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‘  If managers are rational, mergers should always lead to an increase in shareholder

value.’ Discuss this statement in view of the relevant analysis of mergers and acquisitions.

This paper will discuss the effects of mergers on shareholders wealth if the managers act

rational. The first part covers the explanation of the rational and merger concepts followed by

merger motives. In the second part of this paper evidence from UK and USA is used to

analyze these effects and possible reasons for failure are discussed.

irst of all we need to define !rational" and !merger"# the two $ey terms for the purpose of

this essay.

 Rational 

According to S. %. &urlauf and '. (. )lume *+,,- rationality is ubi/uitous in modern

economics but he argues that a rational action is one that maximizes benefits and minimizes

costs. Investopedia *+,01 sustains a rational behaviour is !A decision2ma$ing process that is based on ma$ing choices that result in the most optimal level of benefit or utility for the

individual ". According to the above definition a rational manager will maximise the benefits

of the firm only when it is in his best interest to do so. This implies that even when the firm

loses value the manager will still be rational if his overall satisfaction increases# thus the

manager represents rationally the firm only when this does not decrease his level of utility. If

a conflict appears between his interests and the interests of the firm being rational means that

he must maximize his satisfaction and benefits.

 Merger 3len Arnold *+,04 defines a merger as the process of combining two business entities under

common ownership. A merger is horizontal if the companies which merge are in the same

industry and at the same level in the production chain5 a merger is vertical if the companies

are at different stages in the same production chain. A conglomerate merger involves

 businesses from different industries. 3. Arnold *+,04 argues that the main ob6ective of a

merger should be the same as for any other investment# and that is to create value. 3. 3orton

*+,,7 suggests two other ob6ectives of mergers8 defensive mergers when a firm increases its

size to decrease the possibility of being ac/uired and positioning mergers when they try to

improve the image of the firm to get a higher bid premium when they are ac/uired. In thedefensive mergers category also falls the ac/uisition of a firm to stop a rival from ac/uiring

it# these two types of mergers proposed by 3. 3orton *+,,7 do not necessarily need to create

value.

 Merger motives

urthermore# this paper will analyze the motives behind mergers and their effects on

shareholders and managers wealth. or the purpose of this paper we will loo$ at both the

ac/uirer and the ac/uired firms9 shareholders net value changes.

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:ational mergers are based on synergistic motives5 this concept implies that the combined

company has a greater value than the sum of its parts. *3. Arnold# +,04

  ;<A) = ;<A > ;<) > gains *0

;<A = discounted cash flows of company A5

;<) = discounted cash flows of company )5

;<A) = discounted cash flows of the combined firm.

(/uation *0 shows the value created by the merger process in the form of gains# the net value

added will be positive only if the gains are greater than transaction costs *3. Arnold# +,04.

According to 3. Arnold *+,04 the bid premium can also erode the gains. If the value of the

target firm is ?@m and the gains from this merger are ?+m# paying an ac/uisition premium

means that the ac/uirer pays more than ?@m for the target company# thus reducing the gains.

In this case paying more than ?m will lead to the !winner9s curse"# hence the merger will

actually result in a loss of value. Barconi and Imperial Chemical Industries merger is given

as an example of the winner9s curse by Dohn ;lender *+,,7 in inancial Times. Increasing

market power  is also a reason which falls under the synergistic motives category. Bar$et

 power gives the ability to increase profits. This can be achieved through increasing prices#

shutting down distribution channels for competing firms# creating barriers to entry or forcing

other firms to do business with your company *3. Arnold# +,04. Achieving economies of

scale is another reason for mergers# lowering costs per unit of output increases profits# hence

creates more value which can be distributed to shareholders *3. Arnold# +,04. (conomies of

 production in terms of using larger machines# economies of mar$eting# administrative costs#training programmes# being able to raise funds more cheaply and easily are all advantages of

economies of scale which can be translated into value for shareholders. Eften these mergers

are argued to be !industry consolidators" because combining two firms with different

advantages can create a solid company. 3. Arnold *+,04 argues that a possible drawbac$ of

this theory is that the created value might not be passed on to shareholders or consumers due

to the increase in mar$et power. 3. Arnold *+,04 sustains that internalisation of

transactions is also a motive behind mergers. In order to avoid contract costs a company

might chose to ac/uire another# thus removing the need for a contract. <alue which can be

 passed on to shareholders is created through this process5 however the incentives forefficiency might disappear when managers $now for sure that their output will be sold.  ntry

to new markets and industries is another reason for a merger# although the theory suggests

that this process diversify the company and lowers the volatility of its profits5 a shareholder

does not need diversification because he can achieve it through his portfolio. A merger with a

company from a new mar$et can help a firm reduce the time needed to establish a strong

 position in the mar$et *3. Arnold# +,04. Risk diversification and !a" advantages are also

motives which sustain mergers5 hence firms with high tax losses are ac/uired to reduce the

 present taxable profits of the bidder firm. *3. Arnold# +,04 )ut diversification can lead to

inefficiency due to managerial attention being spread too thin.

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urthermore# we will analyze the effects of the merger on the targeted firm9s shareholders and

on the wealth of the managers of both firms. S. Cartwright and :. Schoenberg *+,,F sustains

that the shareholders from targeted firm en6oy positive returns# this view is also sustained by

3. Arnold *+,04. S. Cartwright et. all *+,,F found that +FG of mergers were made to

increase the managers9 utility but ,G of the executives from the targeted firm departed inthe following five years due to acculturative stress. Bichael irth *0770 argued that it does

not matter for a manager if the merger is a success or not because in both cases they increase

their wealth and satisfaction. As stated in the theoretical section motives li$e increased

remuneration# power# prestige and safety can ma$e a manager start an ac/uisition of which

success rate is low. The profitability of the merger can further be reduced if they overpay as

in the case of the winner9s curse *B. irth# 0770. B irth *0770 observations suggests that

increasing the volume of e/uity owned by the managers in the firm ma$es them more careful

about mergers and decreases the ris$ of failed ac/uisitions. This bac$s the idea that mergers

might be started by managerial motives which do not aim to create value for shareholders. 3.

3orton *+,,7 argues that because managers get satisfaction from running a firm

independently they will engage in defensive mergers to diversify and decrease the ris$ of

getting ta$en over.

)ailure reasons

S. Cartwright and :. Schoenberg *+,,F argue that one of the issues is strategic fit, if two

companies fail to transfer the $nowledge between themselves or share the resources

accordingly can lead to a failure ac/uisition. &low and #ad organi*ation processes between

the two firms together with poor negotiations are also impediments for a merger *S.

Cartwright et. all# +,,F. Another interesting concept according to S. Cartwright et. all *+,,F

is the social identification of an employee with the organi*ation. In general the smaller firm

gets ac/uired and employees of such firms might be emotionally connected to them# thus the

merger process should promote a sense of belonging for these employees. ;. Boran and C.

;anasian *+,,@ sustain Cartwright9s view and argue that mergers create stress# uncertainty

and cultural discrepancies which lead to a decrease in performance. +ompetitive #idding  can

also decrease the probability of success of an ac/uisition *3. 3orton# +,,7. According to 3.

3orton *+,,7 ac/uirer9s returns are negatively related to the its size# this might be the case

due to less complexity in the integration process# lower agency costs and because of the fact

that managers might own a bigger percentage of the firm.

+onclusion

To conclude# a manager can create losses to his shareholders and still behave rational

according to the definition of rational behaviour# thus a manager acting rational does not

implies that he will follow shareholder9s interests. (vidence shows that the ma6ority of

mergers increase the total wealth of the shareholders from both firms. Shareholders from the

 bidding firm losses are offset by the gains from the target9s shareholders.

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