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

AcknowledgementsI 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.

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AbstractMergers 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 casesVodafones 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-------------354

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--------------------------------------------------------------765

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

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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

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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 and8

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

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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 & Acquisitions12

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 crossborder 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 and1

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 study 2 . 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 ratios3

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 researchThe 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.2

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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.

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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 othersynergies; 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 value16

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.

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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 value4

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 for19

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.

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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 not21

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 the22

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 can23

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 in24

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 diversification25

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 Efficiency/Synergy Agency costs Hubris Combined gains positive negative zero Gains to target positive positive positive Gains to bidder Non-negative more negative negative

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

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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 company27

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.

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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.

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

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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.

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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 during33

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 window 6 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. FromThe 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).6

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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 indepth 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 asking35

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 empirical36

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:

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Table 2: Comparisons among each research approach Strengths Weaknesses A direct measure of value Requires significant assumptions created for investors about the functioning of markets: A forward-looking measure efficiency, rationality, and of value creation. In theory absence of restrictions on stock prices are the present arbitrage. Research suggests that value of expected future for most stocks these are not cash flow. 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.

Event studies

Credibility: statements Possibly non-comparable data for have been certified and different years. Companies may accounts have been change their reporting practices. audited. Reporting principles and Used by investors in regulations change over time. judging performance. An Backward looking. indirect measure of Ignores values of intangible Accounting assets. economic value creation. Studies 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. Yields insights into value Gives the perspectives of creation that may not be managers who may or may not be known in the stock market shareholders, and whose Benefits from the intimate estimates of value creation may Survey of familiarity with the actual or may not be focused on Managers success of the acquisition 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. Objectivity and depth in Iii-suited to hypothesis testing reconstructing an actual because the small number of experience. observations limits the Inductive research. Ideal researchers ability to generalize for discovering new from the cases the research reports can be patterns and behaviours. idiosyncratic making it difficult for the reader to abstract larger implications from one or several reports.

Case studies

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

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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 ratiosThe 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.7

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(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 Key Growth Rates Changes in Turnover Net Profit Net profit margin=net profit after tax / sales Gross profit margin= gross profit /sales or = Profitability Ratios sales less cost of sales / sales Return on assets (ROA) = net profit before interest/ total assets Return on equity (ROE) = net profit after tax / equity Current ratio = current assets / current Liquidity ratios liabilities 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.

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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 is41

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 group 8 , 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 firms8

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 techniques 9 . 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.

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).9

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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 rivalMannesmann 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 important44

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).

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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 AG46

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.

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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% 71% ROE 4.7% 32% 1012% ROA 4.67% 21.20% 000146 Total asset turnover 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).

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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 Net profit Equity Operating Profit Gross Profit EPS (basic) 1,402 309.8 1022 465.8 n/a 10.15p 1,749 363.8 770 529.6 n/a 11.89p 4.81p 495.2 1926.6 1013.2 2,471 418.8 282.5 686.4 n/a 13.63p 5.53p 590.8 1911.5 1426.4 3,360 436.7 814.6 847 1,551 20.61p 6.36p 791.5 2852.1 1530 7,873 487 140,833 981 3,514 4.71p 1.33p 2517 150,851 4441

Dividend per 4.01p share Current n/a asset Total asset 1572.1 Current liability n/a

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Net profit 22.1% 20.8% margin Gross profit n/a n/a margin ROE 30.31% 47.3% ROA

16.95% 13% n/a 48.6%

6.19%

46.16% 44.63% 53.61% -0.35% 0.65% 005 0.57 0.52

29.63% 27.49% 35.91% 29.7% 091 0.49 0.47 129 0.41 0.39 118 0.52 0.49

Total asset 089 turnover Current ratio n/a Quick ratio n/a

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% in the five years before the acquisition. After the acquisition, the turnover increased significantly to 34,133mn in 2005, the average turnover figure is 23,695mn in the six years after the acquisition (see figure 3a). Therefore, the revenue synergy motive was achieved through the acquisition. Both net profit and operating profit 10 of Vodafone showed a consistent growth trend and increased to 487mn and 981mn respectively before the acquisition, however, both of them did not maintain a consistent growth trend after the acquisition and they declined largely to -7540mn and -5304mn respectively as showing in their consolidated balance sheets. EPS and dividend per share presented the same growing trend. They were improved before the acquisition, but they did not perform well after Vodafones acquisition of Mannesmann AG.

Operating profit is defined as earnings before interest, taxes, depreciation and amortization (company annual report).10

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From the perspective of financial ratios 11 , Vodafones profitability ratios showed a decreasing trend in net profit margin from 1996 (22.10%) to 2002 (-70.54%) (see figure 4a). Even though net profit margin improved after 2002, it was still negative. This phenomenon was due to the decreasing net profit after the acquisition. In addition, gross profit margin also declined and fluctuated after the acquisition until 39.20% in 2005 because of the increased cost of sales. Therefore, the declined net profit margin and gross profit margin showed that Vodafone overall profitability is not good and the managers did not operate the company successfully. Correspondingly, ROA and ROE of Vodafone presented an increasing trend before the acquisition, but both decreased after the acquisition. Therefore, from the perspective of shareholders, it showed that the amount of profits that which can be made available to pay dividend to shareholders was quite low. This result is consistent with that of Dickerson et al. (1997) and of Meeks (1977), who claimed that profitability of the acquiring company after M & A was lower than that before of M & A.

From the perspective of liquidity ratios, the current ratio of Vodafone increased from 0.49 in 1997 to 1.43 in 2001, but decreased to 0.70 in 2002. In 2005, the current ratio reached to 0.79. The quick ratio also increased from 0.47 in 1996 to 1.40 in 2001 and then it was 0.77 in 2005. The increased current ratio and quick ratio illustrated that the short term liquidity of Vodafone improved after the acquisition due to the more free cash flow.

Consequently, this acquisition composed four largest mobile companies in Europe - Vodafone in the UK, SFR in France, Mannesmann in Germany, and Omnitel in Italy and Vodafone has become the fourth largest company in theThe meanings and formulas of key financial ratios are explained in detail in chapter there-research methodology.11

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world with market capitalization of $393 billion (228 billion) and a customer base of 42 million (Weston et al., 2004).

4.1.4 Comparisons of Vodafones post- financial performance with its industry competitors

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 financial performance of the acquiring company are compared with those of non-acquiring firms that are drawn from the same industry. The top two competitors of Vodafone Group Plc are Deutsche Telekom Group and the O2 Company (www.hoovers.com). The comparisons focused on the changes of key growth rates, profitability ratios, liquidity ratios and activity ratios.

O2 Company

The O2 Company was originally a subsidiary of British Telecom (now BT Group) and was one of mobile phone leaders in the UK, with more than 17 million customers. On 10 May 2001, BT Group demerged its businesses. Consequently, O2 was conducted as an independent entity. At that time, O2 was named as mmO2, with key subsidiary in the UK, Ireland, Germany and Netherland (O2 annual reports). In 2005, the company changed its name from mmO2 to O2 (www.hoovers.com). O2 UK was the companys main business and it contributed to the companys major revenues and profitability.

However, the Spains Telefnica Company acquired O2 in 2006. As a result, O2 became a wholly-owned subsidiary of Telefnica S.A. and its name was changed into Telefnica O2 Europe Plc on 7 March 2006, and then O2s52

ordinary

shares

were

delisted

from

the

London

Stock

Exchange

(www.o2.com).

Deutsche Telekom Group

Deutsche Telekom Group, which is headquartered in Bonn, is the largest telecommunications company in Europe and the third largest in the world. It is also a leading provider of fixed-line telephone service in Germany (St. James Press, 2003). T brands stand for quality, efficiency and innovation. Deutsche Telekom Group has four international subsidiaries- T-Com, T-Mobile, T-System and T-Online. T-Online international is the largest internet service provider in Europe. T-mobile international provides many kinds of mobile phone services in Europe. Key Growth Rates Figure 3a: Key Growth of Vodafone from 2000-2005 Turnover Turnover Net Profit (million) Rates (loss) (% per year) (million) 2000 7,873 134.22% 487 2001 2002 2003 2004 2005 Average 15,004 22,845 30,375 33,559 34,133 23,695 90.58% 52.26% 32.90% 10.84% 1.71% 53.77% (9,763) (16,155) (9,819) (9,015) (7,540) (8,634)

Source: complied from Vodafones annual reports from 2000-2005

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Figure 3b: Key Growth of O2 from 2000-2005 Net Profit Turnover Turnover (loss) (million) Rates (million) (% per year) 2000 2,618 17.82% (250) 2001 2002 2003 2004 2005 Average 3,200 4,276 4,874 5,694 6,683 4,558 22.23% 33.63% 13.99% 16.82% 17.37% 20.31% (3,533) (850) (10,148) 166 301 (2,302)

Source: complied from O2s annual reports from 2000-2005 Figure 3c: Key Growth of Deutsche Telekom from 2000-2005 Net Profit Turnover Turnover (loss) (million) Rates (million) (% per year) 2000 27,429 15.21% 3,970 2001 2002 2003 2004 2005 Average 32,367 35,971 37,411 36,779 38,125 34,680 18% 11.14% 4% 3.66% -1.69% 8.39% (2314) (16,473) 840 3,105 3741 (1,189)

Source: complied from Deutsche Telekoms annual reports from 2000-2005

When looking at the revenues generated by Vodafone, one could come to the conclusion that the turnover have steadily increased from 7,873 million in 2000 to 34,133 million in 2005 (see figure 3a). Therefore, it seemed that the revenue growth of Vodafone was consistent. In the case of O2 and Deutsche Telekom, the growth in revenue of both companies has been consistent and had an average growth of 4,558 million and 34,680 million respectively (see figure 3b and 3c). However, although the three companies

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showed a consistent trend in revenue growth, Vodafone have shown the highest average increase of 53.77% over the six years period. As a result, the revenue synergy was achieved.

With regard to net profit, after the acquisition, Vodafones net profit declined dramatically and got an average net loss 8,634 million, which is higher than those of O2 and Deutsche Telekom. Therefore, Vodafone was making loss after the acquisition.

Profitability Ratios (%) Figure 4a: Profitability ratios of Vodafone from 2000-2005(%) ROA ROE Net Profit Gross Profit Margin Margin 2000 0.65% -0.35% 6.19% 44.63% 2001 2002 2003 2004 2005 -4.17% -6.71% -65.2% -6.76% -12.4% -70.5% -3.45% -7.63% -32.3% -3.56% -7.56% -26.9% -4.34% -7.59% -22.09% -35.13% 42% 41.14% 41.08% 42.01% 39.02% 41.65%

Average -3.61% -6.9%

Source: Complied from Vodafones annual reports from 2000-2005 Figure 4b: Profitability ratios of O2 from 2000-2005(%) ROA ROE Net Profit Gross Profit Margin Margin 2000 n/a n/a -9.55% n/a 2001 2002 2003 2004 2005 -16.3% -4.3% -76.6% 1.39% 2.97% -18.5% -1.1% -4.51% -19.9% -2.15% -2.08% 1.64% 2.93% 2.92% 4.5% 43.31% 36.53% 37.22% 41.80% 43.15% 42.4%

Average -18.57% -4.12% -3.51%

Source: Complie