Mergers and Acquisitions Explained

Corporations Merge for Many Reasons, but Not All Mergers Succeed

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Mergers and acquisitions all have one underlying motive: to protect or improve the strength and/or profitability of the dominant company—in other words, to maximize shareholder wealth.

At least that's the theory. At other times, however, the motives may be less admirable—for instance, to protect a seated board of directors from a different merger that might put their jobs at risk, or to squelch a stockholder reform initiative.

When that happens, the outcome may be less fortunate. Not all mergers and acquisitions maximize shareholder wealth, and in some instances, quite the opposite holds true.

Below are some of the legitimate reasons a company may decide on a merger or acquisition.

Product and Investment Diversification

Mergers sometimes happen because business firms want diversification—a broader product offering, for example. If a large conglomerate thinks that it has too much exposure to risk because it has too much of its business invested in one particular industry, it may buy a business in another industry. That would provide a measure of diversification for the acquiring firm. In other words, the acquiring firm no longer has all its eggs in one basket. In these instances, the underlying motive often is risk reduction. If a company with a strong product line of CD burners sees the market shifting toward digital downloads and streaming, it may acquire another company active in one of those market sectors.

Foreign Exchange and Foreign Market Acquisitions and Mergers

Another kind of diversification attempts to reduce risk by merging with firms in other countries. This reduces foreign exchange risk and the dangers posed by localized recessions. Fiat, the Italian multinational, merged with Chrysler Corporation, which made Fiat more competitive in US markets while also reducing foreign exchange risk.

Acquisitions and Mergers to Improve Financial Position

Improved financing is another motive for mergers and acquisitions. Larger business firms may have better access to ​sources of financing in the capital markets than smaller firms. The expansion that results because of a merger may enable the recently enlarged firm to access debt and equity financing that had formerly been beyond its reach.

Apple, for instance, one of the largest corporations in the world, has successfully issued about $60 billion in bonds, despite the fact that they already hold unprecedented amounts of capital. A smaller company, such as Dell, would be unlikely to succeed with a bond issue of this size.

Since 2014, the successfully merged conglomerate Fiat Chrysler has been seeking another merger with a third corporate automobile giant to further increase their market share and capital base.

If a company is in financial trouble, on the other hand, it may look for another company to acquire it. The alternative may be to go out of business or go into bankruptcy

Tax and Operational Efficiency Advantages of Mergers and Acquisitions.

There are several possible tax advantages associated with mergers and acquisitions, such as a tax loss carryforward.

If one of the firms involved in the merger has previously sustained net losses, those losses can be offset against the profits of the firm that it has merged with, a significant benefit to the newly merged entity. This is only valuable if the financial forecasting for the acquiring firm indicates that there will be operating gains in the future that will make this tax shield worthwhile. 

Another, often-criticized corporate merger/acquisition scheme involves a company in a high-corporate-tax-rate country merging with another corporation in a low-corporate-tax-rate country. Sometimes the corporation in the low-tax environment is much smaller and would normally not be a candidate for a major corporate merger. With the merger, however, the new company is legally located in the low-tax country and subsequently avoids millions and sometimes billions in corporate taxes.

If two companies merge that are in the same general line of business and industry, then operating economies may result from a  merger. Duplication of functions within each firm may be eliminated to the benefit of the combined firm. Functions such as accounting, purchasing, and marketing efforts immediately come to mind. This is sometimes particularly beneficial when two relatively small firms merge. Business functions are expensive for small business firms. The combined firm will be better able to afford the necessary activities of a going concern. But operating economies can be achieved by larger mergers and acquisitions as well. 

Economies of Scale

Economies of scale is an often employed way of increasing operational efficiency. The cost of doing business generally decreases, especially in manufacturing industries, when materials and other purchases are scaled up.

Risks of Mergers and Acquisitions

Even when the CEO and the ​board of directors are honestly motivated to merge with or acquire another corporation to improve the company's financial position in some way, things often do not work out as intended. Shortly after the massive merger of communications giants AOL and Time-Warner, AOL, the acquired company, posted an almost unimaginable $100 billion loss, putting Time-Warner in financial jeopardy and leading to the problematic exits of top executives in both companies who were held responsible for the financial disaster. In some ways, the underlying cause was simply bad timing, as the merger coincided with a growing dot-com financial meltdown. 

At other times, mergers fail because the corporate cultures of the two corporations are incompatible. At other times, mergers can achieve desired financial goals, yet operate against the public good, creating an anti-competitive monopoly.