4.3 Theoretical Literature Review
4.3.1 Financial Theory
Financial theory proposes that, managers of firms must take decisions and actions that will help increase the firms’ value. For example, empirical studies by Mulherin and Boone (2000) and Bradley, Desai, and Kim (1988) provide support for the idea that, synergistic effects result in value creation. As a result, a synergy is viewed by several scholars as a major driver of M&As deals firms execute. Although the motivation may not be the same for all
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acquisitions or mergers, one common determinant to measure whether a merger has been successful is the growth in value of the two combined firms. Based on this measure, synergy is considered as possibly the most justifiable driver of M&As. This present study, therefore, identifies these forms of synergies:
(i) Operational synergies: These types of synergies enable firms to grow and improve on their operating incomes from existing assets. They are generated by means of grouping of firms and also because of efficient operations in the newly formed firm. Operating synergies aim at eliminating duplicate activities, renegotiating contracts with suppliers, achieving economies of scope and scale and bringing costs of transaction down. The benefits to the new firm formed can be obtained from cost reduction synergies or revenue enhancing synergies.
Studies suggest that, many advantages are generated through operational synergies. For example, Devos et al. (2008), after their analysis of 264 large M&As, suggest an average benefit derived from synergies to be 10.3% from the combined value of the shares of the merged firms, of which 8.3% constitute benefits gained as a result of operational synergies.
Other research works have concentrated on the relationships amongst the various types of mergers (such as the vertical, horizontal and conglomerate types of mergers) and the kind of synergies generated. For instance, Shahrur (2005) and Fee and Thomas (2004) demonstrate that, horizontal mergers generate the most important synergies, as is shown by the positive value creation results. Operational synergies can be in the form of either economies of scope or economies of scale;
1. Economies of scope occur when the cost associated with the production of two goods by a firm that produces several products is less than the total costs of producing these products by two single-product firms. Economies of scope measure the cost benefits of production by individual firms who separately specialises in the production of a good or service versus diversified production within a single firm (Baumol, 1982; Bailey & Friedlander, 1982).
2. Economies of scale result from a merger which enables the two firms to be more profitable and efficient in terms of cost. For example, a bigger or a larger bank can be created when either two steel firms or two banks come together. Usually, companies belonging to the same industry or business (horizontal mergers) generate economies of scale in mergers.
(ii) Financial synergies: Such synergies can be derived from acquisitions or mergers and they are of various forms. These include for instance, decreasing the probability of bankruptcy, lowering the risk level to which the firm is exposed, which may result in greater
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cash-flow stability (Lewellen, 1971), increasing the indebtedness capacity of the new entity, reducing the cost associated with accessing the capital markets or minimising the cost of capital as the size of the company increases (DePamphilis, 2008; Gaughan, 2011; Luypaert &
Huyghebaert, 2010). Subsequent to the merger, the new firm may stabilise its results and the offsetting of gains and losses can lead to reduction in losses and lowered risk of entering default and bankruptcy.
Financial synergies include the following:
(a) Combining a firm that has more cash reserves but limited investment opportunities with another firm having more investment opportunities but limited in terms of cash reserve. This can derive a payoff in terms of value that is higher for the two firms combined. The value increase will be as a result of the projects likely to be executed with the extra cash reserve which otherwise would not have been undertaken. This type of synergy is usually noticed when smaller firms are taken over by larger ones or when private firms are acquired by publicly traded businesses.
(b) Increase in debt capacity; the reason is that, the coming together of the firms makes the earnings and cash flow of the combined firm remain more predictable and stable. This gives them the opportunity and space to borrow more than they could have done as separate firms, which offers them tax advantages. These tax advantages usually show itself up in the form of reduction in cost of capital for the business entities that have been combined.
(c) Tax benefits can occur as a result of acquisitions, in order to benefit from the tax rules to write up the assets of the target firm or from using the net operating losses to shelter income.
Therefore, a profit-making firm that acquires a cash-strapped firm may rely on the net operating losses of the cash-strapped firm to reduce the acquirer’s tax burden. On the other hand, a firm that is able to increase its charges for depreciation after an acquisition transaction will improve on its value and save in taxes.
(d) Diversification is one of the ways in which financial synergy can be obtained which appears to be controversial. Several investors in publicly traded companies, can diversify at reduced cost and without difficulty than the firm itself. For closely held firms or individual businesses, there can be likely benefits that can be derived through diversification. This means that, great potential exists for several merger activities. The more relevant issues have to do with determining the amount to pay for the synergy and how to value it.
In summary, operating synergies seek to achieve operational excellence of the joint operations, whereas financial synergies aim at bringing down the cost of capital for the target firm (Loukianova et al., 2017). In addition, operational synergies usually occur basically
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when the two companies are originating from the same industry, but with financial synergies, they largely occur in unrelated mergers or acquisitions. Theoretically, whenever synergistic motive drives acquisitions, the combined firm’s value is usually more than the value of these firms standing alone. The value added will be shared between shareholders of both the target and the acquirer firms.