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chapter provides a review of the related theoretical and empirical literature
on mergers and acquisitions. The theoretical part consists mainly of providing
some theories of M&As and reasons for
undertaking M&As. The empirical part reviews some recent researches and
conclusions on the subject.

Definition and types of mergers 

R.Wayes (1963) defined merger ,also known amalgamation, as being the process by
which two or more companies come together under a single control. On the other
hand he  defined acquisition as the act
of acquiring effective control over management and assets of another company
without the need for  combinating  the companies under a common control.

vertical and conglomerate are the three main types of M&As.

1.      Horizontal

M&As combine two similar organizations in the same industry. Horizontal
M&As are normally motivated by a desire for greater market power, for
example Nissan has acquired a 34% stake in Mitsubishi. The acquisition will enable
Nissan to get a better access to Mitsubishi’s extensive Asian market and reduce
potential duplication costs of Nissan attempting to set up dealerships across
the area. Horizontal M’s are highly regulated by competition authorities
so companies cannot create a monopolistic scenario, for example, the US
competition authorities prohibited the merger of AT&T and T-Mobile as it
would have created the largest US mobile operator and taken a huge market
share. One recent example of a vertical M&A took place between AOL and Time
Warner. Through this business transaction Time Warner supplied information to
consumers via CNN and Time magazine whilst AOL shared such information through
their internet business.

2.      Vertical

vertical M&A takes place between two companies that has a buyer seller type
relationship and combine under a single ownership. For instance, a manufacturer
might decide to merge with a supplier as an example. These companies are
generally at different stages of production. The main goal of vertical merger
is to improve efficiency or reduce costs.


A conglomerate M&A appears when two or
more companies in different markets join to form a single company. These
companies are generally not competitors for example the merger between Proctor
& Gamble, a consumer goods company and Gillette, a man’s personal care
company in 2005. The conglomerate M can be seen as a diversification
strategy allowing the companies to exploit new markets.

3 different types of mergers can take place in different ways that is mergers
by absorption, amalgamation, takeover, exchange
reconstruction and group holding. Merger by absorption involves the
acquisitions of an existing company by another company. It is a situation
whereby a bigger company purchases the assets of a smaller company, as distinct
from acquiring its share capital. The second way is by amalgamation. It occurs
when a new company is formed to takeover an existing company as the existing
shareholder receive share in the company, the old company is therefore
liquidated.  Takeover is another way of
merger by the purchase of controlling interest in one company by another
company. It does not involve purchase of assets of the target company but mere
acquisitions of shares of such company. Exchange
Reconstruction occurs when a new company emerged to takeover an existing
company, the implication here is that due to financial, the structure and book
value of its assets and liabilities. This is normally carried out to facilitate
better trading of operation. Group
holding is another situation of merger whereby new company may be formed to
acquire majority of equity or shareholding of various companies and the will
then become the subsidiary of new holding company.

Theories on mergers

most popular theories on M are the neoclassical theory, agency theory,
behavioral theory and signalling theory.

Neoclassical theory

In the concept of
merger and acquisitions, neoclassical
theory defines the M activity based upon the view of value maximization.
A M deal should generate economic gains to both companies or at least
generate non-negative returns to add value for shareholders (Baradwaj 1992). In other words, M transactions
should help companies create synergy. Synergy is achieved when the value of a
post-merger company is greater than the combined value of each individual
company before M transaction. Gaughan (2011) divided synergy
into 2 types namely are operating and financial synergy. Operating synergy can be achieved through revenue enhancement or cost-reduction.
Revenue enhancement refers to new opportunities that both companies may have
when they are combined. For instance, by engaging into M transactions,
companies are able to get benefits from reduced competition and higher market
share. As a result, companies will have greater pricing power and earn greater
margins and operating income. Operating synergy can come from M
transactions between two companies with two functional strengths such as good
product line and good marketing skills. Cost reduction can
be achieved through economies of scope, economies of scale, or reductions in
assets. Economies of scale refer to the reduction in cost per unit by
production of larger size or scale of products. In addition, cost reduction can
be achieved through specialization of labour and management, efficient use of
capital equipment, but this might not be possible if companies produce at low
output levels. This theory assumes assume that managers maximize profits or
shareholder wealth and thus that mergers increase either market power or
efficiency. It is also based on the assumption of a rational economic man with
total information.

2.3.3 Agency theory

In contrast to neoclassical theories with the aim of
maximizing the shareholder wealth, agency theory states that managers will act
in the ways that maximize their own interests. Therefore, this
leads to the problem that the managers who are working as agents for the shareholders
may have some conflicting interests. This is because some managers are interested
in the actions that provide them with extra power and prestige such as growth,
size and diversification, whereas the shareholders are more likely to be
interested in the profitability of their firm as well as the increase in their
stock prices. Therefore, the
acquirers’ management will purposely overpay for takeovers to maximize their
own wealth and corporate growth rather than maximizing shareholders’ wealth (Seth 2000)

2.3.4 Behavioural theory

The behavioural theory or its hypothesis is more
focused on correlation between merger activity and stock market valuation. As
per behavioural theory, merges and acquisitions occur because of overvalued
markets and managerial timing. The behavioural hypothesis assumes that merger
waves are the result of overvalued markets and managerial timing (Eckbo, 2010).
Here, managerial timing refers to time horizon in which decision regarding
merger and takeover by management takes place. Kropf and
Viswanathan (2004) have stated that such overpriced stocks of bidders are accepted
by target management in the span of short time span making assumption of
synergies. Such overvaluation and timing lead to merger activities.

2.3.4 Signalling theory

The signalling theory occurs because of market
imperfection and means that managers have access to better information than the
remaining shareholders and may act from it. The signals that management sends
out can illustrate the future direction of the firm and which results the
company faces. The market is in need of information and reacts not only on what
the management communicates but also on how it performs. Managers can management sends signal to the market of any potential
M transactions which can influence expectations of the investors. If
there is a strong confidence in the management and the information about the
transaction is explicit, it should be reflected in the reaction of the
investors. If the signals are interpreted by the market as the management has
an optimistic belief in the future, this should cause the stock price rise.
This is also true for the reverse, when there is pessimistic belief in the
future the opposite reaction is expected.

2.4 Merger Motives




Empirical Evidence

 In the past decade
number of studies had been conducted on the topic of merger and acquisition, and
their effects on profitability, leverage and on share prices. (ARSHAD, 2012) considered
M as a strategy to gain profitability, avoid insolvency, maximizing
return on assets and improving asset quality.

The empirical studies looking at post-merger
profitability have mainly used data concerning stock market returns and
accounting ratios to assess the effects of M on firms’ performance. In
fact, Bruner (2004) identified four research approaches namely event studies,
accounting studies, survey or clinical studies. Clinical studies are used due
to a smaller number of observations and an inductive research is conducted with
the objectives of revealing new patterns and behaviours to managers. Researchers
had done many studies on M&As and these studies came with different
results. For instance, Kemal (2011) found that the effects of M&As
activities on acquiring firms caused a worsening of financial ratios especially
liquidity ratios, along with a decline in share prices. Chatterjee (2011) also
noted a reduction in share prices which could be the result of direct and
indirect acquisition costs. Pandit and Srivastava (2016) studied the effects of
mergers by interviewing ten managers of merged companies and by analysing
secondary data of financial ratios.

Oleyede and Adedamola (2012) used ratio analysis with
paired sample test to find the effects on firms’ performance. They concluded
that there was a significant effect in ROA and secondly there was a significant
impact on profitability in conglomerate sector as compare to a very small
impact in manufacturing sector. Pervan (2015) studied the impact of M on company’s
performance. The research targeted only companies which continue to operate
independently after the takeover. He used a sample of 116 companies acquired
between 2008 and 2011.Three different measures of profitability namely return
on assets (ROA), return on equity (ROE) and profit margin (PM) were used. The
result showed that there was no significant difference between pre-merger and
post-merger, the costs
of the acquired companies weren’t lower after companies engaged in M and
the majority of acquisition were carried out by domestic firms. Kurui (2014)
undertook a study on the relationship between M on the financial
performance of listed firms at the NSE using descriptive design. The population
consisted of 10 firms which participated in the M between 2000 and 2013.
This study looks at share price reaction and not financial performance as
measured by ROA during the pre and post-merger period. The study revealed found
a positive relationship in the post-merger period.

Klasa and Walcott (2009) made a suggestion
that acquiring firms use M as a vehicle to move their leverage ratios
towards target levels. They hypothesize that, when managers of acquiring firms
make decisions on the method of payment for the M, they incorporate how
the M transaction changes the firm’s target leverage. They argue that, if
for example, an underleveraged bidder aims to move its leverage ratio towards
target levels, it would finance the M&A with debt, rather than with equity.
Consistent with their prediction, they find a significantly positive
association between the merger-induced changes to the acquirer’s actual and
target leverage ratios. They interpret this finding to imply that when managers
of bidding firms make decisions on how to finance large M, they
incorporate more than two-thirds of the change in the merged firm’s target

Pazarskis et al. (2006) examined the impact of merger
and acquisition transactions on the operating performance of 50 acquiring firms
that were involved in domestic and international acquisitions in Greece. They
conducted their study by examining some of the financial ratios of the
companies over a time period of three years pre-acquisition and three years
after the acquisition. After comparing the means from the sum of each company
ratio for the pre-acquisition years and post-acquisition years, the results in
general show a significant decrease in the profitability and solvency ratios
whereas there are insignificant changes in the liquidity ratios.

Similarly, Mantravadi and Reddy (2008) studied the
effect of mergers on the operating performance of acquirer firms involved in
domestic mergers in India for a sample of 68 mergers between 1991 and 2003. The
study also undertook to examine whether the type of industry had any impact on
the operating performance of acquirer firms. They examined three-year pre- and three-year
post-merger financial ratios. Their results revealed that all the mergers in the
sample showed a decline in the operating financial performance after the
mergers, since there was a decline both in the profitability ratios and returns
on net worth and invested capital. Therefore, the full sample showed a negative
impact of mergers on the performance of acquirer firms in terms of profitability
as well as returns on investment. Furthermore, they found that the type of industry had
an impact on the changes in operating performance of acquiring companies after
the merger, since they found different results for merger samples in different
industry sectors in terms of their impact on operating performance, although
some of the differences were not statistically significant

Ismail, Abdou, and Magdy (2011) examined a sample of
nine Egyptian companies in the construction and technology sectors that were
involved in domestic merger and acquisition deals during the period 1996 to
2003. The main reason for conducting their study was to check whether there was
any significant improvement in the operating performance following mergers and
acquisitions and whether there was an impact from the industry sector on the
companies’ operating performance. In order to examine the operating performance of firms
they compared pre- and post-merger performances of merged firms using
financial-based measures consisting of 26 ratios. The results from comparing
the operating performance ratios of the whole sample in the pre- and
post-merger periods didn’t show any significant difference in the average mean
of profitability, efficiency, solvency and cash flow position. When the sector level
was examined, the results showed that mergers and acquisitions in the
construction sector have resulted in significant improvements in the firms’
profitability whereas there were no significant changes in the efficiency,
liquidity, solvency and cash flow position. In the technology sector, the
results didn’t show any significant improvements following mergers. However,
this study suffers from the very small sample size consisting of only 9

Recently, Rashid and Naeem (2017) examined the impact
of mergers on financial performance of firms in Pakistan during 1995-2012. They
took a sample of 25 merged and acquired firms that are listed on Pakistan Stock
Exchange It was the first time
that empirical Bayesian method was used to analyse the impact of mergers on
corporate financial performance. The result of the regression analysis
conducted revealed that that mergers do not have any significant impact on the
profitability, liquidity, and leverage position of the firms. However, the
result also show that mergers have a negative impact on the quick ratio of

Andreou, Louca, and Panayides (2012) analysed the valuation
effects of merger by taking a sample of 59 merger deals in the transportation
industry for the time period of 1980 to 2009. They concluded that mergers
benefit both target and bidder firm’s shareholders however the target firm’s
shareholders enjoy most of the synergistic gains. They also found that vertical
mergers create greater valuation effects than horizontal mergers. Arikan and
Stulz (2016) compared different theories behind M&As. Their findings were
consistent with neoclassical theories showing that acquirer firms were
better-off and were creating wealth through acquisitions of non-public firms.
Their findings were also consistent with agency theory because older firms
proved that older firms had negative stock reaction for public companies.

Researchers also conducted event study test to find
whether M&As affect share prices. For instance, Carl B. McGowan (2008)
examined the effects of merger announcements on share prices using event study
methodology. He took 61 daily closing prices of 2 banks namely the Arab
Malaysian Bank Berhad and the Hong Leong Bank Berhad. The results from event
study showed that merger announcements are treated as positive information by
the market. He concluded that there might be information leakage or that the
market could easily anticipate the completion of a merger. Similarly, Adnan and Hossain (2016)
investigated the impact of M&A announcement on share prices. An event study
methodology together with a sample of 50 acquired companies were used. The
result showed that the CAAR value was increasing this is may be for the reason
that leakage of information or the anticipation of merger.


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