Economic sense of Mergers and Acquisitions: Case of BAE Systems and EADS - Essay Example

Economic sense of Mergers and Acquisitions: Case of BAE Systems and EADS Introduction Integration in a given firm and/or industry refers to the process of organizing production based on organizational unification as well as technology of different production processes. The management of any given firm should employ a method of integration which offers the specific company technological efficiency. A firm is said to be technologically efficient if it produces a certain quantity of output by employing the lowest amount of production factors and / or inputs. Integration method employed should also offer a given firm economic efficiency. Economic efficiency is the ability of a given company to produce a specific output level using the lowest possible costs. Production can be organized in three different ways (Craig and Campbell 114). Firms diversify in various means. They integrate vertically, horizontally or agglomerate. Vertical integration involves mergers of firms in the vertical; line of production. A firm can merge with other firms up or down the line of production. Mergers up the line of production are called forward vertical integration while mergers down the line of production, the backward vertical integration. Horizontal integration involves mergers between firms at the same level of production. Conglomerate integration involves the merging of companies in different line of production. The benefits of the above diversification methods are that firms are able to improve their performance hence growth and increase in capacity. They increase their market shares, synergies, and due to large-scale production, they realize economies of scope and economies of scope. Low production costs lead to maximized profits. This study examines the impact of mergers and acquisition on the performance of BAE systems. Mergers and Acquisition Diversification is the process through which an organization enters new processes of business in the market with the possibility of manufacturing new products. Mergers and acquisitions are a form of entry that a firm may use to enter a market. Many firms in the financial industry have utilized this means to enter new markets. Mergers and acquisitions can take the form of vertical integration, horizontal integration or conglomerates. Horizontal integration is a form of integration in which firms combine at the same stage of production. Ison and Griffiths (75) note that horizontal integration may help a certain company to increase their share value. Firms that undertake horizontal integration do benefit from economies of scale that result from capacity expansion, technical economies of scale, social economies of scale, financial economies of scale, marketing and managerial economies of scale. Vertical integration is the ability of the firm to own subsidiaries downstream and upstream it line of production. Vertical mergers involve backward and forward linkages in an industry. Backward vertical integration occurs when firms merge or acquire subsidiaries that supply it inputs. Firms that undertake vertical integration realize reduced transaction costs hence increased profitability. Conglomerate integration occurs when an enterprise combines with other companies, which operate in different line of production. Companies Conglomerate to diversify their portfolio and hence spread the risk. These types of diversification are not common in the firming and financial industry. The most common types of mergers and acquisition in the firming industry are horizontal diversification where firms merge with other firms in other countries. Financial institutions such as firms do diversify through mergers and acquisitions because of many reasons. Firms can diversify with the aim of increasing their financial performance, exploiting the available business opportunities or other reasons. According to Shimizu et al. (341), financial institutions may be influenced by the profit that their competitors are making in the global industry to engage in mergers and acquisitions. Diversification in form of mergers and acquisitions can enable firms to exploit many opportunities in the global economy. For instance, the advance in technology has enabled firms to be managed from different places cheaply. Therefore, firms can undertake mergers due to the ability to management subsidiaries from far. Other reasons for mergers and acquisitions include ability for growth, need to reduce operating costs and increased competition in domestic market. In a study conducted by Badreldin and Kalhoefer (5), it was established that firms that participated in mergers and acquisitions increased their financial performance. Despite these findings, the study also established that integration is costly when integrating firms have dissimilar terms of loans and size strategies among other factors. According to Altunbas & Marques (15) the ability of a strategic fit is an important element in determining the success of mergers and acquisitions in terms of performance. It is important that merging firms have similarities in their balance sheets. A survey by Altunbas and Marques (21) to measure the importance of strategic similarities in mergers and acquisitions indicates that the size of the firm is important in determining the post merger performance of the firm. A large size for a domestic merger compared to the size of the bidder results in lower post merger performance. However, for cross border mergers, a large size for the target firm is important because it results in high post merger performance for the firm. Empirical literature indicates that a high pre-merger return on capital has a negative effect on the performance of the firm after the merger both for domestic mergers and cross border mergers. Therefore, firms that perform well before the merger may not be able to improve their performance after merging because their base rate of performance was initially high. The analysis of efficiency of firms measured in terms of cost to income ratio indicates that they are counterproductive in performance perspective. This is due to the difficulties that firms face in integrating the different their cost structures that are different in the short term. According to Altunbas and Marques (17), the difference in capital structure between the merging firms enhances the post merger performance. Capital structure differences for cross border merger is useful at low performance levels. It is difficult for firms involved in cross border mergers to integrate institutions with capital structure that are different. Return on earnings (ROE) is usually positive after mergers. Do mergers make Economic Sense: Case of BAE Systems and EADS Mergers and acquisitions can be traced to many years ago when companies began integrating at different levels. Since mergers have occurred in different periods and involving different levels of capital, the mergers are known by their history. However, whether they make economic sense is controversial. The merger between EADS and BAE systems was valued at €35bn and it is a good idea. Investors were advised to focus on issues that matter to them. The merger between these two firms has been characterized by few cost saving synergies, a sketchy sense of how the two firms would create more value, government interference and exaggerated market position f BAE in the U.S. Despite the status of the merger, the shareholders of the two firms should focus on establishing whether the combination of the two firms is the best way to solve their long term differences, whether BAE would help EADS make a giant leap it craves in North America and whether the terms of the merger are appropriate to both sets of investors. BAE is at crossroads of the merger since both the U.S. and Europe have reduced their defence budgets. On its part, EADS is struggling with the reduction of exposure to civilian aircraft cycle so that it can achieve a 50/50 split I revenue between Airbus and non-Airbus divisions. Major stakeholders in EADS such as Daimler and Lagardere would like the merger to proceed. On its part, the French government would like the creation of a single European defence giant while the UK would like to have more influence at Airbus. These are some of the political factors affecting the merger between BAE and EADS. A merger between BAE systems and EADS is beneficial since the two firms would complement each other and create one large corporation that is dominant in the industry since the military and civilian aerospace that the two dominate balance each other. EADS’ exposure could be reduced through its increased participation in the non-commercial aerospace. On the contrary, bulking up of the civilian aircraft would allow BAE to leverage business in the military platform. EADS is comprised of the Airbus, which make up two thirds of the company’s revenues and earnings it is the reason investors purchase the shares of the parent company. However, EADS’ profit margins are below those of the U.S. giant Boeing due to increasing costs and time overruns on projects. The margins are only about a third of the U.S. Company. On the contrary, Boeing is doing very well especially after its 1997 acquisition of McDonnell Douglas where it reaped $16bn (40%) of the total revenue realized in the first half of 2012. Through leveraging in-house engineering and technology, Boeing has managed to produce the best products and therefore enhanced its profit margins. The merger between EADS and BAE would lead to management of disparate and far-flung operation that may not bring about the returns. In addition, there would be little operational independence since governments would be involved in the management of the organization. Synergy Mergers have always led to better performance of involved companies. Synergy is the financial benefit that results from the merger for both companies and it is one of the determinants of the merger. Synergy is the ability of the merging companies to generate higher value for shareholders of both companies as compared to the standalone entities. Synergy is established through the difference between the present value of the standalone entity and the entity in a merger. Synergy could be driven by various factors such as internal operational processes and integration of systems, initial factors, strategic factors and acquisition premium among others. According to Boland and Kirk (6), a merger is like any acquisition. The most important thing for shareholders of the acquiring firm is to establish whether the annual synergies cover the premium paid to the target company. The premium is the difference between the market capitalization that is not disturbed and the current market capitalization of BAE. The premium affects the share prices of both firms. The synergy in this merger is established using the net present value, which is derived from the estimates of the annual synergies of the firms, the tax rate and the synergy multiple. The ability of the NPV being bigger than the bid premium implies that the acquisition deal is valuable for shareholders of EADS. However, if it is lower, then it means that the shareholders of EADS are not favored by the acquisition. In this case, any premium is good for shareholders of BAE Corporation (Boland and Kirk 6). From the synergy calculator, BAE got an implied premium of 4.78%. The net present value of the synergies was 1400 million, which was in the multiple of 10. From this synergy created, it is evident that the acquisition deal is favorable for the shareholders of EADS and therefore the firm can go ahead and acquire BAE. Empirical evidence from BAE Systems corresponds to these findings from past studies. Conclusion Mergers and acquisitions are forms of business diversification and specialization. The approach is undertaken by various firms with different objectives. However, the goal of maximizing revenue is still relevant. Diversification through mergers involves the interested entity to initiate talks with another firm probably located in different countries across the world. Firms that engage in merger agreements are usually driven by different reasons. To begin with, the firms could be having enough funds for investment and therefore they only need another firm to provide other resources. Second, the firms could be driven by the existence of opportunities in the potential markets. The companies could also be driven by the profitability of the venture and the low costs involved in the entire venture. Despite the benefits that the firm could accrue from international ventures, it is necessary that the firm analyses its current financial position well before undertaking the merger given that the venture requires much capital. In addition, the firm needs to conduct a market analysis in order to establish the competitors and the strategies they use, the level of saturation in the potential market and the ability of the firm to meet the legal regulations for business in the market. After the joint venture, an organization is most likely to experienced reduced costs, increased market share and profitability and economies of scale. However, it is important that the firm considers diluted profits, investors’ returns on equity, increased competition and inadequate financing options. Works Cited Altunbas, Yener and Marques, David. “Mergers and acquisitions and bank performance in Europe: The role of strategic similarities.” Journal of Economics and Business, 60.3 (2008): 204-222 Badreldin, Ahmed and Kalhoefer, Christian. The Effect of Mergers and Acquisitions on Bank Performance in Egypt. The Journal of Economic Policy and Research, 6.1 (2009): 1-111. Craig, Tom, and Campbell, David. Organizations and the business environment. London, UK: Butterworth-Heinemann. 2005. Print. Ison, Stephene, and Griffiths, Alan. Business economics. London, UK: Heinemann publishers. 2001. Print. Shimizu, Katsuhiko, et al. “Theoretical Foundations of Cross-Border Mergers and Acquisitions: A review of Current Research and Recommendations for the Future.” Journal of International Management, 10, (2004): 307–353 Boland, Vincent and Kirk, Stiuart. “Lex in Depth: EADS-BAE.” Financial Times Oct. 8 2012. Read More