Is an Acquisition Required to Realize Tax Gains, Operating Synergies,

Incentive Gains, or Diversification?

To evaluate the benefits of an acquisition, a financial analyst needs to do more than

simply compare the costs and benefits of combining two firms with the current situa-

tion where the two firms have no relationship. The executives in the two companies also

¹⁰Managers

may want to reveal information to investors even if their firms do not want to raise new

capital. First, managerial compensation may be linked to the firm’s stock price. Second, managers can be

sued for failing to reveal information.

Grinblatt1422Titman: Financial	V. Incentives, Information,	20. Mergers and	© The McGraw1422Hill
Markets and Corporate	and Corporate Control	Acquisitions	Companies, 2002
Strategy, Second Edition

Chapter 20

Mergers and Acquisitions

705

should investigate whether the gains from combining the firms can be achieved more

efficiently in some other way. For example, to estimate the tax gains from the increased

leverage associated with an acquisition, it is important to account for the possibility

that the firm could increase leverage in another way, such as by repurchasing its shares.

Similarly, one must consider whether achieving operating synergies between two

firms requires them to merge. For example, the executives at Duracell and Gillette

should have considered whether the benefits of having Duracell use Gillette’s distrib-

utors outside the United States required a merger of the firms. Apossible alternative

might be some kind of joint marketing agreement that allows Gillette to sell batteries

through its international distribution channels and to receive a commission on each bat-

tery sold.

Of course, writing a long-term joint marketing agreement can be complicated

because of the large number of unforeseen circumstances that could arise in the future.

The contract would have to specify what would happen if another company devised a

better battery that Gillette also might want to sell. This would certainly hurt Duracell,

but Gillette may not want to preclude such possibilities. Similarly, Gillette might be

concerned that, after investing resources to promote Duracell batteries, Duracell may

find that it can market its batteries without Gillette. To protect against this contingency,

Gillette could insist on a long-term contract that makes it the exclusive marketing agent

for Duracell. On the other hand, Duracell might be concerned about Gillette’s incen-

tive to expend the appropriate level of effort to market the batteries once Duracell has

signed a contract that gives it no alternative.

In some cases, these incentive problems are best solved with a very explicit con-

tract that specifies how both parties are to act under all relevant contingencies. In other

cases, however, it is impossible to know all the relevant contingencies in advance, mak-

ing it impossible to write a contract that satisfies the concerns of both parties. In such

cases, a merger may be preferred.

We should stress that a merger does not necessarily solve all incentive problems.

The Duracell people and the Gillette people may still bicker about who gets credit for

battery sales in Brazil after a Duracell/Gillette merger. Conflicts within a firm can cre-

ate the same costs as conflicts that arise between firms.¹¹

In addition, as we will dis-

cuss in the next two sections, additional costs and benefits associated with combining

firms also must be taken into account.