Debtholders versus Equityholders

Even in the absence Wilbur G. Lewellen argues that mergers result in "financial synergism," beneficial to investors .15 By merging, he contends, the debt capacity of the combined entity will be greater than the sum of the individual debt capacities of the two companies involved. If, in a world of taxes, debt funds are "cheaper" than equity funds," borrowing more will increase the value of the equity The reason debt capecity supposedly increases is that the variance about the mean of two streams of cash flows often can be reduced by combining them. By reducing the dispersion of the probability distribution of possible cash flows relative to the mean of the distribution, the probability that principal and interest payments on the debt will not be met is reduced.

As a result, lenders are willing to lend more to the combined entity than to the two companies separately. (The reduction in relative dispersion of cash flows affords them a greater degree of protection.) One might be tempted to argue that a lender can achieve this diversification on his or her own. Although it is true that lenders can diversify loans, they are unable to reduce the probability that independent companies will default because their cash flows cannot be merged. Only through an actual merger are these cash flows fused and relative dispersion reduced. For reasons of "financial synergism,'' then, Lewellen argues that mergers, and particularly conglomerate mergers, enhance shareholder wealth.

A number of authors reach a different conclusion, when they come at the issue from a different valuation perspective." They agree that a merger between two firms reduces the bankruptcy risk to creditors by providing a form of coinsurance in the sense that the premerger cash flows of the two firms are fused. They argue, however, that under perfect capital market assumptions, this fusion benefits only the debtholders. The market price of the debt instruments rises, and because the total value of the company remains the same under the assumptions of perfect capital markets, equity values Fall. In other words, there is a wealth transfer from equityholders to debtholders. 1

Perhaps the situation can be better visualized in the option pricing model context of Chapter 4. The equityholders can be thought of as holding an option on the total value of the firm. The debt is represented by zero coupon discount bonds payable entirely at maturity. At maturity, equityholders can exercise their option by paying off the debt, thereby realizing the total value of the firm less the exercise price of the option. The latter is simply the face value of the debt. If the total value of the firm is less than the face value of the debt, equityholders will elect not to exercise their option, and the value of their stock will be zero. Debtholders will own the firm, but its total value will be less than the debt's face value. With an option, of course, an increase in the volatility of the underlying asset results in an increase in the value of the option, whereas a decrease in volatility results in a lower value of the option, all other things staying the same. In this case, the underlying asset is the total value of the firm, so a reduction in its variance will result in a lower value of the option, as represented by the value of the stock. On the other hand, reduced volatility, which may occur with a merger, works to the advantage of the writer of the option, so the value of the debt should increase.

If this line of reasoning holds, equity values should decrease with mergers, whereas debt values should increase. However, Higgins and Schall suggest that this can be prevented if the premerger debt is retired at its premerger market value." In this case, equityholders would not suffer any loss in value with a merger, as debt would later be reissued at a higher postmerger value. Kim and McConnell suggest that the same thing can be accomplished by the firm's increasing its financial leverage to the point where the increase in the postmerger default risk of the previously outstanding debt just cancels any wealth transfer that might occur from equityholders to debtholders."

Essentially, equityholders protect themselves against an erosion in the value of their claim by imposing restrictions on the company. These restrictions frequently are called "me first" rules. Their purpose is to protect debtholders and equityholders against financial policy changes that work to the detriment of their respective wealth positions. In summary, the option pricing model argument implies that diversification does not change the total value of the firm, although there can be a redistribution of value between equityholders and debtholders.