Paper cut of project’s cash flow. Thus

Paper 1:

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

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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 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.

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 Mergers


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

 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:

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:

Momentum and Investor Sentiment: The Stock Market Reaction to Merger


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











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.

Paper 3- Chang, C., & Yu, X. (2004).
Investment Opportunities, Liquidity Premium, and Conglomerate Mergers. The
Journal of Business,77(1), 45-74. doi:10.1086/379861


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