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MERGERS AS A USE FOR SURPLUS FUNDS

Suppose that your firm is in a mature industry. It is generating a substantial amount of cash, but it has few profitable investment opportunities. Ideally such a firm should distribute the surplus cash to shareholders by increasing its dividend payment or by repurchasingits shares. Unfortunately, energetic managers are often reluctant to shrink their firm in this way.

If the firm is not willing to purchase its own shares, it can instead purchase someone else`s. Thus firms with a surplus of cash and a shortage of good investment opportunities often turn to mergers financed by cash as a way of deploying their capital. Firms that have excess cash and do not pay it out or redeploy it by acquisition often find themselves targets for takeover by other firms that propose to redeploy the cash for them. During the oil price slump of the early 1980s, many cash-rich oil companies found themselves threatened by takeover. This was not because their cash was a unique asset. The acquirers wanted to capture the companies` cash flow to make sure it was not frittered away on negative-NPV oil exploration projects. We return to this free-cashflow motive for takeovers later.

We have discussed how mergers may make economic sense, but things can still go wrong when managers don`t do their homework. That was the case for Converse Inc., which produces athletic shoes. In May 1995 Converse announced that it was acquiring Apex One, a leading maker of sportswear. Apex brought with it a number of valuable

licenses for professional and college teams. As one enthusiast observed, ¬By letting them outfit athletes from head to toe, the Apex deal potentially puts them on an even keel with Nike and Reebok. ­ However, 85 days later Converse closed down Apex One after incurring a $46 million loss on its investment.

What went wrong? The problem appears to have begun when Apex was several months late in introducing its fall product lines. Converse`s management complained that, in light of these delays, Apex`s $100 million revenue projection at the time of the purchase had been unrealistic and over the next 3 months projections were progressively scaled back to $40 million. Inevitably, the closure of Apex was followed by a volley of legal suits.4

Dubious Reasons for Mergers

The benefits that we have described so far all make economic sense. Other arguments sometimes given for mergers are more dubious. Here are two.

DIVERSIFICATION

We have suggested that the managers of a cash-rich company may prefer to see that cash used for acquisitions. That is why we often see cash-rich firms in stagnant industries merging their way into fresh woods and pastures new. What about diversification as an end in itself? It is obvious that diversification reduces risk. Isn`t that a gain from merging?

The trouble with this argument is that diversification is easier and cheaper for the stockholder than for the corporation. Why should firm A buy firm B to diversify when the shareholders of firm A can buy shares in firm B to diversify their own portfolios? It is far easier and cheaper for individual investors to diversify than it is for firms to combine operations.