Theories of Merger

HYPOTHESIS CONCERNING MERGERS & ACQUISITIONS

THE PERFECTLY COMPETITIVE ACQUISITIONS MARKET

HYPOTHESIS (PCAM)

The PCAM hypothesis implies that, for an acquiring

firm, there are no monopolistic sources of gains,
due solely to merging as a way of obtaining
productive capacity.
The Efficient Capital Market Hypothesis (ECMH)
The efficient capital market hypothesis states that
stock prices adjust instantaneously to new
information. Stock prices provide unbiased signals
for efficient resource allocation.
The Abnormal Gains Hypothesis (AGH)
This hypothesis states that information regarding
forthcoming acquisitions is generally considered as
good news for the stockholders of the acquiring
firms
The Chain Letter Hypothesis (CLH)
The chain letter hypothesis implies that shareholders
are misled by manipulation of accounting numbers so
that the announcement of a forthcoming merger is
followed by rise in stock prices of the acquiring firm.
The Growth Maximisation Hypothesis (GMH)
This hypothesis states that managers maximize or at
least pursue, as one of their goals, growth in physical
size of their corporation rather than its profits or
stockholders welfare.
Market Power Hypothesis
The market power hypothesis implies that mergers
increase product prices, thereby benefitting the
merging firms and other competing firms in the
industry.
Collusion Hypothesis
The proposition is that rivals benefit from the news of
Wealth Maximizing or Value Maximizing Hypothesis
Mergers should lead to positive expected and total
realized gains on an average, since an increase in
wealth should accrue from the mergers. Both firms
involved in a merger are assumed to be value
maximizers.
Improved Management Hypothesis

This hypothesis retains the assumption that would be

acquirers maximize value, but assumes that potential
target firms are controlled by inefficient
management. This hypothesis is related to the
concept of market for corporate control.
Learning Hypothesis
Learning specifically means that the managers of the
merging firms extract information from the stock
market reaction to the M&A announcement and
Size Maximizing Hypothesis
The size maximizing hypothesis assumes that the net
present value of a merger attempt is non-negative for
potential acquired firms

Theory of Corporate Control

Mergers occur when incompetent managers reduce the

value of the firms shares to the point where it is
profitable for outsiders to gain control. Mergers, then,
can be viewed as effective discipline over
management
.

Differential Efficiency Theories

(a)Differential Efficiency
Differential Theory is the most general theory of
mergers. According to this theory, if the
management of firm A is more efficient than the
management of firm B, and if, after firm A acquires
firm B, the efficiency of firm B is brought up to the
level of the efficiency of firm A, efficiency is
increased by the merger.
(b) Inefficient Management
Inefficient management simply means not
performing upto ones potential.
Another group may be able to manage the assets of
this area of activity more effectively
(c) Operating Synergy

The operating synergy theory postulates economies of

scale, or of scope, and mergers help to achieve levels
of activities at which they are obtained. It includes the
concept of complementarity of capabilities
Operating and financial economies of scale and scope
are major determinants for the merger activity
(d) Diversification

Diversification of the firm may provide managers and

other employees with job security and opportunities
for promotion and, other things being equal, result in
lower labour costs
Diversification may increase corporate debt capacity
and decrease the present value of future tax liability
Combining two imperfectly correlated income streams
can reduce total earnings variability and, hence, risk .
(e) Financial Synergy
The Financial Synergy Theory hypothesizes
complementarities between merging firms in the
availability of investment opportunities and internal
cash flows.

A firm in the declining industry would produce large

cash flows since there are few attractive investment
opportunities. A growth industry would have more
investment opportunities than the cash required to
finance them.

The merged firm would have a lower cost of capital,

due to lower cost of internal funds, as well as
possible risk reduction, savings in floatation costs
and improvement in capital allocation. The debt
capacity of the combined firm may be greater than
(f) Undervaluation
Merger motives may also be attributed to
undervaluation of target companies. One cause of
undervaluation may be operation of the company
below its potential.
Information and Signaling Theory
This theory suggests that the tender offer
disseminates the information that target shares are
undervalued, and the offer prompts the market to
revalue the shares. No particular action by the target
firm, or any other, is necessary to cause revaluation.
The signalling theory states that particular actions
may convey other significant forms of information.
Capital Structure Theory Perspective
This theory suggests that, under reasonable
conditions, changes in capital structure may affect
The capital structure hypothesis states that M&A can
be an effective method to adjust the capital structure
of a firm.

Value is created when firms with low financial

leverage acquire firms with high financial leverage.
Firms with unused debt capacity may be able to
create value by using financial slack to acquire other
firms.
Agency Theory
Corporate managers are the agents of shareholders, a
relationship fraught with conflicting interests.
An attempt is made by the managers to maximize
their own wealth, possibly at the expense of the
shareholders. This explanation has its origin in the
separation of ownership and control in modern
corporations. This is known as Agency Theory.
 Debt reduces the agency costs of free cash flow by
reducing the cash flow available for spending at the
discretion of managers.
Takeovers can be considered as a solution to
agency problems
Managerialism
Mergers are also considered as the manifestation of
agency problems rather than their solution.

Hubris Hypothesis

Roll (1986) hypothesizes that managers commit

errors because of over optimism in evaluating
merger opportunities.
In other words, managers of bidding firms are
infected by hubris, and hence overpay for targets,
because they overestimate their own ability to run
them
Free Cash Flow Hypothesis
The free cash flow hypothesis, advanced by Jensen
(1988), states that managers endowed with free
cash flow will invest it in negative net present value
(NPV) projects rather than pay it out to shareholders.
Jensen defines free cash flow as the cash flow left
after the firm has invested in all available positive
NPV projects.

Tobin q is often used to measure the firms

investment opportunities.

To the extent that Tobins q measures investment

opportunities, the free cash flow hypothesis suggests
that firms with high cash
flow and low q are more likely to engage in
acquisitions that do not benefit shareholders
Market Power
The market power theory suggests that merger will
increase the firms market share.
Increasing market share means increasing the size of
the firm relative to other firms in the industry
Tax Considerations
The effect of tax law on returns to mergers is
relatively straightforward. A highly profitable firm,
faced with highly effective corporate tax rate, can
generate substantial tax savings by acquiring a firm
with large accumulated tax losses
Redistribution Theory
This theory advocates that the source of value
increases in mergers is redistribution among the
stakeholders of the fi rm. Possible shifts are from
bondholders to stockholders and from labour to
Merger Contingency Framework
This framework has been adapted from the
diversification contingency framework.
The theory suggests that whether a buyer firm
gains or loses from a merger is contingent upon the
firms competitive strengths, the growth rate of its
markets, and the degree to which these two factors
achieve a logical or strategic fit with the
competitive strengths and market growth rates of
its targeted
firm.
Asymmetric Theory

This theory explains how any incremental value

associated with a particular merger is shared
between the buying and the selling fi rms.