Reasons For The Merging Of Companies Economics Essay

There is no doubt that mergers play a great role in the development of an economy. In this essay, a merger will be defined as “a combination of two corporations in which only one corporation survives and the merged corporation goes out existence” (Gaughan, 2007, p. 12). After a merger, the newly-established company will hold two merged companies’ assets. In this way, mergers offer more chances for companies to become bigger and stronger. At the same time, customers may receive better services than those before a merger. However, the topic of mergers’ motives has long been the subject of debate, as different companies put forward different reasons to merge. Some of them are economically sound, while some of them are not.

In fact, from the current studies, it can be seen that there are two big types of motives, one is economic motives and the other is non-economic motives. Although some people argue that motives of mergers lie in some non-economic reasons, such as the political reasons, the managers’ reasons, and so on, others take a different view and emphasize that because of that the raison d’être of a company is to make profits, most motives of mergers are for sound economic reasons. Thus, this essay is an attempt to argue that the main motives for mergers are economically sound reasons. It also aims to show the importance of different economic motives, even though some people claim that there are many failures that resulted from those motives. In addition, the ineffectiveness of non-economic motives will also be checked to support the main argument.

In order to demonstrate this, this essay will first focus on the growth motive of mergers. The case of P&O and Stena will also be added into the discussion. Second, different types of synergy will be illustrated to explain how valid this motive is to help companies to become stronger. Third, the electronic giant General Electronic (GE) will be given as a good example to discuss the significance of the diversification motive. Fourth, the example of the Exxon-Mobil Oil Company will be used to show some other economic motives. Finally, there will be discussion about some non-economic motives such as power motives, achievement motives, and political motives and so on, though these are some less common motives for mergers.

2.0 Economic Motives

2.1 Faster Growth

If a company seeks to make a merger with other firms, the most popular motive may be growth. As Denzil (2001) points out, one of the most successful types of merger may be a merger with a growth motive, because it is easy and quick to beat competitors and take the lead in markets. When a company wants to expand, there are several choices: internal growth or growth through mergers. Internal growth means companies go to buy land and build more factories, employ new staff, or search for a market to sell products and so on. This is a long way to go. However, if companies use the method of merging, it will save them much time to do other things such as research and development or market promotion. Moreover, through merging, companies may easily occupy the market, enlarge the market share, and beat the competitors (DePamphilis, 2003). If mergers occur in different regions, this means companies are improving its fame and becoming more globalised, this means more customers may know about the company, in other words, more potential benefits will move to the company.

Although there are a great number of obvious benefits that companies will face, others disagree with the motive of growth. In their opinion, growth is a difficult goal to achieve and is not a sound economic reason. As Gaughan (2007) indicates, when a company has already accomplished growth in the past, it is difficult for corporate managers to keep growing.

However, after achieving growth in the past, managers will look for some other ways to keep growing. Among those ways, Mergers could be the fastest and the most efficient way. Companies do not need to take couples of year to build workshop, and recruit new employees. In addition, with less time to spend, growth via mergers can be gain through the lowest-risk way (DePamphilis, 2003, p. 356). Long time means more uncertainties, which are more risks. How to avoid those risks? It is better to spend less time, and complete mergers quickly.

As a good example of growth motive, the case of Johnson & Johnson should be introduced. Johnson & Johnson is one of the biggest manufacturers of health care industry in the world. It was established by Johnson and his two brothers in 1986 in New Jersey of United States. At that time, it was a company which only had fourteen workers. In the early 1920s, with the development of businesses, Johnson & Johnson began to build branches in other places such as America, Europe, Asia and Africa. However, over the period 1995 to 2005, Johnson & Johnson took a series of mergers. Through those mergers, Johnson & Johnson have gained a greatly fast growth. So far, Johnson & Johnson have owned more than 250 subsidiaries in 57 different countries and 115 thousand employees. Its products are available in nearly 175 countries (Stock Johnson & Johnson, 2010). The global revenue of Johnson & Johnson in 2008 was 63.7 billion US dollars (JNJ Income Statement, 2009).

From the example of Johnson & Johnson, we can see, with the development of an increasingly globalized world, growth can be one of the most efficient and fundamental motives of mergers.

2.2 Different Types of Synergy

As another important motive, synergy is the popular choice for companies to make a merger. Synergy means the extra energy or effectiveness that people or businesses create when they combine their efforts. In mergers, according to DePamphilis (2003), synergy refers to corporate combination will produce more profits than that the sum of their separate status. Therefore, synergy is often used to explain the phenomenon of 1+1=3. In mergers, this means the combination of two companies may generate three companies’ effect. Just because of this, many companies try their best to seek the opportunities to combine with other corporations.

If synergy occurs in mergers, it focuses on two sides to raise the profitable ability of companies: revenue enhancements and cost reductions (Gaughan, 2007, p. 133). For example, if Coca Cola make a merger with a fruit producer, as a result, it will save more spending to buy raw material for its soft drinks. This is called cost reductions. When Coca Cola have gained a lower price of raw material, it can reduce some prices of its drinks. In this way, lower price will make a promotion of its drinks. This is named revenue enhancements. Though the actual fact is more complex than this example, the truth is the related theory would be basically the same.

Although synergy has enhanced the profitability from revenues and costs, some people do not agree synergy should be a good economic reason for mergers (Gaughan, 2007). From their point of view, the synergy effect can only be described the mergers of companies in the same industry or seller-buyer relationship, and it is not suitable to other diversified mergers.

In order to respond this, economies of scope should be introduced as a concept that is confused with economies of scale. Economies of scope can be defined as “the ability of a firm to utilize one of set of inputs to provide a broader range of products and services” (Gaughan, 2007, p. 129). If a company is able to utilize its workforce, and facilities, synergy also can be achieved. Most failures of mergers with synergy purpose are because of their leaders’ inefficient management ability and not the motive of synergy.

Several examples of mergers motivated by the pursuit of synergy have achieved the success. After the 1994 merger between Radisson Diamond Cruises and Seven Seas Cruises, the combined cruise lines began to provide cheaper price of beds and itineraries. This is because, as a result of merger, fewer managers will be needed to maintain the relationship with the same district’s travel agencies. Hence, costs reductions are gained. Moreover, with the larger size of company, the fame of company is improving. This enables sales force to make a promotion more easily. As a result, more customers will come to enjoy their trips. Therefore, revenue is enhanced by this way (Gaughan, 2007, pp. 127-128). With motive of synergy, companies are not only able to increase its revenue, but also decline its cost. Thus, we may see how valid the synergy motive is.

2.3 Diversification

When a company has already been the bellwether of one industry, managers of the company may consider some diversified merger to expand its size and make more profits. Diversification provides conditions of expansion by applying companies’ goodwill in former industry to other different product field, and it can also provide conditions of forming scale effect (DePamphilis, 2003, p. 20). Through diversification, it is foreseeable that companies may have the chance to gain significant earnings, because a new industry means a new opportunity. Opportunity should be the best thing for companies’ managers. Another side about diversification, as Gaughan (2007) pointed out, is that companies may obtain continuous competitive advantage. This is because if General Electronic can hardly sell its military products to armies in a peaceful time, but it can also seek profitable opportunities in other field such as insurance, healthcare, plastics, energy, and so on. This is the theory about continuous competitive advantages. As long as a company becomes a diversified one, it will acquire the privilege of enjoying continuous competitive advantage.

Compared with its positives, one accusation for diversification as not a valid economic reason is that there are some potential risks when companies expand into another industry. If companies can’t handle the risks well, it may bring damages to them. A study carried out by Berger and Ofek (1995), using a large sample of firms over the 1986-1991 sample periods, found that diversification caused an average 13% to 15%’s loss of firm value. The study also found that the loss of firm value was less than that of when the diversification occurred, and it was not affected by firm size.

However, some evidence suggest diversification do not directly lessen firm’s value. One finance researcher, Villalonga, believes that the diversification discount is because of incorrect use of data of several researchers (Villalonga, 2004, cited in Gaughan, 2007, p143). As Gaughan (2007) points out:

“The data used by those researchers were artificially restricted by Financial Accounting Standards Board definition of segments as well as requirements that only segments that constitute 10% or more of a company’s business are required to be reported. Using a data source that is not affected by this problem, Villalonga finds a diversification premium, as opposed to a discount” (Gaughan, 2007, p143).

Although there are many companies that have suffered failures at diversification, others argue that they have achieved great success with mergers at diversification. The most successful example is General Electric (GE). Unlike its name, now GE is no longer an electric company. Through a series of mergers at diversification, GE has become a diversified giant with operations insurance, television stations, plastics, medical equipment, and so on. Especially during the 1980s and 1990s, during the fourth merger wave, GE had made a great number of Mergers with various companies, and it has benefited significantly from those combinations (Gaughan, 2007, p. 137).

In short, although mergers with diversification might have potential risks to the newly combined company, more diversified mergers may provide a bigger market for companies to make profits as what GE have gained.

2.4 Other Economic Motives

There are two sound other types of economic motives for mergers: horizontal integration and vertical integration. Generally, in horizontal integration, market power and market share are raised through mergers. While in vertical integration, both merged firms have a buyer-seller relationship, hence, the combination may provide a dependable source of supply and lower costs advantage (Gaughan, 2007, pp. 145-155).

In horizontal integration, market power stands for the leadership of a market (DePamphilis, 2003, p. 69). Sometimes, market power may gain from market share, and it is well-known that market share may easily gain as a consequence of horizontal integration. Once market power is achieved by one company, all the other rivals in the same market will probably be affected. Their pricing strategy, promotion plan, product research and development and so on will probably all follow with the leader of the market. This is similar to the situation of Nokia in the Mobile Phone industry. However, in a vertical integration, both merged companies will benefit from the integration. One company will not worried about the sales of its products, and the other will not be concerned with the source of its raw materials.

However, there has been a debate that both horizontal integration and vertical integration may bring several negatives to the market and consumers. One of the most being criticized is monopoly competition (DePamphilis, 2003, p. 24). After mergers, the power of merged companies will get bigger. Thus, the structure of the industry will tend to monopoly, which means merged companies may beat others using pricing strategy and the public will pay significantly for this.

Although, sometimes, when this situation happens, government will release various policies to prevent this situation from continuing. This is the reason why Coca Cola failed to merge with one of China’s biggest juice companies, Huiyuan Juice Group. In 2009, Coca Cola planed to purchase Huiyuan Juice with 2.4 billion US dollars. This deal was blocked by China’s ministry of commerce with the reason that Coke might abuse its dominant position in China’s soft drinks industry (Sundeep Tucker, 2009). However, most of the time, as long as companies will not affect markets and customers by means of some illegal ways, government won’t stop these mergers.

In fact, the world’s largest Oil Company, Exxon-Mobil Oil Company, comes from a merger. In 1998, there was a megamerger in the Oil industry. Exxon announced its merger with the Mobil Oil Company. At that time, both two companies were the leading companies in the Oil industry. After merging, in order to achieve the synergistic gains, the companies need to successfully integrate its resources. As a result, this merger was extremely successful. Two years later, the combined Exxon-Mobil announced that the merger saved them approximately $4.8 billion which is higher than the estimated $3.8 billion. With successful operation of the following years, in 2006, Exxon-Mobil announced its highest annual profits that the firm’s annual profits in 2005 were $36 billion and its sales were $371 billion. Exxon-Mobil became the largest company in the world (Gaughan, 2007, p. 146).

From the example of Exxon-Mobil and discussion above, we could see that no matter horizontal integration or vertical integration, those economic motives will be beneficial to merged companies. Therefore, these economic motives are the sound motives for mergers.

3.0 Non-economic Motives

There are several non-economic motives which exist in mergers such as power motives, achievement motives, and political motives and so on. Most of the time, these motives only exist in the mind of managers of merged companies. Therefore, it is less sound for researchers to pay attention to them as motives for mergers.

3.1 Power Motives and Achievement Motives

Power motives refer to the peoples’ pursuit of control over others by means of increasing source of power, and this is particularly serious in some top managers in merged companies (Schmalt, 1987, cited in Carsten Lausberg and Teresa Stahl, 2008, p.6). With the possibility of a higher position through mergers, it is no wonder that these managers will often support the proposal of mergers. Usually, after mergers, these newly combined companies will have a bigger size. More workers will add into different teams or departments for mangers to supervise. These things are what the managers seek for. Through this way, they have got a continuous increase of power.

It is common to see that a person will be judged successful or unsuccessful by various criterions. Hence, achievements become the most vital thing for some managers. Since it may be the fastest and most efficient way to enlarge companies’ size and improve companies’ value though mergers, most managers who have the achievement motive will let companies go to merge. Furthermore, merger is a highly complex and energy consuming thing and people will recognize the managers of successful mergers. Therefore, a person with a strong achievement motive will take the risk of pushing companies to merge (Carsten Lausberg and Teresa Stahl, 2008, p.7).

However, the reason why these two motives and motives like that are not main reasons for companies’ mergers is that, in nowadays companies, decisions are made by the whole members of the Board. Any single man could hardly affect the entire Board of directors’ opinions about decisions except for family firms or totally private companies. In addition, according to Gaughan (2007), mergers often take place in companies that have a good corporate governance structure and a clear responsibilities’ right of shareholders, board of directors, board of supervisors, managers. Hence, it is less common to see mergers with these personal motives.

3.2 Political Motives

It is difficult to find one accurate definition for political motives. In general, however, people regards political motive as a motive which aims to serve for politics. Sometimes, politicians need more economic successes to earn more votes. For instance, in order to enable the Chinese people to enjoy more about the telecom service, in 2008 the Chinese government decided to make several mergers among the six largest state-owned telecom companies including China Mobile, China Unicom, China Telecom, China Netcom, China Tietong, and China Satcom (Xinhua News Agency, 2008).

However, it is hard to see mergers with political motives. This is because, primarily, political motives’ mergers often occur in the countries which have a similar political system like China. There are less of them in the world. Secondly, even though this situation happens, the core of a merger with a political motive is also the economic success. Hence, the political motive is, actually, an economic motive.

Non-economic motives can either be some personal motives or the alias of economic motives, thus, they will not be seen as the sound motives.

4.0 Conclusion

In conclusion, this essay has attempted to demonstrate that economic motives are the main reasons for different companies’ mergers. Despite the fact that some people argue that there are some potential risks among these economic reasons, focusing on negatives, the positives of these economic motives stand out. Furthermore, it is also true that various successful examples have shown the importance of these economic motives that have been discussed above. This is why, in recent years, more and more researchers have put their effort to study the topic of M&A. Economic motives are not only the first step of merging, but the root of mergers, although, in the process of a merger, there will a great amount of works to be done in future.

Currently, after the global financial crisis, there is another trend for companies seeking for mergers. How to avoid the potential risks of these economic motives and transfer them to the real profits is an issue that is open to question.