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Advanced Business Economics Essay

It is often suggested that profit-maximising firms are motivated to grow in size; this can be done either through internal growth or through a merger/acquisition. Mergers permit a quick and more certain expansion. However, sometimes a firm is reluctant to lose its independence and is faced not with a merger option but with a takeover bid from a rival. Very often, the main motive behind merger activity is to increase the firm’s market power and reduce competition in the market place in order to be better able to exploit the market.

The merger therefore acts as a risk-reduction mechanism as the firm will have more control to withstand any small changes in the industry (e. g. the threat of new firms entering the market). It is also suggested that through merger activity, a firm will also be able to increase long-term profitability. However, there is little evidence that an increase in market power is effective in raising profitability. A study by Ravenscraft and Scherer (1987), found that out of 6000 acquisitions in the US between 1950 and 1967, two-thirds of the merged companies had actually decreased its profitability after merging.

Another reason firms may choose to merge is due to the issue

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of cost as it is often cheaper to merge than to grow internally. For example, it may cost 50million to expand internally. However, there may be a firm, which already has the capabilities required and is on the stock market valued at i?? 25million. Even after paying the likely premium on the share price involved in takeover bids, it is clear that it would cheaper to buy the existing firm than to undertake new investment.

The economies of scale theory concentrates on raising profit through the reduction of cost. Once the merger has taken place, the constituent parts can be reorganised through a process of rationalisation. The merger can also increase the efficiency of the combined firm by more than the sum of the parts. Synergy could result from combining complementary activities, such as combining a strong R&D team with an effective production process. The idea of economic efficiency includes productive efficiency as well as Allocative efficiency.

For example, a merger may result in economies of scale having increased the size of the firm. However, the increased market power may mean that a firm can raise its prices above its costs of production and thus reducing Allocative efficiency. The issue of efficiency is controversial as K G Cowling (1980)2 found that many mergers have in fact led to loss of economic efficiency. The managerial theory is a further reason to justify mergers and acquisitions. This theory has greater emphasis on non-profit motives.

One of the main objectives of managers is growth of the firm. Singh’s study (1871, 1975)3, noted that acquiring firms had a significantly higher rate of growth than the acquired firms. The rationale behind this theory is that the growth of the firm raises managerial utility by bringing higher salaries, power, status, and job security to managers. Managers may therefore be more interested in the rate of growth of the firm rather than in its profit performance. Not all firms in the merger market are necessarily interested in growing in size.

Sometimes, the likelihood of a takeover depends on the valuation ratio, which is expressed as the market value of a firm, divided by its asset value. If a firm is undervalued (i. e. its share price is low compared to the value of its assets), then it becomes a prime target for asset strippers. Successful asset strippers will often aim to sell off some parts of the firm for more than it paid for the whole. Parts of the firm may be kept as a useful addition to the profit made on the whole deal.

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