The chief executive officer approaches you about acquisition decision.

QUESTION

The chief executive officer approaches you about acquisition decision. How do you respond in each of the following claims?1. Market price reflects the true value of corporations in an efficient market. Thus, acquiring firms would not be justified in paying premiums above market prices for acquired firm.2. Conglomerate acquisitions are good for shareholders because they help shareholders to diversity risk.
1. It is no doubt that the market price reflects the true value of corporations in an efficient market. However, in a case of acquisition certain other importnat things need consideration. The Prominent one being ˜Synergy. Synergy is the potential additional value from combining two firms. These are Operating Synergy & Financial Synergy: Operating Synergy: These type of synergies allow the firms/ companies to increase their operating income, increase growth or both. These have the following benefits: (a) Economies of Scale: Allow the merged firm/ company to become more cost efficient and profitable. (b) Reduced Market Competition and higher price for the product resulting in higher income. (c) Better Managerial/ Functional Skills of employees of the combined firms. Financial Synergy: It includes either higher cash flows or reduced cost of capital for the combined firm. For example: (a) Acquiring firms with excess cash with limited project opportunities or acquiring firms with cash slack and good project opportunities. (b) Reduced cost of debt since earnings andd profits increase, rate of debt goes down because of viability of operations of the company. (c) Tax Advantages, i.e. by getting advantages of various tax laws in terms of set off of business losses or claiming of increased depreciation, etc. Therefore, the excess price is paid for the above mentioned advantages which the acquirer gets from acquiring another firm, i.e. for the synergy. Hence, acquiring¦

ms would be justified in paying premiums above market prices for acquired firm. 2. There are two school of thoughts on Conglomerate Acquisitions. These are: First School of Thought: Since Conglomerate Acquisition brings in the concept of diversification, the essence of diversification lies in reduced investment risk. A downturn suffered by the acquired firm or business in its product line can be counterbalanced by the stability or profitability of the acquirer firm or vice-versa. Moreover, a successful conglomerate can show consistent earnings growth by acquiring companies whose shares are more lowly rated than its own. Second School of Thought: It does not matter how efficient the manangement team is, in a conglomerate merger, the energies of the team is split into numerous different areas because of diversification which may or may not bring in synergy. Further, it is difficult for the investors to understand conglomerates philosophy or the idea behind the merger. They may think that the current business line of the company is not doing well because of which the company is diversifying its operations or moving towards different business. This can eventually lead to falling market prices of the share. Furthermore, if the investors actually wants to diversify their risks, they can themselves invest in different companies having different business lines and performing well in their respective businesses. Therefore, the fact that whether conglomerate mergers are good or not would differ from case to case based on investors expectations and returns from the company, though these mergers may help in diversifying risk. It is pure investors point of view based on their expectations from the company. Hope this answer was useful and helped the user understand the basics and logics properly.

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