January 12, 2010

Why Do Firms Merge

Introduction

Every business is built on the prayer of growth and expansion. We all have this bias that the bigger the firm is, the more successful it is. Though this may not always be true (Breene & Nunes, 2004), nevertheless every businessman dreams of creating the "big" business. One of the maxims of business analysis is that all industries consolidate as they mature, and that those companies that scale up inevitably win big. By extension, in the era of globalization, those who can scale up definitely win big. This is why many business thinkers still believe that making it "big" is the end all and be all of all business strategy.

Growth through diversification can be achieved in two ways, either by internal, natural expansion or external by acquiring, consolidating with, or merging other firms. A merger is loosely defined as an absorption of one company by another company, including all its assets and liabilities. In effect the combination creates a new corporation; the acquiring firm retains its identity, while the acquired firm ceases to exist. Merged firms are typically rather complex organizations. Accordingly, merger has a more profound effect on the structure of a market than simply reducing the number of competitors (Huck, Konrad & Müller,2001).

Why do Firms Merge?

There is what business analysts called a special alchemy to the concept of merger. And the equation is perplexing, yet simple. One plus one makes three. The key principle behind buying or absorption of a company by another company is to create a shareholder value over and above that of the sum of the two individual company's shareholder value. Two companies together are more valuable than two separate companies; at least that's the reasoning behind mergers and acquisition.

One of the most common arguments for mergers and acquisitions is the belief that "synergies" exist, allowing the two companies to work more efficiently together than either would separately. Such synergies may result from the firms' combined ability to exploit economies of scale, eliminate duplicated functions, share managerial expertise, and raise larger amounts of capital (Ravenscraft and Scherer 1987).

A merger between two firms is also advantageous to the newly formed corporation borne out of merger for it reduces market share competition and costs (Salant, et. al, 1983). By merging, one natural competitor was eliminated in the process. Merger also reduces total costs for the newly formed corporation by implementing a combined effort such as using one set of marketing efforts to the same target market and sharing "best practices", which will enable the new combined business to operate more efficiently than either the two of former firms separately (Farrell and Shapiro, 1990).

In some cases, firms may derive tax advantages from a merger. Merger and acquisitions can either be tax free or taxable event depending on the situation of the merger. In a taxable acquisition, the assets of the selling firm are revalued, by doping so, depreciation deduction will rise. But the selling shareholders will have to pay capital gains taxes and thus will want more for their shares to compensate. This is known as the capital gains effect. The capital gains and write-up effects tend to cancel each other out (Auerbach, 1988).

Some exchanges of stock are regarded tax-free reorganizations, which allow the owners of one company to exchange their shares for the stock of the acquirer without paying taxes. There are three basic types of tax-free reorganizations. Type A reorganization transaction allows the buyer to use its voting and non-voting stocks. It also allows the buyer to use more cash, however at least 50 percent of the consideration must use stock in the acquiring corporation. In addition, in type A reorganization, the acquiring corporation may choose not to purchase all the target's assets. Type B reorganization transaction requires that the acquiring corporation use primarily its own voting common stock as the condition for purchase of the target corporation's common stock. Cash must comprise no more than 20 percent of the total consideration, and at least 80 percent of the target's stock must be paid for by voting stock by the bidder. Stocks acquired are not taxed; taxes would only be paid if these stocks are sold. In type C reorganization, the acquiring corporation must purchase 80 percent of the fair market value of the target's assets. Tax liability only occurs when the acquiring corporation uses other consideration such as cash to purchase assets other than stocks.

The Merger of Casino and Hotel Giants (Harrah's and Caesar's)

 

'Horizontal' mergers, a merger between companies operating at the same level of production in the same industry, may also be motivated by a desire for greater market power. Such as what happened when Harrah-Caesar's deal was inked. That acquisition deal was advertised all over the Las Vegas strip as the largest gaming industry merger ever which would create a gaming giant with a total of 28 hotel-casinos with annual revenues of $6.9 billion and cash flow of $2.1 billion. The merger of Harrah's and Caesars eclipsed the MGM Mirage-Mandalay combination with a total of 53 properties, annual revenues of $9.4 billion and cash flow of $2.3 billion.

The merger of Harrah's and Caesars is part of a wave of consolidation in the casino industry (Mowbray, 2005). The trend originated with the deal between Boyd Gaming Corp. and Coast Casinos Inc. and the merger of MGM Mirage and Mandalay Resort Group. The deal will make new career opportunities for casino workers, who will soon work for one of the largest employers in the region, with about 16,900 employees in Louisiana and Mississippi. Northrop Grumman Ship Systems, by comparison, has about 20,000 employees in the two states. It will put new pressure on more small-scale casino operators in the area to perfect their strategies or merge with other companies. In all likelihood, it will result in new names for various local casinos. And it is expected to create new consciousness of New Orleans and the Mississippi Gulf Coast as a single vacation destination region for national visitors (Mowbray, 2005).

Analysts believe that the prime mover behind the merger was the case of trying to "keep up with the Joneses". With the recently inked $7.9 billion merger agreement between MGM Mirage and Mandalay Resort Group creating the dominant Strip operator, Harrah's outs are fewer. That leaves Caesars Entertainment, with such Strip properties as Caesars Palace, Paris, Bally's, and Flamingo. Harrah is known for having the most cash flow and Caesar's for having the most revenue (Smith, 2004).

 With the merger, Brokopp, the CEO of Harrah's expressed that the merger was the realization of Harrah's desire in wanting a stronger Las Vegas Strip presence. "In this way, as a stated goal, we can now export Harrah's gamers from around the country to the Strip", he added. 

References:

Auerbauch, Alan J., and Reishus, David (1988), "The Impact of Taxation on    Mergers and Acquisitions". In Mergers and  Acquisitions, edited by        Alan J. Auerbauch. University of Chicago  Press.

Ravenscraft, David J. & Scherer, F.M. (1987), Mergers, Sell-offs and  Economic Efficiency. Washington, DC: The Brookings Institution.

Smith, R. (2004) Merger Agreement: Caesars Accept Buyout Offer. Las         Vegas Review-Journal. Vol. 2 p 9.

Shapiro, C. & Farrell, J. (1990). "Scale Economies and Synergies in   Horizontal       Merger Analysis," Competition Policy Center, Working          Paper Series CPC00-015, Competition Policy Center, Institute for            Business and Economic Research, UC Berkeley.

Salant, S., Switzer, S.,& Reynolds, R. (1983) Losses from Horizontal   Merger: The Effects of an Exogenous Change in Industry    Structure on Cournot-Nash Equilibrium. Quarterly Journal of     Economics, Vol. 98, No. 2, pp.  185-199

Huck, S., Konrad, K., & Muller, W. (2001) Merger and collusion in         Contests.        Published in Journal of Institutional and theoretical   Economics, 158 (4)  pp 563-575.

Nunes, P., & Breene, T. (2004). Selling to the Moneyed Masses.          Harvard          Business Review. 13.

Mowbray, R. (2005) Michael Pollock Gaming Observer: What's Making the                News. From the Internet http://www.gamingobserver.com. February 23,     2006.

 


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