Paper 1: Why Do Firms Mergeand Then Divest? A Theory of Financial Synergy The theory of mergers and divestitures is developed in thispaper.
This theory is not dependent on taxes or the acquirer having huge surpluses.The inability of short horizon projects or firms which are marginallyprofitable to finance themselves as independent entities due to problems causedby agency between managers and potential claim holders is given as themotivation behind mergers. Good performance of the once marginally profitableprojects allows for divestiture in the future. There exist two preconditionsfor this theory to be applicable. One that financial distress must be beingexperienced by one of the merging firms and the other that there must be severeagency problems between the mangers and the claimholders of the distressedfirm. Therefore this theory is more applicable to mergers where one of themerging firms is facing cash flow verifiability and is small in size.The fact that positive net present value projects may bedenied funding where the cash flows can be manipulated by the management iswell known. Marginally profitable companies are sometimes unable to supportoutside equity since the manager’s incentive constraint requires that he/shereceives a cut of project’s cash flow.
Thus a merger can serve as a toolwhereby such firms can survive their distressed period as merged entity canraise total finance easier than a standalone entity. Shareholder value isincreased according to the authors’ theory and empirical evidence as mergersallow marginally profitable firms to get funding. However this financialsynergy may not persist. Once the project has reached a stage where it canraise finance on its own there are coordination costs associated with mergers. Thisstems the firms to divest.Paper 2:On the Patterns and Wealth Effects of Vertical Mergers This paper measures vertical relation between two mergingfirms using industry commodity flows information in input output table.
A mergeris classified as a vertical merger when one firm can utilize others’ services orproduct as input for its final output or its output is the input for the otherfirm. Significant positive wealth effect is generated through vertical mergers.During the 3 day event window surrounding the announcement of mergers, theaverage combined wealth effect is about 2.5%.
The paper measures the verticalrelatedness by using an interindustry vertical relatedness coefficient. The mergeris classified as a vertical merger if the coefficient is more than 1% (lenientcriteria) or 5% (strict criteria). Further, those firms which exhibit verticalrelatedness with the lenient criteria (1%) and belong to different input-outputindustries are identified as Pure vertical mergers by the author. To measurethe wealth effect of mergers the authors uses CRSP value weighted index asmarket proxy. Works CitedFluck, Z., & Lynch, A.(1999).
Why Do Firms Merge and Then Divest? A Theory of Financial Synergy. The Journal of Business,72(3), 319-346. doi:10.1086/209617Fan, J., & Goyal, V.
(2006). On the Patterns and Wealth Effects of Vertical Mergers. The Journal of Business, 79(2), 877-902. doi:10.1086/499141