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Why Do Companies Merge? Mergers and Acquisitions Explained

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Question: Why Do Companies Merge? Mergers and Acquisitions Explained
Answer:

A merger happens when two companies are combined and the resulting company takes the form of the company who bought the other company. Why does one company buy another company? In its simplest form, it is the same reason that a company buys any other asset. Why does a company buy a piece of equipment or make an investment in stock of another company? It is because they think it is a good investment and they will earn a positive return on the investment. The goal of any business in a capitalist society is to maximize shareholder wealth and buying a company that helps accomplish that goal is seen as a good thing.

This is the broad financial definition of why companies merge. In the real world, there are actually many reasons that companies merge. Unfortunately, not all mergers lead to maximization of shareholder wealth.

Financial Motives for Mergers

Mergers sometimes happen because business firms want diversification. Diversification is the reduction of risk through investment decisions. If a large, conglomerate firm thinks that it has too much exposure to risk because it has too much of its business invested in one particular industry, it may buy a business in another industry. That would provide a measure of diversification for the acquiring firm. In other words, the acquiring firm no longer has all its eggs in one basket.

Business firms may merge for other reasons regarding diversification. In our diverse economic and political climate, they may be able to reduce risk by merging with firms in other countries. This gives the benefit of reducing foreign exchange risk and localized recessions. We have to look carefully at diversification as a motive for merger and acquisition and make sure that it really does maximize the wealth of the shareholder as there is evidence to the contrary. Imagine the problems in production, for example, a company might face by entering a completely new line of business.

Improved financing is another motive for merger. If a company is in trouble financially, it may look for another company to acquire it. The alternative may be to go out of business or take bankruptcy.

Larger business firms may have better access to sources of financing in the capital markets than smaller firms. The expansion that results because of merger may enable the recently enlarged firm to access debt and equity financing that had formerly been beyond its reach.

There are tax advantages associated with mergers; specifically, a tax loss carryforward. If one of the firms involved in the merger has previously sustained net losses, those losses can be offset against the profits of the firm that it has merged with, a significant benefit to the newly merged entity. This is only valuable if the financial forecasting for the acquiring firm indicates that there will be operating gains in the future that will make this tax shield worthwhile.

If two companies merge that are in the same general line of business and industry, then operating economies may result due to the merger. Duplication of functions within each firm may be eliminated to the benefit of the combined firm. Functions such as accounting, purchasing, and marketing efforts immediately come to mind. This is particularly true if two relatively small firms merge. Business functions are expensive for small business firms. The combined firm will be better able to afford the necessary activities of a going concern.

An important financial reason often given for merger is economies of scale. Economies of scale simply means that the cost of doing business, whether in manufacturing or the aforementioned operating economies, will be lower in the combined business firm. The thinking, in one camp, is that if the cost of doing business is lower, that cost will be passed on to the consumer, resulting in a win-win situation. Not every financier and economist believes this theory but many do. Some believe that merger results in the monopolization of an industry and that will cause the exact opposite effect.

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