Corporate finance Essay Example | Topics and Well Written Essays - 1500 words

Corporate finance - Essay Example As per Grossman and Hart, takeover and mergers can create synergies or savings to the companies involved. For instance, in 2006, Arcelor of Luxemburg was taken over Mittal Steel of Netherland thereby making Arcelor Mittal, the world’s largest steel company. Some of the compelling reasons for takeover or merger is to expand the market due to the threat from competitors or to penetrate into new markets, to achieve cost synergies like eliminating duplicate functions, to attain higher productivity and to attain increased efficiency from acquired assets or to attain increased revenues and to achieve a higher return on investments for shareholders. Revenue synergy can result in access to the new distribution system, attaining extensions of brand and opening up new geographic markets. A takeover or merger strategy should be employed only when the acquiring company is able to enhance its networth through the positive employment of assets of the acquired company. It was established by previous empirical studies that above-average return is earned by the shareholders of acquired companies whereas the share prices of acquiring company is likely to fall immediately after the acquisition or merger. For instance, when Myogen, a pharmaceutical company is taken over by another pharmaceutical giant Gilead Sciences, there was a decline of 10 percent in Gilead’s stock whereas there was about 50 percent appreciation in Myogen’s stock. (Hoskisson 2008, p. 244). In the majority of the cases, mergers and takeovers had negative results like cost overruns, desertion of key employees, and even may leave black holes in the restructured balance sheet. (Greenblat 2011). Theory Though the merger and the takeover are often employed synonymously, there exists a variance in their economic impact between a takeover and a merger. In takeover, the acquiring company is trying to acquire control over the targeted company by acquiring more than 50% of its shares. In contrast, in merger, as per Hampton (1989), there is a merger of two companies to form a new company. Takeover or merger theories can be explained as below: Agency Theory This theory states that when the share price of a company is low, and then it forces the managers to initiate action either to enhance the share price in the market by performing well or to be taken over by a leader in the industry (DePamphills 2010, p. 41). Efficiency Theory It is divided into two – differential efficient theory which tries to improve the efficiency of a company in the same industry by a dominant company and inefficient theory. As per Copeland and Weston (1988), differential efficiency theory offers an academic base for horizontal takeovers whereas inefficiency theory offers insight on conglomerate takeovers (Lee &Lee 2006, p. 543). Market Power Hypothesis This theory explains that companies combine together to enhance their monopoly authority to quote the prices of the product which is not sustainable at a cutthroat competitive market. However, there is very little empirical support is available for this hypothesis (DePamphills 2010, p. 12). Free Cash Flow Hypothesis It is identical to that of agency theory and as per Jensen (1986), if the cash flow is in excess of that need to finance all takeovers or mergers which have net present values if discounted with the specific cost of capital (Lee &Lee 2006, p