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The Reasons for Mergers and Divestitures

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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 the 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.

      1. Financial distress must be being experienced by one of the merging firms and
      2. There 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 the project’s cash flow. Thus a merger can serve as a tool whereby such firms can survive their distressed period as a 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 Mergers This paper measures vertical relation between two merging firms using industry commodity flows information in the 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 mergers. The authors use the CRSP value-weighted index as a market proxy. For 2 different event windows, the CARs (cumulative abnormal returns) are estimated. Thus the wealth effect arrives 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 hold-up problems and market transactions being uncertain leads to vertical mergers Paper 3: Investment Opportunities, Liquidity Premium, and Conglomerate Mergers 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 a 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 manager 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 lead to a 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.

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The reasons for mergers and divestitures. (2018, Jun 21). GradesFixer. Retrieved June 26, 2022, from
“The reasons for mergers and divestitures.” GradesFixer, 21 Jun. 2018,
The reasons for mergers and divestitures. [online]. Available at: <> [Accessed 26 Jun. 2022].
The reasons for mergers and divestitures [Internet]. GradesFixer. 2018 Jun 21 [cited 2022 Jun 26]. Available from:
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