Organic growth versus merger and acquisition

Overview

Organic growth, hostile takeover and how does it work and three advantages of growing by acquisition rather than organically.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What is organic growth, and what are two examples of how it happens?

   Model answer

   Organic growth is expansion achieved by increasing the firm's own output and sales rather than by combining with another business. It happens when a retailer opens additional branches funded from retained profit, or when a manufacturer installs a second production line to serve rising demand. In both cases the firm adds new productive capacity to the economy rather than acquiring existing capacity.

2. 2

   What is a merger, and how does it differ from an acquisition?

   Model answer

   A merger is an agreement between two firms to combine into a single new business, usually with the consent of both boards and a negotiated split of ownership. An acquisition, or takeover, is the purchase by one firm of a controlling interest in another, so the buyer absorbs the target and the target loses its independence. An acquisition may be agreed with the target's board or pursued hostilely by appealing directly to its shareholders.

3. 3

   What is a hostile takeover and how does it work?

   Model answer

   A hostile takeover occurs when a bidder pursues control of a company against the wishes of that company's board. The bidder makes an offer directly to the target's shareholders, usually at a premium above the current share price, hoping that enough of them will sell to give it a controlling stake. If successful the bidder replaces the board, which is why the threat of such bids disciplines managers who fail to maximise the firm's value.

4. 4

   What are three advantages of growing by acquisition rather than organically?

   Model answer

   Acquisition is far faster, since the firm obtains capacity, customers and staff immediately rather than building them over years. It removes a competitor at the same time as it adds capacity, so market share rises by more than the assets acquired. It can also deliver assets that could not be created easily, such as an established brand, a distribution network, patented technology or a skilled team.

5. 5

   What are three advantages of organic growth over growth by acquisition?

   Model answer

   Organic growth avoids paying a premium above the market value of another business, so the capital buys assets at their true worth. It preserves a single company culture and management system, avoiding the disruption and staff losses that follow the joining of two organisations. It is also incremental and reversible, so the firm can adjust the pace as conditions change rather than committing everything to one large and irreversible transaction.

6. 6

   A bidder pays 650 million pounds for a firm whose stock market value was 500 million pounds. Calculate the takeover premium and explain what the bidder must achieve to justify it.

   Model answer

   The premium is 650 - 500 = 150 million pounds, which is 150 divided by 500 multiplied by 100 = 30 per cent above the market value. To create value for its own shareholders the bidder must generate benefits worth more than 150 million pounds in present value, from cost savings, extra revenue or reduced competition. If the gains fall short, the acquisition transfers value from the bidder's shareholders to the target's.

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