From a financial point of view, two firms are related when the net present value (NPV) of the cash flow of the combination of these firms is greater than the sum of the NPVs of the cash flows of these firms acting indepen- dently (Copeland and Weston 1983):
NPV (A + B) > NPV (A) + NPV (B) (10.1)
where NPV (X) is the discounted NPV of the cash flows generated by firm X (Copeland and Weston 1983). When the inequality in equation (10.1) holds, a synergistic cash flow is created if firm A acquires firm B.
A variety of possible sources of relatedness and synergy in mergers and acquisitions have been cited in the literature (Williamson 1975; Benston 1980; Eckbo 1983; Jensen and Ruback 1983; Stillman 1983; Harrison et al. 1991; Goold and Campbell 1998; Hitt, Harrison, and Ireland 2001) Salter and Weinhold (1979), for example, argued that key business skills and product market positions are two potentially important sources of relatedness. From a broader perspective, Lubatkin (1983) classified nine types of relatedness between bidding and target firms into three categories: technical economies (e.g. marketing and production economies), pecu- niary economies (e.g. market power), and portfolio economies (e.g. risk reduction). Jensen and Ruback (1983) identified eleven potential sources of strategic relatedness between bidding and target firms. In this chapter, relatedness between two firms can reflect any one, or any combination, of these sources, as long as equation (10.1) is satisfied.
Mergers or acquisitions between related firms will have no impact on the wealth of shareholders of bidding firms when the price paid for a target firm is exactly equal to the difference between the NPV of the cash flow of the target and bidder firms combined, and the NPV of the cash flow of the bidding firms alone. This price, P , is simply the value added to the bidding firm by acquiring a target:1
P = NPV (A + B) − NPV (A) (10.2)
Note that P does not depend on the value of the target firm acting as an independent business, but rather on the value that the target firm creates when it is combined with the bidding firm. If a bidding firm pays P + k for a target, then that firm has acquired a firm that adds P dollars in additional value (i.e. NPV (A + B) − PV (A)) for the price P + k. If k = 0, then a bidding firm has paid the price P for an addition to its cash flow worth exactly P, and thus the wealth of bidding firm’s shareholders is unaffected. If k > 0, then this acquisition represents a real economic loss to the shareholders of the bidding firm. If k < 0, then the shareholders of the bidding firm will obtain a positive economic return. Thus, specifying the conditions under which a bidding firm’s shareholders will obtain superior returns from mergers and acquisitions reduces to specifying the conditions under which the price of an acquisition or merger will be less than P , that is, specifying the conditions under which k < 0.
Source: Barney Jay B., Clark Delwyn N. (2007), Resource-Based Theory: Creating and Sustaining Competitive Advantage, Oxford University Press; Illustrated edition.