Several reasons have been proposed to justify mergers. Among the more prominent are (1) tax considerations, (2) risk reduction, (3) control, (4) purchase of assets at below-replacement cost, (5) synergy, and (6) globalization. In general, which of the reasons are economically justifiable? Which are not? Which fit the situation at hand? Explain.

Question

Hager’s Home Repair Company, a regional hardware chain that specializes in “do-it-yourself” materials and equipment rentals, is cash rich because of several consecutive good years. One of the alternative uses for the excess funds is an acquisition. Doug Zona, Hager’s treasurer and your boss, has been asked to place a value on a potential target, Lyons’ Lighting (LL), a chain that operates in several adjacent states, and he has enlisted your help.
The table below indicates Zona’s estimates of LL’s earnings potential if it came under Hager’s management (in millions of dollars). The interest expense listed here includes the interest (1) on LL’s existing debt, which is $55 million at a rate of 9 percent, and (2) on new debt expected to be issued over time to help finance expansion within the new “L division,” the code name given to the target firm. If acquired, LL will face a 40 percent tax rate.
Security analysts estimate LL’s beta to be 1.3. The acquisition would not change Lyons’ capital structure, which is 20 percent debt. Zona realizes that Lyons’ Lighting’s business plan also requires certain levels of operating capital and that the annual investment could be significant. The required levels of total net operating capital are listed below.
Zona estimates the risk-free rate to be 7 percent and the market risk premium to be 4 percent. He also estimates that free cash flows after 2021 will grow at a constant rate of 6 percent. Following are projections for sales and other items.

2016 2017 2018 2019 2020 2021
Net sales $60.00 $90.00 $112.50 $127.50 $139.70
Cost of goods sold (60%) 36.00 54.00 67.50 76.50 83.80
Selling/administrative expense 4.50 6.00 7.50 9.00 11.00
Interest expense 5.00 6.50 6.50 7.00 8.16
Total net operating capital 150.00 150.00 157.50 163.50 168.00 173.0

Hager’s management is new to the merger game, so Zona has been asked to answer some basic questions about mergers as well as to perform the merger analysis. To structure the task, Zona has developed the following questions, which you must answer and then defend to Hager’s board.

Answer 1

The economically justifiable rationales for mergers are synergy and tax consequences. Synergy occurs when the value of the combined firm exceeds the sum of the values of the firms taken separately. (if synergy exists, then the whole is greater than the sum of the parts, and hence synergy is also called the "2 + 2 = 5" effect.)
A synergistic merger creates value, which must be apportioned between the stockholders of the merging companies. Synergy can arise from four sources: (1) operating economies of scale in management, production, marketing, or distribution; (2) financial economies, which could include higher debt capacity, lower transactions costs, or better coverage by securities' analysts which can lead to higher demand and, hence, higher prices; (3) differential management efficiency, which implies that new management can increase the value of a firm's assets; and (4) increased market power due to reduced competition. Operating and financial economies are socially desirable, as are mergers that increase managerial efficiency, but mergers that reduce competition are both undesirable and illegal.
Another valid rationale behind mergers is tax considerations. For example, a firm which is highly profitable and consequently in the highest corporate tax bracket could acquire a company with large accumulated tax losses, and immediately use those losses to shelter its current and future income. Without the merger, the carry-forwards might eventually be used, but their value would be higher if used now rather than in the future.
The motives that are generally less supportable on economic grounds are risk reduction, purchase of assets at below replacement cost, control, and globalization. Managers often state that diversification helps to stabilize a firm'searnings stream and thus reduces total risk, and hence benefits shareholders.
Stabilization of earnings is certainly beneficial to a firm's employees, suppliers, customers, and managers. However, if a stock investor is concerned about earnings variability, he or she can diversify more easily than can the firm. Why should firm a and firm b merge to stabilize earnings when stockholders can merely purchase both stocks and accomplish the same thing? Further, we know that well?diversified shareholders are more concerned with a stock's market risk than its stand-alone risk, and higher earnings instability does not necessarily translate into higher market risk.
Sometimes a firm will be touted as a possible acquisition candidate because the replacement value of its assets is considerably higher than its market value. For example, in the early 1980s, oil companies could acquire reserves more cheaply by buying out other oil companies than by exploratory drilling. However, the value of an asset stems from its expected cash flows, not from its cost. Thus, paying $1 million for a slide rule plant that would cost $2 million to build from scratch is not a good deal if no one uses slide rules.
In recent years, many hostile takeovers have occurred. To keep their companies independent, and also to protect their jobs, managers sometimes engineer defensive mergers, which make their firms more difficult to "digest." Also, such defensive mergers are usually debt-financed, which makes it harder for a potential acquirer to use debt financing to finance the acquisition. In general, defensive mergers appear to be designed more for the benefit of managers than for that of the stockholders.
An increased desire to become globalized has resulted in many mergers. To merge just to become international is not an economically justified reason for a merger; however, increased globalization has led to increased economies of scale. Thus, synergies often result--which is an economically justifiable reason for mergers. Synergy appears to be the reason for this merger.