585
31
Mergers and Acquisitions
Mergers and acquisitions (M&A) are an important element of a dynamic econ-
omy. At different stages of an industry’s or a company’s life span, resource deci-
sions that once made economic sense no longer do. For instance, the company 
that invented a groundbreaking innovation may not be best suited to exploit it. 
As demand falls off in a mature industry, companies are likely to have built excess 
capacity. At any time in a business’s history, one group of managers may be better 
equipped to manage the business than another. At moments like these, acquisi-
tions are often the best or only way to reallocate resources sensibly and rapidly.
Acquisitions that reduce excess capacity or put companies in the hands of bet-
ter owners or managers typically create substantial value both for the economy 
generally and for investors. You can see this effect in the increase in the combined 
cash flows of the many companies involved in acquisitions. Even though acquisi-
tions overall create value, however, the distribution of any value they create tends 
to be lopsided, with the selling companies’ shareholders capturing the bulk. In 
fact, most empirical research shows that for large acquisitions, one-third or more 
of acquiring companies destroy value for their shareholders because they transfer 
all the benefits of the acquisition to the selling companies’ shareholders.
For companies in growth mode, acquisitions can be an effective way to 
accelerate their expansion or fill in gaps in products, technologies, or geog-
raphies. Typically, numerous smaller acquisitions can help companies access 
markets faster or help smaller companies get their products to market faster.
The challenge for managers, therefore, is to ensure that their acquisitions are 
among those that do create value for their shareholders. To that end, this chapter 
provides a framework for analyzing how to create value from acquisitions and 
summarizes the empirical research. It discusses the archetypal approaches that 
are most likely to create value, as well as some other strategies that are often 
attempted but have longer odds of executing successfully. It provides practical 
advice on how to estimate and achieve operating improvements and whether to 
pay in cash or in stock. Finally, it reminds managers that stock markets respond 
to the expected impact of acquisitions on intrinsic value, not accounting results.

586  Mergers and Acquisitions
A Framework for Value Creation
Acquisitions create value when the cash flows of the combined companies 
are greater than they would have otherwise been. If the acquirer doesn’t pay 
too much for the acquisition, some of that value will accrue to the acquirer’s 
shareholders. Acquisitions are a good example of the conservation of value 
principle (explained in Chapter 3).
The value created for an acquirer’s shareholders equals the difference be-
tween the value received by the acquirer and the price paid by the acquirer:
Value Created for Acquirer
Value Received
Price Paid
=
−
The value received by the acquirer equals the intrinsic value of the target com-
pany as a stand-alone company run by its former management team plus the 
present value of any performance improvements to be achieved after the ac-
quisition, which will show up as improved cash flows for the target’s business 
or the acquirer’s business. The price paid is the market value of the target plus 
any premium required to convince the target’s shareholders to sell their shares 
to the acquirer:
Value Created for Acquirer
Stand-AloneValue of Target
Value of P
=
+
(
erformance Improvements
Market Value of Target
Acquisition P
)
(
−
+
remium)
Exhibit 31.1 uses this framework to illustrate a hypothetical acquisition. 
Company A buys Company B for $1.3 billion, which includes a 30 percent 
premium over its market value. Company A expects to increase the value of 
Company B by 40 percent through various operating improvements, so the 
EXHIBIT 31.1  Acquisition Evaluation Framework
$ million
Value of performance
improvements
Stand-alone
value
1,000
400
1,000
300
1,400
1,300
100
Acquisition
premium
Market
value
Value
received
Price
paid
Value created
for acquirer