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Bank Mergers and Cost of Capital Coursework

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Updated: May 17th, 2019

Merging, as defined by many scholars, means combining two independent firms to form one company while acquisition refers to a situation where one firm buys another one that is perceived to be financially stable. It is apparent that both vertical and horizontal merging is associated with disadvantages and advantages. In recent times, there have been so many cases of merging between banks over and above other financial institutions.

For instance, the recent mergers formed between JP Morgan and Washington Mutual, Wells Fargo and Wachovia among other mergers are some examples. However, it is scaring that current and future merging would increasingly pose more problems that would see many banks suffer from financial constraints as well as technical problems.

Due to increasing levels of technology, diverse banks are embracing different technologies that would make it difficult for the two merged firms to match their diverse technologies. In addition, management system practiced by different banks would as well create a problem considering that today’s management system is tending to vary across financial institutions due to increased levels of competition.

It is also noted that large banks are merging creating a monopoly problem in the market that subsequently leads to low levels of competition in the market. Loss of employment and uneven distribution of stocks is as well becoming a central issue that may stop merging practices in future (Rosenbaum, & Pearl, 2009).

Merging of financial institutions including banks is likely to face diverse problems within the area of regulation. In recent times, most mergers tend to be kept a secret from the public, including employees. This has made it quite difficult for regulators and the government to determine the number of mergers that occur within a specified period.

Any merging of two or more independent companies should be reported and registered legally by various market regulators.

Furthermore, it is alleged that merging of two dominant firms in the market would create a monopolistic situation, which may hinder competition leading to exploitation of consumers through diverse practices such as provision of low quality products at high prices.

Since merging requires more funds, it would prove difficult for mergers to obtain funds from reputable lenders (Fleuriet, 2008).

The acquiring firm sometimes may face a range of problems while acquiring a given firm. The problems mainly relate to lack of standardization in addition to inadequate knowledge relating to acquired firm. Lack of standardization denotes failure of two merging banks to have similar systems that would exactly match with each other.

The variations arise because of using dissimilar technologies or sometimes having a completely different management system. The acquiring firm might also lack full information regarding the acquired firm management system as well as its financial position.

Sometimes, the acquired firm might hide its true financial position, which later leads to more complications when the firm is already acquired. Knowledge pertaining to the firm’s culture and systems is essential in determining whether structures of the acquired firm would match that of the acquiring firm (DePamphilis, 2008).

There have been continued issues relating to staff reduction while practicing merging and acquisitions among diverse organizations. The mergers always require additional funds to employ new technologies in their systems in order to remain competitive in the market. Initially, the two firms experience increased overhead costs, which can partly be explained by efforts incurred by mergers to restructure new systems.

The merging firms believe that they would be able to pull their funds together and acquire new technology in the industry enabling them to remain effectual in their operations.

The merging firms endeavor to reduce overhead costs by combining different departments, which leads to subsequent reduction of employees. It is notable that two CEOs of the merging two companies would hardly be given the top position of the ensuing merger (Rosenbaum, & Pearl, 2009).

In the contemporary world market, it is imperative for various organizations to acquire funds that would enable them to carry out their operations effectively. There are various sources of funds, including internal and external sources. The internal sources constitute retained earnings as well as reinvested dividends by the existing stockholders whilst the external sources mostly comprises of equities and debts.

However, it becomes essential to determine whether it is more beneficial to raise funds through equity or debts. Each source has its advantages and disadvantages. Although debt has become an expensive way of raising capital, it is evident that debt is the best option of raising capital for further expansion and other investments given that it does not dilute the share capital of existing shareholders (Fleuriet, 2008).

Raising funds through equity to many may seem as the cheapest way of raising capital for any organization seeking to expand its operations. Indeed, if a keen examination were to be done on sources of capital, it would come to one’s sense that equity is perhaps the most expensive way of raising capital.

Generally, the cheapest way of raising capital is through internal sources such as retained profits, even though a firm does not raise sufficient capital for various investment activities. This forces a firm to seek other means such as issue of debts and equities. Although debt is expensive in terms of interests and principal payment, it is obvious that equities of existing shareholders are not diluted to any extend.

On the other hand, issuing equities end up diluting stock of a firm meaning that investors end up sharing dividends with new stockholders. Consequently, investors keep working hard only to take a small portion of net profit after tax as dividends goes mostly to individuals and institutional investors (Peterson, 1999).

In the contemporary economy, it is easier for a firm to raise capital through equity as compared to debt. A number of advantages associated with equities make it possible for investors to prefer equity to debt. Frequently, ordinary stock shares allow all firms’ stockholders to share both profits and losses, thereby distributing equal risks among equity holders.

Conversely, debt calls for the organization to pay interest to debt holder at the end of agreed period irrespective of whether the firm made a profit or a loss. Most firms in a range of markets are normally uncertain of their performance in the industry making them fear commitments linked to debt’s interests and principal payment. It is as well renowned that debt has become expensive due to their regular high interest rates.

A corporate bond, which is offered at a coupon rate of 15%, becomes quite expensive for a firm since most profits go to payment of interests. Finally but not least, equity allows a firm to incorporate diverse experts in running of the firm, which enables the company to make fine and crucial decisions pertaining to operation.

Debt does not allow the company to access new management systems, which would help the firm maneuver through turbulent market environment (Peterson, 1999).

References

DePamphilis, D. (2008). Mergers, Acquisitions, and Other Restructuring Activities. New York, NY: Elsevier Academic Press.

Fleuriet, M. (2008). Investment Banking explained: An insider’s guide to the industry. New York, NY: McGraw Hill.

Peterson, P. (1999). Analysis of Financial Statements. New York, NY: Wiley.

Rosenbaum, J., & Pearl, J. (2009). Investment Banking: Valuation, Leveraged Buyouts, and Mergers & Acquisitions. Hoboken, NJ: John Wiley & Sons.

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