Merger refers to a combination of two or more companies into one company. It may involve absorption or consolidation. In an absorption one company acquires another company. Example: Ashok Leyland absorbed Ductron Casting Limited. In a consolidation, two or more companies combine to from a new company. Example: Hindustan Computers limited, Hindustan Instruments Limited, Indian Software Company Limited, and Indian Reprographics Limited combined to form HCL Limited. Mergers in India, called amalgamations in legal parlance (hereafter we shall use the terms mergers and amalgamations interchangeably), are usually of the absorption variety. The acquiring company (also referred to as the amalgamated company or the merged company) acquires the assets and liabilities of the acquired company (also referred to as the amalgamating company or the merging company or the target company). Typically the shareholders of the amalgamating company get shares of the amalgamated company in exchange for their shares in the amalgamating company.
Mergers may be classified into several types: (1) horizontal, (2) vertical, and (3) conglomerate. A horizontal merger represents a merger of firms engaged in the same line of business. A vertical merger represents a merger of firms engaged in different stages of production in an industry. A conglomerate merger represents a merger of firms engaged in unrelated lines of activities.
Reasons of mergers:
The principal economic rationale for a merger is that value of the merged entity is expected to be greater than the sum of the independent values of the merging entities. What are the sources of additional value? The important one are:
1. Operating economies
2. Financial economies
5. Managerial effectiveness
Operating Economies: When two or more firms combine, certain economies are realized because of the larger volume of operations of the combined entity. These economies arise because of more intensive utilization of production capabilities, distribution networks, engineering service, research and development facilities, data processing systems, so on and so forth. Economies of scale are most prominent in the case of horizontal mergers where the scope for more intensive utilization of resources is greater. In vertical mergers, the principal sources of benefits are improved coordination of activities, lower inventory levels, and higher market power of the combined entity. Finally, even in conglomerate mergers there is scope for reduction or elimination of certain overhead expenses.
Financial Economies: A principal reason for mergers is to avail of financial economies in one or more of the following forms:
When a firm has accumulated losses and unabsorbed tax, merge with a profit making firm, tax shields are utilized better.
The merged entity may enjoy a higher debt capacity because the earnings of the merged entity tend to be more stable than the independent earnings of the merging entities. Further, it may be able to borrow at a lower interest rate.
Growth: If a firm has decided to enter or expand in a particular industry, merger with another firm in that industry, rather than internal expansion, may offer several strategic advantages: (1) As a pre-emptive move it can prevent a competitor from establishing a similar position in that industry, (2) It offers a special timing advantage because the merger alternative enables a firm to leap frog several stages in the process of expansion, (3) It may entail less risk and even less cost. (4) In a saturated market simultaneous expansion and replacement (through a merger) makes more sense than creation of additional capacity through internal expansion.
Diversification: A commonly stated motive for mergers is to achieve risk reduction through diversification. The extent to which risk is reduced depends on the correlation between the earnings of the merging entities. While negative correlation bring greater reduction in risk, positive correlation brings lesser reduction in risk
Managerial Effectiveness: One of the potential gains of merger is an increase in managerial effectiveness. This may occur if the existing management team, which is performing poorly, is replaced by a more effective management team. Often a firm plagued with managerial inadequacies can gain immensely from the superior management that is likely to merge as sequel to the merger. Another allied benefit of a merger may be in the form of greater congruence between the interests of the managers and the shareholders.