Economies of Scale and Economy of Scope

Get Complete Project Material File(s) Now! »

Theoretical framework


GDP (Gross Domestic Product) is a measurement of how the economy is performing in the world and for every country. It measures the total market value of all the final goods and ser-vices produced in a country over a certain time period. GDP is a continuous variable and de-pending on the precision of measurement the value of GDP during a specific interval can take on any value possible within that interval (Gujarati and Porter, 2009). If the economic activity goes down the GDP value will go down as well and if the economic activity increase the GDP will increase. There are different ways of using GDP as a performance measure of countries economy and these could be divided into three different approaches. The approach in this study is the expenditure approach in which M&As are included under the sub category investments (Hannon and Reddy, 2012). Theory suggests there would be a relationship between GDP dy-namics and M&As activity if the movement in GDP was caused by M&A activity.

 Type of Deal

One cause for the increase in merger and acquisition activities during the beginning of the 21st century was the increase in cross-border transactions. A more liberalized view on international trade increased the number of deals during this period (Bjortvatn, 2004). Additionally, the term globalization also rose during this time period which generated an increase in M&A activities. Moving capital across borders and the internet boom increased the awareness of other markets which had a deep impact on the increase in M&As (Sudarsanam, 2003). As explained in previ-ous sections the last two merger waves occurred around 2000 and 2007 which coincide with where the peaks are in Figure 1. We can also see that the average deal value had its peaks around the time when merger waves were strongest.


In theory an acquisition occurs when a company takes control over another company by pur-chasing the other companies stock or asset and consequently gains the majority ownership of that company. The deal would not necessary concern the acquisition of the entire company, but rather the target company will often continue to operate in its line of business as a subsidiary of the acquiring company. The acquiring company may also procure only some specific assets of the target company, such as manufacturing facility, and hence the target company remains in control of the majority of its assets (DePamphilis, 2010). In theory the number of acquisition deals will increase when the market economy is in a good state (boom), and decrease when the market economy is in a bad state (recession). Additionally, minority acquisitions, less than 50 % of the target value, is more likely to occur if the market is unstable (Ouimet, 2013). This could simply be explained as when the economy is good companies are willing to spend money and make investments and vice versa if the economy is in a recession.


A merger occurs when two firms combine their business in the sense that one of the compa-nies take over the other company which in turn lead to the closure of one and the survival of the other. This type of merger is called statutory merger and is just one way to explain merger activity. If a company, however, works as a subsidiary to the acquiring firm the merger is simply called subsidiary merger (Gaughan, 2011).
The difference between merger and consolidation of two companies could be explained through how the final constellation of these two companies are viewed. In a merger, company B merge with company A creating a new company with company A as its main business. In a consoli-dation company A and company B build an entire new company, company C. The companies in a consolidation is not competitors but rather two firms operating in two entirely unrelated industries. For example when Philip Morris acquired General Foods in 1985 (Gaughan, 2011).
Further, we could distinguish a difference in mergers on whether they are accounted as hori-zontal mergers or vertical mergers. The differences between these two merger types is whether there is a competition between the two merging actors, in other words, do they act in the same industry, or what kind of relative position do the merging actors have in the value chain (Porter, 1985). In a horizontal merger two companies combine their businesses and it usually occurs between companies in the same industry and the purpose is to reduce competition and to be-come a bigger actor in that industry. A vertical merger usually occurs when two non-competing companies, sometimes with a buyer-seller relationship, merge (Depamphilis, 2010). Similar to what was said in 3.1.1, when the economy is strong the merger activity tend to increase and if the economy is in a recession the merger activity tend to be slightly lower.

READ  financial services industry

Economies of Scale and Economy of Scope

One of the fundamental pillars with merger and acquisitions is to gain some sort of synergy. Operating synergy focuses on economies of scale and economy of scope where the former de-scribe the relationship between fixed cost and the increase in production volume, and the latter describe the ability to use specific set of skills and combine these skills in one company instead of using skills from several different companies (DePamphilis, 2010). Economies of scale refers to the ability to spread the fixed cost among larger production volumes. Common costs which are accountable for in fixed cost are depreciation, amortization, taxes etc. and these do not in-crease even if the production volume increase.
Economy of scope explains the combination of skills from merging companies in comparison to separated operations. The objective is to make the production more efficient through a single production in one company in relation to have the production in separate companies (DePam-philis, 2010). This type of operational synergy is common in the banking industry. Mergers between banks meant that wider range of services could be reach through fewer banks. Further-more, “smaller-bank-problems”, such as expensive computer systems, trust departments, con-sumer investment products units etc. could be shared, leading to a reduction of unnecessary costs (Gaughan, 2011).
Economy of scale and economy of scope are seen as two cost-reducing operating synergies which are the most common ones. However, some mergers instead focuses on the more ad-vanced approach of revenue-enhancing synergy. By merging, the less developed company can, for example, take advantage of the stronger company’s assets or strong brand-name (Gaughan, 2011).

Reducing cost of capital

When M&As occur there sometimes develops a financial synergy which foremost have an im-pact on the cost of capital on the company being acquired or the newly formed company. What this financial synergy implies is if the merging companies have uncorrelated cash flows the cost of capital could be reduced. One example of this financial appearance could be if a company with excess cash flow merge with a company who lack the internal capital to fund their invest-ment opportunities the cost of borrowing could decrease. The uncorrelated cash flow could also occur if there is one high-growth firm and one stable growth firm where the cost of capital is usually lower in a stable growth firm compared to a high-growth firm and thus a merger could reduce the cost of capital for those two firms (DePamphilis, 2010).

 Method of payment

Different methods of payment are used to complete M&A transactions and the choice of method depends on the size of transaction and what type of transaction. In general, as seen in Figure 3 below, cash deals are more frequent compared to debt deals and shares deals. As displayed in Figure 3 there are two peaks in number of deals, one around 2000 and the other one around 2007. These peaks occur around the same time as the two last merger waves which are explained earlier. Shleifer and Vishny (1992) and Harford (1999) state that merger waves occur in booms and that actors with large cash reserves are more active in M&A activities during these times.

1 Introduction
1.1 Background
1.2 Problem description
1.3 Purpose
1.4 Research Question
2 Previous Research
3 Theoretical framework
3.1 GDP
3.2 Type of Deal
3.2.1 Acquisition
3.2.2 Merger
3.2.3 Economies of Scale and Economy of Scope
3.2.4 Reducing cost of capital
3.3 Method of payment
3.3.1 Cash and Debt
4 Data
4.1 Data collection
4.2 Data selection
5 Method
5.1 Unit Root
5.2 The Augmented Dickey-Fuller (ADF) test
5.3 Cointegration test
6 Empirical Results
6.1 Unit root
6.2 Johansen Cointegration test
6.2.1 Bivariate Cointegration Test
6.2.2 Johansen’s Multivariate Maximum Likelihood Cointegration Test -Method of Payment
6.2.3 Johansen’s Multivariate Maximum Likelihood Cointegration Test –Type of Deals
7 Empirical Discussion
8 Conclusion
List of references

Related Posts