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P.V. Viswanath
Growth
A reason that is often given for an acquisition is growth. However, there is no clear evidence that growth through acquisitions is necessarily value-increasing. In fact, mergers based on the need for growth often end up being undone, later. The size of the firm that maximizes firm value isnt necessarily the size that maximizes CEO compensation. There is some evidence that CEO compensation is increasing in firm size; further CEO compensation is greater for multi-division firms.
P.V. Viswanath
theyd want to reduce the probability of bankruptcy keeping the firm alive can be often inconsistent with taking risks and maximizing firm value. Returning money to shareholders can certainly reduce the probability of a manager being able to collect long-term promised payoffs, such as pensions, etc. A manager with fixed claims on the firm is like a writer of a put; since the value of an option is increasing in volatility, its optimal for the manager to try and reduce firm return volatility by keeping firm risk low.
P.V. Viswanath
More on growth
The market rewards growth. The standard formula for firm value is P = CF1/(r-g). The higher the value of g, the higher is P! However, this has to be growth in CF, i.e. in cash flows, not in revenues or in assets alone. Organic growth, that is growth through internal expansion and internal investment can also be mere growth in revenues. This can happen if the firm objective is to maximize revenues or market share or size instead of profits. However, this is gradual and there is usually time for the CEO, the board and the shareholders to reconsider.
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Inorganic Growth
The other kind of growth is inorganic growth growth through mergers and expansion. In this case, the firm is buying cashflows in return for compensation. In any acquisition, there will be growth in assets and growth in revenues, as well as (presumably), growth in cashflows. The question is what is the purchase price? If the acquisition is a negative NPV deal, the acquisition is bad. Sometimes acquisitions can be used to generate growth because the nature of the industry is such that there are no opportunities for organic growth. In such a case, an acquisition can simply be an acknowledgement of the lack of growth. If this is news to the market, the share price will drop. P.V. Viswanath 5
Synergy
Another reason often given for a merger is the exploitation of synergies. Net Acquisition Value of a merger = VAB (VA+VB) (Acquisition Expenses) If VAB > (VA+VB), there is synergy. Broadly speaking, there are cost synergies and revenue synergies. Cost synergies are often referred to as operating synergies.
P.V. Viswanath
Operating Synergies
Economies of Scale: as output levels rise, per-unit costs decline. This is called spreading overhead. Gains result from increased specialization of labor and management, as well as the more efficient use of capital equipment, which is not possible at low output levels. However, after a given point, there are diseconomies of scale problems of coordinating a larger-scale operation. Example is the cruise industry -- ability to leverage national television, radio and print advertising campaigns. In the banking industry, there is evidence that mergers work better when there is a geographical overlap between the areas of operation of the two merging banks.
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Revenue Synergies
http://www.businessweek.com/magazine/content/04_10/b3873078_mz017.htm
The ink was barely dry on Northrop Grumman Corp.'s (NOC) December, 2002, acquisition of TRW Inc. when the company began marshaling its newly acquired troops for their first big campaign. The target was an eight-year contract to build the Pentagon's new Kinetic Energy Interceptor, a Star Wars-like antimissile system that aims to destroy enemy rockets shortly after takeoff. Separately, Northrop and TRW had both passed on the project, thinking they couldn't compete head to head with missile-defense leaders Boeing Co. (BA ) and Lockheed Martin Corp. (LMT).
P.V. Viswanath
Revenue Synergies
That changed with the merger. Northrop put together a team of people from six of its seven divisions, including specialists in defense electronics, information technology, satellites, and shipbuilding. A former TRW office in Virginia was put in command of the project, and reinforcements were sent from across the country. The effort paid off: Northrop scored a surprise victory, winning the $4.5 billion contract last December and vaulting the company past its own sales targets.
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Access to resources
In some industries, there are huge capital demands, which are difficult to undertake for small firms. The pharmaceutical industry and the water utilities industries are cases in point. Example: McCaw Cellular and AT&T. Question: if the projects are worthwhile, why not just go to the capital markets for funds? Information Asymmetry Cost of accessing capital markets
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Access to Resources
In Craig McCaw, AT&T gets one of the leading visionaries of a future teeming with untethered, low-cost communication and service platforms, ranging from pocket phones to personal electronic gadgets. Combined with Bell Labs (which invented cellular) and AT&T's financial resources (which help neutralize the almost $5 billion of debt McCaw generated to fund its expansion), McCaw may be able to bring his vision to market far sooner than he could have otherwise. Alone, McCaw faced constant trade-offs: Should he invest in more capacity in metropolitan areas, in broader geographic coverage (including overseas), in new digital technology or in wireless data? Each represents a lucrative market. Now he can go after them all.
http://www.findarticles.com/p/articles/mi_m0REL/is_n11_v92/ai_13218026
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SWOT Analysis
What are the resources of the firm? How can the firm use these resources to generate capabilities?
Capabilities integrate resources to reach an objective e.g. to produce custom-designed furniture, a firm must integrate across marketing, design, purchasing, manufacturing, and finance.
Core competencies are strategic capabilities those skills and activities that translate resources into special advantage for the firm e.g. Home Depot has a strategic capability in site location and store openings. Competitive advantage is sustainable, if competitors cannot or will not try to duplicate it.
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Regulatory restrictions (e.g. banking license), brand names (e.g. Xerox, McDonalds can develop customer loyalty; hard to develop and/or imitate) patents (illegal to exploit without ownership; e.g. new drugs cf. also RIM) and unique know-how (e.g. WalMarts hot docking technique of logistics management) Accumulated experience (cf. learning curve)
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Powerful customers can influence prices and product quality. Examples are WalMart (consumer goods) and the US government (US defense industry) If customers are weak, suppliers can keep prices rising, e.g. in filmed entertainment, cigarettes and education.
Powerful suppliers can extract high prices from firms. In contrast, in the 1990s, weak suppliers allowed auto manufacturers to extract price concession. Substitutes limit the pricing power of competitors in an industry. The price of coal for electric power generators is influenced by the price of oil and natural gas.
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Supplier Power
Threat of Substitutes
new product or new process innovation, opening new channels of distribution and entry into new geographic markets
Cartels keep competition low Predatory pricing can keep profits variable and low. Rivalry is sharper where
players are similar in size, the barriers to exit from an industry are high, fixed costs are high, growth is slow, and products/ services are not differentiated.
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horizontal mergers can increase market share Targets with new products or new processes vertically merging downward to obtain new channels of distribution Merging with targets that permit entry into new geographic markets
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Acquire targets in the substitutes industry Acquire targets with R&D to counter the attractiveness of substitutes
For example, a coal producer could integrate vertically and acquire an electricity producer.
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