Chapter six

Diversification, Integration and Merger

5.1 Diversification
• The typical unit of analysis in microeconomic theory is a
single-product, single-plant firm serving a single market.
• In practice, however, many firms produce a range of
products and serve a number of markets. Such companies
are described as diversified.
• Diversification occurs when a single-product firm changes
itself into a multi-product or multi-market firm.
• Most diversification firms get involved in products that are
related to their initial activity; this gives a diversified firm a
degree of coherence and economic logic that may appear
at first sight to be absent.
• However, where the firm diversifies into products that are
unrelated, the economic benefits and logic are not so
easily identified.
By Tolera M (MSc), Lecturer, DaDU 1
 Cont..
5.1.1 Types of Diversification Strategies
• The strategies of diversification can include internal
development of new products or markets, acquisition of a
firm, alliance with a complementary company, licensing of
new technologies, and distributing or importing a products
line manufactured by another firm.
• Generally, the final strategy involves a combination of
these options.
• This combination is determined in function of available
opportunities and consistency with the objectives and the
resources of the company.
• There are three types of diversification: concentric,
horizontal and conglomerate:
By Tolera M (MSc), Lecturer, DaDU 2
 Cont..
• Concentric diversification: This means that there is a
technological similarity between the industries,
which means that the firm is able to leverage its
technical know-how to gain some advantage.
• Horizontal diversification: The Company adds new
products or services that are technologically or
commercially unrelated (but not always) to current
products, but which may appeal to current
customers.
• In a competitive environment, this form of
diversification is desirable if the present customers
are loyal to the current products and if the new
products have a good quality and are well promoted
and priced..
By Tolera M (MSc), Lecturer, DaDU 3
 Cont..
• Conglomerate diversification (or lateral
diversification): The company markets new products
or services that have no technological or commercial
synergies with current products, but which may
appeal to new groups of customers.
• The conglomerate diversification has very little
relationship with the firm's current business.
• Therefore, the main reasons of adopting such a
strategy are first to improve the profitability and the
flexibility of the company, and second to get a better
reception in capital markets as the company gets
bigger.
By Tolera M (MSc), Lecturer, DaDU 4
 Cont..
Motives for Diversification
• The starting point for diversification may occur when a firm’s existing
objectives vis-à-vis profit and growth cannot be met by its existing
product.
• Thus, the threat to profitability is the spur to considering a
diversification strategy. However, the adoption of a diversification
strategy may be driven by a number of push factors arising from the
current position of the firm.
• Push factors may include: the limited size of the existing market; the
existence of underutilized assets that might be used to produce new
products or manage new activities; and surplus investment resources
that could be used to finance new activities.
• There may also be a number of pull factors, or incentives, for firms to
adopt diversification.
• Managers may also be pulled toward diversification where the potential
rewards from investing in new market opportunities promise greater
profitability than ploughing them back into existing activities.

By Tolera M (MSc), Lecturer, DaDU 5

 Cont…
• The pursuit of diversification may be tempered by the need
to make sufficient profits to keep shareholders happy and
to maintain the valuation ratio of the firm.
• If this cannot be achieved, then shareholders may prefer to
see retained earnings returned in the form of dividends.
• A poor stock market performance may threaten the
incumbency of the existing management, either as the
result of shareholder dissatisfaction or by outside interests
buying assets they consider to be undervalued.
• Therefore, managers must also consider the threats and
risks posed to the firm as a consequence of diversification.
The following can be some of the motives of diversification.

By Tolera M (MSc), Lecturer, DaDU 6

 Cont..
Utilization of the firm’s resources
• Making better use of the firm’s existing assets and
competences could lower unit costs and increase labour and
capital productivity. Greater use could be made of:
• Indivisible plant and equipment by making new products
alongside existing ones.
• The distribution and logistics system by distributing related
goods to the same outlets.
• The brand name to sell new products using the goodwill built
up for its existing branded products.
• Retained earnings that are not required to develop current
activities can be used for investment in new activities rather
than keeping them in the non-interest earning form of cash.
• Managerial talent, in general and specific functions of the firm
to extend its range of activities.

By Tolera M (MSc), Lecturer, DaDU 7

 Cont..
• The capacity of the managerial team increases as
managers move down their experience curve and reduce
initially complex procedures into simple and routine
decision-making rules for subordinates.
• This surplus management capacity can then be deployed in
managing new activities.
• The existence of unused resources raises the question of
how long these resources can be used without further
investment.
• While some resources, such as brand names and
knowledge, might be used indefinitely without reducing
their value and contribution, other resources, particularly
those of a physical kind, may soon exhaust their capacity
and require replacement and or expansion.

By Tolera M (MSc), Lecturer, DaDU 8

 Cont..
• An important advantage of the diversified firm is that
its corporate headquarters may have better access to
information than that available to the market.
• The diversified enterprise may be more efficient in
allocating its existing resources between product
divisions and, more particularly, to new activities
than the market.
• Acquiring capital from the market for new ventures is
particularly difficult as external lenders do not have
access to all the information collected by the firm.

By Tolera M (MSc), Lecturer, DaDU 9

 Cont..
Economies of scope and size
• Economies of scope arise from the nature of the
production function, so that two or more
products or activities can be produced more
cheaply together than separately.
• These benefits are not available to single-product
firms.
• The increase in size of the firm that comes with
diversification may also produce economies of
size.
By Tolera M (MSc), Lecturer, DaDU 10
 Cont..
• Size may also allow the company to achieve lower
management costs through organizational efficiency.
• Diversification may be a spur to a firm adopting
more cost-effective organizational forms.
• This structure allows the firm to add new activities
and new divisions with limited disruption to existing
activities.
• Many specialist firms will claim advantages from
lower production, marketing and governance costs
without having to share in the many joint costs of
the diversified enterprise.

By Tolera M (MSc), Lecturer, DaDU 11

 Cont..
Reducing the volatility of profits and risk spreading
• A single-product, single-market firm is vulnerable
to erratic and cyclical variations in demand and
input costs, as well as to long-term decline in
demand.
• Cyclical variations can be offset by the acquisition
of products whose sales move counter-cyclically
to its existing product, while secular decline can
be offset by acquiring products exhibiting long-
term growth.

By Tolera M (MSc), Lecturer, DaDU 12

 Cont..
• Diversification enables a firm to spread risks by
offering a degree of insurance against unexpected
changes in any one market for any one product.
• A market shock affecting a single product will have
greater impact on a specialist firm’s profits than
those of a diversified one.
• A diversified company with a portfolio of two
products whose sales move counter-cyclically can
achieve a more even flow of revenues.
• Counter-cyclical activities could involve products
whose cycles are inversely related to existing
products and products whose cycles lag behind other
products and reach their peak at different times.
By Tolera M (MSc), Lecturer, DaDU 13
 Cont..
• Likewise, shifts toward new geographical markets may
offset fluctuations in sales.
• If the economic cycle in one economy is out of step, then
variations in sales will likewise be reduced. Seasonal
variation in sales in one market can also be overcome by
combining products whose peak sales are in different
seasons.
• Long-term product decline can also be overcome by
having a portfolio of products at different stages of their
life cycles.
• Therefore, the object of spreading risk is to ensure that a
failure of one product or one market does not threaten
the firm with bankruptcy.

By Tolera M (MSc), Lecturer, DaDU 14

 Cont..
Financial synergies
• Diversification may limit profit variability and, hence,
variations in dividend payments to shareholders; this may
give the firm a cost of capital advantage compared with
firms whose profits are more variable.
• The firm may find it can raise new equity capital and loans
on advantageous terms that are unavailable to firms with
greater profit variability.
• If the firm has a choice between equity and debt finance,
then a more stable profit and dividend flow will allow the
firm to increase the proportion of its finance raised
through debt capital.
• The greater stability of earnings reduces the risk to debt
holders of not receiving their interest payments.
By Tolera M (MSc), Lecturer, DaDU 15
 Cont..
• Debt capital may also offer tax advantages to the firm, since the
interest payments are treated as a cost rather than an element of
profit.
• Dividends in contrast are regarded as profits distributed to
shareholders.
• Thus, if a firm wanted to raise an equal amount of capital using
debt and equity, then the level of corporation tax payable would be
higher if the equity route was chosen.
• The risk of no-dividend payment to shareholders is also reduced.
However, individual shareholders do not necessarily require the
enterprise to reduce the risk associated with an individual
shareholding because by acquiring a diversified portfolio of shares
they are better equipped than the firm to spread or counteract
risk.
• A diversified share portfolio enables them to stabilize their
incomes. However, if investors are unable to acquire fully
diversified portfolios, then the firm’s efforts to do so may be
welcomed.
By Tolera M (MSc), Lecturer, DaDU 16
 Cont..
• A larger firm has the opportunity to utilize funds generated
from one activity for investment in another.
• The use of internal funds negates the need for the firm to
borrow from external sources. Such funds are always
available at a price, but spending on diversifying to produce
new products may be viewed as very risky by potential
lenders.
• Shareholders and stock markets appear to have little
confidence in the ability of diversified firms to use available
resources effectively.
• A noted feature of diversified firms is that they trade at a
lower price, given their earnings, than focused firms. This
difference is known as the ‘‘diversification discount’’.

By Tolera M (MSc), Lecturer, DaDU 17

 Cont..
Managerial risks and rewards
• The senior managers of a company, unlike their
shareholders, cannot diversify their employment risks.
• If the firm does badly, then they face being dismissed by
shareholders or the company being acquired by another
enterprise.
• If managerial rewards are also tied to the size of the firm,
then growth by diversification satisfies both their need to
protect security of employment and the desire to see the
remuneration package increase in size.
• However, if managers take diversification too far in pursuit
of managerial security, then it may eventually reduce
profitability and bring managers into conflict with
shareholders.

By Tolera M (MSc), Lecturer, DaDU 18

 Cont..
The pursuit of growth
• Diversification may be pursued as part of the growth
strategy of the firm. Diversification not only reduces
risks but may also be a route to securing the growth
of assets, sales and profits.
• Companies may be pulled toward other geographical
markets when a product is at a late stage of its life
cycle in one market and at an early stage in another.
• If the firm does not have a portfolio of promising
products, then the pursuit of growth will encourage
the acquisition of other companies with portfolios of
potentially successful new products.
By Tolera M (MSc), Lecturer, DaDU 19
 Cont.…
• The rate of growth of demand for existing products is a
constraint on the growth of the firm.
• Marries analysed the optimal or balanced growth position
for a firm in terms of diversification. Diversification is a risky
strategy in that all new products do not necessarily succeed
in winning profitable positions in markets.
• Whether they do so or not depends on the number of
consumers who switch expenditure to the new products.
• The impact of a strategy of diversification on profits will
depend on the number of diversification projects
undertaken.
• Initial ones might earn higher rates of profit than later
ones, because the most profitable projects are undertaken
first.
By Tolera M (MSc), Lecturer, DaDU 20
 Cont..
Transaction costs
• The transaction cost framework has been used to explain the boundaries of the
firm. Efficiency-based arguments for diversification have to be compared with
the alternative of using the market.
• Only if the gains from utilizing unused resources internally exceed the gains
made by arranging to sell the use of the resources to third parties can the
efficiency arguments for diversification hold.
• For diversification to yield competitive advantage requires not only the
existence of economies of scope in common resources but also the presence of
transaction costs that discourage them from selling or renting the use of the
resource to other firms.
• It is not only efficiency gains but also the presence of transaction costs that
discourage the firm from selling or renting the resources to other firms.
• Transaction costs are likely to be substantial when intangible assets, such as
brand names and technical knowledge, are involved. Likewise, the more tacit
the knowledge and the more unique it is to the firm the lower its value outside
the firm.
• If a firm jointly produces two products, then the efficiency argument is that the
combined costs of making both goods are less than if they are made separately.
The alternative to both products being produced by a single enterprise is for a
contract to be agreed between the producer of product 1 and product 2 to
jointly produce the two products.
By Tolera M (MSc), Lecturer, DaDU 21
 Cont…
• Therefore, the transaction cost approach calls for
closer assessment to see whether the efficiency
arguments for diversification are justified.
• The firm should always consider the alternative of
seeking to sell spare resources to outside users
and, therefore, identify the core activities of a
diversified firm.
• The transactions cost approach also focuses
attention on the potential failures of the market
system to organize these resources.

By Tolera M (MSc), Lecturer, DaDU 22

 Cont..
Market power
• Diversification does not add to the market power of
the firm in the sense that its market share is
increased in a single market.
• However, it does increase its ability to adopt other
anti-competitive practices.
• The ability to do so comes from the strength of the
company to finance activity in one market with
support of profits made in another.
• The implication is that diversified firms will thrive at
the expense of non-diversified firms not because they
are more efficient, but because they have access to
what is termed conglomerate power, which is derived
from the sum of its market power in individual
markets. By Tolera M (MSc), Lecturer, DaDU 23
 Cont..
• A diversified firm can engage in practices
unavailable to single-product enterprises.
• It might engage in predatory pricing to make
life difficult for competitors and possibly drive
them from the market.

By Tolera M (MSc), Lecturer, DaDU 24

 Cont..
Benefits and Costs of Diversification
• The benefits of diversification give the firm cost advantages
for given ranges of output and revenue possibilities: for
example, using excess capacity to produce an additional
product must have finite possibilities. Competences whose
capacity expands with use would seem to have no limit to
their exploitation.
• In practice, the firm has to combine cost advantages and
disadvantages and determine the optimal degree of
diversification that aids the maximization of profits.
• Diversification that initially leads to cost savings may later
lead to cost increases; this is more likely to happen the
further the firm moves from its core activities and the
larger the firm becomes.

By Tolera M (MSc), Lecturer, DaDU 25

 Cont…
• The relationship between diversification and profitability
can involve four scenarios: (1) profitability increases, (2)
profitability decreases, (3) profitability increases initially
and at some point starts to decline and (4) profitability
decreases initially but at some point starts to increase.
• Cross-sectional studies show a U-shaped relationship
between profit and diversification. Profit initially increases,
but the more diversified the company becomes so the rate
of profit declines.
• Thus, diversification taken too far eventually brings
increasing costs and dwindling profitability; this is
attributed to greater administrative and managerial costs
the more diversified and complex the firm becomes,
leading to information distortion and control loss.

By Tolera M (MSc), Lecturer, DaDU 26

 Cont..
• Managerial assets that can initially cope with diversification may
be less able to do so the more diversified the firm becomes.
• The competences and skills of the managerial team may
become less appropriate the farther away the new activities are
from the original ones of the firm.
• Organizational structures may likewise become inappropriate
for a larger and more diversified firm, leading to increases in
management costs and less effective management as the span
of control increases.
• The ending of synergy benefits will also contribute to increasing
costs.
• Therefore, a position can be envisaged where the marginal
benefits of increased diversification decrease and marginal costs
increase.
• The optimal level of diversification occurs at a point where
marginal benefits equal the marginal costs of diversification.
By Tolera M (MSc), Lecturer, DaDU 27
 cont..
• If demand for the product is growing more quickly in a
geographically separated market, then the firm may be able
to increase its growth rate by selling in this new market,
assuming it can gain a position in the market and achieve a
faster rate of growth.
• However, entry into a new market incurs marketing and
transport costs that are likely to be higher than those of
existing firms; this will result in lower profits unless in time
the new entrant can match the cost levels of the
incumbents.
• An alternative strategy for the firm, one identified by
Penrose and Marris, is for the firm to diversify.
• Diversification means that the firm produces new products
for either new or existing markets.
• The incentive to diversify lies in the opportunities to use
existing resources and to maintain or increase the growth
rate. By Tolera M (MSc), Lecturer, DaDU 28
 Integration
• It refers to the operations by a firm in two or more
industries representing successive stages in the flow of
materials or products from an earlier to later stage of
production or vice versa.
• Thus, it is a type of diversification but it may be looked as
‘vertical concentration’, and if the process takes place by
merging of two different firms then it is ‘vertical merger’.
• However, vertical integration is a popular term for all
these.
• Essentially, it is the integration among intermediate
products used in production of a commodity.
• It may be initiated in either way, i.e., a firm itself starts
manufacturing all of them or different firms producing
goods at different stages of the process and merge
together.
By Tolera M (MSc), Lecturer, DaDU 29
 Cont..
Types of Integration
• Integration of firms may be either horizontal or vertical in
nature, or conglomerate.
• Horizontal integration occurs when a business merges with
or acquires another business.
• It is the acquisition of additional business activities at the
same level of the value chain.
• In contrast, vertical integration is the process in which
several steps in the production and/or distribution of a
product or service are controlled by a single company or
entity, in order to increase that company's or entity's
power in the market place.
• Conglomerate diversification occurs when a business
moves into a totally different area.
• The foregoing discussion focuses on vertical integration in
particular. By Tolera M (MSc), Lecturer, DaDU 30
 Cont..
• Vertical integration occurs in one of two ways.
• Forward vertical integration occurs when a business acquires
another business, which brings it closer to the customer.
• Backward vertical integration move closer to its sources of
supply. Vertical integration involves joining together under
common ownership a series of separate but linked production
processes.
• Such a strategy is used by many enterprises to widen the
boundaries of the firm and to enlarge its size.
• A decision by a firm to integrate vertically alters both the
boundaries and the size of the firm.
• Vertical integration is the outcome of a make or buy decision.
• If the firm decides to make its own inputs, then it becomes
vertically integrated. If it does not, then it remains vertically
unintegrated.

By Tolera M (MSc), Lecturer, DaDU 31

 Cont.…
• Vertical integration is often taken to mean that the firm
will either supply all its requirements for a particular input
or use all the output it produces.
• However, vertical integration does not necessarily imply
that all the output of every stage is used only within the
firm. Nor does it mean that all inputs are produced within
the firm. It may suit the firm to sell some output at some
stages and to buy some inputs at other stages, resulting in
partial integration.
• Vertical integration in the business sense is the ownership
by one firm of two or more vertically linked processes. The
more stages owned and controlled by one firm the greater
the degree of vertical integration.
• Traditionally, the emphasis has been on ownership of
successive stages and has generally been understood to be
an all or nothing concept. However, some writers have
placed the emphasis Byon control
Tolera rather
M (MSc), Lecturer, DaDU than ownership. 32
 cont..
Motives of Vertical Integration
Firms may decide on a strategy of vertical integration for a
multitude of reasons that do not lend themselves to neat
economic categorizations. The various motivations can be
categorized under four main headings:
• Efficiency gains in terms of technological joint economies.
• The ability to avoid imperfect markets.
• Distribution cost savings.
• Security and planning and avoidance of volatile markets.
Porter suggested examining the advantages to a firm of
pursuing a strategy of vertical integration under six headings:
cost savings, increased control, improved communications,
changed organizational climate, operations management and
competitive differentiation.

By Tolera M (MSc), Lecturer, DaDU 33

 Cont..
The traditional explanations for firms seeking to
vertically integrate are:
1. To establish a source of supply if none exists.
2. To secure cost savings by bringing under single
ownership technologically linked processes.
3. To ensure the quality of the input.
4. To weaken the position of a supplier who appears to
be making excessive profits and hence:
a. To secure a supply of inputs at lower prices.
b. To control retail outlets and ensure market presence.
c. To strengthen monopoly power and raise barriers to
entry.
By Tolera M (MSc), Lecturer, DaDU 34
 Cont..
• Technical efficiency and production cost savings
linking the production of an input and output through
ownership produces a more cost-effective solution.
• Significant cost savings can be made by linking the
production of a key input with a given product.
• Production cost economies resulting from locating
successive stages of production next to each other do
not necessarily require single ownership of each
stage: independent firms will locate such plants close
to the source of the input if there are significant gains
to be made.
By Tolera M (MSc), Lecturer, DaDU 35
 cont…
• Vertical integration may reduce the uncertainties
faced by non-integrated firms.
• The controller of a firm is a bounded rational
individual making decisions with imperfect
information in an uncertain environment.
• The controller may be called on to react to
unexpected or unforeseen events.
• Vertical integration may be seen as a way of
reducing information deficiencies and having to
react to market or industry changes.
By Tolera M (MSc), Lecturer, DaDU 36
 cont..
• The sources of uncertainty in relation to supply
include:
– Unexpected unreliability of suppliers to deliver on
time and the consequences for production
scheduling of losing critical supplies.
– Unexpected use of monopoly power by suppliers.
– Variable quality of input that affects quality of
output.
• The sources of uncertainty in relation to selling
the product include:

By Tolera M (MSc), Lecturer, DaDU 37

 Cont..
– Fluctuating price movements and consequent
changes in output leading to either cuts in output or
increased storage of unsold output.
– Unexpected changes in demand with similar
consequences.
– Greater certainty of access to sales outlets,
particularly if the sector is dominated by powerful
monopsonistic groups.

By Tolera M (MSc), Lecturer, DaDU 38

 cont..
• Vertical integration allows the firm to become more of a
planning system.
• It enables management to overcome uncertainties relating
to quality of product, uncertainty of supply and
unexpected changes in prices for inputs.
• It does not, however, remove uncertainty relating to the
market for final users in the production chain.
• Vertical integration may give the firm two advantages in
relation to information: first, the firm learns about the
production issues relating to all aspects of linked activities
compared with competitors who are not integrated and,
second, the vertically integrated firm may also be able to
hide information from competitors since all processing
takes place in-house.

By Tolera M (MSc), Lecturer, DaDU 39

 Cont..
• The newer theories explaining the motivation for
vertical integration make use of transaction cost
economics. It is argued that vertical integration
will result in:
– Savings in transaction costs by not using the market,
whereas buying through the market involves: incurring
costs in searching for suppliers, discovering prices;
writing, agreeing and monitoring contracts.
Contracting costs are avoided.
– Increasing management costs because internalized
activities will require supervision and co-ordination.

By Tolera M (MSc), Lecturer, DaDU 40

 Cont..
• Thus, the increase in management cost has to be less
than the savings in transaction costs to justify vertical
integration. Integration also avoids problems
associated with contracts.
• If incomplete, long-term contracts are signed, they
can create problems when unforeseen changes take
place in the business environment and the contract
has to be revised; this gives the supplier the chance
to engage in opportunistic behaviour, particularly if
the buyer wishes to increase the quantity supplied.
• If suppliers have invested in highly specialized assets
to produce the required input, then they may be able
to exploit this to negotiate a higher price.
• Vertical integration allows the buyer to avoid
opportunistic behaviour by the supplier.
By Tolera M (MSc), Lecturer, DaDU 41
 Cont..
Vertical Integration and Profitability
• The lessons of many vertically integrated mergers
show that the key factor influencing success or failure
is the corporate parent’s influence on the acquired
business. For this to be a positive influence:
– The acquired business must have the potential to improve
its performance independently of its relationships with
other divisions or business units within the company.
– The parent company must have the skills or resources
necessary to help the business. In practice, they may not
have the skills, and the methods chosen to integrate the
company may cause more problems than they solve.
– The parent company must understand the business well
enough to avoid influencing it in ways that damage its
performance.
By Tolera M (MSc), Lecturer, DaDU 42
 Cont..
• However, in many mergers these three conditions
are rarely met because the parent company does
not have the necessary skills or competences that
can be applied to new areas of a chain.
• Vertical integration should only be considered if
there is a major obstacle to a voluntary
arrangement.
• Voluntary arrangements are more likely to
produce a better result because both groups will
concentrate on what they do best, whereas
acquisition may create more problems than they
solve.
By Tolera M (MSc), Lecturer, DaDU 43
 Mergers
• This term refers to the amalgamation or integration
of two or more firms.
• The firms under different ownership and
management controls come under a united one
through merger.
• The terms ‘acquisition’ and ‘takeover’ are also used
for ‘merger’, which implies that a firm acquires assets
or stocks in part or full, of other firm(s) to get
operational control over them.
• In legal sense, there is a difference between these
terms but from the point of view of the economic
analysis they are similar.
• The important feature of merger, that is relevant to
us, is the transfer of control of business activity from
one or more firms to another.
By Tolera M (MSc), Lecturer, DaDU 44
 Cont..
The Nature of Merging
• The words ‘‘merger’’ and ‘‘acquisition’’ are used
interchangeably. If the two terms are to be
distinguished, then a merger occurs when two or
more firms are voluntarily combined under common
ownership, while an acquisition, or takeover, occurs
when one firm acquires or buys the assets of another
without the agreement of the controllers of the
target company.
Types of Mergers
• Economists have identified three types of mergers
formed by firms. These are: horizontal mergers,
vertical mergers and conglomerate mergers. The
following discussions highlight each of them.
By Tolera M (MSc), Lecturer, DaDU 45
 Cont..
– Horizontal mergers occur when two firms in the same
market are consolidated into a single enterprise; this
means that the new enterprise will have increased its
market share. This type of merger is designed to acquire
market power.
– Vertical mergers take place between firms, which engage in
successive stages of production such as brewing and
running public houses; so both upstream (backward) or
downstream (forward) are possible. The output of one
stage of operation serves as an input or market outlet to
the other stage.
– Conglomerate mergers occur when two firms producing
independent products for different markets merge.
Conglomerate mergers create larger diversified firms.
Although these do not generate concerns about market
dominance, there are concerns about their ability to
compete unfairly against undiversified competitors because
of their ability to cross-subsidize.
By Tolera M (MSc), Lecturer, DaDU 46
 Cont..
• Types of mergers will vary according to the nature of
the industry and the degree of fragmentation. In a
sector like legal services, the vast majority of mergers
will be horizontal because there are large numbers of
small law practices that are currently consolidating.
• Some may be of a conglomerate nature in that firms
in different industries may merge (e.g., legal and
accountancy firms).
• In other industries that are more concentrated but
have strong vertical linkages, mergers are less likely
to be horizontal in nature and more likely to involve
vertical integration.

By Tolera M (MSc), Lecturer, DaDU 47

 Cont..
Motives for Merging
• The motives for merging are different in
managerial and owner-controlled firms: the
former may be more concerned with increasing
the growth rate of the firm, while owners are
presumed to be more concerned with increasing
profits or shareholder value.
• The main sources of economic gain which enable
firms to achieve higher growth and/or higher
profitability through the pursuit of mergers are
the same.

By Tolera M (MSc), Lecturer, DaDU 48

 Cont..
• There are different causes/motives for mergers,
among which, the following are included:
1. Those relating to the structure of markets, i.e.
the pursuit of either of economies of scale or of
market power;
2. Those which centre on management efficiency;
3. Theories based on the tax effects of merger.

By Tolera M (MSc), Lecturer, DaDU 49

 Cont..
Economies of scale: Efficiency Gain
• The first efficiency argument is the advantages of
economies of scale.
• Perhaps the most obvious justification of merger is a
desire to reap economies of scale and hence
enhance efficiency.
• There are assets, which are costly, indivisible and
‘fungible’ (that is capable of being used in several
industries).
• Such assets give rise to ‘economies of scope’: they
make it relatively easier for a company to enter new
lines of business.
• When fungible assets are the motive for merger, the
result is likely to be diversification.
By Tolera M (MSc), Lecturer, DaDU 50
 Cont..
• Management Performance: Merger as the Outcome of
‘Market of Corporate Control’: Efficiency gain
• The second efficiency argument is based on the fact that
the existence of market for corporate control can lead to
efficiency gain through mergers. The underlying theory of
this outlook lies in both the ‘managerial’ and ‘principal-
agent’ theories of the firm. It is all about allocational
takeovers.
• This is all about ‘market for corporate control’ that may
lead to hostile take-over. Participants in this market are
the management teams of companies, together with
financiers or investors. Managers (both incumbent and
raider managers) engage in competition for the control of
companies. This competition takes the form of bids:
‘raiding’ teams bid for the control of other companies by
offering cash or securities (bonds or shares) to investors.
By Tolera M (MSc), Lecturer, DaDU 51
 Cont..
• The implication of this competition in management is the fact that this
spurs efficiency.
• If managers fail to maximize profits they lay themselves open to takeover.
The causes of inefficiency are not difficult to list.
• Attaining least-cost requires attention and vigor and, if the pressures of
competition are not too great, it is clear that slackness on the part of
management will suffice.
• Inefficiency may also arise from the incentive structure of the company.
• It can be hypothesized that since mergers are indeed a market for
corporate control, then a merger should be followed by an enhanced
performance in terms of higher sales and/or an increase in profits.
• One of the critics forwarded against this role of mergers is that of short-
termism. The argument that mergers are a spur to management to run
companies efficiently has its converse side.
• Mergers (or that simply the threat of mergers) force managers to
maintain profits and dividends in the short run for the sake of bolstering
share values.
• This could lead to a tendency to reduce capital spending or investment in
R&D.
By Tolera M (MSc), Lecturer, DaDU 52
 Cont..
Taxation
• Another hypothesized cause of mergers is taxation: merging
may have the effect of reducing the aggregate tax liability of the
companies concerned. Tax authorities treat transactions
differently. Since interest payments on companies’ borrowed
funds are tax-deductible there is an incentive to issue bonds
against shares. Rebalancing a company’s capital structure so
that there are fewer shares and relatively more bonds is not
easy to negotiate, but mergers can provide an opportunity.
• Second, while company profits are taxed, losses entitle a
company to a refund or a reduction in future tax.
• These losses may be ‘carried forward’ from the year in which
they are sustained and used in a year in which profits are made,
a process of smoothing or averaging. Such credits can also be
transferred to an acquiring company.
• This feature of the tax system in some countries means that a
profitable raider, which acquires a victim with tax losses can use
those losses to reduce ByitsTolera
own tax
M (MSc), liabilities.
Lecturer, DaDU 53
 Cont..
Mergers and growth
• Marris (1964) in his analysis of growth envisaged
the firm having to create opportunities for growth
to satisfy managerial preferences.
• If the firm is limited in its growth opportunities in
its existing activities, then the acquisition of other
enterprises is one way of increasing its size and
increasing its average growth rate as long as the
acquired activity is in a faster growing sector.
Acquisition is viewed as a more rapid way of
achieving greater size and a higher growth rate
than pursuing internal or organic growth.
By Tolera M (MSc), Lecturer, DaDU 54
 Cont..
Mergers and market power
• Market power arises from a firm having a significant presence in a
market. Greater market power can be achieved by increasing market
share at the expense of rivals. Competing away the market share of rivals
requires the firm be in a relatively stronger competitive position than its
rivals; this may be achieved by having superior products, lower costs and
better distribution systems.
• These advantages allow the firm to undercut its rivals’ prices or to
achieve a higher profit margin at any given price. As the competitive
process evolves, some firms will gain market share at the expense of
others and some firms may withdraw or be forced from the market; this
will free up market share which existing competitors can strive to win.
• The second way of achieving a higher market share is to acquire a rival;
this eliminates a competitor and at the same time increases the market
share of the acquiring firm.
• The firm can strive to maintain this increased market share against its
remaining competitors. The larger the firm relative to its remaining
competitors the greater its ability to raise prices above marginal cost; this
allows the firm to increase revenue and its profits, as a consequence of
restricting output. By Tolera M (MSc), Lecturer, DaDU 55
Acquiring competences
Cont..
• A firm may be motivated to acquire another because of the assets the
target firm possesses.
• In particular, the concern is to acquire intangible assets or competences
that cannot be purchased in the market. These assets may include
knowledge of a particular market, or of a particular technology, or a
strong reputation for product quality.
• Such knowledge is embedded in individuals and the architecture of the
firm; this means that these resources can be utilized within the firm at a
constant or declining marginal cost and have high market transaction
costs, so that the most profitable way to exploit them is within the firm
and the only way to acquire them is through acquisition.
• It is these competences that make a firm potentially more profitable
than its competitors, but it is also these competences that make the firm
a potential target.
• The problem with acquiring a firm for its competences is that they reside
in one or more individuals; so, if they leave after the acquisition, then
the takeover may have been in vain.

By Tolera M (MSc), Lecturer, DaDU 56

 Cont..
Mergers and cost savings
• The majority of mergers are intended to produce cost savings from
synergy between existing and acquired activities; these may arise from
reorganizing the production, selling, distribution and management
functions of the combined enterprises.
• The main source of these gains will be: economies of scale as production
is concentrated at fewer facilities; from economies of scope as
administrative functions are shared and purchases of raw materials are
co-ordinated; and from economies of size, which allows larger firms to
achieve lower costs than smaller ones.
• For example, motor car assemblers who merge their operations may be
able to achieve benefits from all three sources.
• Whether the expected cost savings are achieved depends on the success
or otherwise of the acquiring firm to integrate the new operation into its
existing organizational and management structure and to pursue the
necessary restructuring.
• If the costs of restructuring and setting up new management structures
prove more expensive than anticipated, then the merger may not
achieve its expected benefits.
By Tolera M (MSc), Lecturer, DaDU 57
 Cont..
Defensive and opportunistic reasons
• The management of a firm may seek to merge for defensive reasons,
such as to protect their own positions, to avoid bankruptcy or to avoid
being taken over by an unwelcome bidder. Alternatively, an acquisition
may be made because a company becomes available.
• If a firm fears that it will become the subject of a takeover bid, then it
may itself launch a bid to increase its size and make the firm a more
expensive target. An alternative approach to such a threat or to a
launched bid is to seek another firm, or suitor, of the firm’s own
choosing to take the firm over in preference to the original bid.
• Opportunities to make acquisitions or seek mergers may present
themselves from time to time.
• Two smaller firms in a market might merge to create a stronger firm to
survive the challenge of a larger rival.
• There may be opportunities to deploy liquid assets (or a cash mountain)
to acquire companies, which will improve the growth prospects of the
firm and keep shareholders happy because of their dislike of excessive
non-working assets.

By Tolera M (MSc), Lecturer, DaDU 58

 Cont..
Changes in the economy
• Mergers are sometimes motivated by general changes in an industry,
such as changes in demand and technology, and trends in the economy
as a whole, such as globalization.
• For example, declining demand in the defence sector following the end
of the cold war led to mergers of defence companies and consolidation
of the industry. The general state of the economy may also be conducive
to mergers. For example, boom conditions with rising stock market prices
may make takeovers financed by shares extremely attractive and
encourage predatory firms to seek targets.
• Changes in particular economic policies may create opportunities for
merger activity as previous restrictions on firm behaviour are removed.
Deregulation in the US airline market created new opportunities for
business experiment and consolidation.
• Deregulation and privatization, which have been features of economic
development in many countries, created market structures that were
designed by committee.
• The new firms that were created have often taken the opportunity to
merge with each other or have themselves been taken over by others
keen to enter the market.
By Tolera M (MSc), Lecturer, DaDU 59
 cont.…
Profit and efficiency benefits
• The economic case for horizontal mergers is generally
based on higher unit revenues from the use of market
power and lower unit costs from efficiency savings.
• If two firms were to merge, then the new firm could use its
market power to restrict output and raise prices.
• For vertical mergers there may be cost savings where two
technologically linked stages of a production chain are
joined together under common ownership.
• Such a link avoids recourse to market transactions and
avoids transaction costs; however, these may be offset by
increases in governance costs.
• For conglomerate mergers where the activities are
unrelated, the cost savings may arise from more efficient
management, from a lower cost of capital for market
funding and from operating an internal capital market.
By Tolera M (MSc), Lecturer, DaDU 60
Thank You!!

By Tolera M (MSc), Lecturer, DaDU 61