Analysis of statement that “acquiring foreign companies creates shareholder wealth and helps reduce many risks”
The above statement discusses risk reduction as a benefit of acquisitions. I will split the statement into two parts; one that discusses the reduction of risks through acquisitions, and the other which explains the creation of shareholder wealth through acquisitions. The first part of this statement can be explained through the various forms of risk that are reduced due to acquisitions. One major risk that is reduced through acquisitions is the risk from competitors, through acquiring a fair market share. It is difficult for firms which invest through greenfield strategies to attract clients from the existing competitors.
This is because a new firm has to prove its performance to clients before it can successfully attract clients from the present competitors. This is a move that takes time, since the clients have to analyze the products of new firms before the firm can gain the necessary goodwill to attract new clients. However, acquisitions enable firms to use the goodwill of the firm that has been acquired to retain the existing clients or share of the market. The market associates the new firm, in this case TPS Connection Plc, with the brand name of the firm that has been acquired, and if it had favorable goodwill, the new firm will have less problems in retaining the existing clients, as well as attracting new clients from the competitors.
An example of a firm that has undergone a successful acquisition process and enjoyed this benefit is Tata Steel of India, which acquired Corus of Netherlands. Before sealing of this deal, Tata Steel Company had to undergo a long and costly process of bidding, which was estimated to cost about $13.7 billion. However, this process paid off after Tata steel benefited from among other things, the market share of Corus Company. In fact, after the acquisition, Tata steel moved from being the fifty-sixth producer of steel globally, to the fifth position (ICFAI Center for Management Research 2007: 8).
The second risk that is reduced through acquisitions relates to the distribution channels. A new firm has to create new distribution channels that are effective enough to gain a share of the market. This is challenging since the present competitors already use the best distribution channels available. A new firm faces the risk of reduction of sales due to inferior distribution channels. However, acquisitions enable new firms to make use of the already existing distribution channels of the firm that has been acquired. This enables the new firm, in this case, TPS Connection Plc to penetrate the market more easily through the use of the existing distribution channels of the firm that has been acquired. The Tata Steel acquisition that has been discussed above benefited Tata from Corus’ European distribution channels, and this is among the factors that made it gain a large share of the market.
The third risk that can be reduced through acquisitions relates to the costs of market research. A new company has to effectively study the market it is penetrating so that it can have full information on the products to manufacture, the pricing system, modes of advertising among other qualities of the market. This is an expensive process, and if not done efficiently, it might lead to the inability of a new firm to penetrate the existing market.
Due to the high nature of the costs, this might be inhibiting to firms which do not have the necessary resources and technology. However, in cases of acquisitions, for instance by TPS Connection Plc, the company that is being acquired already has valuable information on the market segmentation and trends. It therefore becomes relatively easier for TPS company to penetrate the market using the available information from the acquired company. It is important to note that nonetheless, TPS has to do research on its own, but this will be less difficult and will consume lesser funds as compared to a scenario where it was implementing a greenfield investment.
Another risk that is reduced is the systematic risk that may occur in certain parts of the world, or certain markets. For instance, there is currently conflict that is going on between Palestine and Israel. The largest brunt of the war is felt by Palestine, and it can be said that firms in this country are facing a systematic risk. Firms in this country with interests in foreign countries can be said to have reduced their risk through diversification. They can rely on the profits from the foreign firms in a period like this, when their profits are prone to decreasing. This is one risk that an acquisition reduces, and TPS Connection Plc should use an acquisition as a form of entering the Chinese and Indian markets in order to reduce the systematic risk through diversification.
Creation of wealth through acquisitions.
There are several companies that have undertaken acquisitions which have proved to reduce risks and improve the wealth of shareholders. Hindalco is one such company, and it acquired Novelis Inc, which is a company that deals with aluminum and is based in Canada. Since both companies had a large market presence, the combination of resources, distribution channels, goodwill and market share ensured that Hindalco built a very strong market presence. This presence is felt in almost all continents of the world.
Creation of shareholder wealth is achieved through the following benefits of acquisitions. The first benefit is greater value generation, and this means that a company that undertakes an acquisition or merger is likely to achieve higher value as compared to both individual firms. This is explained by the fact that a company that undertakes an acquisition is more likely to generate a higher shareholder value that is much larger than the total number of shares of the individual companies.
Another benefit that arises from acquisitions and which is likely to increase the wealth of shareholders is the gains in market share. This benefit can be well illustrated when a firm is facing challenges in the market. In such a scenario, an acquisition especially by another firm which has a strong presence in the market, is likely to make the weaker firm experience greater levels of cost efficiency and competitiveness. In this case, there are two beneficiaries to the acquisition; the weak company benefits from elimination of its market problems, while the joint company benefits from a larger share of the market.
A third benefit of an acquisition which is consistent with the wealth creation goal of a company is the cost efficiency gain. This benefit is realized through economies of scale benefits that are realized from acquisitions and mergers. Such benefits include ease of raising capital, sharing of resources by both firms, advancement of discounts from bulk purchases among other benefits. Other benefits include increase in production due to the acquisition, which then leads to the reduction of the production costs of individual units. Increase in efficiency can also be achieved through sharing of technology. In the Hindalco acquisition, this firm gained very useful technology from Novelis Inc., which some experts estimate would have taken a decade to develop.
The fourth benefit that can be attributed to the acquisitions and mergers is the reduction in the administration costs. This occurs due to the sharing of established resources between the two firms. For instance, when a firm enters a new market through an acquisition, it does not spend much funds setting up the different departments that are needed for operations. Instead, a firm will use the existing departments of the new firm that is being acquired.
A fifth benefit of an acquisition which TPS Connection Plc would enjoy is the increase in global presence. When this firm acquires a company which has a strong brand name, its presence will be felt in the market, which would attract more clients to the company. When Hindalco, an India based company acquired Novelis, a large Canada based aluminum company, this increased the global presence of the former (ICFAI Center for Management Research 2007: 6). This was achieved through combining the strengths of the two companies and their distribution network, thereby ensuring that it had a presence in almost all continents of the world. All these benefits either help to increase revenue or decrease costs, which is consistent with the goal of a company of increasing the wealth of the shareholders.
Assessment of the decision to invest using FDI.
The decision to invest in these countries using FDI is borne out of the benefits that are present in this form of investment. This decision arises out of many factors that are present in the countries where these companies seek to invest. For instance, when TPS Connections Plc is assessing the type of investment to undertake when penetrating the Chinese and Indian markets, it will be guided by some factors. Some of these factors include the macroeconomic conditions of these markets, such as the benefits that foreign investors gain. Other factors include the nature of the competition and the available forms of financing. However, in totality, some of the main factors that make FDI a favorable form of investment are discussed below;
The first reason originates from the fact that nation states usually encourage FDI in their countries. This is due to several benefits that such states reap from the FDI. One benefit includes the increase in revenue for the host country. In any country, economic growth is increased through investments. This increases the purchasing power of residents of the country due to the increase of incomes attributable to economic growth. The increase in purchasing power leads to the increase in demand for services and goods produced within the country, and this also increases revenue for the government. The government increases revenue due to the tax paid from the products as well as consumer spending and wages.
The second benefit attributable to FDI in the host country is the increase of capital available for investment. This especially useful to Least Developed Countries which do not have sufficient capital to invest in large projects. FDI also helps local investors to acquire the currency needed for the purchase of investment resources. These benefits create export opportunities thereby increasing the total capital that is available for local investment.
Another reason that makes host countries encourage FDI is the increased employment opportunities that are associated with this type of investment. Worldwide, multinationals employ over 55 million people directly, and another 10 million indirectly. Greenfield foreign investments create the most employment opportunities, especially the creation of new industries. However, acquisitions and mergers have been known to cause redundancies due to reduction or retraining of employees. FDI can also lead to reduction of employment levels if weak local industries are forced to shutdown due to competition from foreign players.
A third reason which leads to encouragement of FDI by countries is the introduction of technology and new skills. Most multinationals invest in other countries due to the superior technology that they possess, which makes their products more competitive than those of their competitors. This is achieved through increased efficiency and quality of products due to technology. This benefits the host country by making its products more competitive in the global market.
Finally, there are other spillover effects that benefit the host country, and some of them include linkages between local firms and multinationals. Competition between local firms and multinationals enables the local industries to produce higher quality products. Since the foreign firms export some of the products that are produced to home countries, the host country benefits from foreign exchange. FDI also encourages the development of infrastructure either by the government or by the investors, which is a long term benefit to the host country.
All these are reasons which make countries encourage FDI. When TPS Connections Plc is entering the Chinese and Indian markets, the two countries are likely to encourage FDI for similar reasons. They already have laws that encourage FDI and an infrastructure that supports the same. For instance, the Chinese labor laws keep the cost of labor cheap, thereby encouraging investment by Hong Kong multinationals. Other benefits include the strong economic growth and open door policies that seek to attract foreign investors. These are benefits that TPS Connections Plc seeks to gain from. It is therefore beneficial for TPS Connections Plc to enter these markets and enjoy a favorable macroeconomic environment. This will ensure that costs are reduced and sales maximized in order to boost profits.
Another reason why TPS Connections Plc should undertake FDI in its entry to the Chinese and Indian markets is to tap the existing potential in the two markets. China is the largest country in the world in terms of population, and this shows that there is a huge potential in terms of the market size (Easson 2004: 23). As previously discussed, its macroeconomic environment favors FDI, a fact which leads to half of the exports in China being attributed to FDI by firms. The large market size when combined with the favorable macroeconomic environment highly favors the success of foreign investors who invest in these two countries. TPS Connection Plc should therefore take advantage of this factor to invest in these countries through FDI.
Labor is also relatively cheap in both of these countries and FDI would enable both countries to reduce the cost of production, which would ultimately increase efficiency and hence profitability. This strategy is consistent with the comparative advantage theory which states that companies should specialize in what they can easily produce better than their competitors.
In this case, access to cheaper labor would have be beneficial to TPS Connections Plc, since it would reduce costs, and make its products cheaper than those of its competitors. One multinational that has effectively used this strategy is the Unilever Company. This company has branches in different parts of the world, due to the need of having access to raw materials as well as cheap labor. This company has concentrated its labor intensive operations in Asian countries due to the availability of cheap labor, especially from countries such as India. This has enabled this company have an edge over its competitors, and it is currently among the biggest global producers of foodstuffs and household products.
In assessment of the above factors, I would highly recommend the entry of TPS Connections Plc to the Indian and Chinese markets through FDI, since this will be beneficial not only to TPS Connections Plc, but also to the Chinese and Indian economies. Since this move is beneficial to both the economies, these two countries are likely to make the entry process faster and relatively easier, as compared to the situation that would have been present if the entry would adversely affect the economy of the two countries. This would also enable this company to reap the benefits of globalization through the transfer of technology from the parent company to its subsidiaries and vice verse.
Easson, E. J. (2004). Tax incentives for foreign direct investment. New York:Kluwer Law International, p 23.
ICFAI Center for Management Research. (2007). Hindalco’s Acquisition of Novelis. Retrieved on January 5, 2009 from <www.hindalco.com>, p6.
ICFAI Center for Management Research. (2007). Tata Steel’s acquisition of Corus. Retrieved on January 5, 2009 from <www.tata.com>, p8.