on multinational companies. Specifically, this project is integrated with empirical evidence by providing statistical data and presenting a case study which includes supplemental comments and recommendations.
Fundamental background of acquisitions
Type of acquisitions
Vertical integration
Vertical integration can be defined as a merger of two companies in the same industry but at different stages of production. Normally, this can be classified into two sub-types which include forward integration and backward integration depending on acquisition occurring in upstream or downstream business [Evans, 2000]. This is beneficial for companies because this allows them to acquire market power and to reduce operational costs. Consequently, business performance might be increased after acquisitions. To illustrate, Merck, a large manufacturer of pharmaceuticals, combined with Medco, a large distributor of pharmaceuticals, in order to take an advantage of the distribution its products. Presently, Merck & Co also which is known as Merck Sharp and Dohme is one of the largest pharmaceutical companies in the world.
Horizontal integration
Horizontal combination involves with joining of two companies that run their businesses in the same industries and product lines [Pike and Neale, 2006]. Horizontal mergers are designed to produce substantial economies of scale and scope and to decrease in the number of competitors in the industry. The best illustration is a merger of multinational oil and gas companies between Exxon and Mobil in 1999. This merger enables ExxonMobil to become a leading petroleum company. Additionally, Fortune magazine, annual rankings of the world largest corporations in 2010, reports that ExxonMobil ranked third in the world with its revenue of $284,650 million. However, a horizontal integration can deteriorate economic systems. Specifically, owing to an increase in economies of scale, it enables firms to take an advantage of cost-efficiency by offering better prices to customers than rivals. Hence, competitors might lose their market power and be excluded from the market.
Conglomeration
Conglomeration can be fundamentally described in terms of an amalgamation of two firms in unrelated businesses such as a gas pipeline company merging with a financial service firm [Pike and Neal, 2006]. This type of business combinations is beneficial for businesses in mature stages of industry life cycle to adopt as a method to stabilize a massive fluctuation in earnings and to obtain the long term growth in business performances. Commonly, corporates performing in mature stages of industry lifecycles which include highly competitive in costs and incremental rivals try to diversify their businesses through acquisitions. For example, General Electric (GE) has diversified its businesses through acquisitions by combining with new sectors such as Genworth Financial (international financial services) and National Broadcasting Company (NBC) (television broadcasting).
Motives for acquisitions
Risk diversifications
Risk diversifications are one of the various motives for acquisitions which can be adopted in order to mitigate agency problems in terms of employment risks. This is due to the fact that corporates have a chance to confront unforeseen circumstances that might contribute to financial distress such as occurrences of bankruptcy. The subsequent consequence is that employees might lose their current positions. Thus, acquisitions may reduce these risk factors by diversifying endogenous risk (i.e. internal risk: operational risk) factors to other businesses.
"Managers can therefore be expected to diversify this employment risk by other means, such as engaging their firms in conglomerate mergers, which generally stabilize the income stream and may even be used to avoid the disastrous effects bankruptcy has on managers and employees" [Amihud and Lev, 1981].
However, this motive is not persuasive factors for shareholders because they cannot gain more profits from this motive. Levy and Sarnat [1970, as cited in Amihud and Lev, 1981] state that in perfect capital markets, which investors can transfer and proportion their investments independently. It can be concluded that shareholders can manage their portfolios by allocating their investment to other businesses in order to balance their risk instead of weighted risk in one business.
Acquiring undervalue firms
Typically, maximization of shareholder wealth is the main objective of businesses. Acquisitions are one of the various approaches which can be applied to enrich shareholder value. Specifically, acquirers purchase undervalued firms on the market in order to gain profits from a gap between intrinsic value and market value. Nonetheless, Damodaran [2002] states that bidder companies should be skeptic about a validity of acquisition prices. In reality, asymmetric information also exists in financial market. It leads to occurrences of moral hazard in organisations. To illustrate, upper managers can make profits by transferring prospective agreements of acquisitions to ordinary investors. After financial markets perceive this information, it can be reflected via stock prices to be increased. Obviously, acquisition prices also rise in the same direction as stock prices. The consequences of this are that bidding companies have to spend a large sum of money in order to acquire target businesses than they expect. Therefore, acquirers might confront multitude negative outcome such as a lack of financial liquidity which is a major reason of bankruptcy.
Increases in economic values
In the new global business world, technological advancement plays a crucial role in improving productivity and in accelerating an increase in the volume of competition in the market. Corporate amalgamation may enable firms to improve a quality of products and to maximize utilisation of resources in order to increase their competitive advantages. Moreover, Damodaran [2002] states that combined companies can generate synergetic benefits which allow firms to create more wealth to shareholders. Thus, synergetic benefits can be divided into two sub-types:
Operating Synergy
Operating synergies enable businesses to raise their earnings and growth. This may be represented in terms of obtaining economies of scale, acquiring market power, strengthening core competencies [Damodaran, 2002; Pike and Neale, 2006]. This can be concluded that exploiting synergies may contribute to cost-efficient production that enables amalgamated firms to trade goods or services at a lower price than their rivals. Consequently, operating profit and growth of businesses including enterprise values might increase.
Financial synergy
"With financial synergies, the payoff can take the form of either higher cash flows or a lower cost of capital (discount rate)" [Damodaran, 2002]. Normally, financial synergies may provide a vast amount of advantages to businesses in several aspects such as an increase in debt capacities. This is due to the fact that combined companies can generate more stable and predictable incomes and cash flows. Hence, this may increase the level of confidences in financial statements in order to convince financial institutions or shareholders to finance more funding.
The impact of acquisitions on business performance
Acquisitions are one of the most popular restructuring approaches that companies adopt to improve their performance by providing economic benefits such as operating and financing synergies, economies of scale and expansions of market power. Specifically, operating cash flow, stock prices and non-cash benefits are normally increased after acquisition. However, business performance can be evaluated by these factors:
Incremental operating cash flow
"Through time, firms have also acquired or merged with other firms to gain the benefits of synergy, in the form of either higher growth or lower costs" [Damodaran, 2002]. This leads to an increase in revenues and profits in post-acquisition period. Consequently, it impacts on operating cash flow to change in the same direction. Nonetheless, a change in operating cash flow arises from several factors including changes in operating and investment policies.
Changes in operation
Combined businesses may increase their core competencies by generating synergies. Specifically, costs of production might decrease significantly since firms can reduce overlapping expenses such as a decline in a number of workers in the same functions. Evidently, according to figure 1, operating profit of ExxonMobil increased dramatically by 91.18 percent after Exxon combined its business with Mobil at the end of 1999. It is interesting to note that companies can increase sale growth and raising more profits from acquiring more market share and maximize utilisation of resources from acquiring synergies. Therefore, this can be assumed that acquisition can enhance business performance.
Additionally, Healy, Palepu and Ruback [1992] study on the impacts of acquisitions on business performance throughout the largest 50 merged firms during the period 1979 to 1983. This research cites that merged firms can increase their asset productivities more than industry counterparts. Thereby, it can be implied that combined companies might increase their sales more than competitors in the same industry.
Changes in investment policy
Investment policies are one of the crucial factors that enable businesses to enhance their cash flow. Specifically, asset disposal is formulated as an approach in order to increase asset turnover. Thus, merged firms can capture synergies and make a vast amount of profits through selling redundant assets or assets with low turnover.
Nonetheless, a study by Healy, Palepu and Ruback [1992] shows that an increase in asset divestiture after acquisition cannot improve operating cash flow. Obviously, a volume of sold assets in post-acquisition is insignificant amount relative to market value since these assets are devalued by depreciation expenses. Thus, it seems to be true that asset disposal cannot enhance their cash flow.
Tax benefits
Tax benefits can be categorized as one part of financial synergies which can be caused by either taking an advantage of tax laws or using net operating losses to shelter net incomes. Obviously, prestigious firms that acquire underperforming firms are able to use the net operating losses of target companies to reduce their tax expenses.
On the other hand, some amalgamated companies cannot utilise tax benefits by absorbing losses from one business with the operating profits of the remaining firms. Additionally, a study by Berger and Ofek [1994] shows that tax benefits of merged businesses are only 0.1% relative to total sales which cannot absorb net loss of underperforming segments.
Alternatively, acquirers can exploit benefits from assets of target companies to increase more depreciation expenses in order to lessen their tax charges. Traditionally, businesses record depreciation expenses as a group of costs for income statements. Specifically, businesses are allowed to qualify cost of depreciable assets in terms of tax deduction. Hence, combined businesses can qualify more depreciation expenses in order to lower their annual tax charges.
Increasing in earnings per share (EPS)
Most shareholders are commonly concerned about impacts of acquisitions on their wealth. Specifically, earnings per share (EPS) which can be categorized as one of the financial indicators are used to measure business performance. This is due to the fact that EPS can evaluate profitability of businesses on one share. Thus, EPS are adopted as a parameter for corporates to formulate future schemes and for shareholders to evaluate their wealth.
Merged companies can gain benefits by combining resources that enable these firms to raise their incomes. This results in an increase in EPS value. Evidently, it can be clearly seen in figure 1 that EPS values doubled after occurrences of acquisitions (i.e. during 1999 and 2000). Additionally, shareholders can exploit their benefits in terms of dividends. According to figure 2, there was a gradual increase in annual dividend payment along last two decades. In addition, it is interesting to note that a gap of long-term shareholder return between ExxonMobil and S&P 500 widened more than other periods. Consequently, it can be assumed that ExxonMobil can exploit benefits from acquisitions and then make much more profit than other firms in the S&P 500 in the post-acquisition periods.
Conclusion
Acquisitions, undoubtedly, are one of the most popular restructuring methods among multinational corporates. This approach provides a vast amount of advantages to companies and shareholders, yet acquisitions are also controversial issues about their benefits. This is due to the fact that acquisitions have various dimensions of models which can cause negative ramifications to combined firms. Hence, this project aims to evaluate the impacts of acquisition on operating performance and shareholder wealth.
Most merged companies can capture economic values from takeovers by exploiting economies of scale, obtaining synergies and acquiring market power. Specifically, a raise in asset productivity results in a dramatic increase in profits of businesses. Moreover, tax benefit is another factor that contributes to cash flow improvement. Nonetheless, if merged companies should allocate their redundant assets to expand their product lines, it can create efficient use of existing assets. This enables businesses to generate more profits instead of selling their redundant assets. Overall, it can be concluded that amalgamated firms can exploit economic values which lead to an improvement in business performance.
Regarding shareholder wealth, shareholders commonly realize their profits via stock prices. Obviously, stock prices might increase significantly during acquisition announcements since investors revalue the new entities after acquisitions. This contributes to a significant increase in demands for this stock. Hence, shareholders can exploit their profits from a gap between market values and book values through selling their stocks in capital market. Evidently, according to figure 3, there was a dramatic increase in stock prices of ExxonMobil in the period of acquisition announcement by around 23 percent.
However, it is interesting to note that financial distress can be caused by conglomerate acquisitions. The value-destroying arises from a failure in utilising tax benefits in the post-merger. This is due to the fact that tax benefits from business combinations cannot offset operating loss of underperforming target companies.
Although acquisitions can provide various benefits for businesses and shareholders, they may deteriorate to business performances. Specifically, risk diversifications to unrelated businesses might contribute to financial distress since managers are lack of capabilities to control all product lines. Therefore, amalgamated businesses should probe alternative approaches to mitigate these risk factors by combination horizontal integration with conglomeration in order to exploit positive sides of both approaches via capturing synergetic benefits, stabilizing their income including diversifying operational risk to other businesses.
Appendix
Figure 1: ExxonMobil: Key ratio and financial highlight between 1999 and 2000
ExxonMobil
Indicator
Pre-Merger (Year 1999)
Post-Merger (Year 2000)
Different (Percent)
- Total revenue (million USD)
184.80
231.80
- Operating profit (million USD)
20.64
39.46
- Capital expenditure rate
5.9
3.7
- Debt to equity ratio (percent)
27.20
9.00
- EPS
1.19
2.40
Source: ExxonMobil summary annual report 2002 Financial Summary
Figure 2
Source: ExxonMobil summary annual report 2002 Financial Summary
Figure 3: ExxonMobil: Historical stock price data from Nov,1999 to Dec, 1999
Source: Thomson Reuters
