Mergers Managers Rationality Essay

Download this Essay in word format (.doc)

Note: Sample below may appear distorted but all corresponding word document files contain proper formatting

Excerpt from Essay:

Mergers

The hypothesis is that "if managers are rational, mergers should always lead to an increase in shareholder value." In principle, this statement should hold, but there are a couple of pragmatic considerations that must be taken into account. Before examining the nuts and bolts of mergers, the statement needs to be corrected a little bit -- if managers are rational mergers should always lead to an expected increase in shareholder value. Rationality does not imply omniscience, so managers can only make decisions based on what they expect will happen, not with perfect knowledge of the future. In other words, if a merger fails to increase shareholder value, that does not imply that the manager failed to act rationally. Now that we understand that, we can investigate the core principles behind the statement.

Agency Theory

The first underlying concept at work in this statement is agency theory. Agency theory lies at the root of the rational manager perspective. Agency theory holds that managers act as agents for the owners of the firm (Eisenhardt, 1989). The owners invest their money in the firm to earn a return, because they are rational. The view is predicated on the idea that a corporation is simply an organization of resources with the intent to earn a return. The return is how the resources are acquired in the first place, and the corporation's resources can be deployed any way that will serve the purpose of earning a return -- the theory of the firm (Jensen & Meckling, 1976; Fama, 1980). Thus, managers are free to do whatever they feel will enhance shareholder value, because they are simply a resource that is being put to use for that purpose. This argument has been extended to hold that the only role managers have is to enhance shareholder value, and no other (Friedman, 1971).

If we examine the merger motives (Fitzsimons, 2014), it should be noted that only two reflect rationality on the part of managers. Synergy and bargain buying reflect managerial rationality; managerial motives and third party motives do not. Managerial motives like empire-building, hubris are clearly emotional. The free cash flow argument, wherein managers use free cash flow for acquisitions rather than returning it to shareholders, is managerial preference and not necessary based on rational analysis. Third party motives may be rational -- they are not mutually exclusive to either synergy or bargain buying, but they are framed in the lecture as being more of an emotional response to pressure.

Bounded Rationality

Bounded rationality is an important concept to take into consideration. The above statement reflects the economic principle of perfect rationality. While perfect rationality is useful in solving theoretical problems, it bears no resemblance to the realities of managerial decision-making, which are bounded by a number of constraints, and not just a lack of omniscience (Arthur, 1994). Rationality is bounded by information limitations, time constraints and cognitive constraints. Perfect rationality requires managers to have perfect information, in addition to the time and the cognitive tools to process that information. It is easy to see how this makes sense when applied to academic model-building but these conditions almost never exist in real world managerial situations. The way that the information is process and the choices are made -- even when using a model like net present value, will differ between managers (March, 1978). Managers have beliefs that help inform the assumptions that are built into the NPV model, and often these lead managers not to utility maximization (i.e. pure rational decision-making) but rather to "satisficing," striking a balance between multiple different objectives (Kahneman, 2003). An assumption of bounded rationality should be assumed in the context of this discussion because pure rationality is not possible. The presence of bounded rationality inevitably leads to at some degree of deadweight loss (Huang, Allon & Bassamboo, 2012).

Bargain Buying

Of the two rational reasons for merger and acquisition activity, bargain buying is perhaps the easier to explain. The idea is that "the target can be purchased at a price below the present value of the target's future cash flow." The second clause of the statement "…when in the hands of new management" is actually a synergy argument. Bargain buying occurs when the asset is mispriced based on current intrinsic value. This can occur, unless one believes in the strong form of efficient market hypothesis, but there is evidence that in the long-run at least unusually low price-to-book ratios are correlated with superior returns, lending credence to the concept of bargain buying as rational decision-making leveraging market mispricing (Sun, 2012). When the asset is not publicly-traded, the obvious lack of liquidity means that EMH will not hold, but even for publicly-traded assets the strong form of EMH is a dubious theory. There is, however, evidence for weaker forms of EMH (Eom et al., 2007). Thus, the acquiring firm would have more information about the asset's value than the overall market, leading it to conclude that the asset is underpriced.

Synergy

Synergy is the major explanation for rationality in merger and acquisitions. If managers are rational, mergers should be based on an expected increase in shareholder value. There are two distinct elements to the merger transaction. The first is the price paid, and the second is the value that the acquiring firm expects. With respect to the price paid, there will be an acquisition premium, especially where control of the company is concerned (Megginson, 1990). The first assumption is that the target firm is priced in line with EMH, so that its current price reflects the present value of expected future cash flow. The acquiring firm needs to entice the shareholders of the target firm, since if it offered intrinsic value the shareholders of the target firm would have no motivation to sell. Thus, an acquisition premium must be offered. The acquisition premium is one of the most important concepts in mergers and acquisitions, because in order to justify paying above intrinsic value for acquisition the acquiring firm needs to earn a positive net present value on the transaction.

The basic concept is synergy is that the combined entity will be more efficient and effective that the two entities separate, and will therefore have higher value. A basic example would be if PepsiCo bought a small soda maker. The small soda company's value is based on its current operations, but given access to Pepsi's distribution network, it would be much more valuable. Alternately, two firms could be similar in many respects and the merger will allow for a reduction of redundant expenses, making the combined entity more profitable than either entity could be on its own (Fitzsimons, 2014).

There are many criticisms of the acquisition premium and synergy Studies have noted, for example, that the acquiring firm's pre-acquisition performance is often overextrapolated in the market, leading to post-acquisition performance that is below market expectations (Rau & Vermaelen, 1998). Others have noted that large acquisition premiums are not rational at all. Hayward and Hambrick (1997) argue that CEO hubris is indeed responsible for large acquisition premiums, rather than positive expected NPV, though their study was based on ex-post data -- they looked at mergers that failed to provide a positive NPV and sought correlation with CEO hubris, without looking at other factors.

Agrawal and Jaffe (1999) note that performance extrapolation is a major challenge for managers that often leads to poor performance of post-merger entities. Past performance is often extrapolated, which makes sense because that is the most concrete starting point. However, managers typically fail to take into account all of the changes that will experienced with the combined entity, one of the key lessons of bounded rationality. Particularly where synergies will be gained from the elimination of redundancies (Schweiger & Very, 2003), operations will change as a result. The more operations change, the less accurate the extrapolation of past performance will be. Firms often do not have full information prior to a merger, which also leads to problems with extrapolation when past performance is not as it was thought to be at the target firm.

The synergy argument is challenged by the future orientation of synergy assumptions. While Agrawal, Jaffe and Mandelker (1992) have sought to rule out many reasons for chronic post-merger underperformance, ultimately the errors derive not from managers failing to act rationally, but because one can only act rationally based on expectations of future performance. In light of the fact that most managers lack omniscience, it is only reasonable that there will be errors in their calculation. Even the most rational of managers can only extrapolate past performance or estimate future performance with a certain degree of accuracy, and that will always be well south of 100%. It almost seems funny to pinpoint specific types of extrapolation errors when there is no known forecasting method that can consistently match expected NPV at the time of the merger with actual post-merger NPV. The most important thing to understand is what some of the pitfalls in these calculations are. It is…[continue]

Cite This Essay:

"Mergers Managers Rationality" (2014, March 27) Retrieved December 3, 2016, from http://www.paperdue.com/essay/mergers-managers-rationality-186109

"Mergers Managers Rationality" 27 March 2014. Web.3 December. 2016. <http://www.paperdue.com/essay/mergers-managers-rationality-186109>

"Mergers Managers Rationality", 27 March 2014, Accessed.3 December. 2016, http://www.paperdue.com/essay/mergers-managers-rationality-186109

Other Documents Pertaining To This Topic

  • Challenge of Managing All Stakeholders in the Context of a Merger...

    Managing All Stakeholders in the Context of a Merger Process Review of the Relevant Literature Types of Mergers Identifying All Stakeholders in a Given Business Strategic Market Factors Driving Merger Activity Selection Process for Merger Candidates Summary, Conclusion, and Recommendations The Challenge of Managing All Stakeholders in the Context of a Merger Process Mergers and acquisitions became central features of organizational life in the last part of the 20th century, particularly as organizations seek to establish and

  • Dollar Oil Economy Analyzing the

    John Perkins (2007), likewise, examines how the modern American Empire has affected our economy and our society in his book the Secret History of the American Empire. Perkins reveals nothing new when he contends that the United States makes up "less than 5% of the world's population…[yet] consumes more than 25% of the world's resources" (p. 5). What he does do with this information is use it as a platform

  • Structure Constrains Growth Bounded Rational

    404). They found that complexity especially in hierarchical organizations strongly determines success of design choice outcomes, especially when endogenous adaptation in different modules delivers "local performance improvement" (Ethiraj and Levinthal, 2004, p. 404). This is based on H.A. Simon's 1962 model of organizations, products and technology as complex, evolving systems where some choices constrain decision-making in the lowest levels, and also "near-decomposability" (Ethiraj & Levinthal, 2004, p. 404), the

  • Edgar Allan Poe s Influence on

    Watson, and his several forays into the real world to solve mysteries that confounded others. In this regard, Magistrale reports that, "Dupin solves crimes in part from his ability to identify with the criminal mind. He is capable of empathizing with the criminal psyche because Dupin himself remains essentially isolated from the social world" (21). In fact, Dupin also has a "sidekick" who serves as his narrator. According to

  • Behavioral Finance Human Interaction a Study of the Decision Making...

    Behavioral Finance and Human Interaction a Study of the Decision-Making Processes Impacting Financial Markets Understanding the Stock Market Contrasting Financial Theories Flaws of the Efficient Market Hypothesis Financial Bubbles and Chaos The stock market's dominant theory, the efficient market hypothesis (EMH) has been greatly criticized recently for its failure to account for human errors, heuristic bias, use of misinformation, psychological tendencies, in determining future expected performance and obtainable profits. Existing evidence indicates that past confidence in the

  • Managing Conflicts Executive Summary the

    It is not that managers do not see the benefit in conflict that they eschew it; it is that conflict is high-risk and can have significant negative externalities, some of which linger with the organization for a long time. Managers are less enthusiastic about conflict because they are taking into account a longer time frame and the totality of externalities, which makes their views a reflection of better information

  • Enron Was the Seventh Largest

    Enron could engage in their derivative trading strategy with no fear of government intervention because derivative trading was specifically exempted from government regulation. Due in part to a ruling by the Commodity Futures Trading Commission's (CFTC) chairwoman, Wendy Graham, derivatives remained free of regulatory oversight. Ms. Graham, wife of Texas senator Phil Graham, made this ruling 5 weeks before resigning as chairwoman of the CFTC and joining the Enron Board


Read Full Essay
Copyright 2016 . All Rights Reserved