Corporate Diversification

Mergers and Acquisitions

Growth through diversification can be achieved in two ways, either by internal (or "natural ") expansion or externally by acquiring, consolidating with, or merging other firms.

A purchase of another business is an acquisition. A sales contract is executed under which the buyer assumes all or some of the seller's assets and assumes all, some, or none of the seller's liabilities. The sale of the RCA computer division to Sperry-Univac in 1971 was through acquisition.

A consolidation unites two companies into a new corporation which assumes all assets and liabilities of the combining businesses which are then dissolved. In 1967 McDonnell Douglas Corporation was formed from the consolidation of McDonnell and Douglas corporations. Douglas shareholders received 1.75 shares of the new company, and McDonnell shares were swapped on a one-to-one basis.

A merger is an absorption of one company by another company, including all its assets and liabilities. In 1937, Nash Motors absorbed the Kelvinator Corporation, and changed its name to Nash-Kelvinator Corp. Then, in 1954 , the Nash-Kelvinator Corp., changed its name to American Motors, and merged with the Hudson Motor Car Company.

The opposite of growth, frequently referred to as "reorganization", also occurs. When reorganization includes selling of corporate businesses, the term often used to describe this strategy is sell-offs. A spin-off occurs when the corporation establishes a new legal entity and distributes its shares to existing shareholders in the same proportions as the parent company. A divestiture occurs when the business is sold to an outside part, usually for cash.

Internal or "natural" expansion of a company is usually financed through retained earnings (a form of equity financing). The advantages of "growth the old fashion way" of making money and reinvesting funds into new and expanded businesses are:

1. Add assets specific to needs of the firm
2. Retain internal control - no involvement of financial institutions or outsiders
3. No requirement to obtain stockholder consent to SEC approval
4. Less visible to anti-trust actions

But, there are limitations to natural natural growth:

1. Limitations on available internal funding
2. Reduces equity position to investor's - reduces retained earnings
3. No tax advantage - can be more costly that acquisitions
4. Takes time to build additional market share and profits.

Because of these limitations, the most common way for companies to achieve diversification is through acquisitions, seeking growth opportunities outside the company. External expansion may be financed by equity, usually through an exchange of securities (stock swap), or debt financing (leverage). Leveraged buy-outs (LBO's) involve the use of borrowed funds to acquire a company's stock. When it is the firm's management that buys-out the company, the deal is termed a management buy-out (MBO), and the firm goes private, that is there are no shares traded publicly.

The advantages of mergers and acquisitions are:

1. Expansion not limited by internal resources
2. No drain on working capital - can use exchange of stocks
3. Faster - buy available assets, instead of building
4. Cheaper, if creating new assets is more expensive than ac quisition
5. Gain quickly a new technology, skills, or needed resource s
6. Can be attractive as a tax benefit - interest payment is a cost
7. Can consolidate industry - increase firm's market power

There are limitations on mergers and acquisitions. These include:

1. Usually requires stockholder's consent - problem with dissidents
2. Incur costs of fees for lawyers, brokers, investment bankers
3. May require added funds to accommodate acquisition to needs
4. Integrating acquires firm into operations can be a problem
5. If debt used - will fixed future costs of debt service offset profits?
6. May require special SEC reporting, attracts Justice Department attention for anti-trust action

Do Mergers and Acquisitions Create Value?

In a 1983 study of mergers and acquisitions over eleven years, Jansen and Ruback reported that most of the value from these strategies were earned by the selling business, not the acquiring company. This was especially true in the case of tender offers to buy a target's shares publicly. The study found that holders of the target firm usually earned a 30% on their investment, while holders of shares in the acquiring firm usually earned a 4% return on their investment with the completed acquisition. We need not infer from this finding that mergers and acquisitions do not create value, rather commonly acquiring firms simply pay too high a price for their acquisitions.