Theories and Concepts - M&a

Theories and concepts

First of all, it is important to define the main principles of doing a merger and acquisition. The first one is synergy which is the association, here, of two companies, the acquirer and the bidder, in a particular fruitful way that produces an effect greater than the sum of their individual effects. Two main concepts are inside this theory. The first one is the economy of scale which is the reduction in long-run average and marginal costs arising from an increase in size of an operating unit. In the other hand the second concept is scope of work which is the division of work to be performed under a contract or subcontract in the completion of a project, typically broken out into specific tasks with deadlines.

The second theory is “Market for Corporate control” or also called by other financial specialists “Disciplinary reasons”. It the way of buying a company and then changing the board director in order to put a new more performed one. The bidder acquires a company and is persuaded that the acquirer company is under performing because of a bad management process. By naming new directors, they think that this company will perform again and create value.

The third theory is “Entrenchment and Empire Building”. This theory explains that a company buys another one just to satisfy the personal director strategy. Indeed, in order to follow their own idea of how business must be done, directors make acquisitions without looking for shareholder’s satisfaction. It creates an agency cost.

The last theory about why mergers and acquisitions are made is “CEO’s Hubris” or also called “Overconfidence”. This theory explains that a company is making a merger because of self-confidence of its director. Indeed, after successful previous mergers and acquisitions, the director fells self-confident and is sure that his choice of doing the acquisition is the best one. In order to do it, he will be able to pay a higher premium price than the marker, shareholders and sometimes the acquirer will expect.

In order to better understand the previously concepts. It is first important to explain what is the price of a merger. First of all, the price of a merger should be less than the expected earnings of this transaction. Then it is the sum of all cash flow of the company minus the cost plus the premium. Premium is so the supplementary amount of money that a bidder is ready to pay in addition to the nominal value of the company to convince acquirer directors.

The agency cost, cited in the “Entrenchment and Empire building” theory, is the cost of lack of discussions and global point of views between the different agents of a company: shareholders, directors, managers and/or bondholders.

The contract theory is directly linked to agent’s decisions. The “Adverse selection” is the part before merger and acquisition. The goal of a director is to erase it. In fact, it is a risk of a bad quality target. This theory is applied before the signature of the acquisition. Filtering, which means more research and information, is necessary to avoid this risk but has a cost.

In the other hand, the “moral hazard” appears after the signature of the merger. The director has also to limit this risk of non-respect of the contract. Monitoring, which means supervision and reports, is the solution to avoid this risk but has also a cost.