Academic journal article IUP Journal of Applied Finance

Profitability Analysis of Acquiring Companies

Academic journal article IUP Journal of Applied Finance

Profitability Analysis of Acquiring Companies

Article excerpt

Introduction

In the past few years, India has followed the worldwide trends in consolidation amongst companies through Mergers and Acquisitions (M&A). Companies are being taken over, units are being hived off, joint ventures are being forged, and so on. Restructuring old business has become a necessity in the wake of globalization and liberalization. As restrictions and controls have been minimized in the new regime, restructuring has become essential. Restructuring involves major organizational change, which includes change in corporate strategies to meet increased competition. This can take place either internally in the form of new investments in plant and machinery, and Research and Development (R&D), or it can take place externally through M&A or joint ventures.

Merger is defined as combining two or more companies into a single entity where one survives and the other loses its corporate existence. The survivor acquires the assets as well as liabilities of the merged company or companies. Generally, the company which survives is the buyer, and it retains its identity and the seller company is extinguished. Though liberalization, initiated in 1991, propelled the M&A activity, yet the actual activity in the Indian context is said to have started after 1994.

Many explanations have been advanced as to why mergers occur. Mergers are basically inspired by two reasons: profit maximization and growth maximization. Profit maximization benefits shareholders, as profits are distributed among shareholders, whereas growth-maximizing mergers aim at expansion of size in terms of assets or capital employed and net sales. Such mergers are inspired by the pursuit of managerial self-interest and are not intended to improve profitability. The managerial interests may lead to the emergence of 'unsuccessful' mergers in terms of profitability and account for the poor average performance often noted in the literature.

Profit maximization hypothesis states that successful mergers must lead to enhanced profitability of merging companies. A number of reasons have been quoted in the literature as to how these gains may arise. The acquiring firm may obtain economies of scale by expanding its operations geographically by acquiring another firm in a different region or it may seek economies of scope by expanding its product line. Profitability may also be increased by increasing the market share or vertical integration or diversification.

Another viewpoint is the impact on profitability through selection in the capital market. This argument is based on the view that merger leads to efficiency improvements not through any scale or complementary factors, but simply through the replacement of inferior by superior management of existing assets in the market for corporate control (Cosh et al., 1995). Profitability is not the objective of merger in all the cases. Therefore, only those mergers that are inspired by the pursuit of managerial self-interest may appear to be unprofitable.

Whether mergers lead to improved performance is a debatable issue. Many studies have examined the long-run operating performance of the acquiring firms after mergers. Using this approach, research reports that on an average, takeovers reduce the value of the acquiring firm (Meeks, 1977; Cosh et al., 1980; Clark and Ofek, 1994; Kruse et al., 2002; and Yeh and Hoshino, 2002). However, a conclusion of underperformance is not conclusive, as results are not all one-sided. Some studies, such as Healy et al. (1992), Heron and Lie (2002) and Rahman and Limmack (2004), have documented a significant improvement in operating performance after acquisitions.

Performance after mergers is a relative concept. Analysis of performance changes after the merger is helpful in understanding the outcome of mergers. All the theoretical benefits of mergers can be tested by analyzing the performance changes over the long run. Many studies have compared the performance of the merged companies between the pre- and post-merger periods. …

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