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Paper 1: Why Do Firms Merge and Then Divest? A Theory of
Financial Synergy

The paper aims to explore the reasons
for mergers and divestitures. This theory is not dependent on taxes or the
acquirer having huge surpluses. The inability of short horizon projects or
firms which are marginally profitable to finance themselves as independent
entities due to problems caused by agency between managers and potential claim
holders is given as the motivation behind mergers. Good performance of the once
marginally profitable projects allows for divestiture in the future. There exist
two preconditions for this theory to be applicable.

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distress must be being experienced by one of the merging firms and

must be severe agency problems between the mangers and the claimholders of the
distressed firm.

Therefore this theory is more
applicable to mergers where one of the merging firms is facing cash flow
verifiability and is small in size. The fact that positive net present value
projects may be denied funding where the cash flows can be manipulated by the
management is well known. Marginally profitable companies are sometimes unable
to support outside equity since the manager’s incentive constraint requires
that he/she receives a cut of project’s cash flow. Thus a merger can serve as a
tool whereby such firms can survive their distressed period as merged entity
can raise total finance easier than a standalone entity. Shareholder value is
increased according to the authors’ theory and empirical evidence as mergers
allow marginally profitable firms to get funding. However this financial
synergy may not persist. Once the project has reached a stage where it can
raise finance on its own there are coordination costs associated with mergers. This
stems the firms to divest.

Paper 2: On the Patterns and Wealth Effects of Vertical

This paper measures vertical relation
between two merging firms using industry commodity flows information in input
output table. A merger is classified as a vertical merger when one firm can
utilize others’ services or product as input for its final output or its output
is the input for the other firm. The paper measures the vertical relatedness by
using an inter-industry vertical relatedness coefficient. The merger is
classified as a vertical merger if the coefficient is more than 1% (lenient
criteria) or 5% (strict criteria). Further, those firms which exhibit vertical
relatedness with the lenient criteria (1%) and belong to different input-output
industries are identified as pure vertical mergers by the author. Through their
framework the authors also claim that significant positive wealth effects are
generated through vertical mergers. During the 3 day event window surrounding
the announcement of mergers, the average combined wealth effect is about 2.5%.
The authors use the following steps to estimate the wealth effect of vertical

authors use CRSP value weighted index as market proxy.

2 different event windows the CARs (cumulative abnormal returns) are estimated.

the wealth effect is arrived as the weighted average of CARs of bidders and targets.

A popular view
of why vertical mergers occur stems from the transaction cost theory which
states that mitigation of holdup problems and market transactions being
uncertain leads to vertical mergers

Paper 3: Investment Opportunities,
Liquidity Premium, and Conglomerate Mergers

This paper
investigates how information about the investment opportunities of business
units serves as an incentive to speculators which in turn is affected by a
conglomerate merger of two very different businesses. The author creates a model
wherein stock prices in the secondary market convey the above and the output
thus arrived at helps in making investment decisions. Firm’s optimal investment
decision leads to an equilibrium in this market micro structure model. This
model helps in identifying the costs and benefits of acquiring this allocative
information which is linked to nature of the investment decisions of a firm,
which the authors believe to be a leading factor when in determining mergers.
Whether or not the allocative information is valuable determines the cost and
benefits. If there is a little uncertainty (i.e the variance is not bigger than
the mean) surrounding the NPV of a project, the social importance of the
information to the business is small. Informed traders gain from this and it is
the uninformed ones who lose out. Therefore the firm should discourage the
informed ones from producing this information. A conglomerate merger can
achieve this. The model computes means and variances of the net present values
(NPV) of the 2 units’ investments alternatives and the liquidity shocks of the
investors which help in determining the value of the firms under mergers and
spinoff. The paper cites the example of companies such as Microsoft ,Cisco,
Intel to explain that when a firm is starting out is project’s NPV is uncertain
compared to its mean. As the company grows and becomes established this metric
used decreases. This co-inside with the period when its product’s demand is
significant compared to before and there are very less competitors. Once it
reaches the maturity stage, the mean of NPV decreases compared to its
uncertainty. Therefore the investment opportunities adapts to the cycle when
returns are high with low risk to when returns are low. The paper thus
establishes that firms initially start out as more focused and then
diversifies  and then finally become
focused once again.

Paper 4: Merger Momentum and Investor
Sentiment: The Stock Market Reaction to Merger Announcements

The paper
examines the interaction between the market responses to a merger and the
overall market conditions. Hot stock markets are examined by the author. He
also focuses on hot merger markets. Empirical evidence shows that when merger
announcements have received positive reaction from the market, it tends to do
so for a period of time. Hence all those mergers getting a positive response
from the market are usually announced during a hot stock market rather than a
cold one. The paper explores the sources of momentum and finds that reaction to
an announcement is completely reversed in the long run as compared to the short
run. The paper’s finding reinforces the fact that investor sentiment is an
important aspect in the reaction of the marker to a merger deal announcement.
If synergies in operations are expected from a broad range of mergers then
investors react in a favourable manner but on the other hand if optimism is the
sole reason on which expectations are based then a short term thrust in price
caused by an announcement to merge is reversed in the longer frame of time as
the quality of performance of the merger becomes known to the investors.
Another viewpoint put forward by the paper is that manger incentive can serve
as a reason for mergers. Managers acting in their private interest, when it
comes to mergers, can lead to a defensive merger wave. The paper finds evidence
consistent with the fact that mergers occurring during a merger wave are worse
off than mergers at other times in the long run. The problem lies when managers
are rewarded for short term performance. Since merger announcements leads to
boom in price in the short term in a hot merger market, managers tend to be
complacent and lower their guard and are likely to make bad acquisitions just
to earn the short term rewards.

Paper 5: Type of Merger and Impact on Operating Performance: The Indian

This paper focuses
purely on the operating performances of different types of mergers in the
Indian context using various ratios. The result is summarised as follows. There
was a major decrease in return on net worth, return on capital employed and net
profit margin in the post merger period while there was no significant change
in the gross profit margin ratio and operating profit margin ratio. These results
establish the fact that for merging firms the operating performance declines or
stagnates after mergers. While other profitability ratios witnessed no change,
net profit margin declined due to an increase in the interest cost for mergers
between same group companies. These significant declines showcase that these
mergers were not undertaken to increase the efficiencies. Rather it was done to
increase the asset base to become larger in size. Evaluating the pre and post
operating ratios of the different types of mergers paints a picture that the
highest decline was caused by horizontal mergers followed by conglomerate and
vertical mergers. The paper concludes by stating that since there was no
significant statistical difference between different combinations of mergers,
the results of mergers were similar for the different types.



Works cited

Paper 1- Fluck, Z.,
& Lynch, A. (1999). Why Do Firms Merge and Then Divest? A Theory of
Financial Synergy. The Journal of Business,72(3), 319-346. doi:10.1086/209617

Paper  2- Fan, J., & Goyal, V. (2006). On the
Patterns and Wealth Effects of Vertical Mergers. The Journal of
Business, 79(2), 877-902. doi:10.1086/499141

Paper 3-
Chang, C., & Yu, X. (2004). Investment Opportunities, Liquidity Premium, and
Conglomerate Mergers. The Journal of Business,77(1), 45-74.


Paper 4- Rosen, R. (2006). Merger Momentum and Investor Sentiment: The
Stock Market Reaction to Merger Announcements. The Journal of Business, 79(2),
987-1017. doi:10.1086/499146


Paper 5- Mantravadi, P., & Reddy, A. (2008). Type of Merger and
Impact on Operating Performance: The Indian Experience. Economic and
Political Weekly, 43(39), 66-74. Retrieved from

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