If managers are rational, mergers should always lead to an increase in shareholder

value. Discuss this statement in view of the relevant analysis of mergers and acquisitions.
This paper will discuss the effects of mergers on shareholders wealth if the managers act
rational. The first part covers the explanation of the rational and merger concepts followed by
merger motives. In the second part of this paper evidence from UK and USA is used to
analyze these effects and possible reasons for failure are discussed.
First of all we need to define rational and merger, the two key terms for the purpose of
this essay.

Rational
According to S. N. Durlauf and L. E. Blume (2008) rationality is ubiquitous in modern
economics but he argues that a rational action is one that maximizes benefits and minimizes
costs. Investopedia (2014) sustains a rational behaviour is A decision-making process that is
based on making choices that result in the most optimal level of benefit or utility for the
individual. According to the above definition a rational manager will maximise the benefits
of the firm only when it is in his best interest to do so. This implies that even when the firm
loses value the manager will still be rational if his overall satisfaction increases, thus the
manager represents rationally the firm only when this does not decrease his level of utility. If
a conflict appears between his interests and the interests of the firm being rational means that
he must maximize his satisfaction and benefits.

Merger
Glen Arnold (2013) defines a merger as the process of combining two business entities under
common ownership. A merger is horizontal if the companies which merge are in the same
industry and at the same level in the production chain; a merger is vertical if the companies
are at different stages in the same production chain. A conglomerate merger involves
businesses from different industries. G. Arnold (2013) argues that the main objective of a
merger should be the same as for any other investment, and that is to create value. G. Gorton
(2009) suggests two other objectives of mergers: defensive mergers when a firm increases its
size to decrease the possibility of being acquired and positioning mergers when they try to
improve the image of the firm to get a higher bid premium when they are acquired. In the
defensive mergers category also falls the acquisition of a firm to stop a rival from acquiring
it, these two types of mergers proposed by G. Gorton (2009) do not necessarily need to create
value.

Merger motives
Furthermore, this paper will analyze the motives behind mergers and their effects on
shareholders and managers wealth. For the purpose of this paper we will look at both the
acquirer and the acquired firms shareholders net value changes.

Rational mergers are based on synergistic motives; this concept implies that the combined
company has a greater value than the sum of its parts. (G. Arnold, 2013)
PVAB = PVA + PVB + gains (1)
PVA = discounted cash flows of company A;
PVB = discounted cash flows of company B;
PVAB = discounted cash flows of the combined firm.
Equation (1) shows the value created by the merger process in the form of gains, the net value
added will be positive only if the gains are greater than transaction costs (G. Arnold, 2013).
According to G. Arnold (2013) the bid premium can also erode the gains. If the value of the
target firm is 5m and the gains from this merger are 2m, paying an acquisition premium
means that the acquirer pays more than 5m for the target company, thus reducing the gains.
In this case paying more than 7m will lead to the winners curse, hence the merger will
actually result in a loss of value. Marconi and Imperial Chemical Industries merger is given
as an example of the winners curse by John Plender (2009) in Financial Times. Increasing
market power is also a reason which falls under the synergistic motives category. Market
power gives the ability to increase profits. This can be achieved through increasing prices,
shutting down distribution channels for competing firms, creating barriers to entry or forcing
other firms to do business with your company (G. Arnold, 2013). Achieving economies of
scale is another reason for mergers, lowering costs per unit of output increases profits, hence
creates more value which can be distributed to shareholders (G. Arnold, 2013). Economies of
production in terms of using larger machines, economies of marketing, administrative costs,
training programmes, being able to raise funds more cheaply and easily are all advantages of
economies of scale which can be translated into value for shareholders. Often these mergers
are argued to be industry consolidators because combining two firms with different
advantages can create a solid company. G. Arnold (2013) argues that a possible drawback of
this theory is that the created value might not be passed on to shareholders or consumers due
to the increase in market power. G. Arnold (2013) sustains that internalisation of
transactions is also a motive behind mergers. In order to avoid contract costs a company
might chose to acquire another, thus removing the need for a contract. Value which can be
passed on to shareholders is created through this process; however the incentives for
efficiency might disappear when managers know for sure that their output will be sold. Entry
to new markets and industries is another reason for a merger, although the theory suggests
that this process diversify the company and lowers the volatility of its profits; a shareholder
does not need diversification because he can achieve it through his portfolio. A merger with a
company from a new market can help a firm reduce the time needed to establish a strong
position in the market (G. Arnold, 2013). Risk diversification and Tax advantages are also
motives which sustain mergers; hence firms with high tax losses are acquired to reduce the
present taxable profits of the bidder firm. (G. Arnold, 2013) But diversification can lead to
inefficiency due to managerial attention being spread too thin.

Another category of rational motives is the bargain-buying merger motives which covers
concepts like superior management of the acquiring firm or conglomerates superiority in
allocating capital (G. Arnold, 2013). A small efficient firm can struggle to find sources of
cheap finance, thus this issue can be solved by merging with a bigger company. Undervalued
shares due to the ignorance of managers to the importance of a good stock market image can
also become a motive for a merger according to G. Arnold (2013).
Finally we look at managerial motives for mergers which do not create any value for
shareholders. Status, power and remuneration are all reasons for managers to start a merger
and still behave rational because the managers are trying to maximize their benefits. Survival
and empire building are similar because managers afraid of losing their job due to takeovers
will try to acquire other firms. These acquisitions might prove not to be so efficient and the
result will be a loss in value for shareholders. (G. Arnold, 2013) Hubris means arrogance or
too much self-confidence in your ability to succeed, mergers based on this concept tend to
happen in periods of high economic growth when the managers overestimate their own
abilities resulting in a loss of value (G. Arnold, 2013). Another motive is free cash flow; the
manager will use these resources to finance mergers instead of distributing them to the
shareholder. By merging with another company the manager directly increases his status,
power, remuneration and benefits.

The impact of mergers evidence

This section will primarily focus on the impact of mergers on shareholders wealth but will
also analyse the managers gains. According to S. Cartwright and R. Schoenberg (2006) the
performance is mixed, out of 30 000 acquisitions completed globally in 2004 only 56% of
them had achieved its original objectives. S. Cartwright et. all (2006) paper suggests that the
aggregate results of merger activity have a negative or close to zero return. This view is
sustained by P. Moran and C. Panasian (2005); they argue that USA has a success rate of 23%
and UK 50%. However, C. Edward et. all (2004) contradicts their results suggesting that 66%
of cases have positive total returns, while A. Antoniou et. all (2005) supports the idea of
mixed results.
According to S. Cartwright and R. Schoenberg (2006) the share price decreases for the
acquirer after the merger, thus the shareholders lose value. Only 34% to 45% of the acquirers
achieve positive returns in the following three years, the most profitable acquisitions are the
hostile ones. A. Antoniou et. all (2005) sustains the fact that shareholders from the bidding
firm lose in the long-run after the merger. Michael Firth (1991) argued that the difficulty of
the integration process is behind the loss of the acquirers shareholders. Despite the increased
research done in this area the failure rates have not changed, S. Cartwright and R. Schoenberg
(2006) point out that mergers might be initiated by non-value maximizing motives. J. R.
Franks and R. S. Harris (1989) showed that at the beginning of the merger in the
announcement phase targets shares prices increase with 25-30% while bidders shares have
an increase close to 0% or negative. In the long-run according to A. Agrawal et. all (1992) the
shareholder of the bidding firm lose up to 10% of their wealth, while the overall result of the
merger is just a 3% increase in value for both firms shareholders.

Furthermore, we will analyze the effects of the merger on the targeted firms shareholders and
on the wealth of the managers of both firms. S. Cartwright and R. Schoenberg (2006) sustains
that the shareholders from targeted firm enjoy positive returns, this view is also sustained by
G. Arnold (2013). S. Cartwright et. all (2006) found that 26% of mergers were made to
increase the managers utility but 70% of the executives from the targeted firm departed in
the following five years due to acculturative stress. Michael Firth (1991) argued that it does
not matter for a manager if the merger is a success or not because in both cases they increase
their wealth and satisfaction. As stated in the theoretical section motives like increased
remuneration, power, prestige and safety can make a manager start an acquisition of which
success rate is low. The profitability of the merger can further be reduced if they overpay as
in the case of the winners curse (M. Firth, 1991). M Firth (1991) observations suggests that
increasing the volume of equity owned by the managers in the firm makes them more careful
about mergers and decreases the risk of failed acquisitions. This backs the idea that mergers
might be started by managerial motives which do not aim to create value for shareholders. G.
Gorton (2009) argues that because managers get satisfaction from running a firm
independently they will engage in defensive mergers to diversify and decrease the risk of
getting taken over.

Failure reasons
S. Cartwright and R. Schoenberg (2006) argue that one of the issues is strategic fit, if two
companies fail to transfer the knowledge between themselves or share the resources
accordingly can lead to a failure acquisition. Slow and bad organization processes between
the two firms together with poor negotiations are also impediments for a merger (S.
Cartwright et. all, 2006). Another interesting concept according to S. Cartwright et. all (2006)
is the social identification of an employee with the organization. In general the smaller firm
gets acquired and employees of such firms might be emotionally connected to them, thus the
merger process should promote a sense of belonging for these employees. P. Moran and C.
Panasian (2005) sustain Cartwrights view and argue that mergers create stress, uncertainty
and cultural discrepancies which lead to a decrease in performance. Competitive bidding can
also decrease the probability of success of an acquisition (G. Gorton, 2009). According to G.
Gorton (2009) acquirers returns are negatively related to the its size, this might be the case
due to less complexity in the integration process, lower agency costs and because of the fact
that managers might own a bigger percentage of the firm.

Conclusion
To conclude, a manager can create losses to his shareholders and still behave rational
according to the definition of rational behaviour, thus a manager acting rational does not
implies that he will follow shareholders interests. Evidence shows that the majority of
mergers increase the total wealth of the shareholders from both firms. Shareholders from the
bidding firm losses are offset by the gains from the targets shareholders.

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