Despite substantial evidence, drawn from different countries and different time periods, that suggests the wealth of shareholders in a bidding company is unlikely to be increased as a result of taking over another company, takeovers remain an important part of the business landscape.
Required:
i) Explain briefly when takeover will make economic and financial sense. (3 marks)
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A merger will only be worthwhile for a company that is committed to maximising shareholder wealth, if gains arise that would not otherwise arise if the bidding and target businesses had not been combined. The value of a business may be defined as
the present value of its future cash flows. This means that a takeover will make economic sense if the present value of the combined business exceeds the aggregate of the present values of each business when taken separately.
Thus: PV Combined business > PV Bidding business + PV Target business
ii) Discuss briefly FIVE (5) reasons why a takeover may fail to deliver an expected increase in wealth for the bidding company’s shareholders. (5 marks)
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Paying too much for the target company
The management of the bidding company may pay too much for the target company. It is quite common for a premium to be paid to the shareholders of the target company in order to encourage them to sell their shares. Unless there are benefits accruing from the takeover, this premium paid will simply transfer wealth from the shareholders of the bidding company to the shareholders in the target company.
Hidden problems
Problems that were hidden at the time of the takeover may emerge later to eliminate any gains that were anticipated. These problems may have been deeply buried and so may have been difficult to unearth, even where proper due diligence procedures were carried out prior to a takeover agreement.
Integration issues
Integrating the two businesses following takeover may prove a difficult task. There may be differences in culture, management style, and organisational methods and systems that cannot be easily reconciled. Integration problems are most acute where
there is an attempt to impose a common style and common systems following takeover. Where the former target company is allowed to maintain its own identity and its own systems, integration problems are likely to be much less of an issue.
Management attitudes and motivation
Once the takeover has been completed, managers may expect the enlarged business to achieve success without the need for much effort. They may feel that the takeover was the most important ingredient for success and expect that future operations will run smoothly. In some cases, an exhausting takeover struggle may leave managers with little energy or enthusiasm for ensuring that things go according to plan.
Errors in valuing a target firm
Managers of the bidding firm may advise their company to bid too much as they do not know how to value an essentially recursive problem. A risk-changing acquisition cannot be valued without revaluing your own company on the presupposition that the acquisition has gone ahead. The value of an acquisition cannot be measured independently. As a result, the merger fails as the subsequent performance cannot compensate for the high price paid.
The target being too large relative to the acquirer
A literature review suggests that the difficulties associated with a merger or acquisition increase as a function of the relative size of the target. This tends to happen because the target becomes more and more difficult to absorb as it becomes relatively larger. A target equal in size to the acquirer can only be effectively absorbed in a merger of equals.