07 January 2006

Mergers and Acquisitions

A corporate merger is the combination of the assets and liabilities of two firms to form a single business entity. In everyday language, the term acquisition tends to be used when a larger firm absorbs a smaller firm, and merger tends to be used when the combination is portrayed to be between equals. In a merger of firms that are approximate equals, there often is an exchange of stock in which one firm issues new shares to the shareholders of the other firm at a certain ratio. For the sake of this discussion, the firm whose shares continue to exist (possibly under a different company name) will be referred to as the acquiring firm and the firm whose shares are being replaced by the acquiring firm will be referred to as the target firm.

Excluding any synergies resulting from the merger, the total post-merger value of the two firms is equal to the pre-merger value. However, the post-merger value of each individual firm likely will be different from the pre-merger value because the exchange ratio of the shares probably will not exactly reflect the firms' values with respect to one another. The exchange ratio is skewed because the target firm's shareholders are paid a premium for their shares.

Synergy takes the form of revenue enhancement and cost savings. When two companies in the same industry merge, such as two banks, combined revenue tends to decline to the extent that the businesses overlap in the same market and some customers become alienated. For the merger to benefit shareholders, there should be cost saving opportunities to offset the revenue decline; the synergies resulting from the merger must be more than the initial lost value.

To calculate the minimum value of synergies required so that the acquiring firm's shareholders do not lose value, an equation can be written to set the post-merger share price equal to the pre-merger share price of the acquiring firm as follows:

Pre-merger Stock Price =

(pre-merger value of both firms + synergies) ----------------------------------------------
post-merger number of shares

The above equation then can be solved for the value of the minimum required synergies.

The success of a merger is measured by whether the value of the acquiring firm is enhanced by it. The practical aspects of mergers often prevent the forecasted benefits from being fully realized and the expected synergy may fall short of expectations.

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