Theory of Mergers

Operating Synergy
Pure Diversification

Sabdha S Kumar
Sruthi Gangavaram
Joyal .P. Joseph
 What is a Merger?

A merger is the combination of two

companies into one by either closing the
old entities into one new entity or by one
company absorbing the other. In other
words, two or more companies are
consolidated into one company.
 Types of Mergers

● Horizontal mergers

● Vertical mergers

● Conglomerate

● Concentric Mergers
 Horizontal Merger

★ Horizontal –Combination of two or more firm

operating in same stage of production.

★ Ex: Merger of Tata Industrial finance Ltd with Tata

Finance Ltd
 Vertical Merger

➢ Vertical-When two or more firm operating in the

different stage of production.

➢ Ex: Merger of Reliance Petrochemicals Ltd with

Reliance Industries Ltd is a Backward Integration
 Conglomerate Merger

◼ Conglomerate Merger-These mergers involve

firms engaged in unrelated type of business
activities i.e. the business of two companies are
not related to each other horizontally ( in the
sense of producing the same or competing
products),nor vertically.

◼ Example: General Electric buying NBC television.

 Concentric Mergers

● Concentric Mergers- Merger of two firms that

are so related that there is a carry over of specific
management functions (research, manufacturing,
finance, marketing, etc.)

Example: Citigroup (principally of a bank)buying

Salomon Smith Barney (an investment banker/stock
brokerage operation)
Motives Behind Mergers

● Quicker way to growth.

● Accessing new markets.
● Taking on the global competition.
● Improving operating margins and efficiencies
● Acquiring visibility and international brands .
● Buying cutting-edge technology rather than
importing it.
● Developing new product mixes
 Benefits of Mergers

➔ Limited Competition

➔ Gaining Market Power

➔ Diversification

➔ Improving Profitability

➔ Cost Reduction

➔ Faster Growth
 Example

❏ Tata steel buys Corus Plc : 12.1$ billion.

❏ Hindalco acquired novelis: 6$ billion.

❏ Tata buy jaguar and land rover : 2.3$ billion.

❏ Essar steel buys Algoma Steel: 1.58$ billion.

❏ Vodafone buys hutch : 11$ billion.

❏ POSCO to invest in building steel manufacturing plants and facilities in

India by 2016.

❏ Goldman Sachs Plans investment in private equity, real estate, and private

wealth management.
Merger Between Air India &
Indian Airlines
➢ The government of india on 1st march 2007

approved the merger of air india and indian airlines.

➢ Consequent to the above a new company called

national aviation company of india ltd was

incorporated under the companies act 1956 on 30

march 2007 with its registered office at new delhi.

 What is Synergy ?

● Synergy is a stated motive in many mergers and

acquisitions.

● If synergy is perceived to exist, the market value of the

combined firm, after a merger announcement, should

be greater than the sum of the market values of the

bidding and target firms(standalone), prior to that

same announcement.
V(AB) > V(A) + V(B)

Where :

V(AB) = Value of a firm created by combining A and B

V(A) = Value of firm A, operating independently

V(B) = Value of firm B, operating independently.

Popular definition:
1+1>2
Round about dfinition:
If am I willing to pay 6 for a business
market-valued at 5 there has to be the synergy justifying
the same.
More technical definition:
Synergy is ability of merged company to generate higher
shareholders wealth than the standalone entities.
 Types of Synergy

● Manufacturing synergy
● Marketing synergy
● Operations synergy
● Tax synergy
● Financial synergy
 The values of synergy in three
steps
◼ First, we value the firms involved in the merger
independently, by discounting expected cash flows to each
firm at the weighted average cost of capital for that firm.

◼ Second, we estimate the value of the combined

firm, with no synergy, by adding the values obtained for
each firm in the first step.

◼ Third, we build in the effects of synergy into expected

growth rates and cash flows and we revalue the combined
firm with synergy.

The difference between the value of the combined firm with

synergy and the value of the combined firm without
synergy provides a value for synergy.
 why do bidders overpay for
synergy?
◼Biased Evaluation Process.

◼Managerial Hubris.

◼Failure to plan for synergy.

Operating synergy and what
leads to it?
❖ Operating synergy occurs when two
companies measure their combined
force of operating income and decide in
reaching a higher growth.
❖ Their performance level is definitely
much better than their independent
efforts.
There are few circumstances involved when
two companies come to an operating
synergy:

● Economies of scale
● Compilation of different valuable skills for better
productivity and market management.
● Lower competitions
● Great pricing power
● Better growth and appearance in larger scopes,
such as international markets.
● Greater market share etc.
Diversification provides several benefits to
managers, other employees and owners of the firm as well
as to the firm itself. Moreover, diversification through
mergers is commonly preferred to diversification through
internal growth, since the firm may lack internal resources
or capabilities required.
PURE DIVERSIFICATION

Pure diversification is the result of merger

which is proven to be an exclusive
method to gain new skills in various fields
and be benefited.
Goodwill is created with a positive merger and
diversification. The combined force of the firms is
attained through financial and tax benefits also.

diversification isn’t just beneficial to the firms

combined through merger but also some other
participants get largely affected positively. They
are:
● Employees
● Shareholders
● Owner
● Managers
Employees: -
◼ The employees of a firm develop firm-specific skills over
time, which make them more efficient in their current
jobs.
◼ These skills are valuable to that firm and job only and
not to any other jobs. Employees thus have fewer
opportunities to diversify their sources of earning
income, unlike shareholders who can diversify their
portfolio.
◼ Consequently, they seek job security and stability, better
opportunities within the firm and higher compensation
(promotions). These needs can be fulfilled through
diversification, since the employees can be assigned
Owner-managers: -
The owner-manager of a firm is able to retain
corporate control over his firm through
diversification and simultaneously reduce the
risk involved.
Firm: -
◼ A firm builds up information on its employees over time,
which helps it to match employees with jobs within the
firm. Managerial teams are thus formed within the firm.
◼ This information is not transferred outside and is specific
to the firm. When the firm is shut down, these teams are
destroyed and value is lost. If the firm diversifies, these
teams can be shifted from unproductive activities to
productive ones, leading to improved profitability,
continuity and growth of the firm.
 Goodwill: -
◼ A firm builds up a reputation over time in its
relationships with suppliers, creditors, customers and
others, resulting in goodwill.
◼ It does this through investments in advertising,
employee training, R&D, organizational development
and other strategies. Diversification helps in preserving
its reputation and goodwill.
Financial and tax benefits: -
◼ Diversification through mergers also results in financial
synergy and tax benefits.
◼ Since diversification reduces risk, it increases the
corporate debt capacity and reduces the present value
of future tax liability of the firm.
The following are the reasons why firms opt for
diversification:

● For growth in business operations.

● To ensure maximum utilization of the existing resources

and capabilities.

● To escape from unattractive industry environments

On gaining knowledge on the concept of diversification,
let’s have a look at the advantages and disadvantages of
the same.
ADVANTAGES OF DIVERSIFICATION

● As the economy changes, the spending patterns of the

people change. Diversification into a number of
industries or product line can help create a balance for
the entity during these ups and downs.
● There will always be unpleasant surprises within a
single investment. Being diversified can help in
balancing such surprises.
● Diversification helps to maximize the use of potentially
underutilized resources.

● Certain industries may fall down for a specific time

frame owing to economic factors.

● Diversification provides movement away from activities

which may be declining.
Disadvantages of diversification

● Entities entirely involved in profit-making segments will

enjoy profit maximization. However, a diversified entity
will lose out due to having limited investment in the
specific segment. Therefore, diversification limits the
growth opportunities for an entity.
● Diversifying into a new market segment will demand
new skill sets. Lack of expertise in the new field can
prove to be a setback for the entity.
 ● A mismanaged diversification or excessive ambition can
lead to a company over expanding into too many new
directions at the same time. In such a case, all old and
new sectors of the entity will suffer due to insufficient
resources and lack of attention.
● A widely diversified company will not be able to respond
quickly to market changes. The focus on the operations
will be limited, thereby limiting the innovation within the
entity.
On understanding the advantages and disadvantages of
diversification, we’ll see the types of diversification
strategies.
Types of diversification
strategies
HORIZONTAL DIVERSIFICATION

This strategy of diversification refers to an entity

offering new services or developing new products
that appeal to the firm’s current customer base. For
example, a dairy company producing cheese adds a
new variety of cheese to its product line.
Vertical Diversification
This form of diversification takes place when a
company goes back to a previous or next stage of
its production cycle. For example, a company
involved in the reconstruction of houses starts
selling construction materials and paints. It may
be forward integration or backward integration.
CONCENTRIC DIVERSIFICATION
In this form of a diversification strategy, the entity
introduces new products with an aim to fully utilize the
potential of the prevailing technologies and marketing
system. For example, a bakery making bread starts
producing biscuits.
CONGLOMERATE DIVERSIFICATION
In this form of diversification, an entity launches new
products or services that have no relation to the current
products or distribution channels. A firm may adopt this
strategy to appeal to an all-new group of customers. The
high growth scope and return on investment in a new
market segment may prompt a company to take this option.
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