With all of the publicity surrounding company takeovers and companies joining together it is imperative to discuss the topic of whether or not mergers and acquisitions create value.
A merger is the combination of two business entities under common ownership. An acquisition is where a business entity engulfs another and takes ownership and managerial control. Differentiating between these two acts in real life cases has proven to be difficult and it has even been suggested that it is impossible to classify the relationships within the combined entity as a merger or a takeover. Such as the case of Unilever, where they bought a majority stake in a water purification company, Qinyuan. Although Unilever holds the majority stake in the company the chief executive of Qinyuan is keeping his position, which makes it difficult to distinguish whether or not it is a "takeover" or a merger. Therefore, I am going to discuss the value of mergers and acquisitions combined.
Firstly, I think its appropriate to acknowledge the motives behind mergers and acquisitions:
- Synergy - The company will have a greater value combined than separate.
- Market power
- Economies of scale
- Entry to new markets and industries
- Internalisation of transactions - Improving efficiency!
- Tax advantages
- Risk diversification
- Bargain buying
- Inefficient management - The management of the acquiring company is much more capable than that of the "acquiree".
- Undervalued shares
- Managerial motives
- Survival
- Free cash flow
- Third party motives - Advisers, suppliers and customers!
Reflecting some of these motives, according to the The Guardian, Dixons and Carphone Warehouse are discussing a £3.5bn merger. This deal will bring almost all of the above motives, if, of course ,it is a successful merger. They will have great market power, with over 3,000 stores, both companies will be expanding into new markets and industries.
To understand whether or not mergers or acquisitions add value to the entity we must consider different parties within the company. Mainly, stakeholders and managers. The essence of mergers and acquisitions, within capitalism, is too create value for the shareholders of the acquiring firm. However, various studies have examined whether acquisitions create value, and they have found that the target shareholders generally fare pretty well, while most acquisitions fail to create value for the acquirers. This is represented by the share price movement when the acquisition or merger is announced. Studies have concluded that the share price of the target company usually go up substantially, whilst the share price of the bidding company either experiences no increase or a reduction.
Of course the share price after the announcement is short-term and to look at shareholder value we must look at long-term value. A study by Hazelkorn and Zenner found that over the long-term, acquirers tended to slightly outperform their industry peers. They also stated that obviously some acquisitions create great shareholder wealth and others diminish it. It is down to whether or not the acquisition is successful.
For example, the merger of AOL and TimeWarner is probably one of the biggest failures in recent business history. In 2001 the deal was crowned "the deal of the century", in 2002 AOL had 26 million dial up customers and in 2009 it had 5.4 millions. Vast amounts of shareholder wealth was destroyed and the two eventually became separate entities in 2009.
However, in the case of mergers and acquisitions, success can be dependent upon the capabilities of the acquirer. For example, when Jaguar and Land Rover were under the ownership of Ford, up to 2008 they were struggling, and Ford was seeking financial assistance for the two companies and made the decision to sell them. Ford originally paid £1.6bn for Jaguar and £1.7bn for Land Rover in 1989 and 2000 respectively. Ford sold both businesses to Tata Motors for £1.15bn in 2008. Many analysts believed Tata Motors to be "round the twist". They are now eating there words as in 2013 Jaguar Land Rover was estimated to be worth around $16bn! This is down to successful leadership and extremely good decision-making from Tata Motors.
So do mergers and acquisitions create value? This is all down to whether or not they are successful (obviously). How do you generate a successful merger or acquisition? This is down to the capabilities of the leaders and the management. In the case of Ford the acquisitions were diabolical, whereas under Tata Motors, who took a very different approach to the company, it has become a roaring success. The success of mergers and acquisitions is not down to chance, but down to excellent decision-making!
Firstly, what is foreign direct investment (FDI)?
It is the purchase of physical assets or a significant amount of the ownership of a company in another country to gain a measure of management control. Firms that make FDIs typically have a significant degree of influence and control over the company in which the investment is made. Open economies with skilled workforces and good growth prospects attract large amounts of FDIs.
China is an example of the success of FDI. From 1978 to 2005 China has an economic growth rate of 9% on average. This is essentially down to the adoption of initiatives encouraging inward FDI. So obviously economies can be successful by accepting FDI, there are many reasons why China encouraged FDI. FDI offers the ability to obtain overseas resources, increase access to return markets, increase local capital markets and drive economic growth. The final advantage of FDI has clearly resonated in China! In the case of China, one of the biggest gains from FDI is the expansion of China's manufacturing exports. The numbers speak for themselves, in 1980 China was ranked 26th in the world for exports, and in 2005 China was ranked 3rd!
It all seems like nothing can go wrong with foreign direct investment in developing economies but examining further there are negative impacts.
FDI can create adverse effects on local competition because of the spending power of MNCs. Also the government will usually give in to the requests of the MNC, loosing national autonomy. There are other contextual factors such as environmental damage, human rights implications and corruption. In my opinion the biggest losers in foreign direct investment are the domestic small businesses. There are people that argue that FDI does not positively affect the host countries and they state that, for the purpose of long-term economic growth, it may be better to protect domestic infant industries rather than rely on foreign capital.
On the other hand, there have been studies that show that MNCs can be good for domestic business and that FDI benefits domestic companies in the same sector and in the upstream sectors initially, before the MNCs become dominant. My question is what happens to the domestic businesses when the MNCs do become dominant?
Perhaps, these are the stakeholders that the government and the MNCs should consider protecting in someway?
To consider whether companies should hedge, we must first establish what hedging is. Hedging is considered to be making an investment to reduce the risk of adverse price movements on an asset. One of the risks associated with hedging is the risk from change in currency in foreign currency transactions.
There are three exposures that companies hedge against relating to foreign currency transactions, these are transaction exposure, translation exposure and economic exposures.
Transaction exposure relates to the exposure created when the company has agreed to either receive payment through foreign currency, or to make payment in foreign currency. Simply put, if you were to purchase a product or service from a foreign country and agree to pay them in their currency, but you weren't required to pay until 30 days, there is a risk that the payment you have agreed to make now, will be higher in 30 days because of the exchange rate.
Translation exposure relates to translation the company's foreign subsidiaries from the foreign currency to the currency that the parent operates under. What the company risks is the subsidiaries loosing value because of the exchange rate.
Finally, economic exposure arises because the trading position of the company becomes at risk to adverse changes in the short and long term movements in the exchange rates.
What is essential to remember when deciding whether company's should hedge away this risk, is that the exchange rate, although slightly predictable, can swing either way and the company could be hedging away a gain.
The main argument against hedging is that shareholder's can hedge their own risk by creating an investment portfolio. Although I agree with this argument, to an extent, my opinion is why should a company bear unnecessary risk by not hedging, because the impact it will have on individual shareholder's won't be severe because they have undertaken their own hedging? It is my opinion, that the company should not bare the risk and that necessary hedging is important in success.
Although fuel hedging is not the same concept as hedging against exchange rate risk, the example I will introduce exemplifies my argument. The price of fuel has seriously affected the airline industry and Southwest Airlines has managed to successfully hedge against the risk from fuel prices. Since 1999, Southwest Airlines has managed to save around $3.5 billion. My argument is, because the price of fuel can rise and fall, Southwest Airlines may have missed out on some gains, but by hedging the amount they have saved outweighs the gains. In essence, surely avoiding losses is more important than taking advantage of gains? I suppose that is at the indiscretion of individuals as to what risk they are willing to take!
There are many ways a company can raise capital for projects or any other requirements but why do public companies favour equity financing? They can float on the stock market issuing bonds and shares, they can take on long-term or short-term debt, or they can dip into their retained earnings/profit (if they have any!).
There are issues involving risk and return with raising capital which I would like to discuss.
With equity finance, the shareholder bares the risk. The company is under no obligation to repay any of the capital to the investors through dividends or any other means. Sounds ideal, and you may be thinking that's too good to be true, and it is!
Take the example of Martin J. Sullivan at AIG, America's largest insurance company, who was pressured out of the company by a group of high-profile investors. The investors were not happy after the company slumped and compared Sullivan to his predecessor and felt he should be replaced. The pressure from these investors instigated an emergency meeting from AIG's board of directors and shortly afterwards the announcement of Martin J. Sullivan's departure from the company was announced. Sullivan was begrudged by this an argued that he had to face everything apart from "a swarm of locusts". Sullivan is not the only one to be pressured out of a company by investors and this example demonstrates the power investors have. So, although there are no legal obligations to pay dividends or to act on behalf the shareholder's, if you do otherwise, you won't last long!
So, what other options do firms have?
Financing through debt is another option be it short-term or long term. These involve bonds, loans and other forms. What is evident in debt-financing, the lender will receive interest on top of repayment of the initial loan. Relatively speaking, this usually works out cheaper than equity finance because the amount paid in interest by a firm is less than what is paid out in dividends. If we consider what GlaxoSmithKline paid in interest and dividends for 2012 this will be reflected. The interest they paid was £779m and the dividends they paid was £3,814m. However, following the concept of risk and return, the risk associated with debt financing is higher than equity financing, because the firm is contractually obligated to repay the debt financing.
Taking these factors into consideration, which source of financing is best for a firm? The answer to that is quite simple, a mixture of both but favouring equity finance. When shareholder's invest in a company, their aim is for the company to do well, which is generally the consensus amongst other parties involved in the company. Therefore, although shareholder's can put pressure on a company, the goals of shareholders and the company usually align. Also, if the company has a downslide, or a bad year, they can usually negotiate with shareholders relatively easily to cope with what the company's experiencing. Negotiating with lenders or banks is usually much more difficult and can cause problems possibly leading to insolvency. The downside of equity financing is clearly the cost of dividends, this is why there should be a mix of equity finance and debt finance, to slightly reduce the cost.
