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9. Managerial Motivation and Corporate Takeover

Introduction

If analysts could successfully measure the going-concern value of business assets based on their income potential using data drawn directly from published accounts, the valuation of one company by another for the purpose of takeover would present little difficulty. Unfortunately, even financial information based on GAAP data (generally accepted accounting principles) measures different assets in different ways, so that a value cannot be placed on a company as a whole. With the exception of property, fixed assets may be seen in balance sheets at their net book value (historic cost less depreciation) rather than market value. The inventory (stock) components of current assets may be valued at market value or cost, whichever is the lower. Moreover, intangible items, including brand names, and human resources may be ignored altogether. There are also the effects of synergy and the residual value of excess or idle assets to consider.

Fortunately, alternative approaches to share valuation are available to investors, which are not asset based but income driven. These utilize discounted revenue theory and the capitalisation of a perpetual annuity (using dividends or earnings) that can be made operational through a series of investment ratios. As we explained in the Chapter Eight, each may assist the analyst when determining the market capitalisation of equity and a price per share based on the maintainable yield for a company coming to the market for the first time. We shall now develop this concept further, through a series of activities concerning the most important strategic decision that corporate management is ever likely to encounter:

- How to value a business as a going concern in the event that it falls prey to takeover

Whereas companies seeking a stock exchange listing are motivated primarily by the need to finance expansion, which must satisfy the expectations of future shareholders, we shall discover that the rationale for expansion through takeover activity is more varied and complex. So much so, that it may run counter to wealth maximisation criteria and shareholder welfare.

First, we shall present an overview of the motivational factors that underpin the case for composite business entities and the problems which can ensue. The reasons why the majority of takeovers fail to match shareholders' expectations will also become clear.

Armed with this information, in subsequent Chapters we shall evaluate various methodologies for equity valuation once a company has selected another for acquisition. Finally, we shall review the case for managerial takeover activity from a shareholder perspective.

9.1. Objective Motivational Factors

Before a predator company pounces on a target company with a share bid, it seems reasonable to assume that management's over-arching objective for the takeover should be to:

Maximise current shareholders' wealth through a significant improvement in long-term earnings post-acquisition (the agency principle).

This normative objective should be supported by a comprehensive analysis of a company's strategic commercial considerations to satisfy shareholder expectations, which embrace:

Business areas Resource areas Influence areas

- Business areas are those sections of the domestic and global economy that receives the company's output.

- Resource relates to the firm's inputs of finance, assets and personnel.

- Influence represents those constraints upon the business and resource decisions of the firm which arise from legal limitations, societal pressures and the self-interest of internal and external non-managerial groups.

Given the wealth maximisation criterion of the predator firm and the influence constraints imposed upon it, the business motives (illustrated in Figure 9.1) commonly advanced by management to justify an acquisition programme are to:

(i) establish a balanced diversified portfolio of investment which will either maximise or stabilize post-tax earnings commensurate with risk

(ii) balance product life cycles

(iii) secure economies of scale and achieve synergy

(iv) avoid barriers to entry

(v) increase or maintain market share

(vi) increase or maintain the rate of growth

(vii) reduce competition

(viii) secure new products or services

(ix) guarantee outlets for existing products and services

Objective Managerial Motives for Acquisition or Takeover

Figure 9.1: Objective Managerial Motives for Acquisition or Takeover

The greatest problem that confronts predatory companies is resource risk associated with their inventory supply chain. Three threats can be envisaged depending on the company's degree of market independence. One is a supplier's decision to switch its allegiance to another company. Secondly, a supplier may suffer financial distress because of takeover activity, which necessitates a rescue operation, or even its acquisition. Finally, there might be the possibility of a supplier being acquired by a competitor that requires a pre-emptive strike.

Other resource factors that could also justify an acquisition are the availability of excess funds from reserves, the sale of fixed assets or working capital, the benefits of tax advantages and the procurement of valuable personnel (workforce or management).

Now, assuming that a strategic analysis of corporate wealth maximisation objectives confirms the rationale for expansion, management's options are either an external acquisition, or internal investment. Two economic criteria should favour the former:

- Speed

- Cost

Obviously, there are trade-offs. Time must be compared to cost. Cost must be assessed in relation to benefit and the potential earnings that the takeover delivers.

 
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