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Lecture

ADMS 3585 Lecture Notes - George Stigler, Horizontal Integration, Vertical Integration


Department
Administrative Studies
Course Code
ADMS 3585
Professor
John

Page:
of 6
A. Definition of Take-overs (v. Mergers)
The term take-over is broadly defined in Canada by both corporate and securities law. Generally,
it is considered to be an offer to all or most shareholders to purchase shares of a target (offeree)
corporation, where the offeror, if successful, will obtain enough shares to control the target
corporation. For the purposes of this paper, a take-over will have the meaning specified in
Section 194 of the CBCA:
an offer, other than an exempt offer, made by an offeror to shareholders at approximately the
same time to acquire shares that, if combined with shares already beneficially owned or
controlled, directly or indirectly, by the offeror or an affiliate or associate of the offeror on the
date of the take-over bid, would exceed ten per cent of any class of issued shares of an offeree
corporation and includes every offer, other than an exempt offer, by an issuer to repurchase its
own shares.
The Ontario Securities Act(3) provides a similar definition, the most notable exception being that
the OSA doesn't deem a take-over to have occurred until a 20 percent share of ownership is
exceeded.(4)
While the focus of this paper is take-overs, it is important to note the distinction that exists
between take-overs and other forms of corporate reorganizations such as mergers and
acquisitions. For example, although the term merger doesn't have a legal meaning in Canadian
corporate law, it is generally employed to refer to "any transaction whereby one corporation
acquires control of another, whether by take-over bid, amalgamation or arrangement."(5) Thus, a
take-over is just one form of the various types of mergers.
B. Categories of Takeovers
Take-overs can generally be grouped into one of three major categories: horizontal, vertical and
conglomerate take-overs. A horizontal take-over occurs when the offeror and the offeree
corporations are both engaged in the same broad sector of industry or commerce, and are actual
or potential market competitors of each other. In a vertical take-over the offeror and the offeree
are actual potential suppliers or customers, such as when a motor manufacturer purchases a
producer of electrical components. A conglomerate or diversifying take-over is the catch-all
category, taking place where the offeror and the offeree belong to different sectors of business,
and stand in neither a competitive nor a buyer-seller relationship to one another.(6)
C. Motivating Factors Behind Take-overs
It would be imprudent to conduct an analysis of corporate take-overs and their regulation without
first being aware of the motivating factors underlying take-overs. A review of the pertinent
scholarly research reveals at least seven major theories of takeover motives: synergy,
diversification, economics, tax, the improved management hypothesis, the undervaluation theory,
and the hubris hypothesis.
(i) Synergy
Synergy is the most cited motive for takeovers.(7) Its basic assumption is that the value of the
combination of the offeror and the offeree is greater than the sum of the individual values of the
two corporations. The source of such gains in a take-over is the potential cost-savings realized
from the integration of the production and investment infrastructure of the offeror and the
offeree, especially economies of scale, enhanced organizational efficiencies and increased
market power.(8)
(ii) Diversification
Take-overs are frequently inspired by the offeror's desire to avoid "putting all its eggs in one
basket." Instead, a corporation may wish to "hedge its bets." The coinsurance theory suggests
that by acquiring another corporation having imperfectly correlated earnings (irrespective of
whether the offeree is inside or outside of the offeror's industry); such an offeror corporation will
be able to derive a combined earnings stream that is less volatile than either of the individual
companies' earnings stream.(9)
(iii) Economics
In addition to the synergy benefit of economies of scale, two other economic motives that
stimulate take-overs are horizontal and vertical integration. In theory, horizontal integration, or
the acquisition of competitors, provides the offeror corporation with an increase in market share
and market power, and in turn, allows the corporation to set and maintain prices above
previously competitive levels.(10) Furthermore, vertical integration, or the acquisition of potential
buyer or seller firms, offers a variety of possible benefits to the offeror corporation, including a
more dependable source of supplies, and lower inventory costs.(11)
(iv) Tax
A variety of tax savings may result from a take-over. To illustrate, the offeror obtains a valuable
savings if the offeree possesses transferable tax losses that the offeror is able to offset against its
own income.(12)Another potential tax benefit arises where the market value of the offeree's
depreciable assets is greater than their book value.(13)
(v) Inefficient Management Hypothesis
The inefficient management hypothesis suggests that where a corporation has inefficient
management, there exists an incentive for an offeror company to acquire it and install new
leaders who are better able to harness the full potential of the offeree's assets. If more effective
and efficient management of the offeree's assets is ultimately achieved, then the resulting gains
accrue directly to the offeror.(14)
(vi) Undervaluation Theory
The undervaluation theory is based on the assumption that the offeree firm is undervalued by the
market, and that the offeror is in possession of such special or inside information which will not
become available to the market generally, until after the take-over. Thus, the offeror is motivated
to acquire the offeree with the expectation of reaping the gain that will result once the market
valuation adjusts upward.(15)
(vii) Hubris Hypothesis
The hubris hypothesis of take-overs, proposed by Richard Roll, implies that managers of an
offeror corporation may pay a premium to acquire an offeree that the market has already
correctly valued for their own personal motives rather than for pure economic gains. Roll
suggests that the pride of the offeror's managers may cause them to place greater significance on
their own valuation of the offeree than on that of the market's valuation.(16)
D. History of Take-overs
The history of take-overs in the United States and Canada has been characterized by four cycles
or waves - periods of high levels of take-overs followed by periods of relatively low activity. The
four waves occurred between 1897 and 1904; 1916 and 1929; 1965 and 1969; and 1984 and
1989.(17) The first wave, beginning after the Depression of 1883, was stimulated in the United
States and Canada by the development of large national markets and the expanding overseas
markets for manufactured products. Firms wanting to grow as quickly as possible during these
opportunistic times bought other corporations in the same industry in order to acquire their