Impact Of M&a On Financial Performance

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Effects of mergers on corporate performance: An empirical evaluation using

OLS and the empirical Bayesian methods

Abdul Rashid*, Nazia Naeem

International Institute of Islamic Economics (IIIE), International Islamic University, Islamabad, Pakistan

Received 7 March 2016; revised 19 July 2016; accepted 5 September 2016

Available online 15 October 2016

Abstract

In this paper, we empirically examine the impact of mergers on corporate financial performance in Pakistan using data on the deals occurred

during the period 1995e2012. Ordinary least squares (OLS) and empirical Bayesian estimation methods are applied to carry out empirical

analysis. The OLS regression results suggest that the merger deals do not have any significant impact on the profitability, liquidity, and leverage

position of the firms. However, the estimates indicate that the merger deals have a negative and statistically significant impact on quick ratio of

merged/acquirer firms. We show that the results of the empirical Bayesian method are largely consistent with the OLS results.

Istanbul Anonim S¸irketi. Production and hosting by Elsevier B.V. This is an open access article under the CC BY-NC-

ND license (http://creativecommons.org/licenses/by-nc-nd/4.0/).

JEL classification: G32; G34

Keywords: Mergers and acquisitions; Financial performance; Profitability; Liquidity; Leverage; Empirical Bayesian

1. Introduction

One of the fundamental objectives of a corporate firm is to

achieve the highest, effective, and sustainable growth level.

However, most of firms, which are expected to spread their

business, have limited resources due to lack of internally

generated funds, inadequate access to financial markets, small

scale of business etc. Therefore, in order to achieve their goals,

corporate firms have several other options in their hands. For

instance, organic and inorganic growth strategies are among

the most famous strategies for improving growth of business,

sales expansion etc. Under organic growth strategy, firms

expand their business by new product development, produc-

tivity enhancement, increased output, cost reduction, finding

new markets, and customer base expansion. On the other hand,

inorganic growth is the process of growth of assets and sales

expansion by occurring new businesses through, mergers, ac-

quisitions, divestitures, spin-offs, take-overs etc. Although, as

compared to organic growth, inorganic growth strategy is a

fast way for corporate firms to expand their business, it in-

troduces several risks to merged/acquirer firms as well.

Indeed, realize of the inorganic growth proves to be difficult

and not fully free of risk. For instance, losing existing cus-

tomers and a conflict in firm cultures are two of the major risks

faced by the merged/acquirer firms.

In financial and economic perspective, inorganic strategy is

one of the most important strengths for corporations across the

world (Vanitha &Selvam, 2007). Among several strategies of

inorganic growth, merger and acquisition (M&A) is one of the

important characteristics of this strategy. According to

Weston, Mitchell, and Mulherin (2004), through mergers and

acquisitions firms are able to overcome the problem of limi-

tation by efficient use of limited resources. Further, it gener-

ally believed that mergers and acquisitions (M&A) are

expected to fuel the rate of growth of business and sales.

Mergers and acquisitions are also important to improve the

competiveness of a firm and performance of firm managers

*Corresponding author.

E-mail addresses: Abdulrashid@iiu.edu.pk (A. Rashid), naziii82@yahoo.

com (N. Naeem).

Peer review under responsibility of Borsa

Istanbul Anonim S¸irketi.

Available online at www.sciencedirect.com

Borsa

Istanbul Review

Borsa

Istanbul Review 17-1 (2017) 10e24

http://www.elsevier.com/journals/borsa-istanbul-review/2214-8450

http://dx.doi.org/10.1016/j.bir.2016.09.004

Istanbul Anonim S¸irketi. Production and hosting by Elsevier B.V. This is an open access article under the CC BY-NC-ND

license (http://creativecommons.org/licenses/by-nc-nd/4.0/).

(Huh, 2015). Many corporate firms consider mergers and ac-

quisitions a best way to expand their ownership boundaries

(Dash, 2010). Similarly, firms also pursue mergers and ac-

quisitions to increase their market power, diversification, ef-

ficiency (both production and cost efficiency), achieve

internationalization, and to get operation, financial, and

managerial synergies (Moeller &Brady, 2007; Petitt &Ferris,

2013). Recently, owing to globalization, liberalization, im-

provements in technology, and competitive business environ-

ment, mergers and acquisitions are becoming more important

throughout the world (Leepsa &Mishra, 2012; Usman,

Mehboob, Ullah, &Farooq, 2010).

Finance theories suggest both positive as well as negative

effects of mergers and acquisitions on corporate firms‘per-

formance. According to merger and acquisition theory, suc-

cessful merger and acquisition deals increase the profitability

of the merged/acquirer firms. This increase in profitability

could be result of improved monopoly or an increase in effi-

ciency (Beena, 2000). On the other hand, according to the

managerial theory of a firm, mergers and acquisitions have a

negative impact on merged/acquirer firm‘s financial perfor-

mance and profitability specifically (Ghatak, 2012;Kumar &

Bansal, 2008). There is also empirical evidence that merger

and acquisition deals do not significantly influence the prof-

itability and financial performance of corporate firms (Al-

Hroot, 2016; Bhabra &Huang, 2013; Pilloff, 1996;

Poornima &Subhashini, 2013).

Mergers and acquisitions may also have either negative or a

positive impact on a firm‘s leverage position. As in Lewellen

(1971), owing to mergers, especially in conglomerate merger

deals,

if the income flow becomes more stable, then the

lenders can enhance the limits on lending to the newly created

firm and this limit would be greater than the sum of the

original limits that would be available for the merging firms

independently.

Another motive behind mergers and acquisitions is the

expected enhancement in the liquidity of the merging firms

(Pawaskar, 2001). Liquidity is important for firms like blood

for human body to survive (Beena, 2000). Liquidity position

of a business can be evaluated with the help of current ratio,

quick ratio, and working capital etc (Kumar &Bansal, 2008).

Many researches have documented that higher value of these

ratios show safe liquidity position of the firm and if these

values are small the firm is at risk (Kumar &Bansal, 2008;

Pawaskar, 2001; Poornima &Subhashini, 2013). Merger and

acquisition deals can affect liquidity in either way, that is, it

may improve or decline liquidity position of merged firms.

Merger deals can take place among the firms of similar

industries as well as in different industries. On the basis of this

reality, mergers have basically three types: horizontal, vertical,

and conglomerate mergers. When two or more firms get

together in same industry in finance such deal is known as

horizontal merger. This can be explained with the help of an

example that a textile firm merges with another textile firm.

The merger of two firms dealing in same business takes shape

of horizontal merger, which bring about synergetic gains in

terms of increased market share, cost saving, and exploring

new market opportunities. Similarly, a vertical merger may

occur, when textile firm buys its own dealer/supplier of cotton.

The vertical merger is likely to decrease operating costs of

operations and reduce costs by expanding economy of scales.

The third type of mergers is a conglomerate merger in which

two distinctively irrelevant companies from different in-

dustries merge together. For instance, textile firm buys an Art

College or a restaurant chain. The primary objective of such

merger deals is to reduce concentration risk through diversi-

fied capital investment.

Merger and acquisition trend in Pakistan has increased over

the years. However, it is not in that much higher numbers as it

happening over the entire world, especially in our neighbor

countries India and China. The total number of merger and

acquisition deals from June 1995 to February 2012 is 122,

highest being 39 deals in 2004. Out of total 122 merger and

acquisition deals only 36 deals have been placed in non-

financial sector. Although few studies have been done on

this area in Pakistan, a comprehensive study has not yet been

conducted, especially in manufacturing sector. Hence, our

analysis is an effort to evaluate merger deals and their impacts

on financial performance of the listed non-financial companies

of Pakistan. It should be noted that almost all of these 36

merger deals are horizontal with few exceptions. These ex-

ceptions are Nagina cotton mills limited, which was acquired

by Ellahi electric company limited, and D.G. Khan Cement,

which was acquired by D.G. Khan Electric.

The main objective of this study is to evaluate the financial

performance in terms of profitability, solvency, and risk position

of the non-financial merged/acquirer companies of Pakistan.

Specifically, regression analysis is carried out to analyze the

impact of mergers on profitability, leverage, and liquidity po-

sition of firms. As the selected sample size is relatively small, so

we also have applied Empirical Bayesian Estimation method in

addition to ordinary least squares (OLS) technique in this study

to acquire more precise results. Because empirical Bayesian

technique provides better results as compare to the traditional

OLS estimation in case of small sample. In this study, we seek

the answer of the following questions.

Does merger and acquisition affect profitability positively

in non-financial sector companies in Pakistan?

Does merger and acquisition impact liquidity position

positively in non-financial sector companies in Pakistan?

Does merger and acquisition influence leverage positively

in non-financial sector companies in Pakistan?

The significance of this study rests on several grounds. So

far in Pakistan, large number of mergers and acquisitions has

taken place in financial sector that is 86 out of total 122 merger

and acquisition deals from 1995 to 2012. This is why, in

Pakistan, most of empirical studies have been conducted in

banking sector (Kemal, 2011). In Pakistan, there is limited

Conglomerate merger is a deal in which two quit different firms of

different industries get together for enjoying the benefits of mergers.

11A. Rashid, N. Naeem / Borsa

Istanbul Review 17-1 (2017) 10e24

empirical evidence on the effect of mergers and acquisitions

on a firm‘s financial performance in terms of profitability,

liquidity, and leverage position for non-financial sector com-

panies. Only few studies have been conducted to find the ef-

fects of mergers and acquisitions on financial position of non-

financial merged/acquirer firms. In this respect, Usman, Khan,

Wajid, and Malik (2008) examined the operating and financial

performance of merged companies in the textile sector of

Pakistan for the period of 2001e2005 (only 5 merger deals are

taken as sample).

Usman et al. (2010) evaluated the financial performance

of merged firms from manufacturing sector of Pakistan by

using the accounting based approach for pre and post merger

period relative to their industrial peers (14 merged firms are

included in sample). The above-mentioned studies are not

comprehensive. This is because Usman et al. (2008) covered

only textile sector while other sectors are ignored altogether.

However, Usman et al. (2010) selected only 14 firms and

used ratio analysis technique only for comparison purpose.

We have extended our sample size to 25 merged/acquirer

firms, out of total 36 merger and acquisition deals concluded

in non-financial sector of Pakistan as well as time period that

is about 18 years (1995e2012). Remaining 11 firms are

dropped from our analysis because of either non-availability

of important data or those are group merger deals. This is

tangible contribution in literature of mergers and acquisi-

tions for corporate sector from Pakistan. Further, non-

financial companies intending to plan merger and acquisi-

tion can obtain substantial guidance from the findings of this

study.

The rest of the study is organized as follows. The next

section presents a brief review of the studies that examine the

effects of mergers and acquisitions on corporate firms‘per-

formance. Econometric methodology and data are discussed in

Section 3. The empirical results and their interpretation are

given in Section 4. Finally, Section 5presents some

concluding remarks.

2. Literature review

Mergers and acquisitions (M&A) are becoming famous

among financial as well as non-financial sectors of corporate

world. When we review the empirical literature we find several

studies that have examined the impact of mergers and acqui-

sitions in financial sector. Similarly, for non-financial sector,

enough literature is available for different countries, specif-

ically for India, the USA, China etc. Nevertheless, the

empirical literature on the effects of mergers and acquisitions

in non-financial sector is very limited. Further, the available

studies for Pakistan are limited in their scope and objectives.

After reviewing literature carefully we come to know that

many tools and techniques are available for analyzing the ef-

fects of merger and acquisition deals. Analysis of financial

ratios is widely used by researchers to find out the effects of

mergers and acquisitions. Yet, different results are found in

different studies (Kumar and Bansal, 2008). We have divided

the existing studies into two parts according to their results.

2.1. Positive impacts of M&A on financial performance

Several studies have found that merger events have a pos-

itive effect on the financial position of a firm specifically

profitability, leverage, and liquidity. For example, Pandit and

Srivastava (2016) explained that valuation of merger deal is

essential aspect while comparing the performance of mergers.

According to authors valuation method is important for

effective negotiation. They took interview of ten executives of

merged companies and also analyzed secondary data of

financial ratios. They have concluded that only fair valuation

prudent post merger management can create synergies and

positive effects on corporate firms‘performance.

Arikan and Stulz (2016) compared different theories and

established that younger firms can create a more valuable and

well-diversified merger as compare to old firms. Their findings

are consistent with neoclassical theories that showed that

acquirer firms performed better and also created wealth

through acquisitions of nonpublic firms. Furthermore, their

findings are consistent with agency theory because their

findings depicted that older firms have negative stock price

reactions for public firms.

Drees (2014) used meta-analysis on 204 studies to assess

the corporate strategies for this purpose he took joint ventures,

mergers and acquisitions, and alliances as data. He concluded

that joint ventures and mergers and acquisitions enhance

substantive performance. He also found that merger deals have

more positive effects on accounting based and market based

performance as compared to joint ventures and alliances.

Andreou, Louca, and Panayides (2012) investigated the

valuation effects of merger deals in the transportation industry

taking 59 merger deals as sample for the time period of

1980e2009. Their study found that mergers create synergy,

specifically those tender offers which are consistent with the

observation that transportation mergers take place for syner-

gistic reasons rather than management‘s want for bonus con-

sumption. They have discussed that though both kinds of

shareholders (target and bidder firm‘s shareholders) are better

off, the target firm‘s shareholders enjoy most of the synergistic

gains. Further, they found that vertical mergers have greater

valuation effects than horizontal mergers and the wealth ef-

fects of bidders are greater for open mergers.

Leepsa and Mishra (2012) examined the effects on post

merger financial performance in companies dealing in

manufacturing sector of India. They also observed the long-

term changes in post merger performance of these com-

panies. The study was carried out for 4-year period under

consideration using accounting based approach and using

three different financial parameters that are liquidity, profit-

ability, and leverage. Average of before and after merger

financial ratios were compared to examine if there is any

noteworthy change in financial performance due to mergers,

using paired two sample t tests. The liquidity position of the

firms was found improving so does the profitability of firms

which also improved in terms of return on capital and

decreased in terms of return on net worth of firms. The

improvement was noticed in solvency position terms of

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Istanbul Review 17-1 (2017) 10e24

networking capital. Overall, an improvement was seen in the

financial performance of the firms after merger in terms of

liquidity that is current ratio, quick ratio and in terms of

profitability that is return on capital. Similarly, the study

showed improvement in terms of leverage that is interest

coverage ratio. Nevertheless, most of their results were not

statistically significant.

Ghatak (2012) studied the impact of mergers on the

financial position of Indian pharmaceutical companies by

taking 52 listed drugs and pharmaceutical companies

(2005e2010) as a sample. He found that the size, selling

effort, exports, and imports intensities of firm positively in-

fluence the profitability after merger. It was also found that

merger deals showed insignificant positive effects on profit-

ability of firms in the long run on the account of X-inefficiency

and free entrance of new firms into the industry.

Indhumathi, Selvam, and Babu (2011) compared the sam–

ple of merged companies from the years 2002e2005. They

analyzed the performance of the both target firm and buying

firms using data for three year before and after occurrence of

mergers by using ratio analysis and t-test. They found that the

wealth of shareholders of the buying firms increased after the

merger deal. Kumar and Bansal (2008) argued that increase in

profits and synergy gain is not only possible by only getting

into the merger deals. By using ratio analysis for 74 merger

deals for the time period 2000e2006, they found that in large

number of the merger deals, the acquiring firms had generated

synergy in the long run in form of higher cash flows, more

(DEA) to study the production structure of merged and non-

merged banks. The results depicted improvement in cost ef-

ficiencies and profit efficiencies after a merger deal. In addi-

tion to this, their results showed that non-merged banks have

higher costs than merged banks because merged banks were

focusing on technical efficiency as well as allocative effi-

ciency. Frederikslust, der Wal, and Westdijk (2008) discussed

the wealth creation and redistribution theories of mergers in

their study by taking a sample of 101 merger events

(1954e1997). They showed that more than 50% of the buying

companies had a positive response to share value at the

announcement of merger, while 82% of the merger deals

showed that share price performance for target firms

improved.

Vanitha and Selvam (2007) compared the financial position

of 17 merged entities out of 58 manufacturing firms in India

(2000e2002) by employing ratio analysis and t-tests. They

found that it was possible for the merged firms to get success

in financial performance because the merging firms were taken

over by those firms that had good repute and also efficient

management. Similarly, Pawaskar (2001) has evaluated the

financial position of firms using data for 36 merger deals. He

compared the state of operating performance before and after

merger of the companies. Significant changes in the financial

performance of the firms involved in merger activity were

seen. According to his findings, the mergers seemed to lead to

financial synergies and a one-time growth only.

Gugler, Mueller, Yurtoglu, and Zulehner (2003) contributed

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