Mergers and Acquisitions

A company can grow by taking over the assets or facilities of another. The various methods by which one firm obtains or “marries into” the business, assets, or facilities of another company are mergers, combinations, or acquisitions. These terms are not used rigidly. In general, however, a merger signifies that one firm obtains another by issuing its stock in exchange for the shares belonging to owners of the acquired firm, or buys another firm with cash. Company X gives some of its shares to Company Y shareholders for the outstanding Y stock. When the transaction is complete, Company X owns Company Y because it has all (or almost all) of the Y stock. Company Y’s former stockholders are now stockholders in Company X. In a combination, a new corporation is formed from two or more companies who wish to combine. The shares of the new company are exchanged for those of the original companies. The difference between a combination and a merger lies more in legal distinctions than in any discernible differences in the economic or financial result. In practice, the terms merger and combination are often used interchangeably. The study of merger profitability is as old as corporate finance itself. Arthur S. Dewing (1921, 1953) reported on the relative unsuccessfulness of mergers for the 1893–1902 time period; and Livermore (1935) reported very mixed merger results for the 1901–1932 time period. Mandelker (1974) put forth the Perfectly Competitive Acquisitions Market (PCAM) hypothesis in which competition equates returns on assets of similar risk, such that acquiring firms should pay premiums to the extent that no excess returns are realized to their stockholders. The PCAM holds that only the acquired firms’ stockholders earn excess returns. Jensen and Ruback (1983) reported that acquired firms profited handsomely, while acquiring firms lost little money such that wealth was enhanced. Recent evidence by Jarrell et al. (1988), Ravenscraft and Scherer (1989), and Alberts and Varaiya (1989) finds little gain to the acquiring firm and significant merger premiums paid for the acquired firms.