Business Expansion

Joint Ventures (JV's) and Mergers & Acquisitions (M&A's)

• Joint Ventures (JV's):

  • Business arrangement where two or more companies pool resources for a specific task.

  • Often used to enter a foreign market with a local business.

• Merger:

  • Joining of two or more firms under common ownership to become one.

• Mergers vs. Acquisitions:

  • Merger: Mutual consolidation of entities to form a new enterprise with shared ownership, control, and profit.

  • Acquisition: Purchase of a business by another enterprise, either through asset purchase or acquiring over 51% of share capital; doesn't require mutual agreement.

Why Companies Merge:

• The principle behind buying a company is to create shareholder value over and above the sum of the two companies.

  • This principle relies on synergy, growth, and intangible assets (human, customer, and structural capital).

Growth of Firms:

• Internal (Organic) Growth:

  • Expanding a business's own operations without relying on takeovers or mergers.

  • Increasing production from inside the business and productive capacity internally.

• External Growth:

  • Fastest route for growth through joint ventures, mergers, or acquisitions/takeovers.

Internal Growth - Reasons:

• Opening new retail outlets and expanding markets.

• Taking on more staff.

• Expanding existing production capacity through investment in new capital and technology.

• Increased activity in sourcing and more suppliers.

• Developing and launching new products.

• Finding new markets (i.e., exporting).

• Growing a customer base through marketing.

• Economies of Scale: Large-scale production results in lower unit (average) costs (cost per unit).

  • Average Cost = Total Cost / Quantity

Internal & External Economies:

• Internal Economies:

  • Technical.

  • Purchasing.

  • Financial.

  • Managerial.

  • Risk Bearing.

  • Marketing.

• External Economies:

  • Location/Transport links.

  • Skilled Labour.

  • Organization Infrastructure.

  • Reputation of Area.

Underlying Rationales for Mergers

• Strategic rationale: control in the chosen sector

• Speculative rationale

• Management failure rationale

• Financial necessity

• Political rationale

Merger Drivers:

• Requirement for specialist skills and/or resources.

• National and international stock markets.

• Globalization drivers.

• Diversification drivers.

• Industry and sector pressures.

• Capacity reduction.

• Vertical integration.

• Increased management effectiveness and efficiency.

• To acquire a new market or consumer base.

• To buy into a growth sector.

• Motives: cost, profit, market power, risk, and management.

Types of Mergers:

• Horizontal Mergers:

  • Two companies in direct competition sharing the same product lines and markets.

  • Example: Two car manufacturers or drinks suppliers.

  • Branding is an important consideration (unique selling proposition, logos, mascots).

• Vertical Mergers:

  • Acquiring a business in the same industry but at different stages of the supply chain.

  • Supply chain: process by which production and distribution gets products to the final customer.

  • Examples:

    • Film distributors owning cinemas.

    • Brewers owning/operating pubs (forward vertical) or buying hop farms (backward vertical).

    • Drinks manufacturers integrating with bottling plants.

• Conglomeration/Diversification:

  • A company buys another firm in an unrelated industry.

  • Two companies with no common business area.

  • Examples:

    • Samsung (electronics, military hardware, apartments, ships, amusement park).

    • Facebook buys WhatsApp.

Why Mergers Fail:

• Mislead value for investment

• Lack of clarity in the integration process

• Mismatch in culture

• Poor communication

• External factors

• Negotiation errors

Advantages of Mergers:

• For Consumers: Lower costs passed onto consumers through lower prices.

• For Firms:

  • Generation of economies of scale.

  • Higher profits invested into new R&D, new technology, new products/services.

  • Increased scope of global competition (more exports).

  • Higher shareholders return/profit.

  • Large firms have better access to funding (capital markets) than smaller ones.

• For the Wider Economy:

  • Higher scope for more government corporate tax revenues, and better provisions for merit and public goods.

Disadvantages of Mergers:

• For Consumers: Creation of monopoly or oligopoly which could lead to consumer exploitation.

• For Firms:

  • Diseconomies of scale, decreasing returns to scale, law of diminishing returns.

  • Benefits may not occur in the long term

  • Cost savings may not materialize, or passed onto consumers

• For the Wider Economy:

  • Attract interest and investigation from Competition & Markets Authorities (CMA).

Short-Term Measures of Financial Performance:

• Financial performance in the short-term could differ from its long-term performance.

• Two standard measures:

  • Return on Capital Employed (ROCE).

  • Earnings Per Share (EPS).

Return on Capital Employed (ROCE):

• Formula: \frac{Profit \, before \, interest \, and \, tax}{Average \, capital \, employed} × 100\%

• Indicates how well a business uses its capital to generate profits.

• Expressed as a percentage for easy comparison between companies.

Earnings Per Share (EPS):

• Formula: \frac{Profits \, after \, interest, \, tax \, and \, preference \, share \, dividends}{Number \, of \, ordinary \, shares \, issued}

• Represents profits available to ordinary shareholders, expressed per share.

• Directors decide dividend payouts.

• To calculate a rate of return, the acquisition price of a share must be considered.

• Main weakness: does not directly correlate to the goal of maximizing shareholder wealth.

Calculating ROCE & EPS: Example

• Company A:

  • Profit Before Interest and Tax (PBIT): £175,000

  • Interest: £25,675

  • Taxation: £45,000

  • Preference Share Dividends: £28,000

  • Ordinary Dividends: £50,000

  • Share Capital: £2,000,000 (Nominal value of £0.50 per share)

Calculating ROCE & EPS: The Answer

• ROCE

  • Formula: ROCE = \frac{PBIT}{Average \, Capital \, Employed} × 100\%

  • ROCE = \frac{£175,000}{£2,000,000} × 100 = 8.75\%

  • Indicates how well the business uses its capital to generate profits

• EPS

  • Formula: EPS = \frac{PAT}{Number \, of \, Shares}

  • EPS = \frac{£175,000 - £25,675 - £45,000 - £28,000}{\frac{£2,000,000}{£0.50}}

  • EPS = \frac{£76,325}{4,000,000} = £0.019 \, per \, share

  • Indicates the profits available to ordinary shareholders, expressed per share