Chapter 2 Literature Review
2.1 The Concept of Merger
The determinants of merger and acquisition behavior have long been a topic of interest to researchers. Epstein (2004) provide that merger defines as a business activity involves two entities of relatively comparable stature coming together and taking the best of each company to form a completely new organization.
Mergers are often categorized as horizontal, vertical or conglomerate mergers. Gaugham (2007) provide the brief definition of the three type of merger. Two competitors combination is called horizontal merger. Vertical mergers are the combinations of companies which exist with a buyer-seller relationship; A conglomerate occurs when two combined companies are not competitors and without a buyer-seller relationship.
2.2 The Motives of Merger
In order to achieve an ideal position for the organization's business, company may decide to undertake merger activities. There are probably many different motivations for merger as involving bidders and targets.
Trautwein (1990) offers several theories of merger motives including efficiency, monopoly, raider, valuation, process, empire-building and disturbance theory. Ikeda and Doi (1983) point out that company take advantage of merger activities to increasing market share or market power, increasing efficiency, firm growth and increase of research and development all are the merger motives.
Lam and Chiu (2005) suggest that objectives for merger are diverse, including fillings critical capability gaps, achieving synergies and economic of scale, acquisition of tax losses and tending off an income trust structure and replacement of management. However, corporate takeovers and acquisitions give rise to vastly differing attitudes between the parties (Gerold 1989). Both parties are seeking to promote, or perhaps one of the companies wish to receive a friendly rescue for the financial difficulties situation.
Other than the above motivations, several empirical studies provide support to the synergy as a key merger motives. For example, Leland (2007) points out that the both positive and negative operational synergies are the primary motives for restructuring the company. Bradley et al. (1988) mention that a successful tender offer will increase the combined value of the target and acquiring firms by an average 7.4%. Berkovitch and Narayanan (1993) document that synergy is the primary motive in takeovers with positive total gains Mukherjee et al. (2004) suggest that a premium to the target firm is justified if the merger produces synergistic benefits. It will be detail discussed in the session of Literature Review.
Furthermore, Sun and Tang (2000) create the support for two firms merged in the same line of business is for the purpose of achieving economies of scale in production, distribution, or some other phases of their operation. (The detail of economies of scale will have a further discuss)
2.2.1 Economies of scale
Economy of scale is a practical concept that refers to the reduction in fixed cost per unit resulting from increased production through the operational efficiencies. (Dranove and shanley 2005) Applying to the merger aspect that is combined company can often reduce its fixed costs of the production by simplifying complicated departments or operations. Thus, profit margins are increased. Kasman (2005) mention that lower the costs proportionally by changing the production output can result to economies of scale.
Some scholars view economies of scale as one of the main motives of merger and have formed comment on the circumstances. Rezitis (2008) suggest that the occurrence of the economies of scale is due to the control of cost-saving technologies has been achieve or the fixed cost regarding to a large volume of output has been spread by the merged company and thereby average cost reduced and efficiency enhanced. Dranove and shanley (2005) point out that strategic rationale for the merger activities include economies of scale and scope which can be achieved by shifting the production to a centralized facility or investing the resources necessary to build sufficient capacity.
Goold and Campbell (1998) report six forms of synergy including shared know-how, shared tangible resources, pooled negotiation power, coordinated strategies, vertical integration and combined business creation. Anderson (1987) defines that synergy can represent the nature of the successful acquisition game, which violating the laws of mathematics and causing one plus one to equal three. (i.e. 1+1=3) Synergy is also defined as increases in competitiveness and resulting cash flows beyond what the two companies are expected to accomplish independently (Sirower 1997).
126.96.36.199 Generation of synergy
The theory of synergistic merger is meaning company can achieve efficiency gain by combining the good business or plants of the acquired firms with their own business or plants. It was discovered that synergies may arise from a variety of sources and denote the incremental positive and negative cash flow consequences of being merged (Fulghieri and Hodrick 2006).
Srinivasan and Mishra (2007) point out that synergy is created when the merged firm's value is worth more than the firm individual existing. Three main categories are classified as operational synergy, financial synergy and managerial synergy. Operational synergy is generated by the combination of operation separate units. The lower cost of capital cause financial synergy appears. Managerial synergy occurs when the superior planning and monitoring of the acquiring and target firm are the complementary abilities.
There are several research discussed the way of synergy generation. Maldonado (2002) indicates that operational synergies or technical economies constitute synergies are cost of production related and arise from the sharing between activities of lumpy or intangible multi-use assets. Sun and Tang (2000) mentions that one means of achieving operation synergy is to combine two firms having complementary resources to eliminate duplicate facilities, operations or departments. Beside, Rezitis (2007) point out that the attainment of the operational synergies via mergers and acquisitions depends on the realization of economies of scale and scope. Also, the generation of financial synergy is discussed. Fluck and Lynch (1999) note that financial synergy may occur when mergers increase the combined values of acquirers and targets by financing positive NPV projects that cannot be financed as stand-alones.
Gaughan (2007) develop the process of realizing synergistic gains. Achieving synergistic gains should begin with careful strategic planning. (Refer to the figure 1) If the merger planning has been well thought, there is a better chance to being successful. After that, it is necessary to integrate the two merged business. Aware of the cultural, operational and strategic difference is required. Lastly, the synergy gain is realized according to the analysis of financial performance, which may be broken down enhancements may come from the broader product line. Cost reduction is due to the elimination of duplicate costs on the merged companies.
188.8.131.52 Evaluation of synergy
In order to have a successful merger, company should consist of business talent that you can cause the predicted synergy to be realized (Anderson 1987). Thus, evaluation of synergy plays a significant role for the merger success. No trial can be found in merger and acquisition is the main reason for the company to evaluating of synergy (Kode et al. 2003). It was found that there are some literatures give opinion about the synergy evaluation.
Fulghieri and Hodrick (2006) mention that both positive and negative synergies can be evaluated by the incremental expected joint production which merged firm generated. In addition, high quality evaluation of acquisition candidates is an essential element of success which leading synergistic gain (Anderson 1987). A variety of techniques for valuing companies such as discounted cash flow, price/earnings multiple and earnings dilution are suggested by him.
Gupta and Gerchak (2002) suggest the determination of whether or not a merger is an economic success, valuation is the major focus. The purpose of valuation is helping bidders to gain a better understanding of key drivers of operational synergy. The comparable companies or transactions approach and the discounted cash flow approach are proposed.
2.3 The impacts of merger
Company carry out merger activities may generate positive impact or negative impact as well as the neutral result. The following provide some example which select from diverse literatures and relate to the evaluation of merger impact.
2.3.1 Positive impact
A number of articles have studied and measured the benefit of M&A and found that the advantages focus mainly to the area of the shareholder value, business competitiveness and productivity.
By using the transitional and new market-model measures, mergers in general are a means to permanent gains in the wealth position of the stockholders of acquiring and acquired firm (Lubatkin 1987). However, the changes in stockholder value are associated with the type of merger. Nguyen and Ollinger (2006) state that most merged firms can improve their productivity growth after merger. The productivity of about 85% of the acquired plants grew faster than the productivity of nonacquired plants. Also, mergers can produce the serious anticompetitive consequence. The reason is if a merger is likely to have efficiency and market-power consequences, the response of downstream firms will represent the anticipated net effect of these consequences on product market prices (Mullin et al. 1995).
The more the successful of the merger activities, the more the positive impacts are produced. Epstein (2005) point out the mainly reason for the successful merger is the merger strategy. The careful development and implementation of merger strategy can significantly increase the likelihood of overall merger success through.
2.3.2 Negative impact
If the merger activities unsuccessfully carried out, some harm will cause to the difference aspect of the company's business practices. The most common one is the effect of financial aspect. Maldonado (2002) has performed the investigation about whether merger and acquisitions result in improved financial performance. It was found that mergers did not have a positive effect on financial performance since the efficiency and pricing have not been improved. Hoshino (1982) point out that adverse effects are caused by mergers. There are is no evidence that merged firms have a higher growth ratio than the firm without merger which can enjoy a higher rate of growth of equity in long run.
Apart from the financial aspect, ethical aspects are also subject to discuss. Syrjala and Takala (2007) study on corporate merger and focus on the ethical aspects in the Nordic Electro-business industry. They show that the merger process will lead to decreased responsibility among the organizational members, which due to the inconsistency between genuine ethical thinking and executive talk. The moral attitudes of the managers will be influenced in the turmoil of organizational change because of the new operating model and new corporate management.
For the part of effects on the stakeholder, Tuch and O'Sullivan (2007) failed to find consistent evidence of improvements in shareholder wealth after the volume of merger and acquisition activity and thereby management is troublesome and raises important questions about the wisdom of takeover activity.
Epstein (2005) outlines six key determinants of merger success namely strategic vision and fit, deal structure, due diligence, premerger planning, post merger integration and external factor. The lack of clarity regarding the elements of merger success and implementation will lead to measurement problem and mergers desirable or of dubious value.
2.3.3 Impact on both Positive and Negative
The effects of merger not only positive but also negative may be generated. There are some literatures show merger are able to generate positive and negative at the same time.
Corlton et al. (1980) state that merger activities will be a great benefit for product improvement to the company. In the meantime, the adverse competitive effects of the merger also caused since the potential competition is likely to issue in merger case only if the market is defined. Otherwise, there is no significance to assign the elimination of the potential entrant by the merger.
Dickerson et al. (1997) disclose the relative advantages and disadvantages of acquisitions growth for the company performance. Here are the three advantages provided. The first one is the returns from the acquisition are likely to materialize quickly. Secondly, acquisition can provide a firm with new internal investment opportunities by facilitating entrance into new product areas and by providing new information in those areas. The ability to remove the potential competitor is the last advantage. However, there are also three disadvantages are mentioned. Since the firm purchases an already existing company, it may not get exactly what it prefers. The second disadvantage of acquisition is that the acquired firm might have its own set of problems. Thirdly, it is difficult for integrating it with the existing organizational structure of the acquirer.
2.4 Evaluation approach for merger performance
Numerous empirical studies have investigated the evaluation approach for merger performance such as financial performance, operating performance, marketing performance and managerial performance etc.
2.4.1 Financial ratio
Sun and Tang (2000) have carried out the examination on the operating performance of merged railroad, which based on financial measures that are related to a firm's efficiency performance. They are operating income to operating revenues (operating margin) and net income to operating revenues (net margin). Ikea and Doi (1983) discuss various financial aspects for measures of merger performance such as profitability, rate of firm growth, R & D expenses, selling, general and administrative expenses/sales etc.
In addition, the financial performances of the acquiring firms during pre and post merger periods have been analyzed with the help of various financial ratios (Vanitha and Selvam 2007). Liquidity ratios, leverage ratios and profitability ratios are the three selected to test the results. Liquidity ratios indicate the company's ability to meet all its obligations both long-term as well as short term without strain. The leverage is for measuring the ability of a company to use funds to enhance the returns to its investors. Profitability ratios are calculated to measure the overall efficiency of an organization (Vanitha and Selvam 2007). Hoshino (1982) also mentions that the performances of corporate mergers, before and after the merger, can be compared on the basis of the financial data. Financial ratio should be performed such as net worth to total liabilities and assets, current ratio, debt-equity ratio, turnover ratio and net profit to total liabilities and assets etc.
For the aspect of comparison, Sun and Tang (2000) suggest that the post-merger performance is compared with pre-merger performance. It will assist to determine whether changes in firm condition following announcements of mergers tend to indicate deterioration or improvement of performance.
2.4.2 SWOT Analysis
Houben et al. (1999) state that SWOT analysis is an effective means for analyzing internal and external environments in order to attain systematic approaches and supports for successful industry strategy formulation. Global competitive and its competitive strategy are largely influenced by changes in both internal and external environments of the machine tool industry since it is aimed at establishing a profitable and sustainable position. Therefore, analyzing the competitive environment in detail and strengthening the competitive advantages have become necessities for establishment of a successful strategy (Shinno et al. 2006).
2.4.3 Value Creation
Baker (1992) addresses that company can create value in several ways with its dairy acquisitions program such as increasing the economies of scale in production. Gerold (1989) mention that in general the valuations provided will be on an open market value basis, which is defined as the best price at which an interest in a property might reasonably expected to be sold at the date of the valuation.
Tuch and O'Sullivan (2007) point out that merger create the impact of the market value of acquirers on post acquisition performance and the market value of acquirers can be measured by Price Earning Ratio. The higher the P/E ratio, the higher valuation cause on the stock market.
2.5 Real Practice of Merger Cases in Hong Kong
The trend of mergers and acquisitions in Hong Kong become active since 1980s. It is one of the popular methods for the company restructuring (Lang 1999). Deacons (2006) also mention that the Hong Kong has experienced an increase in merger and acquisition activity over the past decade. This situation is now continue since the overseas companies are willing to invest in Hong Kong as which is well established with the main financial and services hub for the PRC's economic development and the economy of which has undergone substantial recovery since the post-1997 deflationary era. It is known that Hong Kong has a long history of mergers. Both successful and failure merger cases in Hong Kong and are selected for discussion (Lang 1999).
Hong Kong and Shanghai Banjing Corporation (HSBC) and Midland Bank case is one of the most successful overseas acquisitions by a Hong Kong company. The unique feature of this case is that while the HSBC shareholders were pessimistic in the beginning, they completely changed their view towards the completion of this event. It indicated Hong Kong market is efficiency in that the corporate announcement effect is consistent with the performance of HSBC after the acquisition of Midland Bank (Lang 1999)
Swilynn and Teletech case occurred in 1990, which involve two medium-sized Hong Kong firms was overlooked by people; however, it represents the fiercest fight between bidder and target. Emotional factor is an important element for the suitability of Teletch as a target being questionable at the beginning. Both companies went bankrupt a couple of years after the acquisition.