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Companies often grow by combining with other companies. One company may purchase all or part of another; two companies may merge by exchanging shares; or a wholly new company may be formed through consolidation of the old companies. From the financial manager’s viewpoint, this kind of expansion is like any other investment decision; the acquisition should be made if it increases the acquiring firm’s net present value as reflected in the price of its stock.

The most important term that must be negotiated in a combination is the price the acquiring firm will pay for the assets it takes over. Present earnings, expected future earnings, and the effects of the merger on the rate of earnings growth of the surviving firm are perhaps the most important determinants of the price that will be paid. Current market prices are the second most important determinant of prices in mergers; depending on whether asset values are indicative of the earning power of the acquired firm, book values may exert an important influence on the terms of the merger. Other, nonmeasurable, factors are sometimes the overriding determinant in bringing companies together; synergistic effects (wherein the net result is greater than the combined value of the individual components) may be attractive enough to warrant paying a price that is higher than earnings and asset values would indicate.

The basic requirements for a successful merger are that it fit into a soundly conceived long-range plan and that the performance of the resulting firm be superior to those attainable by the previous companies independently. In the heady environment of a rising stock market, mergers have often been motivated by superficial financial aims. Companies with stock selling at a high price relative to earnings have found it advantageous to merge with companies having a lower price–earnings ratio; this enables them to increase their earnings per share and thus appeal to investors who purchase stock on the basis of earnings.

Some mergers, particularly those of conglomerates, which bring together firms in unrelated fields, owe their success to economies of management that developed throughout the 20th century. New strategies emphasized the importance of general managerial functions (planning, control, organization, and information management) and other top-level managerial tasks (research, finance, legal services, and technology). These changes reduced the costs of managing large, diversified firms and prompted an increase in mergers and acquisitions among corporations around the world.

When a merger occurs, one firm disappears. Alternatively, one firm may buy all (or a majority) of the voting stock of another and then run that company as an operating subsidiary. The acquiring firm is then called a holding company. There are several advantages in the holding company: it can control the acquired firm with a smaller investment than would be required in a merger; each firm remains a separate legal entity, and the obligations of one are separate from those of the other; and, finally, stockholder approval is not necessary—as it is in the case of a merger. There are also disadvantages to holding companies, including the possibility of multiple taxation and the danger that the high rate of leverage will amplify the earnings fluctuations (be they losses or gains) of the operating companies.

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