In the previous unit you learnt about the history of M and A. All the companies do not always have acquisition strategies, and not all companies that have acquisition strategies will stick to them. In this section, we will learn different motives for acquisitions.
Acquisition motives are mentioned hereunder:
Acquiring undervalued firms: An acquirer would want to buy a company that is undervalued by financial markets. The difference between the purchase valve and the true valve of the target company give certain amount of profit to the acquirer. For this strategy to work, three basic components are essential.
- A capacity to find company that is for sell than its true value: This capacity would require either access to better information than is available to other investors in the market, or better analytical tools than those used by other market participants.
- Availability of funds needed for acquisition: The availability of the required capital to carry out the acquisition when the company is undervalued. Access to the capital depends on the size of the acquirer.
- Skill in execution: The acquirer sometimes drives the stock price up to and beyond the estimated value, where there will be no value or profit from the acquisition.
Strategy of buying undervalued company always has a great deal of spontaneous appeal, but it is daunting as well. Because, acquisition happens publicly in efficient markets, where the premiums paid on market prices very quickly eliminate the profit, when the market price goes up.
Diversifying to reduce risk: Another reason of acquisition is the belief that buying companies and diversifying can reduce earnings volatility and risks as well as increase potential value.
Diversification has its own benefits although the question is if it can be accomplished efficiently by investors or the companies who acquire other companies in the name of diversification.
Comparing the costs associated with investor with the cost associated by the company getting into diversification, investors in most publicly traded companies can diversify far more cheaply than acquirer.
Creating operating or financial synergy: Some companies operate below their potential and become less efficient. Such companies are likely to be acquired by another company. Synergy is the prospective additional growth in terms of value obtained by combining two companies. It is widely used and misused principle for mergers and acquisitions.
- Sources of operating synergy: Operating synergies enable a company to increase their operating income, increase growth or both. The categorises for operating synergies are mentioned below:
- Economies of scale arising from the merger, allows the combined companies to become more cost-efficient and profitable.
- Greater pricing power arising from reduced competition and increased market share, resulting in, higher margins and operating income.
- Combination of different functional strengths happens when different skills set are merged. For example, a company with strong marketing skills acquires one with a good product line thus the marketing team upon merger will do the job essential to promote the product with extra human resource.
- Higher growth in new or existing markets arising from the combination of the two firms of the same product line.
Operating synergies can affect margins and growth, which in turn affect the value of the firms involved in the merger or acquisition.
Sources of financial synergy: Financial synergies can happen when the payoff takes the form of either higher cash flows or discount rate. Below are mentioned few forms:
- A combination of a company with extra cash but less projects and a company with high-return projects but little cash can yield a payoff in terms of higher value for the combined company.
- Debt capacity will increase as two companies combine. Their earning and cash flows will become more stable and predictable.
- Tax benefits can be achieved from the acquisition by using tax laws to reduce the taxes or by reducing operating cost to shelter income.