Discussion on Mergers and Acquisition (Term Paper Sample)

Name:
Instructor:
Institution:
Date:
1 Though M&M’s proposition II argues that value is maximized with 100% debt, explain how the agency conflict, bankruptcy, personal taxes, and signaling affect the optimal capital structure.
A firm’s optimal capital structure is that which the firm derives the maximum value and it regarded as the best composition of debt to equity financing to the firm. Modigliani and miller came up with the dividend irrelevancy theory with their basic argument being the value of the firm is not affected by the amount of dividend it pays as shareholder who don’t receive dividends may sell part of their shares to acquire money they need. Agency conflict arises when one party who acts on behalf of another known as the agent breaches the agreement they have with the person with whom he is acting on his behalf known as the principal. Bondholders provide debt to the firm. When a firm is financed 100% by debt shareholders ceases to control the firm as there 0% equity. This is against shareholders wish and therefore agency conflict arises between shareholders and the management. They influence the optimal capital structure by determining the composition of debt in the firm. Bankruptcy arises if a firm is unable to manage financial distress. When bankruptcy occurs the firm assets are sold and the bondholders have the preference in receiving repayment as compared to ordinary shareholders. When a firm is in financial distress it may borrow heavily to meet other financial obligations although at a higher cost of capital. Personal taxes are taxes charged on individual incomes by the state. Ordinary shareholders may not prefer cash dividends as they are not tax exempt as compared to the cost of debt. According to Modigliani he assumes there exist no different tax treatment on dividends as well as capital gains. The firm may end up retaining profits and reinvesting it. Interest on debt is tax deductable hence debt will be preferred as compared to raising equity. This is only applicable up to that point when firm cost of debt is management as high debt leads to increased default risk to the firm. Miller and Modigliani assumed that all stakeholders have equal access to information and therefore the stock prices are a reflection of the information available. This is not true as in most business shareholders are distinct from the managers.
1 Do dividend changes convey information about a firm’s future profits? Summarize the evidence.
Dividends are returns that ordinary shareholders derive from the company they have invested in. dividends are paid from the company profits. There are no legal requirements that they must be paid. Dividends are either paid in cash or through bonus stocks. Various dividends theories have been brought forward to explain the relevancy or the irrelevancy of the dividend to a firm. There is no static formula used in determining the amount to pay as dividends. When dividends are paid in cash they reduce the amount available to the firm for reinvestment. When a firm is consistent in paying of dividends then the changes in dividends may reflect the firm’s profitability. A firm is likely to have higher dividend payout if there are few shareholders and it has made huge profits and or has no immediate need for cash. Dividends are paid to shareholders as returns and sometimes they use them to gauge the management performance in generating earnings. When there is an increase in dividend payout without a proportionate drop in shareholding of the firm then this is an indicator of increased profitability of the firm. Increase in dividends denotes increased profitability while a decrease in dividends shows decreased profitability. Dividends are used to send signals to the existing as well as potential investors on the firm’s performance in the present and in the future. They are communication tools used by managers to convey information to the market.
2 Explain the agency-based arguments about dividend policy.
Dividend policy plays a critical role to any firm. Various arguments have arisen on the relevancy and irrelevancy of the dividend policy. It sets out the portion of the firm’s earnings that will be paid out to the ordinary shareholders. Managers acts as agents of the shareholders. Managers have their interest which may vary from those of the shareholders and the differences results in agency costs. When a firm pays higher dividend it reduces the amount available for reinvestment and therefore it has to borrow externally. This increases the firm scrutiny and thus reduces agency costs.
3 Compare and contrast dividends with share repurchases.
Dividends are payments that made to shareholders as a share of the company’s earnings. They vary from one year to another and sometimes may not be awarded. They may be offered on cash basis or bonus stock. A share repurchase occurs when a company buys back its shares. Dividends are more preferred by shareholders as opposed to the company’s management who see stock repurchase as being more flexible. Stock repurchase are also known as stock buybacks and may also be referred as share buyback. Stock repurchase are preferred when the price of the share is undervalued than when overvalued. Share repurchases results in increased management control by limiting shareholders control over the firm. There is greater flexibility obtained from the money obtained as dividends rather than that which is obtained from share repurchase. Share repurchases are treated fairly in terms of taxes. Dividends are crucial to those in search of current income and acts as a disciplinary measure to both the shareholders and the company management. Dividends have an effect the prevailing prices of stock with its payment resulting in increase of the price in most cases.
List and explain three valid reasons for mergers.
When two companies bring their effort together in a form of restructuring and agreement mergers and acquisitions arises. Various reasons have been brought forward as being the main drivers of mergers and acquisitions. The firm achieves competitive advantage due to combined effort synergy, availability of skills, and increased efficiency. This enables the firm to have a greater market share. A firm also engages in merger in order to diversify. The merged firms are able to develop a product that is more competitive in the market they had before the merger. A firm may benefit from cost cutting as a result of merging. All unnecessary workforces are laid off and the firm is able to make maximum utilization of the available resources. Some also merge as a survival tactic.
4 Explain why diversification is a poor reason for two firms to merge.
Mergers are usually undertaken by firms for strategic reasons such as achieving synergy and benefiting from the economies of scale and increased efficiency. Some firms are likely to enter into a merger for diversification purposes. Diversification involves a firm venturing into a new business area other than what it is currently...