Motives and Effects of Mergers and Acquisitions

by

JUANJUAN WANG

September 2007

A dissertation presented in part consideration for

the degree of MA in Finance and Investment

Acknowledgements

I would like to take this opportunity to express my sincere appreciation to all

those people who helped me complete this dissertation. Firstly, I do

appreciate my supervisor Ms. Lynda Taylors assistance. She gave me

valuable feedback and guidance throughout this dissertation.

In addition, I would like to send my deepest gratitude to Dr. Stephen

Praffenzellers assistance. He helped me proof-reading the majority of this

dissertation.

My sincere thank is also extended to my parents, my boyfriend and my

cousin who gave me unconditional support and encouragement all the time

during my study in the UK.

Further thanks to my parents who gave me this precious opportunity to

study in the University of Nottingham in the UK.

2

Abstract

Mergers and acquisitions, nowadays, play significant roles for helping

companies achieve certain objectives and financial strategies. This

dissertation, firstly, presents three major types of motives of participating in

M & A. This part involves the motives that increase or decrease

shareholders value or has uncertain impact on shareholders value. The

motives which increase shareholders value include the synergy motive,

improvement of managerial efficiency, achievement of economies of scale or

scope, increased market power and increased revenue growth; whereas the

motives which decrease shareholders value include the agency motive,

managerial hubris and free cash flow; the diversification motive has

uncertain impact on shareholders value. Secondly, the effects of engaging

in M & A are examined based on four approaches in literature review.

Generally speaking, M & A increase shareholders value for the target

company, whereas they decrease shareholders value for the acquiring

company or the newly combined company. Lastly, this dissertation advances

quantitative research methodology- an accounting study-to measure the

changes in the financial performance of the target and the acquiring

company.

In order to control firm-specific, industry-specific, economic wide factor that

may pose impact on the post-acquisition performance of the acquiring firm,

the different financial performance indicators of the acquiring firm are

compared with those of its non-acquiring peers. Moreover, two cases-

Vodafones acquisition of Mannesmann AG and the merger between AOL and

Time Warner- are selected in order to check the literature results. The

findings present that both the target company and the acquiring company

had a healthy financial performance before mergers and acquisition, but the

acquiring firm suffered a great deal of loss after mergers and acquisitions.

3

Table of Contents

Page Number

List of Tables-------------------------------------------------------------6

List of Figures------------------------------------------------------------6

Chapter 1 Introduction--------------------------------------------------8

1.1 Background of mergers and acquisitions---------------------------------8

1.1.1 Definition of mergers and acquisitions-----------------------------9

1.1.2 Types of mergers and acquisitions--------------------------------10

1.2 Objectives of the dissertation--------------------------------------------13

1.3 Research Methodology---------------------------------------------------14

1.4 Organization of the dissertation-----------------------------------------14

Chapter 2 Literature Review-------------------------------------------16

2.1 Motives of engaging in mergers and acquisitions-----------------------16

2.1.1 Motives which increase shareholders value----------------------16

2.1.2 Motives which decrease shareholders value---------------------22

2.1.3 Motive which has uncertain impact on shareholders value------25

2.2 The Effects of the motives in mergers and acquisitions: post-M & A

performance------------------------------------------------------------27

2.2.1 Empirical evidence based on accounting studies---------------27

2.2.2 Empirical evidence based on event studies----------------------31

2.2.3 Empirical evidence based on clinical studies--------------------35

2.2.4 Empirical evidence based on executives of surveys-------------35

4

Chapter 3 Research methodology-------------------------------------39

3.1 Overview of an Accounting Study Research Methodology--------------39

3.2 Data Source--------------------------------------------------------------42

3.3 Limitations of this study--------------------------------------------------43

Chapter 4 Case Studies Analysis--------------------------------------44

4.1 Overview of Vodafones acquisition of Mannesmann AG---------------44

4.1.1 The historical development of Vodafone and Mannesmann AG--45

4.1.2 The motives of Vodafones acquisition of Mannesmann AG------46

4.1.3 Effects of Vodafones acquisition of Mannesmann AG: financial

performance-------------------------------------------------------48

4.1.4 Comparisons of Vodafones post-financial performance with its

industry competitors---------------------------------------------52

4.2 Overview of AOL and Time Warner merger------------------------------60

4.2.1 The historical development of AOL and Time Warner------------60

4.2.2 The motives of AOL and Time Warners merger and acquisition-61

4.2.3 Effects of AOL and Time Warners merger and acquisition: financial

performance------------------------------------------------------62

4.2.4 Comparisons of Time Warners post- financial performance with its

industry competitors---------------------------------------------63

Chapter 5 Conclusion, Limitations and Recommendations of Study

5.1 Conclusion----------------------------------------------------------------72

5.2 Limitations of this study--------------------------------------------------74

5.3 Recommendations for further study-------------------------------------75

References--------------------------------------------------------------76

5

List of Tables: Table 1: The relationship between the motives of M & A and gains------26 Table 2: Comparisons among each research approach--------------------38 Table 3: Formulas of Key Financial Ratios----------------------------------40 List of Figures: Figure 1: Key figures and ratios of Mannesmann AG from 1998-2000 (in million) ----------------------------------------------------------------------48 Figure 2: Key figures and ratios of Vodafone from 1996-2000(in million)-49 Figure 3a: Key Growth of Vodafone from 2000-2005-----------------------53 Figure 3b: Key Growth of O2 from 2000-2005------------------------------54 Figure 3c: Key Growth of Deutsche Telekom from 2000-2005-------------54 Figure 4a: Profitability ratios of Vodafone from 2000-2005(%) -----------55 Figure 4b: Profitability ratios of O2 from 2000-2005(%) -------------------55 Figure 4c: Profitability ratios of Deutsche Telekom from 2000-2005(%) --56 Figure 5a: Liquidity ratios of Vodafone from 2000-2005 -------------------56 Figure 5b: Liquidity ratios of O2 from 2000-2005---------------------------57 Figure 5c: Liquidity ratios of Deutsche Telekom from 2000-2005----------57 Figure 6a: Activity ratios of Vodafone from 2000-2005 --------------------58 Figure 6b: Activity ratios of O2 from 2000-2005 ----------------------------58 Figure 6c: Activity ratios of Deutsche Telekom from 2000-2005 ----------58 Figure 7: Key figures and ratios of Time Warner from 1996-2000(in $ million) --------------------------------------------------------------------------------62 Figure 8a: Key Growth of Time Warner from 2000-2005-------------------64

6

Figure 8b: Key Growth of Walt Disney from 2000-2005---------------------65 Figure 8c: Key Growth of News Corporation from 2000-2005--------------65 Figure 9a: Profitability ratios of Time Warner from 2000-2005(%) --------66 Figure 9b: Profitability ratios of Walt Disney from 2000-2005(%) ---------66 Figure 9c: Profitability ratios of News Corporation from 2000-2005(%) ---67 Figure 10a: Liquidity ratios of Time Warner from 2000-2005 --------------67 Figure 10b: Liquidity ratios of Walt Disney from 2000-2005 ---------------67 Figure 10c: Liquidity ratios of News Corporation from 2000-2005 --------68 Figure 11a: Activity ratios of Time Warner from 2000-2005----------------68 Figure 11b: Activity ratios of Walt Disney from 2000-2005 ----------------68 Figure 11c: Activity ratios of News Corporation from 2000-2005-----------68

7

Chapter 1 Introduction

1.1 Background of Mergers & Acquisitions

Several decades ago, mergers and acquisitions have seldom dominated the

headlines as much as at present. Whereas, the pace and scale of mergers

and acquisitions, nowadays, are remarkable in the world. For instance,

academic research has shown substantial mergers and acquisitions

activities in a wide range of sectors, such as banking, insurance,

pharmaceuticals, electricity, oil, gas, automobile, steel etc. In the US,

corporations spent more than $1.7 trillion on mergers and acquisitions in

2000 (Brealey et al., 2006).

From the perspective of historical development of mergers and acquisitions,

they appear to follow a historic pattern with several boom periods. The first

period of mergers and acquisitions occurred at the beginning of the 20th

century and the second one took place in the 1920s. During the period from

1967 to 1969, it was a boom period for mergers and acquisitions and the

same in the 1980s and in the 1990s. Although each period was characterised

by the fluctuations in share prices, it had some differences in payment

methods and types of firms that merged or acquired (Brealey et al., 2006).

During the most recent mergers and acquisitions boom periods, managers

and investment bankers spent much time on mergers and acquisitions

transactions every day, which can be worth hundreds of millions or even

billions of dollars. For instance, in January 2000, the merger and acquisition

between Time Warner and AOL (American On line) broke a record of $181

billions of stock (www.bbc.co.uk). Therefore, not surprisingly, these

transactions always make the news. Unfortunately, according to the survey

of researchers, in many CEOs opinions, only 37 percent of mergers and

8

acquisitions activities are considered to be very successful or somewhat

successful (Reeves, 2000).

Even though different companies have diverse reasons for engaging in

mergers and acquisitions, the main purpose is to create shareholders value

over and above that of the sum of two companies (Sudarsanam1995).

According to Sudarsanam (1995), the fundamental objectives of doing

mergers and acquisitions involve enhancement of shareholders wealth,

increased competitive advantages (i.e. economies of scale or scope or

increased market power), expansion of acquirers assets, sales and market

share. In short, one plus one equals three. This equation is the essence of

mergers and acquisitions. Whatever the motivating factors, the same

principle always applies (Reeves, 2000).

In a word, the hot issue of participating in mergers and acquisitions seems

to be on the rise.

1.1.1 Definition of Mergers & Acquisitions

Both the terms merger and acquisition mean a corporate combination of

two separate companies to form one company and they are often used

synonymously in practice (Chiplin & Wright, 1987), but there are slightly

different meanings between them.

In a merger activity, it usually takes place when two separate firms which

have similar size agree to form a new single company. Then both companies

stocks will cease to exist and the newly created companys stock will be

issued in its place. This kind of activity is often referred as a merger of

equals (www.investopedia.com). A typical example of a major merger is

the merger between AOL and Time Warner in 2000.

9

While in the case of an acquisition, one company is purchased by another

one and then no new company is formed subsequently. From a legal point of

view, the target company ceases to exist, the acquirer occupies the business

of the target firm and the acquirer's stock continues to be traded. In addition,

the acquiring firm collects all asset and gains of the target company as well

as the liability (www.investopedia.com). An example of a major acquisition

is Manulife Financial Corporation's acquisition of John Hancock Financial

Services Inc in 2004 (www.investopedia.com).

From the degree of friendliness between the acquirer and the acquired,

there are two general types of acquisitions: friendly and hostile (Schnitzer,

1996). When the board of directors and managers of the target company

agree an acquisition from the acquiring firm, it is called a friendly acquisition.

The top managers of the target firm will keep their positions within the newly

created firm. In contrast, a hostile takeover takes place in a situation when

the acquired firm resists an acquisition from others; in this case the top

managers in the target firm may lose their jobs after the hostile takeover

(Schnitzer, 1996).

In a word, the degree of friendship among companies board of directors,

senior managers and shareholders decides whether the takeover process is

a merger or an acquisition (www.investopedia.com).

Nevertheless, the slightly different meanings between mergers and

acquisitions will not be strictly distinguished in this dissertation and both are

refer to under the term of M & A, which literally means mergers and

acquisitions.

1.1.2 Types of Mergers & Acquisitions

10

From the perspective of business structure and the relationship between two

corporations, according to Gaugham (2005), there are four main categories

of M & A: horizontal, vertical, conglomerate and cross-border. Each type has

its own characteristics and nature, which are described as follows.

1.1.2.1 Horizontal Mergers & Acquisitions

Horizontal M & A describes that one company merge with or acquires

another one from the same business field. Moreover, this kind of M & A is the

most popular in the modern world (Brealey et al., 2006). For example, the

Vodafone Group (UK) acquired the German telecommunications

giant-Mannesmann AG in 2000.

Horizontal M & A may arise from the possible side effects on competition in

the same industry, in that after horizontal M & A, companies may occupy a

monopoly position by decreasing the number of firms in the same field

(Weston et al., 2004). Furthermore, horizontal M & A usually occurs between

small or immature firms and when there is no dominant leader in the same

business. They combine to achieve the goal of economies of scale in

purchasing, marketing, information systems, distribution, and senior

management (Weston et al., 2004, p.7). Consequently, the newly merged

firms are usually financed by initial public offering (IPO), but this kind of M &

A is not the best way to achieve economies of scale (Weston et al., 2004).

1.1.2.2 Vertical Mergers & Acquisitions

Vertical M & A refer to the vertical integration of two firms, which operate in

the same production line. Specifically speaking, there are two major

categories of vertical M & A, which are forward integration (i.e. the acquirer

expands forward of the ultimate consumer) and backward integration (i.e.

11

the buyer expands backward to suppliers of raw materials) (Brealey et al.,

2006). Examples of this type M & A are typical in the oil industry and in the

pharmaceutical industry.

The primary reasons for companies to be vertically integrated are

technological economies such as the avoidance of reheating and

transportation costs in the case of an integrated iron and steel producer and

the reduction of transaction cost (i.e. the cost of searching for prices,

contracting, payment collecting, and advertising and also might reduce the

costs of communicating and coordinating production) (Weston et al., 2004,

p.7). Moreover, the more efficient information that flows into the firm gives

rise to the improvements of production and inventory. Vertical M & A can

also help companies avoid the uncertainty about input supply of long-term

contracts due to the difficulty of writing and executing of long-term

contracts (Weston et al., 2004).

1.1.2.3 Conglomerate Mergers & Acquisitions

Conglomerate M & A refer to a combination of two firms which do business in

diverse fields. This kind of M & A is the least popular nowadays (Brealey et al.,

2006). There are three categories of conglomerate M & A: product extension

mergers, geographic market extension mergers and the other conglomerate

mergers. The first type is also called concentric mergers, which means two

firms merger or acquire in related businesses in order to broaden the

product lines of firms. The second one occurs when two firms, which have no

overlapping businesses, merge in different geographic areas. The last kind

refers to a pure conglomerate M & A in different business field (Weston et al.,

2004; Sudarsanam 2003).

1.1.2.4 Cross-border Mergers & Acquisitions

12

Cross-border M & A refer to M & A across national boundaries and involving

substantial cash flow into other countries (Sudarsanam, 1995). It seems

that cross-border M & A have an increasing trend over the past few years

due to the globalization and the development of the internet. With the

advent of globalization, companies prefer to seek a competitive area that is

worldwide in scale in order to have customers worldwide through cross-

border M & A. The typical example is the biggest cross-border M & A at the

beginning of 21st century -Vodafone (UK) acquired Mannesmann AG

(Germany) and it has a record of worth $203 billion.

However, regardless of which type of M & A, the main goal is to create the

value of the combined companies greater than the value of the two single

entities and the success relies on the synergy effect of the new company

(www.investopedia.com).

1.2 Objectives of the dissertation

The main purpose of this dissertation is, firstly, to examine motives of

participating in M & A. It asks what factors result in these activities and the

reasons why one company seeks to merge with or to acquire another one. In

this part, the role of synergy, of the agency problem, of the free cash flow, of

the increased market power, of diversification etc that influenced the

decision of managers to participate in M & A will be indicated. Moreover, the

motives are categorized into three kinds: increase or decrease shareholders

value 1 or have uncertain impact on shareholders value. Secondly, the

effects or the consequences of these motives on companies post M & A

performance will be investigated. To illustrate this point, two case studies

that happened in two different sectors and different countries (i.e.

Vodafones acquisition of Mannesmann AG and the merger between AOL and 1 Shareholders value means the increased acquirers returns or profitability in this study.

13

Time Warner) at the beginning of the 21st century will be analyzed in order

to check the literature results in terms of companies financial performance.

1.3 Research Methodology

The major research methodology of this dissertation is a quantitative

approach- an accounting study2. The relevant data is mainly collected from

companies annual reports, as well as online and printed publications, such

as research papers and articles. Specifically speaking, an accounting study

is used to measure the changes of firms financial performance before and

after M & A and to see how M & A affect the companys financial performance.

This process involves the calculation of the key ratios 3 including

revenue/turnover growth rates, key profitability ratios, liquidity ratios and

activity ratios. Lastly, in order to control firm-specific, industry-specific and

economic-wide factors that might pose impact on the measurement of

companies financial performance, the comparisons among the acquiring

company and its non-acquiring peers in the same industry during the same

period will be examined.

1.4 Organization of the dissertation

The dissertation is structured as follows: the first chapter serves as an

introduction to the dissertation including background, types of M & A, the

main purpose, research methodology and organization of this dissertation.

Chapter two refers to the literature review, which gives an overview of the

theoretical literature on motives of engaging in M & A and the empirical

literature on the effects of M & A. In chapter three, the quantitative research

2 The definition and meanings of an accounting study are specifically explained in Chapter three-research methodology. 3 The formulas, meanings and explanations of the key ratios refer to chapter three-research methodology.

14

methodology-an accounting study- will be overviewed. Chapter four looks at

two case studies (i.e. Vodafones acquisition of Mannesmann AG and the

merger between AOL and Time Warner) in two different sectors to study the

motives behind M & A, as well as companies historical development, effects

of motives of engaging in M & A and comparisons between the acquiring

company and its competitors in the same industry in terms of financial

aspects. The last chapter briefly reviews the major findings, presents some

limitations and suggestions of this study and concludes the dissertation.

15

Chapter 2 Literature Review

2.1 Motives of engaging in M & A

Mergers and acquisitions play a significant role in the majority of companies

strategies. The motives for M & A can be defined as the acquirers corporate

and business strategy objectives, which are varied in different companies.

Empirical evidence has provided many possible motives for M & A, just as

Andrade et al. (2001) summarized as follows:

efficiency-related reasons that often involve economies of scale or other

synergies; attempts to create market power, perhaps by forming monopolies or

oligopolies; market discipline, as in the case of the removal of incompetent

target management; self-serving attempts by acquirer management to

over-expand and other agency costs; and to take advantage of opportunities

for diversification, like by exploiting internal capital markets and managing risk

for undiversified managers (p.103)

However, the appeal and frequency of M & A drive scholars not only to

investigate the motives behind M & A, but also to question that whether

these motives increase or decrease shareholders value.

In this section, the motives which are concerned with shareholders value

are examined. Different motives have different characteristics and

contribute to diverse effects on shareholders value. Thus, the motives can

be mainly categorized into three types as follows: motives which increase or

decrease shareholders value or have uncertain impact on shareholders

value.

2.1.1 Motives which increase shareholders value

16

In this section, the motives which can benefit shareholders value will be

investigated. Empirical evidence concludes that these motives mainly

include the synergy effect, improvement of managerial efficiency,

achievement of economies of scale and economies of scope, increased

market power and revenue growth.

2.1.1.1 The Synergy Motive

The synergy motive is regarded as the most popular motive for M & A. It

refers to acquire or to merge with the resources of two separate firms and

thus it contributes to the value of the newly combined firm greater than that

of two separate unities (Seth et al., 2000). One important source of synergy

is from the transfer of some valuable intangible assets, such as know-how,

between targets and acquirers (Seth et al., 2000). Evaluating synergy

effects from M & A deals has become one of major tasks of managers. From

the perspective of the relationship between targets and total gains, they are

positively correlated in synergy motivated M & A. This means that the higher

the synergy, the higher the target gains as well as the acquiring firms

shareholders benefits (Berkovitch & Narayanan, 1993).

To sum up, the empirical results show that the synergy motive has a positive

effect on targets, acquirers and total gains (Berkovitch & Narayanan, 1993;

Gondhalekar & Bhagwat 2000; Bradley et al., 1983). Sudarsanam et al.

(1996) further support this view: the synergy motive creates shareholders

value for the acquirer and the acquired or the new company.

Specifically speaking, according to Chatterjee (1986), there are three types

of synergy creation: operational synergy, financial synergy and collusive

synergy.

17

Operational Synergy

Operational synergy represents the achievement of production and/or

administrative efficiencies (Chatterjee, 1986). In addition, it can be

classified into revenue-enhancing operating synergy and cost-reducing

operating synergy (Gaughan, 1999). As Copeland et al. (2005, p.762)

report that the theory based on operating synergies assumes that

economies of scale and scope do exist in the industry and that prior to the

merger the firms are operating at levels of activity that fall short of achieving

the potential for economies of scale. In other words, either economies of

scale or economies of scope can lead to operational synergy. Moreover,

operational synergy can help companies realize some potential benefits

such as purchasing, training programs, common parts and the development

of larger scale manufacturing facilities (Harrison et al., 2001).

Financial Synergy

When the capital of two unrelated companies is combined and results in the

reduction of the cost of capital and a higher cash flow, that is so called

financial synergy (Fluck & Lynch, 1999; Chatterjee, 1986). Specifically

speaking, financial synergy applies into financing expensive investment

projects which are difficult to accomplish on an individual basis (Chatterjee,

1986). In addition, another type of financial synergy is to purchase a target

at bargain basement prices. When the q-ratio 4 is low, the acquirer is

considered as successful in buying the target (Copeland et al., 2005).

Compared with external financing, the lower cost of internal financing is one

major source of financial synergy (Copeland et al., 2005). Thus, the value 4 The q-ratio is defined as the ratio of the market value of the firms securities to the replacement costs of its assets (Copeland et al., 2005, p.762).

18

creation of financial synergy comes from the advantage of lower cost of

internal funds and greater growth investment of excess cash flow.

Sudarsanam (2003) further points out cost of savings are one aspect of

value creation in M & A. Another source of financial synergy is from the

potential benefits of tax savings on investment income, because the debt

capacity of the new firm is greater than the sum of the two firms capacities

after M & A. The savings of transaction costs from economies of scale is also

regarded as a benefit of financial synergy (Copeland et al. 2005).

Furthermore, it is supported that financial synergy, on average, tends to be

associated with more value than do operational synergies (Chatterjee,

1986, p.120).

Collusive Synergy

Collusive synergy means the scarce resources are gathered together and

then the market power will be increased. Furthermore, researchers have

found that collusive synergy creates more value than operational synergy

and financial synergy (Chatterjee, 1986).

2.1.1.2 Achievement of Economies of Scale or Scope

Most companies pursue to save production cost through M & A, because low

costs are vital for corporations profitability and success. However,

economies of scale and economies of scope can help companies achieve that

goal.

Economies of scale refer to the average unit cost of production going down

as production increases (Brealey et al., 2006; Seth, 1990). Achieving

economies of scale is the goal not only for horizontal M & A, but also for

19

conglomerate M & A. Since economies of scale in horizontal M & A and

conglomerate M & A apply to the same line of business, so the economies

come from sharing central services such as office management and

accounting, financial control, executive development and top-level

management (Brealey et al., 2006, p.874).

Economies of scope are attributed to an increase in the variety of products

leading to the declining production cost. This feature of economies of scope

is more suitable for vertical M & A in seeking vertical integration (Brealey et

al., 2006). Corporations may find it is more efficient to outsource the

provision of many services and various types of production; one method to

achieve this aim is to merge with or to acquire a supplier or a customer.

In addition, complementary resources between two firms are also the

motive for M & A. It means that smaller firms sometimes have components

that larger ones need, so the large companys acquisition of the small

company often take place (Brealey et al., 2006).

To sum up, although economies of scale and economies of scope can result

in companies value creation, firms should also be aware of diseconomies of

scale and diseconomies of scope, which may result from the diffusion of

control, the ineffectiveness of communication and the complexities of

monitoring (Sudarsanam, 2003).

2.1.1.3 Increased Market Power and Revenue Growth Motive

According to Seth (1990, p.101), market power is the ability of a market

participant or group of participants to control the price, the quantity or the

nature of the products sold, thereby generating extra-normal profits.

20

As Zheer & Souder (2004) state, increased market power and increased

revenue growth are the most common objectives for firms participating in M

& A. These motives can be achieved through horizontal M & A. As Andrade et

al. (2001) state market power may be increased by forming monopolies or

oligopolies. Furthermore, increased market power can help companies

compete more effectively and revenue growth can be achieved by lowering

the prices of products which are highly price sensitive. New growth

opportunity comes from the creation of new technologies, products and

markets (Sudarsanam, 2003). As a result, the financial position of the

acquiring firm will be strengthened by increased market power and revenue

growth. Thereby the profitability of the firm will increase as well as the

shareholders value. Gaughan (2005) has expressed a similar view.

2.1.1.4 Improvement of Managerial Efficiency

In order to improve managerial efficiency, a company may prefer to merge

or to acquire a target to improve managerial efficiency by restructuring its

operations (Copeland et al., 2005). As a result, efficient management mainly

comes from the potential benefits of the combination between two firms

unequal managerial capabilities.

Generally speaking, the improvement of managerial efficiency in M & A may

be attributed to two methods (Martin & Mcconnell, 1991). On the one hand,

the market for corporate control plays a significant role in improving the

managerial efficiency of target firms, in that potential bidders may pose a

threat on managers positions and monitor their performance as well

(Jenson & Ruback, 1983). Therefore, senior top executives and managers

will improve managerial efficiency to avoid of dismissal after M & A and

minimize non-value maximizing behaviour (Manne, 1965; Alchian &

Demsetz, 1972). On the other hand, when the threat of M & A can not

21

minimize managers non-value maximizing behaviour, the acquirer will

replace the management of the target company (Martin & Mcconnell, 1991).

Consequently, the improved managerial efficiency may help managers

operate the company efficiently and maximize shareholders value.

However, M & A may not be the only way to improve management efficiency,

but sometimes it may be the most practical and simple method (Brealey et

al., 2006).

2.1.2 Motives which decrease shareholders value

In contrast to the theories based on synergy effects, managerial efficiency,

economies of scale, economies of scope and increased market share, a

number of theories argue that the motives including managerial hubris,

agency problem and free cash flow theory are the potential responses to

shareholders value destruction for M & A.

2.1.2.1 Managerial Hubris

Managerial hubris, according to Seth et al. (2000), contains two major

issues: the hubris hypothesis and the managerialism hypothesis.

Managers are considered to have the incentive to create economic value and

have the ability to assess the potential value of targets (Seth et al. 2000).

However, when the management of the acquirer underestimates the value of

the target firm and usually overestimates the potential synergies, the hubris

hypothesis will take place (Berkovitch & Narayanan, 1993). A study by Roll

(1986) showed that the hubris hypothesis can be served as an explanation

of corporate M & A deals, because managers seek to acquire firms for their

own benefits, rather than for the whole companys economic gains as the

22

major motive. Therefore, acquirers may pay more than the current market

price for their targets due to the hubris factor (Roll, 1986; Seyhun, 1990).

Gaugham (2005) further supports the hubris hypothesis. He states that top

executive management hubris is positively related with the size of premiums

paid. As a result, there will be zero correlation between target and total

gains, since target gains are merely a transfer of wealth from acquirers,

(Berkovitch & Narayanan, 1993, p.348).

From the perspective of managerialism hypothesis, it could be concluded

that managers prefer to carry on M & A at the expense of shareholders, in

order to maximize their own competence (Firth 1980; Caves 1989). Just as

Marris (1964)s opinion, which was cited by Seth et al. (2000), reported that

since managerial compensation is usually associated with the amount of

assets, which are under the control of managers, managers prefer a higher

growth to higher profits. Langeteig (1978) also supports the view that

managerial welfare may be one motive of M & A.

To sum up, managerial motives drive bad M & A (Morck et al., 1990) and it

has been proven that when M & A is driving by managerial hubris, (a) the

combined value of the target and bidder firms should fall slightly, (b) the

value of the bidding firm should decrease, (c) the value of the target should

increase (Roll, 1986, p. 213).

2.1.2.2 The Agency Motive

In some circumstances, the agency problem might force managers to

engage in M & A (Malatesta, 1983). With the separation of ownership and

control, the agency problem implies M & A occur when managers want to

increase their wealth at the expense of the acquirers shareholders benefits

(Berkovitch & Narayanan, 1993). However, the agency problem can

23

stimulate competition among companies but it can not be eliminated by

competition, and the gains to the target shareholders increase with

competition (Berkovitch & Narayanan, 1990; 1993).

Even though the agency motive may reduce the value of the acquiring firm,

management still prefers to seek a target and then the dependence of the

firm so that their own competence can be enhanced (Shleifer & Vishny,

1989). Thus, it seems that the agency motive is the main reason for value

destruction in M & A.

In a word, in contrast to the synergy motive, when the agency motive is the

main motive in M & A the returns to the target is positive, whereas the

returns to the acquirer is more negative, thus the returns to the newly

company is negative (Gondhalekar & Bhagwat, 2000).

2.1.2.3 Free Cash Flow Theory

Free cash flow is cash flow in excess of that required to fund all projects that

have positive net present values when discounted at the relevant cost of

capital (Jenson, 1986b, p.323). When the acquiring company has

substantial free cash flow and a low growth prospect, managers would like

to concentrate on M & A in order to keep control of internal funds and

maintain their power, in that the payment of the high cash flow as dividends

or share buyback can reduce managers control and power. In addition,

managers regard a pay out of dividends or repurchasing shares as a

complete waste, whereas M & A are considered a very attractive way to

conserve corporate wealth (Shleifer & Vishny, 1991). Jenson (1986b; 1988)

argues that free cash flow is regarded as a source of value destruction for

shareholders and that the returns for the combined company are negative.

In order to strengthen his opinion, Jenson (1986b) cites the oil industry in

24

the 1970s and concludes that excess free cash flow results in shareholders

value destruction.

2.1.3 Motive which has uncertain impact on shareholders value

2.1.3.1 The Diversification Motive

The diversification motive can serve as a motive of conglomerate M & A. The

reason of engaging in M & A that are driven by diversification is to reduce the

top managers employment risk, such as the risk of losing job and the risk of

losing professional reputation (Amihud & Lev, 1981). Many large firms seek

to achieve diversification by external M & A, rather than internal growth

(Thompson, 1984; Levy & Sarnat, 1970). Gorecki (1975) indicates that

diversification also has a significant effect on an industrys structural

change.

According to Berger & Ofeck (1995), diversification has an uncertain effect,

i.e. either value creation or value destruction, on shareholders value. On

the one hand, the potential benefits of diversification include greater

operating efficiency, less incentive to forego positive net present value

projects, greater debt capacity and lower taxes (Berger & Ofeck, 1995,

p.40). In addition, the value of the acquiring company is increased through

diversification in terms of economies of scale, economies of scope and

market power. However, the potential costs of diversification involve the cost

of undertaking value destructing investments, resources which are allocated

from better-performing departments to poor ones, are not sufficiently used,

and there is a conflict of interest problem among diverse managements

(Berger & Ofeck, 1995).

On the other hand, Graham et al. (2002) argue that corporate diversification

25

destroys companies value. The destruction effects from diversification

resulte from overinvestment and the subsidization of failing segments

(Jensen, 1986a; Stulz, 1990). However, the benefits of the increased debt

capacity and the reduced tax payments that result from the combination of

two firms may mitigate the value loss from diversification (Lewellen, 1971).

Just as Berger & Ofeck (1995, p.59) stated, Diversification creates a further

tax advantage by allowing the losses of some segments to be offset

contemporaneously against the gains of others, rather than merely carried

forward to future tax years.

Furthermore, the opinion of Seth et al. (2000, p.391) indicates in an

integrated capital market, firm-level diversification activities to reduce risk

are generally considered non-value maximizing as individual shareholders

may duplicate the benefit from such activities at lower cost.

To sum up, as Berger & Ofeck (1995) state, there is no clear prediction about

the overall value of diversification.

Conclusion

In conclusion, with regard to the relationship between motives of M & A and

gains to the target, the acquiring company and the newly combined

company, the following table summarizes the different patterns of gains in M

& A.

Table 1: The relationship between the motives of M & A and gains

Theory Combined gains Gains to target Gains to bidder

Efficiency/Synergy positive positive Non-negative

Agency costs negative positive more negative

Hubris zero positive negative

Source: Weston et al., 2004, p.136.

26

2.2 The Effects of the Motives in M & A: Post-M & A Performance

After presenting diverse kinds of motives for M & A, it is essential to assess

the effects or consequences of these motives which force managers to

engage in M & A. This can be found out by studying the post M & A

performance for acquirers and targets. According to Bruner (2002), there

are four approaches (i.e. accounting studies, event studies, survey of

executives and clinical studies) to measure post- M & A performance. The

former two are quantitative methods, while the latter two are qualitative

approaches. It is undeniable that each research approach has its own

advantages and disadvantages, which will be described at the end of this

chapter.

Although lots of researchers have studied this popular thesis, it seems that

they used diverse estimation techniques and the results may be a slightly

different. In this part, the empirical evidence about the effects-post M & A

performance, which mainly focus on the findings in the UK and in the US, will

be presented. The implications of the empirical evidence are also discussed

in each part and at the end of this chapter.

2.2.1 Empirical Evidence Based on Accounting Studies

Accounting studies examine the changes in financial performance, which are

based on pre- and post- M & A accounting data of the target and the acquirer

or the newly combined firm. More specifically, the changes of net income,

profit margin, growth rates, return on equity (ROE), and return on asset

(ROA) and liquidity of the firm are the focus of accounting studies (Bruner,

2002; Pilloff, 1996). Furthermore, the comparisons between the acquirer

and the non-acquirer based on similar size in the same industry will also be

investigated in order to illustrate whether the acquiring company

27

outperforms its non-acquirer competitors (Bruner, 2002).

UK Findings

Dickerson et al. (1997) are the first researchers to study the relationship

between M & A and profitability for UK firms in the period 1948-1977. Their

findings indicated that there was no evidence that M & A brought benefits to

the acquiring companys financial performance, which was based on the

measurement of profitability. Conversely, the growth rate and profitability

was lower after M & A than that of before M & A. In addition, after controlling

other uncertain factors that might affect profitability, Dickerson et al. (1997)

observed that M & A had a negative effect on the acquirers profitability by

measuring return on assets (ROA) in both the short term and the long term

period. This finding was consistent with that of Meeks (1977), who also

found that ROA for acquiring firms decreased after M & A in the UK. However,

Dickerson et al. (1997)s paper did not investigate acquired firms nature

that may be horizontal, vertical or conglomerate, because the nature of a

firm may affect the final findings.

Firth (1980), who cited many other previous researchers results, concluded

that based on accounting studies, generally speaking, acquired companies

do not have great profitability and have low stock market ratings before M &

A, but obtain a great deal of profit after engaging in M & A. In contrast,

acquiring companies generally have average or above average profitability

prior to M & A, whereas they suffer a reduction in profitability after M & A.

This finding is very evident in the UK, whereas it is inconclusive in the US,

because some studies found there was no change in profitability for

acquiring firms after M & A; while others indicated a reduction in profitability

for acquiring firms following M & A.

28

The work of Caves (1989) showed a conflict result for the effects of M & A in

financial performance through event study and accounting study

respectively. He found that in event study the target shareholders obtained

positive gains, while the bidder shareholders had zero or negative return; in

contrast, accounting studies found negative average productivity for

mergers or acquirers.

Surprisingly, Chatterjee & Meeks (1996) studied the reasons of Caves

(1989)s conflicting results and reported that the choice of accounting policy

in M & A had an impact on the reported profitability. In the UK during the

period from 1977-1990, there was no significant increase in profitability for

mergers following M & A until 1985 when some new accounting standards

were introduced. The new accounting regulations were much more

transparent for evaluating M & A and made new discretion over the valuation

of assets that might affect future profit.

US Findings

In a study of Mueller (1985), one studied the relationship between M & A and

market share for the 100 largest US companies between 1950 and 1972 by

analyzing market share data. In order to avoid some uncertain factors that

might affect market share, the market share of other non-acquired firms

were selected to be compared with those of acquired firms. The finding

showed that the acquired companies suffered substantial losses in market

share following M & A, regardless of whether they were participating in

horizontal or conglomerate M & A. However, this finding did not directly

imply decreased profitability or shareholders return, but the return on

assets (ROA) or sales may decline for the acquired companies relative to

their industry.

29

From the perspective of operating performance, Healy et al. (1992)

examined the post M & A operating performance of the 50 biggest M & A in

the US during the period from 1979 to mid-1984 and the same industry

performance was used as a benchmark. The authors indicated that after M &

A, the increased asset turnover resulted in significant improvements in the

operating cash flow for acquired firms, compared with its non-acquired

peers. While the increased asset productivity was not at the expense of

long-term performance, because sample firms in this paper maintained

capital expenditure and R & D rate relative to their industries after M & A. In

addition, this finding is more evident in overlapping businesses. More

importantly, this paper came to conclude that there is a strong positive

relationship between the improvement in operating cash flow after M & A

and the abnormal stock returns at merger announcements. This means the

share price at announcement can be explained by the expected economic

gains.

It must be recognised that the above empirical evidence is limited to study

the profitability of the acquiring firm or the acquired after M & A, they do not

reveal the effects of payment on profitability. Ghosh (1997) is the first

researcher to examine the correlation between post-merger operating cash

flow and the method of payment used in M & A for the acquiring company for

315 mergers over the period from 1981 to 1995. The results showed that if

the acquiring firm paid with cash and then was compared with its industry

peers, the cash flow would increase significantly through improved asset

turnover after the M & A. In contrast, the cash flow of the acquirer decreased

significantly with stock payment. Even though stock acquisitions are a good

strategy to reduce cost, the benefits from such a strategy are less than the

loss of declined asset turnover. However, the author did not find any

evidence that the acquiring company outperforms its peers in term of cash

flow following large M & A.

30

However, one of drawbacks of accounting studies is that the calculated

outcome often neglects current market value and is merely based on

historical data (Pilloff, 1996), the more specific of advantages and

disadvantages of accounting studies will be presented later.

2.2.2 Empirical Evidence Based on Event Studies

Since Fama, Fisher, Jensen and Rolls 1969 study of stock, event studies

have become the predominant methodology for determining the effects of

an event on stock return, and it has become a powerful tool that can help

companies to determine whether there are abnormal returns (Boehmer et

al., 1991; McWilliams & Siegel, 1997; MacKinlay, 1997). It is well recognized

that the reliability of an event study depends heavily on a series of strong

assumptions (Brown & Warner, 1980).

According to Bodie et al. (2005, p.381), an event study describes a

technique of empirical financial research that enables an observer to assess

the impact of a particular event on a firms stock price. For example, an

event study may infer the relationship between stock returns and dividend

changes. Bruner (2002, p.4) also points out that an event study examines

the abnormal returns 5 to shareholders in the period surrounding the

announcement of a transaction. The standard event study methodology

involves the use of Sharpes (1963) market model and capital asset pricing

model (CAPM) (Dimson & Marsh, 1986).

Even though numerous event studies show that M & A creates shareholders

value, most of gains are belonged to shareholders of targets. For instance,

Bruner (2002) points out target shareholders can earn positive market

5 The abnormal return is simply the raw return less a benchmark of what investors required that day (Bruner, 2002, p.4).

31

returns, while acquiring shareholders may earn zero adjusted returns, the

combined company may earn positive adjusted returns.

The results of empirical studies of M & A impact on stock returns can be

classified in terms of short term and long term approach. The short term

approach assumes stock market efficiency that means the stock market

reaction to acquisitions when they are announced or completed provides a

reliable measure of the expected value of the acquisition. The long term

performance assessment assumes the stock market spends time to evaluate

the value implications of acquisitions and wait new information about the

progress of the merger. Besides, the probability of M & A will be analyzed

(Sudarsanam, 2003, p.71).

UK Findings

Based on event studies, Firth (1980) studied 496 targets and 434 acquirers

in the UK during the period from 1969 to 1975 and presented a conflict

result in terms of shareholders returns to acquiring firms in the UK and in

the US respectively. In the UK, he found that the share price of acquiring

firms on average declined on the announcement of takeover and the

profitability was also reduced. This phenomenon will last a few years. In

addition, there was a zero overall gain in M & A and there was no overall

improvement in profitability for merged firms, because the benefits to

acquired firms are offset by the loss to acquiring firms. In contrast, in the

US, M & A have small or zero gains for the acquiring firms shareholders.

From the perspective of total gains, M & A results in overall stock market

gains and thus the profitability of the merged firms is increased. In all, the

overall benefits are attributed to improvement of the profitability

performance of the acquired firm.

32

US Findings

Langeteig (1978), who cites Mandelker (1973, 1974) and Franks, Broyles,

and Hecht (1977)s work, concludes that the combined firm earned a normal

rate of return based on capital asset pricing model. He further cited Dodd

and Ruback (1977)s research, which shows that M & A have negative but

normal gains for the acquiring companies after the date of first public

announcement. In addition, Langeteig (1978) used a three-factor

performance index to measure long term stockholders gains from M & A.

The sample size was composed of 149 mergers among NYSE firms between

1929 and 1969. He concluded that post-merger excess returns were

insignificantly different from zero and provided no support for mergers. The

acquired had an average excess return of 12.9%, while bidders return was

only 6.11%.

Moeller et al. (2004) examined a sample of 12,023 US acquisitions by public

firms between 1980 and 2001 over the event window of three days (-1, +1).

They found a link between firm size and acquisition announcement returns.

It proved that when corporations make an acquisition announcement, small

firms obtain more benefits than larger ones. In more detail, the abnormal

return associated with acquisition announcements for small firm is higher

than that for large ones by 2.24 percentage points, whereas this finding is

not true for acquisitions of public firms paid for by stock; and large

companies suffer shareholder wealth losses regardless of the payment of

acquisition.

Based on a study of 947 acquisitions during 1970-1989 in the US, Loughran

& Vijh (1997) found a relationship among the post-acquisition returns and

the mode of acquisition and form of payment. Acquirers obtain negative

excess returns of -25.0 percent when they complete M & A by stock during

33

a five-year period following the acquisition, whereas acquirers obtain

positive excess returns of 61.7% when they complete M & A by cash.

Furthermore, the overall wealth gains of target shareholders from stock

mergers by combing the pre-acquisition and post-acquisition returns were

investigated. In the finance literature, it has been generally accepted that

target shareholders get benefits from all types of acquisitions. However, this

paper questiones this opinion and supportes that target shareholders who

sell out soon after the acquisition effective date gain from all acquisitions,

those who hold on to the acquirers stock received as payment find their

gains diminish over time (Loughran & Vijh, 1997, p.1789).

Most previous researchers investigated share price performance of

acquiring firms after M & A by using single factor benchmarks, while Franks

et al. (1991) are the first to use multifactor benchmarks from the portfolio

evaluation literature to do the same research, in that multifactor

benchmarks can get rid of some drawbacks, such as mean-variance, of

single factor benchmarks. As a result, based on a sample size of 399 US

takeovers between 1975 and 1981, Franks et al. (1991) conclude that target

firm shareholders had much higher cumulative abnormal returns (28.04%)

than shareholders of acquiring firms (-1.45%) over the event window6 of

(-5,5). Therefore, it seems that the poor performance following M & A may

be due to benchmark error, rather than the wrong evaluation for a target at

the announcement time of M & A.

To sum up, Based on short term stock performance, target firm shareholders

obtain significant, positive abnormal returns, while acquiring firm

shareholders earn zero or negative abnormal returns and the combined

entity seems to be slightly better off and create shareholders value. From

6 The event window is defined as the period over which the security prices of the firms involved in the event will be examined (MacKinlay, 1997, p.14).

34

the perspective of long term stock performance, abnormal returns are still

negative or zero for acquiring firm shareholders and they underperformed

their non-acquiring peers three to five years after M & A. However, this

underperformance has been attributed to the smallest acquirers (Bouwman

et al., 2003).

2.2.3 Empirical Evidence Based on Clinical Studies

Clinical studies originated from anthropology, sociology and clinical methods

in the 1920s, and a clinical study is also called a case study, which is an in-

depth study by one person through field interviews with executives and

knowledgeable observers and is a form of qualitative descriptive research

(Bruner, 2002). The purpose of a case study is to seek the patterns and

causes of an activity by analyzing the history and nearly every aspect of a

case. In addition, it is observed that case studies are usually subjective

(Wagner, n.d.).

There are many case studies to discover the motives and measure effects of

motives in post M & A performance. A typical example can be referred to the

case study by Lys and Vincent (1995)s work about the AT&Ts acquisition of

NCR Corporation in 1991. This is the largest computer industry acquisition.

The profitability of AT&T after acquisition was decreased by between $3.9

billion and $6.5 billion and resulted in negative synergies of $1.3 to $3.0

billion. Therefore, one can conclude that this result is consistent with

Dickerson (1997), Firth (1980), Caves (1989)s findings.

2.2.4 Empirical Evidence Based on Surveys of Executives Studies

Surveys of executives present one study based on questions put to

executives by means of a standardized questionnaire, such as simply asking

35

managers the motives of M & A or whether M & A create or destroy value for

shareholders. Then the post-merger performance can be inferred from the

questionnaire (Bruner, 2002).

One example of survey of executive studies is Ingham et al. (1992), who

surveyed 146 of UKs top 500 companies during the period from 1984-1988

on the basis of a questionnaire. However, with regard to whether the

profitability of acquiring firms increased following M & A, this study got

different findings. From the point short-term (0-3years), 77% of managers

claimed that short term profitability increased after M & A, whereas in the

long-term (over 3 years), 68% of managers indicated the profitability

increased. However, one problem should be realized in this survey. The

samples in this study involved the acquisition of private companies; while

the previous finance literature mainly concentrates on studying public

companies M & A.

Conclusion

Given the empirical evidence, it can be seen that the post- M & A

performance, just as Bouwman et al. (2003) concludes that, it depends on

various factors, such as the valuation methods (using short term or long

term stock performance or accounting methods), the investigated entity

(acquired, target or the combined firm), the type of M & A (friendly or

hostile), the method of payment (cash or stock or mixed), the type of target

(public, private or subsidiary). Generally speaking, M & A increase

shareholders value for the target company, whereas they decrease

shareholders value for the acquiring company or the newly combined

company.

However, one problem should be noted that all of the above empirical

36

evidence, which uses accounting studies, is limited to evaluate one or two

aspects of financial performance, such as ROA, profit, or sales. This is

obviously not enough, because as stated earlier, the changes of net income,

profit margin, growth rates, return on equity (ROE), return on asset (ROA)

and liquidity of the firm are the focus of accounting studies (Bruner, 2002).

Therefore, in this dissertation, in chapter four-analysis and results, all of the

financial information will be analyzed in case analyses.

Finally, each approach has its own strengths and weaknesses as follows:

37

Table 2: Comparisons among each research approach

Strengths

Weaknesses

Event studies

A direct measure of value created for investors A forward-looking measure of value creation. In theory stock prices are the present value of expected future cash flow.

Requires significant assumptions about the functioning of markets: efficiency, rationality, and absence of restrictions on arbitrage. Research suggests that for most stocks these are not unreasonable assumptions, on average and over the time.

Vulnerable to confounding events, which could skew the return for specific companies at specific events. Care by the researcher and law and large numbers deal with this.

Accounting Studies

Credibility: statements have been certified and accounts have been audited.

Used by investors in judging performance. An indirect measure of economic value creation.

Possibly non-comparable data for different years. Companies may change their reporting practices. Reporting principles and regulations change over time.

Backward looking. Ignores values of intangible

assets. Sensitive to inflation and deflation

because of historic cost approach. Possibly inadequate disclosure by

companies. Great latitude in reporting financial results.

Differences among companies in the accounting policies add noise.

Differences in accounting principles from one country to the next make cross-country comparison difficult.

Survey of Managers

Yields insights into value creation that may not be known in the stock market

Benefits from the intimate familiarity with the actual success of the acquisition

Gives the perspectives of managers who may or may not be shareholders, and whose estimates of value creation may or may not be focused on economic value.

Recall of historical results can be hazy, or worse, slanted to present results in the best light.

Typically surveys have a low rate of participation (2-10%) that makes them vulnerable to criticisms of generalizability.

Case studies

Objectivity and depth in reconstructing an actual experience.

Inductive research. Ideal for discovering new patterns and behaviours.

Iii-suited to hypothesis testing because the small number of observations limits the researchers ability to generalize from the cases

the research reports can be idiosyncratic making it difficult for the reader to abstract larger implications from one or several reports.

Source: Does M & A Pay? A survey of evidence for the decision maker (Bruner, 2002, p.16).

38

Chapter 3 Research Methodology- an Accounting Study

As stated earlier, although there are four approaches to measure the

profitability for M & A, due to the limitations of this studythis dissertation

advances an accounting study research methodology to study the effects of

M & A on companies financial performance.

3.1 Overview of an Accounting Study Research Methodology

An accounting study 7 , which is based on the valuation of operating

performance improvements, provides an additional insight into the effects of

M & A especially for the situation when share price data is not available for

researchers. Furthermore, it directly provides the impact of M & A on the

acquiring and the acquired firm or the combined firms costs, revenues,

profits, cash flows etc. Therefore, an accounting study has become a

significant financial analysis tool in evaluating the financial performance of M

& A.

To begin with, I will overview each companys financial highlights, balance

sheet, loss and profit account in companies annual reports. From the

financial highlights and balance sheet, I will select the key figures such as

current assets, inventories, current liabilities, total assets and equity. The

important figures such as net profit, operating profit, gross profit,

turnover/revenue, and cost of sales can be obtained from profit and loss

account. The reason of choosing these key figures is that these accounting

data is necessary for calculating financial ratios which include profitability

ratios (i.e. net profit margin, gross profit margin, return on asset and return

on equity), liquidity ratios (i.e. current ratio and liquid ratio), activity ratios

7 The definition and explanation of an accounting study can refer to the effects of the motives in M & A- empirical evidence based on accounting studies in chapter three.

39

(i.e. total assets turnover and inventory turnover) and key growth rates (i.e.

turnover, turnover rates and operating profit). Different financial ratios are

used to assess various aspects of the companys financial performance and

have diverse meanings.

Table 3: Formulas of Key Financial Ratios

Turnover

Changes in Turnover

Key Growth Rates

Net Profit

Net profit margin=net profit after tax / sales

Gross profit margin= gross profit /sales or =

sales less cost of sales / sales

Return on assets (ROA) = net profit before

interest/ total assets

Profitability

Ratios

Return on equity (ROE) = net profit after tax /

equity

Current ratio = current assets / current

liabilities

Liquidity ratios

Quick ratio = current assets- inventories/

current liabilities

Total asset turnover = sales / total assets

Activity ratios Inventory turnover = cost of sales / inventories

Source: Global financial accounting and reporting Walton & Aerts (2006,

p.237)

Profitability ratios are usually used to measure the companys

performance, because profitability is a major measurement of the overall

success of a company and obtaining a satisfactory profit is the significant

goal of each company.

40

According to Walton & Aerts (2006), it is necessary to use margin ratios for

trend analysis and comparisons among companies. Gross profit margin

analyzes the companys operating profitability and operating efficiency.

Moreover, it shows managers ability of controlling manufacturing or

purchasing costs.

The net profit margin mainly measures the companys overall profitability

and is also referred to as return on sales. It is usually compared among

companies in the same industry or among different years to show that how

successful the management is in creating profit from a given quantity of

sales (Walton & Aerts, 2006).

ROA measures the efficiency of companies. This means it reflects how much

the company has earned on all assets. The ratio of ROE measured how

much the company has earned on the shareholders funds. It reflects the

perspective of shareholders and is also used to compare profitability among

diverse companies or from one year to another year (Walton & Aerts, 2006).

Liquidity ratios usually include current ratio and quick ratio. Current ratio

and quick ratio measure the short term liquidity problem, which is resulted

from a situation when current cash inflows do not match current cash

outflows. For example, the cash receipts from sales are unequal to the cash

payment to suppliers, employee etc. In the calculation of quick ratio, it

excludes inventory on the basis, because actually inventory is the least

liquid current asset and should not be contained in the category of quick

maturity to cash (Walton & Aerts, 2006).

Activity ratios mainly measure how efficiently the management uses the

companys assets. Total asset turnover presents how efficiently a company

utilize its total asset. Because of this characteristic, total asset turnover is

41

also used to compare among different companies based on the same

industry or compare from one year to another. Inventory turnover refers to

not only the operating efficiency but also liquidity needs, so this ratio

indicates how efficient the working capital management is (Walton & Aerts,

2006).

Secondly, the major point is the changes of ratios from one year to another

or the comparisons among various companies, because absolute ratios do

not have any meanings.

Lastly, in order to control firm-specific, industry-specific and economic-wide

factors that might pose impact on the measurement of companies

profitability, the changes in profitability for the acquiring company will be

compared with its benchmark group8, which are usually the acquiring firms

top competitors on the basis of similar size and in the same industry through

similar measurement. In this dissertation, the benchmark group is

composed of the acquiring companys top two competitors. This step mainly

involves the financial ratio analysis, which is one of the important tools of

financial analysis and it can provide the easiest comparisons among

companies. Furthermore, the selected benchmark group neither made large

acquisition nor were acquired during the observation period.

3.2 Data Source

The database of this dissertation is mainly from companies annual reports

including balance sheet, profit and loss account, income statement and cash

flow statement, which are available at companies websites. The reason of

choosing these statements is that they can provide a snapshot of a firms

8 Since the target companies are most often de-listed after M & A, the post-merger, long-term data are available only for the acquirers (Sudarsanam, 1995).

42

financial position and performance. The annual reports of the Mannesmann

Company are obtained by email contacting the companys top manager.

Besides, some relevant data and information are collected from online

publication, such as proxy statements, financial journals and research

papers.

3.3 Limitations of this study

Since the accounting data and the key information of each company in this

dissertation are secondary source, there maybe a possibility that the data in

annual reports might have a little bias due to the potential creative

accounting techniques9. The disadvantages of accounting studies in detail

can refer to the end of chapter two. On the other hand, even though this

dissertation analyzes the key financial ratios, there is still a possibility that

some other financial aspects that are not analyzed thoroughly. Therefore,

due to the limitations, it is appropriate for further research to compare the

results of accounting studies with those of other studies, such as event

studies, survey studies or clinical studies, because different approaches may

get diverse conclusions about the effects of M & A. For example, clinical

studies attempt to identify the organizational mechanisms and management

practices that might affect changes in productivity and performance (Kaplan

et al., 1997), whereas in accounting studies those factors are not examined.

9 Creative accounting techniques imply that companies published accounts may not be a true and fair reflection of the companies financial position (Dickerson et al., 1997, p.347).

43

Chapter 4 Case studies Analysis

In order to check the results of literature review, in this chapter, two cases

that have completed M & A in 2000, namely Vodafones acquisition of

Mannesmann AG and the merger between AOL (American On Line) and Time

Warner, will be analyzed so as to investigate what motives drive these two M

& A and the effects of these activities by studying the post- M & A

performance. The reasons of choosing these two cases are as follows:

Vodafones acquisition of Mannesmann AG is the largest cross-border

acquisition in Europe on record at the beginning of the 21st century and the

merger between AOL and Time Warner showed a combination of a new

economy company and an old economy company (Weston et al., 2004,

p.20). More importantly, in order to analyze the long-term company

performance after M & A, the cases that took place in 2000 are selected.

4.1 Overview of Vodafones acquisition of Mannesmann AG

At the beginning of the 21st century, the largest cross-border hostile

acquisition in the telecommunications industry happened due to the

increased liberalization, competition and a relaxation in regulatory regimes

in many countries.

On 13 November 1999, Vodafone, as the worlds biggest mobile phone

company, launched the biggest hostile acquisition to its German rival-

Mannesmann AG, which was the Europes biggest mobile phone company. It

was also the first hostile takeover for a German company by a foreign

country (BBC, 1999). On 11 February 2000, Vodafone was finally in charge

of Mannesmann AG successfully and it cost $203 billion. Meanwhile, this is

the largest cross-border acquisition in Europe on record. Subsequent to the

acquisition, Vodafone successfully acquired two of Europes most important

44

markets, Germany and Italy (Vodafone annual reports), the new company

had 42 million customers and Mannesmann AG still headquartered in

Dusseldorf, but it was delisted from Frankfurt's Xetra Dax share index (BBC,

2000).

After paying $203 billion for Mannesmann AG by stock, the total value of the

Vodafone Company on the stock market worth $365bn. As a result,

Vodafone becomes the largest company on the London stock market and the

fourth largest in the world. Just as one Vodafone spokesman said "we were

two strong businesses and together we can go from strength to

strength"(BBC, February, 2000).

4.1.1 The historical development of Vodafone and Mannesmann AG

4.1.1.1 Historical development of Vodafone

Vodafone was founded in 1984 as a subsidiary of Racal Electronics Plc. In

September 1991, it was fully demerged from Racal Electronics Plc and

became an independent company, and then its name was reverted to

Vodafone Group Plc. On 29 June 1999, the name was changed to Vodafone

AirTouch Plc because of the merger between Vodafone and Air Touch

Communication Inc., whereas the name was changed back as Vodafone

Group Plc on 28 July 2000. Vodafone undertakes its businesses in two ways.

On one hand, it uses fixed line broadband services like DSL (Digital

Subscriber Line). On the other hand, it is doing business wirelessly through

3G and HSDPA (High-Speed Download Packet Access). The Company's

ordinary shares are listed on the London Stock Exchange. On 30 June 2007,

it had 232 million customers and on 3 July 2007 it had a total market

capitalization of approximately 88 billion (www.vodafone.com).

45

Vodafone, nowadays, is the world's leading mobile telecommunications

company, with a significant presence in Europe, the Middle East, Africa, Asia

Pacific and the United States through the Company's subsidiary

undertakings, joint ventures, associated undertakings and investments

(www.vodafone.com).

4.1.1.2 Historical development of Mannesmann AG

Mannesmann AG, one of Germanys oldest industrial concerns, was founded

in 1885 by the brothers Reinhard and Max Mannesmann because of their

invention of cross-rolling process, so it was originally formed to produce

seamless steel tubes. After Second World War, it was diversified to develop

hydraulics. At the beginning of the 1980s, Mannesmann had the opportunity

to access to the developing electronic markets. Since then, the company

began to develop telecommunications service sector and in 1990 it further

had the license to construct and to operate the private D2 cellular telephone

network, which was the largest mobile phone service in Germany. In order

to concentrate on developing telecommunications, the company sold off

traditional business steel tube production, and spent US$42 billion on

telecom acquisitions. In 1999, Mannesmann acquired the Orange Company

and its sales reached as high as 23.27 billion at the same time. As a result,

Mannesmann AG became a leading German telecom provider. However,

Vodafone Group plc successfully acquired 99 percent of Mannesmann AG in

February 2000 (St. James Press, 2001).

Nowadays, Mannesmann AG has become a public subsidiary of the Vodafone

Company, which is doing businesses in 25 countries on five continents (St.

James Press, 2001).

4.1.2 The motives of Vodafones acquisition of Mannesmann AG

46

Firstly, with the rapid growth of telecommunications sector in early 2000,

Vodafone seek to increase market share across domestic country. Since

Vodafone had a low market share in Europe at that time, so its first target

was the European market. Consequently, it acquired a Germany company

Mannesmann AG, because Germany has the lowest penetration rate, huge

potential users and revenue growth in Europe at that time, and the most

important reason is that Mannesmann AG already had a great market share

in Europe (Byles, 2006). Secondly, the achievement of economies of scale is

also the motive of Vodafones acquisition of Mannesmann AG, because the

major goal of Vodafone is to maintain a competitive advantage as a low cost

and technological leader in the telecommunication market through the

achievement of economies of scale. This motive can be achieved by

technological complementary that the combination of fixed-line phone and

mobile phone, and existing customer relationship management between the

two companies (Vodafone annual reports). Furthermore, the revenue

synergy motive of Vodafones acquisition of Mannesmann AG can be

indicated by the low switching cost due to the low product differentiation

between the two mobile phone operators. In addition, the financial

resources, organizational resources and human resources of Vodafone

stimulate itself to seek one target to achieve that goal (Vodafone annual

reports). Finally, the diversification purpose can be reached by the

acquisition if Vodafone takes advantage of the fixed line capabilities of

Mannesmann AG (Byles, 2006). And the diversification purpose may

contribute to Vodafones economies of scope by sharing activities and

transferring core competencies. The geographic diversity and a strong

financial base also stimulate Vodafone to seek new development

opportunities, such as mergers and acquisitions (Vodafone annual reports).

The competition between the two companies is also eliminated to a certain

extent.

47

4.1.3 Consequences of Vodafones acquisition of Mannesmann AG

post-merger and acquisition: Financial Performance

Figure 1: Key figures and ratios of Mannesmann AG from 1998-2000 (in million) 1998 1999 2000 Sales 13,666 14,110 13,597 Net profit 384,913 1,057,235 11,291,424 Changes in sales n/a 3.25% -3.64% Gross profit 3,158 4,246 4,334 Equity 5,417,074 22,448,748 35,233,738 Total asset 9,330,979 47,724,088 60,437,499 Retained earnings 239,195 528,618 5,645,712 Gross profit margin 23% 30.1% 31.9% ROE 71% 4.7% 32% ROA 1012% 4.67% 21.20% Total asset turnover 000146 0.000296 0.000225 Source: complied from Mannesmann AGs annual reports from 1998-2000

After analyzing the key figures of Mannesmann AG from 1998 (see figure 1),

it can be concluded that there was no increasing trend for its sales from

1998 (13,666mn) to 2000 (13,597mn). However, two other key figures

increased significantly before Vodafones acquisition. The net profit of

Mannesmann AG showed that the company has been performing

consistently well in the period before the acquisition. From net profit of

384,913mn in 1998, it increased steadily to 11,291,424mn in 2000. Thus

there was a consistent trend for retained earnings, which significantly

increased 5,406,517mn from 239,195mn in 1998 to 5,645,712mn in

2000. The substantial increased net profit is due to Mannesmann AGs

acquisition of the British telecommunications company Orange Plc at the end

of 1999, but in May 2000, Mannesmann AG sold Orange to France telecom.

These transactions largely increased Mannesmanns liquidity and

contributed to further growth and further improvement of strong market

position (Mannesmann AG Annual Reports).

48

With regard to key financial ratios, gross profit margin showed an increasing

trend from 23% in 1998 to 31.9% in 2000. ROE almost increased

significantly to 32% as much as five times from 1998 to 2000, although it

decreased about 3% in 1999. This is the same situation to ROA. However,

total asset turnover declined substantially. This means Mannesmann AG

operated its profitability efficiently and managers effectively controlled the

companys purchasing costs, which can be inferred from gross profit margin,

ROA and ROE. This also implied that the company was making profit on the

total asset and shareholders equity before Vodafones acquisition.

To sum up, Mannesmann AG had a good financial position before Vodafones

acquisition in 2000. The year 2000 was a significant milestone for the future

development of Mannesmann AG. Nowadays, the development of Vodafone

determines the financial position of Mannesmann AG- as a business

segment of Vodafone.

Figure 2: Key figures and ratios of Vodafone from 1996-2000(in million) 1996 1997 1998 1999 2000

Turnover 1,402 1,749 2,471 3,360 7,873

Net profit 309.8 363.8 418.8 436.7 487

Equity 1022 770 282.5 814.6 140,833

Operating Profit

465.8 529.6 686.4 847 981

Gross Profit n/a n/a n/a 1,551 3,514

EPS (basic) 10.15p 11.89p 13.63p 20.61p 4.71p

Dividend per share

4.01p 4.81p 5.53p 6.36p 1.33p

Current asset

n/a 495.2 590.8 791.5 2517

Total asset 1572.1 1926.6 1911.5 2852.1 150,851

Current liability

n/a 1013.2 1426.4 1530 4441

49

Net profit margin

22.1% 20.8% 16.95% 13% 6.19%

Gross profit margin

n/a n/a n/a 46.16% 44.63%

ROE 30.31% 47.3% 48.6% 53.61% -0.35%

ROA 29.63% 27.49% 35.91% 29.7% 0.65%

Total asset turnover

089 091 129 118 005

Current ratio n/a 0.49 0.41 0.52 0.57

Quick ratio n/a 0.47 0.39 0.49 0.52

Source: Complied from Vodafones annual reports from 1996-2000

The turnover figure of Vodafone showed that the company has been

performing consistently well in the period before the acquisition (see figure

2). From turnover 1,402mn in 1996, it increased steadily to 7,873mn in

2000. This increase included a full years turnover from the acquisition in

January 1999 when Vodafone and AirTouch had agreed to join forces to

create the worlds largest mobile telecommunications group. The turnover

increased at an average of 59%