Finance

Module 1
Q Provide a brief description of the company that is chosen and the developments in history of the company.

The roots of British Petroleum can be traced to the Iran and the efforts for oil exploration in the region at the inception of the twentieth century. When the first commercially viable find of the Middle East was unearthed in Iran, the Anglo-Persian Oil Company was formulated in the year 1909. After a brief placid existence, the outfit began to lobby heavily with the political forces in Britain to gain monopoly access over the Persian oil resources, owing to the strong presence and influence of the British in the region. This allowed the company to enjoy significant concessions which eventually came to be challenged by forces in Iran after the Second World War as the terms were usually in favor of the corporation. With the death of a pro Western leader of the country, the parliament decided to nationalize the APOC, which faced strong resistance from the company and the British but to no avail. The National Iranian Oil Company was established on the former properties of the British business. Eventually, the United States moved to sponsor a coup in the country with British support which saw a pro Western leader being brought upon the political spectrum once again and the new Iranian company became a consortium of international partners of which the former British company also got a share. The companys name was also altered to British Petroleum at this time and it continued to operate in Iran for some time until the Islamic Revolution saw its properties confiscated and it expelled from the region altogether without compensation. BP then decided to put greater emphasis on the North Sea and engaged in a few successful drills in Alaska as well as acquiring share in a company based in Ohio. During the days of Thatcher when a strong privatization drive accompanies her policies, the British government did away with its share in the company after which it saw a string of acquisitions and mergers with Britoil as well as Amoco. The main sphere of operations of the company has been the North Sea as well as a string of drills near the Mexican coast as well as exploring options in Russia.

Q Explain why you chose this company.
I am personally interested in the company because of its history which appeared intriguing to me. British Petroleum has been involved in the business of oil exploration for a substantial amount of time and has operated in some of the most volatile regions of the world. Today, while most of the other companies flocked to the Middle East and other areas, BP has chosen to rely on the North Sea and its Atlantic explorations to be the bulk of its operations and this strategy has paid off in the form of jackpot wells along with giving the company a name for deep sea exploration. The steps being taken by the organization to safeguard its future have also been daring to a great extent. In the auction for Iraqs oil fields, British Petroleum emerged as the only company to bid high enough for contracts which have been initiated, choosing to jump head on into the region in competition with the big drillers in the Middle East while openly associating with one of the most volatile regions of the world. Finally, oil prices have been fluctuating increasingly in recent years and the spike of a few years ago resulted in market world wide being affected. This led me to a certain fascination with the high risk and high return business of oil exploration and extraction which is one of the reasons that augmented my choice of British Petroleum for the project.

Q Find out what you can about the companys IPO. If it is old and information is not available, outline how you would go about an IPO of the company today.
British Petroleum has been operating for the good part of the century and details relating to its Initial Public Offering are difficult to obtain. However, if the task had to be conducted today, it would incorporate certain standard steps. Since the steps involved of assessing the market, contacting certain brokers, marketing the issue and deciding upon an appropriate price are beyond the scope of the finance department that the company has and would incur extra costs if carried out by BP, an investment bank will be contacted for this purpose. The first thing to be kept in mind is that the investment banker acts also as an informational intermediary (Damodaran 2002). Therefore, the better the reputation of the bank, the more favorable view will be held of the price being offered and potentially more investors will subscribe to the issue. The underwriter that is contracted will then approach investors and the process of going about the issue will be carried out according to the terms established. It is in the companys interests that a best efforts underwriting takes place whereby the quantity of stock that can be sold by the investment bank is done and a commission is charged. BP already has a good reputation for returns and successes and recent investment in Iraq should help to increase subscription. In addition, a firm commitment underwriting may be too expensive as the underwriter will take the risk of the issue and hence charge higher commissions. A law firm with an established practice in securities law may also need to be contracted for the issue. The underwriter may be allotted a green shoe option so that if the subscription is substantial, additional shares can be issued to capitalize on the high demand. The issue will be underpriced but only to a certain extent as it is a large issue and represents holding in a company that is investing in a variety of exploration and extraction sites while the price of oil is speculated to go further up in the near future. The issue should also be preceded by a preferably favorable earnings announcement and should come at a time when trading activity is up. Since preferred stock issue will increase the constant dividend outlays that have to be made by BP,  common stock should be issue which may increase risk of ownership change and dilution but would not be accompanied with obligations, thus allowing British Petroleum to make use of the capital inlay for useful long term investments (Damodaran 2002).

Module 2
Q How much would you pay for the 1000 bond today taking into consideration personal risk preferences, interest rates, inflation and the ability of the company to pay back
A bond that will pay 1000 a year from today has to be taken into consideration with many other factors. The relevant interest rate on US government bonds has been very low in the recent years on the back of Federal Reserves policy of spurring borrowing. It has recently been increased following the financial crisis and hovers around the 2 mark. Therefore, the bonds yield has to be such that it provides for more that 2, adjusted for an appropriate risk premium on account of British Petroleums specific risk as well as the conditions in the economy (Gitman 1998). Inflation also becomes relevant in this scenario as the amount that is received at maturity will be able to buy a basket with fewer goods. This has been kept low in the United States recently with the January figures for the CPI approaching 1.6 while the annual inflation was closer to 2.6. This means that bonds are a safe bet as inflation will not erode their value too much but forces in the market show that investors are double minded about being careful with inflation or aiming to invest in longer term bonds. Given the current scenario however, inflation will have little impact on the value a BP 1000 bond will have today.

The next aspect to consider is the fundamentals of the company itself. The company performance has been strong as it has been able to whether the storm of the financial crisis and is making investments in Iraq in order to expand. It is not debt ridden, having substantial reserves in the Shareholders equity section and not having too many long term debt obligations. There is a strong asset base to support the debt payments of British Petroleum supposing events take an extremely bad turn. Liquidity position is also strong which implies that the company will be able to meet its payments, given that it had cash flow from operations worth 38.095 billion in 2008. This also results in favorable coverage ratios for British Petroleum, reducing the risk of default. Therefore the bond issued by the company should enjoy a significant rating, as shown by the AA position assigned to it by Standard and Poors.

Given all this information, the decision comes down to the individual risk preferences of the investor. I am a risk averse person who prefers the surety of regular returns with little possibility of default or rescheduling of payments. The volatility in oil prices as well as the potential failure of new drills coupled with the expectation that OPEC will cut production leading to reduced prices make me prefer a significant return to invest in a bond issue by British Petroleum. Therefore I would invest in a BP bond worth 1000 in a years time at 800 today.

Q What would be the discount rate for this bond
The formula for obtaining the discount rate for the investment utilizing present values is as given below.

PV  FV  (1R)n
The FV in this case is 1000 while the PV has already been decided to be 900 in the previous question. Since the bond will mature in 1 year, therefore n will be equal to 1. Utilizing these figures, the discount rate R will turn out to be
800  1000  (1R)1
(1r)  1000  800
R  0.25  or  25

Q Pick two companies in the same industry as yours, one for which you would pay more for a 1000 bond today and another for which you would pay less. Explain why you would pay more or less for these bonds.

Another company that operates in the same industry is the Royal Dutch Shell group. I would be willing to pay more for a 1000 bond issued by the company today compared to one for British Petroleum because it enjoys a higher credit rating at AA by Standard and Poors The economic environment for both is the same as well as the factors impacting the industry. However Shell has been able to show strong degree of reserve replacement along with downstream and upstream profit generation. In addition, it has a greater reliance on Middle Eastern oil and land based drills as compared to BP which relies on the more dangerous deep sea drills which are exposed to challenges such as hurricanes which have been arising in increasing numbers such as in the Mexican seas. Shell also enjoys higher revenues and greater earnings which accounts for the better value its bond enjoys.

ConocoPhillips is also in competition with British Petroleum. However I would be willing to pay a reduced amount for its 1000, one year bond. This is because it enjoys a lower credit rating of A by Standard and Poors and also has substantially less revenues and net income compared to British Petroleum. It further has drilling operations in Asia as well as in North America, particularly in Alaska but has not gotten involved too much in the Middle East. Thus it can be said to be missing out on some of the big reserves present in the world today.

Module 3
Q Show the work used to obtain the cost of equity for the SLP Company
R  Rf   (Rm   Rf)

 0.75 Rm   Rf  7 Rf  0.33

R  0.33  0.75 ( 7 )  5.58

Thus the cost of equity for British Petroleum is 5.58.

Q Is this cost of equity lower or higher than expected Average cost of equity for a firm in SP 500 is 10.2. Would you expect your firms to be higher or lower than the average

This cost of equity of 5.58 is lower than expected for British Petroleum. This is because the cost of equity is basically the return investors and the market demands from the firm for owning its shares and thus undertaking risks associated with owning its assets. The oil exploration and extraction sector is very competitive and drills are often risky. Firms have to undertake a significant amount of exploration before a successful drill is made and the supply of oil in the world is declining every year. There is also stiff competition for limited fields among the big six oil companies as well as a range of nationalized state owned enterprises that already have monopoly access to majority of the oil reserves present in the world. In addition, there is volatility associated with the price of oil and OPEC is under increasing pressure to increase production and drive down price of oil. Thus cost of equity for BP was assumed to be higher than 5.58 given the risk associated with the firm.

Cost of capital for British Petroleum is the cost of financing it carries out via debt, common stock and preferred shares. Logic shows that the cost of capital for BP will be less than the average for an SP 500 company. This is because it already has a low cost of equity and studies show that the cost of debt is usually lower than cost of equity (Damodaran 2002). The company also issues very little preferred stock as compared to common shares. Thus the cost of capital will not go beyond 10.2 even if debt is the major source of financing for the company. Intuition supports this conclusion to some extent as BPs operations are of a global nature and hence it is able to raise financing from many sources around the globe, allowing it to access the cheapest source available. This will reduce the cost of capital to a great extent.

Q Compare cost of equity for the other firms analyzed before to your company. How do they compare Are you surprised that some have a higher or lower cost of equity
(Shell)  0.86 (ConocoPhillips)  1.11
The beta for British Petroleum is lower than that for both the Royal Dutch Shell group as well as Conoco Phillips.

R(Shell)  0.33  0.86  7  6.35
R(ConocoPhillips)  0.33  1.11  7  8.1

The cost of equity for both Shell and ConocoPhillips is higher compared to British Petroleum. This is a surprise because all three companies operate in the same industry more or less. The range of their operations is also global with presence in multiple areas and access to investors there. The expected cost of equity was thus closer to that for British Petroleum. As the results shows however, the market wants higher return to hold the risk of the assets of both the companies. This could potentially be accredited to the limited presence of BP in the more volatile regions of the world as compared to the other two and pursuance of more secure projects.

Q How would you go about finding cost of equity via the dividend growth model or the arbitrage pricing theory model

The cost of equity can also be calculated via the Gordon growth model. The formula for cost of equity in this case is
R  ( D1  P )  g
The assumption in this case is that the company issues a dividend which grows at a constant rate of g per year. Thus D1 then becomes that dividend multiplied by (1g). P is the price of the stock of the company as it is today. Thus inputting all these figures into the model gives us the cost of equity for the firm under question. This requires additional information in terms of the present price of the BP stock as well as the dividend payments made and the growth rate of those dividends. This method suits British Petroleums case as it has had a relatively constant rate of dividend growth which makes calculation of g easier. However in most cases, dividends are not constant and tend to vary.

Another option is the Arbitrage price theory model. It calculates cost of equity by assuming that multiple macroeconomic factors impact the return on a particular asset or equity in our case. These are loaded according to their particular sensitivity to the cost of equity, represented by their individual betas, which are then multiplied with the risk premium associated with each factor. The risk free rate is then added to the figure that is obtained to give cost of equity by the arbitrage price theory model. This result is good since it takes into account multiple factors that have an impact on the cost of equity. However additional information is required to use this model since an analyst has to assess what factors have an effect on the cost of equity of BP stock and their sensitivities to R have to be calculated. Apart from that, the risk premium attached to each also has to be formulated.

Module 4
Q Compute debt ratio of your company and the debt to equity ratio. Also calculate these ratios for the short and long terms debs individually. Show all work and calculations.
Debt ratio  (Total Liabilities)  (Total Liabilities  Total Equity)
136.129 B  (136.129  164.45) B
0.453
Debt to equity  Total Liabilities  Total Equity
136.129  164.45
0.828
Short term debt ratio  Total Short Run Liabilities  (Short run liabilities  Total Equity)
69.793 B  (69.793  164.45) B
0.298
Long term debt ratio  Total Long Run Liabilities  (Long run liabilities  Total Equity)
66.336 B  (66.336  164.45) B
0.287

Q Give recommendation as to whether you consider these ratios to be too small or too big Should the company take steps to pay off debt or increase its debt

The company has a debt ratio which shows that the majority of its assets are financed via equity and a relatively smaller portion is through debt. This is good for the company since it has sufficient assets to pay off its debt obligations if things take a bad turn. The debt to equity ratio is similarly around the 0.8 mark which shows that debt is less than equity, a secure base for the company. Thus it can be argued that these ratios for British Petroleum are neither too high nor too low but are just at the tipping point.

The short term and the long term debt ratios are just about close to each other, highlighting the fact that the company has just as much short term denominated debt as that which will last longer than a year. This may be a dangerous sign with regards to the short term as payments for that debt have to be made soon which requires availability of cash. It signifies that the company has high need for short term cash and is able to access it after some period of time, thereby requiring short term financing roughly equal to long term debt. This level can be said to be on the higher side.

As the debt position of BP stands, it can afford to still issue more debt to raise capital as its assets outstrip debt leaving it room to maneuver. However, the company is just at the tipping point after which its debt financing will outstrip equity, leading to a debt to equity ratio of greater than 1. Therefore the company could increase its debts still further. However, it would be healthier if this increase comes in the long term liabilities while short term liabilities are reduced as cash would be required immediately to pay the latter, which could put BP in troubled waters.

Q Compute debt to equity ratios for two other firms in the same industry. Which of these has the highest debt to equity ratio and why do you think it choose that Which has the lowest debt to equity ratio and why do you think it chose that

Debt to equity (Shell)  35.03 B  160.62 B
0.218
Debt to equity (ConocoPhillips)  30.46 B  71.47 B
0.426
British Petroleum at 0.828, appears to have the highest debt to equity ratio of the three firms in the industry. The decision could have been taken due to a variety of factors. Debt is cheaper than equity and has advantages in terms of providing tax shields. Thus BP may have been optimistic regarding drills leading it to try and capitalize on the advantages of debt on the income statement compared to the other two companies. However, there is also the chance that it may have come under need of short term funds and had to resort to debt financing which could have been due to exposure to oil price decline, decreasing revenues for the company, making it acquire quick debt.

Shell has the lowest debt to equity ratio as 0.218. This shows that the company prefers equity over debt financing. Since it is choosing to forego some of the advantages that debt brings, the company must be increasingly optimistic of the strength of its stock. In addition, it may also be looking to make some capital expenditures and perhaps finance new exploration or drills as ordinary stock issues do not require regular annual payments and thus Shell can choose to pay its stockholders dividend returns when the projects become fruitful. In addition, the stockholders will be able to sell their stock in the market if there is immediate need for funds.

Module 5
Q If you were to pick one company to merge with, what would that be Explain with respect to possible benefits of the merger and why you would choose this company over any other
British Petroleum could potentially merge with Centrica which is a company operating the in gas energy and other utility sectors. It would be of interest to BP to join with the gas giant because it would allow it to move beyond just oil exploration and extraction and into gas based energy supply. Centrica already has operations in most of the areas BP chooses to operate in such as regions in North America, the North Atlantic and in Europe. This would allow for advantages from synergies as well as complementing the base established by the company already in these areas. It is also based in Britain which is where BP originated from and from where it gets its primary management form. This will allow cultural similarities between the two companies as well as accounting for continuity in hiring practices, not being bogged down by fundamental differences or rigidity in managerial style as well as change.

Cenrtrica also has been following a growth trend that mimics the one followed by British Petroleum. It has continuously been engaged in mergers and acquisitions of other energy businesses and is aggressive in acquiring exploration rights in new areas. Its recent venture in Nigeria to sign a memorandum of understanding with a consortium operating in the region is representative of the growth trend in the gas sector that is being pursued by Centrica. Furthermore, with the volatility in the prices of oil, the relatively safer haven of the gas industry may be able to provide a degree of stability to BP. This company is also preferable to others as it is based in Britain already and follows many trends that can be traced to BP as well and the management and procedures of the two may fit in well compared to other companies in the same sector. It will allow BP to consolidate more in the energy sector and even possibly lead to potential transfer of technology in some areas of operations.

Q How would you finance a takeover of this chosen corporation Explain your reasoning.
The financing for the proposed merger of British Petroleum with Centrica should take place with an issue of common stock, complemented with a debt issue which should be in a ratio of two to one. This is important because considering the recent financial situation of BP it has a debt to equity ratio of around 0.45 which means it is just at the tipping point after which an additional debt issue would raise its debt beyond equity. Considering that BP already has a greater reliance on debt than some of its other competitors in the industry as analyzed previously, it would do well to reduce its reliance on debt. It would raise bankruptcy risk if debt is made to increase beyond a controllable level. BPs credit rating has already been downgraded to AA by Standard and Poors and given the recent credit crunch, it will only be able to acquire debt at greater interest rates, raising pressure to take more risks and extract greater revenues from Centrica holding during the crucial transfer phase as regular interest payments have to be paid. Raising equity and debt in a two to one ratio would mean that the capital structure will be altered to reduce debt to a certain extent, accounting for 33 of the new financing. An equity issue will comparably put less pressure on BP to perform during the transformation phase as regular dividends do not have to be paid necessarily and investors may be able to benefit from the potential increase in share price if the market recognizes the synergies present in the merger between Centrica and British Petroleum (Brealey 2007). Thus, the merger will be completed and transformation made without undue pressure allowing the rewards to be reaped in terms of potentially high returns in the future.

Q What would be the second and third choices for a merger with your company Explain your reasoning for the choice of companies and why they would be the second and third options.
The second choice for a merger with British Petroleum can be the Royal Dutch Shell group. This will be a mega merger between two established oil companies that operate in the same industry. This has many advantages for BP. The big six oil companies are always in constant competition with each other in terms of profitability as well as in acquiring control of resources. BP and Shell have particularly been at loggerheads for battle over particular resources. A merger would mean that both could share the resources that are diminishing day by day and instead aim to form one big profitable company. There would be technological synergies involved as well as the added advantage of the company being form the European continent which would allow cultural similarities as well as other benefits in terms of managerial style that accompanies these companies to some extent. The scale of operations of both will also be increased substantially, allowing economies of scale to be exploited to a greater extent.

However there are certain factors that make this the second choice decision. BP primarily has deep sea drills while Shell has land based drills which is a fundamental difference and may not lead to effective merger. There has already been a sense of rivalry between the two companies which may a source of conflict among management and employees. Furthermore, while competition may be reduced, action may be attracted by competition regulators. Both companies are in the oil industry which does not allow for a great degree of diversification, considering the volatility in oil prices as well as diminishing resources. Finally, the deal would not be as beneficial since the primary resources of oil reside with many state owned companies rather than private companies such as BP or Shell, limiting the benefits they gain from sharing of resources.

Another option could be to attempt a merger with a company in a completely different industry. This could be with Rio Tinto, the mining giant. There are certain similarities in the procedures involved for extraction, although oil extraction does take on different dynamics after the initial stage. The company is also in the commodities business which allows for certain business practices to match. This merger will allow BP to expand into a completely new area and reduce dependency on oil exploration and extraction given the diminishing nature of resources. Certain transfer of technology can also take place between the two allowing greater efficiencies and management style of the two can be seen to match, given the Australian roots of Rio Tinto.

However, there are disadvantages which lead to this being the third choice decision. Moving into a completely new area carries its own set of risks for British Petroleum. It does not have experience in mining and synergies may not be that great. In addition, the companys name relates to petroleum exploration which may need to be altered to some extent to reflect the new sphere of operations of the company. This may have consequences in terms of name recognition and goodwill that already exists for British Petroleum which may be lost by a change in name. Overall, it does happen to be a venture exposed to more volatility than going for a merger with a company in the same industry or operating in the gas energy sector in Britain.

In calculating cost of equity for this company Capital Asset Pricing model is used. This model estimates profitability of financial assets that are used. This model is used as a theoretical basis for a number of various financial methods of earnings and risk management in a long-term and mid-term investment decisions. CAPM considers profitability of assets depending on the market behavior as a whole( Fama and  French, 2004, p. 26).

According to CAPM the risk from investing in any financial tool can be divided on two kinds of risk systematic and non-systematic. The systematic risk is caused by the general market and economic changes which are influencing all investment tools. This risk is not unique for a particular company or asset. The non-systematic risk is closely connected with the concrete company-emitter.

It is impossible to reduce systematic. However, it is possible to measure how market correlates with a profitability of companys financial asset. As a measure of non-diversifiable risk in CAPM is used  (Beta) coefficient that characterizes the sensitivity of company financial asset profitability to the changing market portfolio profitability. By knowing the  coefficient for a particular company financial stock or asset, it is possible to estimate the quantitative risk for this asset connected with changing prices of the market as a whole. The Beta for market equals 1. If Beta for company  1, then company stocks prices will go up and down by the same percentage as for market as a whole. If 1 then company stock prices are less sensitive to market movements, while if 1 they are more sensitive and therefore more risky ( Fama and  French, 2004, p. 26).

Johnson and Johnson s Cost of equity
The formula that will be used to calculate cost of equity for the company will be
Rj  RF  j RM - RF
Where as Rj is the cost of equity to be calculated.  RF is the risk free rate which is yield to maturity for one year USA Treasury bond. RM is the market rate or SP 500 rate and j is the company beta.
The beta of the company is 0.63(Finance yahoo, 2010) and yield to maturity for one year bond is 3.6 (bloomberg.com). The premium is 7 that is the difference between the market rate and the risk free rate.

Therefore, expected Return on equity  3.6  0.63  7  8.1
Cost of equity and weighted average cost of capital
Cost of equity obtained is lower than what I expected because the use of one year yield to maturity and it has a beta of less than one. It is important to note that a beta of less than one means that the company is less risk than the market it self. Therefore it is expected to a lower risk than 10.2 which is the average market rate.

Cost of equity of other two companies
The company JW Surety and Treasury Bonds whose Betas are 1.53 and 0.13 respectively. The expected returns are for these companies
JW Surety expected Return on equity  3.6  1.53  7  14.31
Treasury bond  expected Return on equity  3.6  0.13  7  4.51
Am not surprised with results as their betas are first case higher and the second case higher.
Dividend growth model and arbitrage pricing model

Arbitrage Pricing Model defines the risk premium as follows Risk premium  b1 (premium1)  b2 (premium2)  b3 (premium3) .... The APM defines the risk premium by specific pervasive macroeconomic factors and their individual weights. There is no need to be concerned with measuring a market portfolio or dig deep in the theory about investor behavior as the model is based on the absence of arbitrage opportunities it fails, however, to give an explicit prescription about which factors to use and how they are weighted. This gives the model a general appeal, but at the same time makes it difficult to apply in practice. Empirical attempts at identifying the factors have been made, but with limited success.

Dividend growth model The concept behind this model of investing is to buy a solid share with tracks of increasing dividend annually. The increase rate of dividends would likely support higher stock prices over long term as many investors were searching for attractive yields. The model is proven to be prudent since the increase of dividend rate will also increase ones yield as a percentage of a purchase price.

Estimating the cost of equity for any firm is a task which requires a lot judgment and estimation. Different methodologies and theories exits on the best way to calculate the cost of equity which is basically the rate of return investors require on their investors. After careful consideration we are to present to the esteemed Board the findings on the subject. The dividend growth model provides the best estimate of the cost of equity. While it has its limitations, it uses dividends, the only cash flow other than capital gain associated with investments in stock, to derive at a cost of equity. It also uses the current market price which lends the method more credence as investors have the option to sell off their shares at the market price if they deem the return too low. A more detailed review of the dividend discount model, the capital asset pricing model and arbitrate pricing theory is given below.

Dividend Discount Model
There are two types of cash flow associated with a stock the dividends and the expected share price at the end of the holding period. And because the expected price is based on future dividends, the value of a stock is the present value of the dividends that will be relieved for an infinite period of time. The same concept can be used to calculate the cost of equity. With todays share price and the expected dividends, we can use the dividend growth model to come to a conclusion about the rate of return required by the investors.

One of the basic variants of the dividend discount model is the Gordon growth model. The main assumption underlying the Gordon growth model is that firms will continue to pay dividends which will grow at a sustainable and stable rate through infinity.  (Forbes, 2010)

While the major advantage of the Gordon growth model is its ease of use, its major limitation is the very assumption that makes it so easy to implement. The assumption that dividends will continue to grow at a stable rate till infinity is quite unrealistic. Since it is being assumed that dividends will continue to grow at a stable rate, it can also be said it is being assumed that earnings will also continue to grow at a stable rate. This is because if dividends continue to grow at a certain rate while earnings increase at a slower or deteriorating rate, there will come a time when dividends will equal earnings and there will be no more room for the dividends to continue to grow at the stable rate  (Damodaran Online, 2009).

The second limitation is also related to the stable growth rate. What criterion should be used to derive this stable growth rate How high or low should it The uncertainty regarding inflation, economic cycles, whether the firm is operating in a mature or growing industry, all make it more difficult to ascertain a growth rate for dividends which can be assumed to last till infinity. The assumption regarding the stable growth rate makes the Gordon growth model most appropriate for companies operating in mature industries where it is more reasonable to assume that dividends and earnings can both grow at a stable rate.  (Damodaran Online, 2009)

Now that we understand the basics of the dividend growth model, we look at some of its other variations. The two stage dividend growth model, as its name suggests, uses two stages of growth. There is an initial phase with a growth rate that is expected to last for a limited time horizon, followed by the growth phase with the stable rate of growth through infinity. The limitations of the Gordon growth model regarding the stable growth rate also apply to the two stage dividend growth model.  (Forbes, 2010)

Added limitations include specifying the length of the initial phase of extraordinary growth. Since the growth rate is usually higher during the initial phase, the value of the investment will increase at a higher rate during this period. When the growth rate declines and stabilizes, the rate of increase in the value of the investment will slow down. Consequently, the longer the initial phase, the higher the value of the investment. The second limitation specifically associated with the two stage growth model is that we assume that the growth decline overnight as the firm enters the stable phase. This is unrealistic as the growth will slow down gradually before stabilizing.  (Damodaran Online, 2009)
Another variation of the dividend discount model is the H Model which allows for a gradual linear decline in the growth rate during the initial phase. While this model overcomes the limitation of the low stage dividend model in that it allows for a gradual decline in the growth rate, the assumption that it decreases at a linear stage is a limitation of this model. Another variant, an extension of the two stages and H Model dividend growth model, allows for an initial phase of high growth, a second stage where growth declines and a final stage of infinite stable growth.  (Damodaran Online, 2009)

Capital Asset Pricing Model
The capital asset price model (CAPM) attempts to explain the relationship between risk and return. CAPM states that the expected return on scrip is equal to the rate of return on a risk free asset plus a risk premium. The required rate of return is also the cost of equity, i.e. the return at which investors are willing to invest in the company. CAPM is calculated using the following formula

Required rate of return  Risk free rate of return   (Market Return   Risk free rate)
Beta () is a measure of risk which is considered relative to the risk of the market. Each company has its own beta which tells us how risky the company is compared to the market. A company with a beta of 2 is considered to be twice as risky as the market. The CAPM differentiates between systematic risk and unsystematic risk. Systematic risk is the market risk which cannot be diversified away. Unsystematic risk is firm specific risk and can be eliminated through diversification. It also states that for a given level of risk, investors have a required rate of return and as risk increases so do their required rates of return.  (Forbes , 2010)

CAPM is based on a set of assumptions which are stated below
Investors are risk averse
Investors have homogenous expectations
There exists a risk free asset and investors can borrow and lend at the risk free rate
All assets are perfectly divisible and priced in a perfectly competitive market
All investors are equally informed about the market
No markets imperfections such as transaction costs or taxes exists
These assumptions are quite unrealistic and while the whole concept of CAPM is based on these assumptions, they are also its limitations. However, each of these assumptions can be relaxed one at a time to see the effect it has on the required rate of return. CAPM requires the calculation of beta which involves significant judgment. Another limitation of the CAPM is the risk free rate and the risk free asset. Generally, government securities are considered to be risk free but give the superfluity of such securities, an appropriate one needs to be chosen.  (Forbes , 2010)

Arbitrage Pricing Theory
Arbitrage pricing theory (APT) states that there are many sources of risk and a lot of uncertainty in the economic climate. It tries to explain the underlying reasons for assets returns and use them to derive an appropriate rate of return for a security. APT can be used to conduct a sensitivity analysis on the various economic factors and how they affect the risk and return of a particular security or portfolio. While this is advantageous in the sense that it allows us to incorporate specific factors and does away with the restrictive assumptions of the CAPM, it also makes the APT difficult to implement because of the large number of economic variables and the uncertainty regarding their impact on a security.  (Goetzmann, 1996) (Pietersz, 2006-2009)

APT is also based on a number of assumptions which are stated below
Security returns move in a linear manner because of the existence of some systematic risk
Inventors are able to distinguish these risks and estimate how they will impact security returns
Some investors will be risk takers who will try to exploit differences in returns through arbitrage

A major advantage of ATP is that it allows for a number of risk sources and that they are the drivers for security returns. However, it is required that investors are able to identify these risk sources and gauge their impact on security returns is a mammoth undertaking which is not always possible to a reliable degree of accuracy.  (Goetzmann, 1996)

INTRODUCTION
Background
Mergers and acquisitions are pervasive occurrences. Estimates by the International Labour Organization indicate that each year there are close to 4,000 mergers and acquisitions which are carried out (ILO, 2001). According to the United Nations Commission on Trade and Development, the past 3 decades have seen a 40 expansion in the total value of mergers and acquisitions globally. There were a total of 24,000 mergers and acquisitions which generated more than 2.3 trillion as at the beginning of 2000 (UNCTAD, 2008).

In corporate mergers, two or more different firms join together to create a single entity. On the other hand, one larger firm absorbs another smaller one in acquisitions. The management and or assets of the less dominant firm are taken over by the more dominant one in acquisitions and there is no physical consolidation of the 2 companies. Three different types of mergers have been described and these are horizontal, vertical and conglomerate mergers. In horizontal mergers, there is the union of 2 or more firms which have similar distribution and production activities or which deal in the same kinds of businesses. In contrast, vertical mergers entail the union of 2 or more firms which have very different production and or distribution activities and which take part in very different businesses. The normative characteristic that is inherent in vertical mergers is that the businesses involved have a pre-existing buyer-seller relationship (Kargin, 2001 Agrawal, Jaffe  Mandelker 1992).

Like vertical mergers, conglomerate mergers involve the marriage of firms which are engaged in businesses that are in no way related. According to studies, conglomerate mergers are more prone to failure than non-conglomerate mergers. This relatively high failure rate has been attributed to among others the fact that the acquirers are usually not very well acquainted with the operations of the target companies and the prevailing complexities inherent in the industry in which the target firms operate. Additionally, acquiring firms usually spend more free cash flow on the target firms, making generally unattractive purchases during conglomerate mergers (Kargin, 2001 Agrawal, Jaffe  Mandelker 1992 Mandelker 1974).

There is a blatant geographical bias in mergers and acquisitions activity, with most of these transactions occurring in the developed nations of Europe and North America and to a lesser in the Caribbean and Latin America. The merger and acquisition activity in Asia, Africa and South America is nominal. Besides the seeming geographical clustering, merger and acquisition activity is seen often in certain industries than in others. There is a disproportionately higher merger and acquisition activity in the banking and finance, ICT, and agrochemical industries (Buehlens, 2008). Mahheswari (2002 p.37) and Sirower (2000 p.52) further identify high levels of mergers and acquisitions in the cement, steel, auto, textiles, and pharmaceuticals and aluminium industries.

There has been a substantial merger and acquisition activity in the US. According to Dykema (2007) and Uhrig (2008), the total value of mergers and acquisitions in the United States in 2007 alone stood at nearly 2 trillion and these were primarily attributed to the availability of many strategic buyers and inexpensive credit, high interest from buyers in other countries in particular European nations and China, and stronger balance sheets. In 2000 for instance, the US accounted for 50 of all mergers and acquisitions which were worth an estimated 3.2 trillion. A cursory look at merger and acquisition activity the world over reveals that these activities have been, generally, on an upward trend over the past 3 decades (Buehlens, 2008).

This trend has been attributed to several reasons. First, firms engage in mergers and acquisitions as a means of maximization of shareholder wealth and profits (Gugler, Mueller, Yurtoglu  Zulehner 2001 p.626). Secondly, mergers and acquisitions are carried out by firms in order to enable them achieve economies of scale (Devereux  Johnson 2006). According to Manne (1965) and Jensen  Ruback (1983), companies may engage in mergers and acquisitions with the objective of staking corporate control. Ravenscraft  Scherer (1988) and Weston (1994) explain that a key driver of many mergers and acquisitions is the quest to dispose the target firm in bits. Further, tax reduction and high cash reserves or low debt levels in the target company have also been cited as reasons behind mergers and acquisitions (Gilson, Scholes  Wolfson, 1988 King, 1987 Morck, Shliefer and Vishny 1988). Changes in technology, globalization, market deregulation and liberalization have also been cited as key drivers of mergers and acquisitions (Mallikarjunappa  Nayak, 2007).

As indicated, the profit motive has been cited as one of the main reasons which drive merger and acquisition activity. However, Baumol (1959) Marris (1964) and Mueller (1969) posit that mergers and acquisitions are primarily tools which are utilized by managers in order to attain specific growth objectives and not necessarily maximization of profit. Grossman and Hart (1980) explains that some managers use mergers and acquisitions in order to make the management of the firm become more complex and this is done so as to discourage shareholders from assiduously assessing how the firm is being managed. To enhance the value of a firm and prevent the payment of cash reserves to the firms owners, companies with free cash flows may take part in mergers and acquisitions (Jensen, 1986).

Raj  Forsyth (2002) and Jensen and Ruback (1983) studied merger and acquisitions and explain that 4 theories exist to explain why firms take part in mergers and acquisitions. These theories are the synergistic theory, the disciplinary theory, the undervaluation theory and the hubris theory. The synergistic theory states that companies engage in mergers and acquisitions in order to achieve higher efficiency levels since they attain greater synergies when combined together than when they are not combined. The disciplinary theory posits that companies which under perform are likely targets for hostile takeovers. Hubris is witnessed whenever managers of the acquiring firm pay much more for the target firm, largely because they have overestimated their abilities to manage it (Buehlens, 2008 Wang, 2007).

Many other reasons have been advanced to explain why mergers and acquisitions remain popular the world over. They include the desire to overcome competition, enhance revenues, enter and penetrate a particular market or market segment, attain economies of scope and scale, achieve greater cost efficiencies, enhance the human resource capacity, attain savings on corporate tax, enhance the research capacity and eliminate mediocrity  (Buehlens, 2008 Mallikarjunappa  Nayak, 2007).

From the foregoing, it is evident that mergers and acquisitions are powerful tools that can help a company leverage its competitive edge and easily attain its strategic intents.  However, mergers and acquisitions have been associated with many other disadvantages the most obvious of which is massive staff lay offs and redundancies.  There has been a high failure rate of mergers and acquisitions all over the world and these have been associated with declining profits, lower shareholder wealth and suboptimal employment levels. According to Schweiger (2003) between 50 and 75 of all mergers and acquisitions do not live up to the expectations of the companies involved. Where positive outcomes are seen, it is the target company which usually gets most of the benefits (Mallikarjunappa  Panduranga, 2007).

This thesis examines the impact of mergers and acquisitions on US companies between 2000 and 2006 in order to determine whether they helped in the creation of value. The role of corporate governance in the companies is equally examined in order to determine its impact on the success of the merger and acquisition.

Problem statement
Mergers and acquisitions are very popular occurrences the world over. Research indicates that most mergers are unsuccessful and lead to losses especially for shareholder of acquiring companies. Mergers and acquisitions are also associated with declining profitability in many instances. Whereas many studies have investigated the impacts of mergers and acquisitions and whether they create value for the companies involved, many of these studies are old and the number of studies assessing the utility of mergers and acquisitions which were carried out in the past 8 years in the US are very few. The old studies cannot be entirely applicable in the present as several studies have demonstrated different outcomes based on the period of time within which the merger and acquisition activity was carried out. Therefore, there is need to carry out a study which evaluates recent mergers and acquisitions in order to conclusively determine whether there was any value created by recent mergers and acquisitions.

Purpose statement
The main purpose of this study was to determine whether mergers and acquisitions in the U.S create value to the firms involved in the transactions

Aims and objectives
Aim 1
To determine the impact on shareholder wealth of mergers and acquisitions in the US between the period 2000 and 2006

Objective 1.1
To calculate the mean announcement-period cumulative abnormal returns (CAAR) for companies involved in mergers and acquisitions in the U.S and compare this with the pre-merger value of stocks for both acquiring and target companies

Objective 1.2
To carry out multivariate regression in order to determine whether there is a statistically significant difference between the CAAR of acquiring and the target companies before and after the merger or acquisition

Aim 2
To determine the impact on profitability of mergers and acquisitions on companies in the US between the period 2000 and 2006

Objective 2.1
To determine the earnings before income tax (EBIT), return on investment (ROA), Tobins Q and leverage of the companies before and after the merger and acquisition

Objective 2.2
To carry out multivariate regression in order to determine whether there is a statistically significant difference between the profitability of acquiring and target companies before and after the merger or acquisition

Hypotheses
Alternate hypothesis 1(H0)1
There is a statistically significant difference between the CAAR of target companies in the US before and after a merger or acquisition

Null hypothesis 1
There is no statistically significant difference between the CAAR of target companies in the US before and after a merger or acquisition

Alternate hypothesis 2 (H0)2
There is no statistically significant difference between the CAAR of acquiring companies in the US before and after a merger or acquisition

Null hypothesis 2
There is a statistically significant difference between the CAAR of target companies in the US before and after a merger or acquisition

Alternate hypothesis 3(H0)3
There is a statistically significant difference between the profitability of target companies in the US before and after a merger or acquisition

Null hypothesis 3
There is no statistically significant difference between the profitability of target companies in the US before and after a merger or acquisition

Alternate hypothesis 4(H0)4
There is no statistically significant difference between the profitability of acquiring companies in the US before and after a merger or acquisition

Null hypothesis 4
There is a statistically significant difference between the profitability of acquiring companies in the US before and after a merger or acquisition

Definitions
The following definitions will be applicable in this study

Asset mergers
Asset mergers will be used to describe a situation where one firm buys just a portion of another firms assets (GAO, 2008)

Corporate merger
Corporate mergers will define a situation where one company purchases all the shares and assets of another company to create a single entity (GAO, 2008)

Cumulative abnormal average returns (CAAR)
CAAR will be defined as the sum of the differences between the actual return and the expected return. The expected return will be calculated by multiplying the systematic risk with the product of the realized market return.

Hostile and friendly takeovers
A hostile takeover will describe a situation whereby a dominant company assumes the ownership of a less dominant company without the express will of the less dominant companys management. Where the dominant company assumes ownership of the less dominant company after having obtained approval from the management of the less dominant company, the situation will be referred to as a friendly takeover.

Scope, limitations and delimitations
The scope of this research was limited to the study of mergers carried out between 2000 and 2006 in the US. A number of limitations were encountered and these included insufficient time, financial constraints, scarcity of literature and drawbacks related to the selected study design. With regard to delimitations, the inadequate time constrained the investigator to make do with a small sample size which could be effectively handled within the available time and this had the effect of reducing the validity of the study. Scarcity of recent literature also affected the research since this was a Meta analysis and the success of the research depended on obtaining a large sample of studies in order to enable the researcher to come up with well reasoned and representative outcomes. Thus, the scarcity of data reduced the sample size.

Due to financial constraints, the investigator was unable to subscribe to premium content journals and databases to access the latest studies from authoritative figures. This could have introduced selection bias into the study and could have negatively affected the validity of this research. As pertains to the drawbacks related to the study design, the stringent inclusion and exclusion criteria also limited the number of available samples. Besides, the Meta analysis approach has been faulted for incorporating blemished studies which end up distorting the outcomes obtained. It is also possible that the investigator may have failed to identify null and negative results which may have been inherent in the studies which the investigator evaluated. Additionally, the evaluations made are largely associative and this may have weakened the conclusions. Finally, a small element of subjective bias may have been introduced into the study since comparisons of different studies rely on the interpretation by the investigator.

Organization of the thesis
This thesis has been divided into 6 chapters. Chapter 1 is the introduction chapter and is followed by chapter 2 which reviews literature associated with mergers and acquisitions in the US. The methodology used in this study is presented in chapter 3 while chapter 4 is the findings and data analysis section. This is followed by chapter 5 which is the discussion chapter and finally chapter 6 which is the conclusion and recommendations chapter.

CHAPTER 2 LITERATURE REVIEW
Introduction
Many studies have been carried out in order to determine the effect of mergers and acquisition on the performance of the companies involved. Creation of value following mergers and acquisition has been ascertained by assessing the announcement period abnormal return as a measure of shareholder wealth and by assessing the profitability of the firms involved in the acquisition or merger. Studies have also assessed the post acquisition employment levels, evaluating the impact of these activities on employee retention.

This section reviews studies which have been conducted on mergers and acquisitions in the US. First though, a global perspective of mergers and acquisitions is presented and the concept and occurrence of merger waves, with a particular reference to the US, delineated. Factors associated with merger failures and the utility of both accounting and event studies are also considered. The main purpose behind all these is to critically analyze all the factors associated with merger and acquisition activity in the US, identify all the studies on the effect of these activities in US firms and determine exactly how the shareholder wealth and profitability has been affected. This will help answer the main question in this study on whether mergers and acquisitions lead to the creation of value.

Global Merger and Acquisition Activity
According to Buehlens (2009), there has been an exponential increase in the number of deals relating to mergers and acquisitions worldwide since 1992. Rising from a low of nearly 15,000 deals in 1992, merger and acquisition activity peaked in 2000 with nearly 40,000 deals being transacted. In the US however, the peak was reached in 1998. There was a marginal decline in the 2 years that followed before the next peak was observed in 2006 (figure 1 below).
Figure  SEQ Figure  ARABIC 1 Global merger and acquisition activity between 1982 and 2006

Source Buehlens (2008)

At the same time, the total value of merges and acquisitions rose from nearly 250 billion euros in 1992 to an all time high of 4 trillion euros in 2000. Subsequently, the total value declined with each successive year, bottoming out in 2003 before ascending again to hit about 2.8 trillion euros in 2006. This is represented in figure 1 above. As can be seen, a new merger wave begun in 2003 but this wave has been associated with relatively lower values.

As figures 2 and 3 below shows, the contribution of Asian firms in merger and acquisition activity has increased in recent years. Nevertheless, the cumulative value of the Asian contribution is stills small. The US has surpassed the EU and now contributes the most to the total merger and acquisition activity in terms of deals and value (Buehlens, 2008).

Figure  SEQ Figure  ARABIC 2 Regional distribution of merger and acquisition activities by target between 2000 and 2006

Source Buehlens (2008)

Figure  SEQ Figure  ARABIC 3 Regional distribution by acquirer region between 2000 and 2006

Source Buehlens, 2008

Mergers and Acquisitions by Sector

Figure 4 below depicts the distribution of merger and acquisition activity in the US between 2000 and 2006 by sector. As can be seen, majority of transactions involved companies in the services sector. Together with the manufacturing sector, the services sector contributed more than half of all the merger and acquisition deals. Deals attributable to companies in the finance and real estate sector formed more than 16 of the total transactions. At the bottom end were deals by network, distribution and extractive industrial and construction industries in that order (Buehlens, 2008).

Figure  SEQ Figure  ARABIC 4 Distribution of Merger and Acquisition Activity in the US by Sector (2000-2006)

Source Buehlens (2008)

In the US petroleum industry 1,088 mergers took place between 2000 and 2007 (GAO, 2008). Trends in this industry over the period indicate that there was a general rise in the number of mergers and acquisitions every year as shown in the figure 4 below. Most of the mergers and acquisitions (about 69) were in the upstream segment. The rest took place in the midstream and downstream segments Majority (75) were asset mergers while the remaining 25 were corporate mergers. The mean value for all the mergers totalled nearly 500 million (figure 5 below)

Figure  SEQ Figure  ARABIC 5 Merger and acquisition activity in the US petroleum industry between 2000 and 2006

Source GAO (2008)

Figure  SEQ Figure  ARABIC 6 Mean value of mergers in the US petroleum industry between 2000 and 2006

Source J.S Herold cited in GAO (2008)

Laws regulating merger and acquisitions in the US
The Federal Trade Commission (FTC) is a government body that is mandated to ensure that there is competition among firms across industries by reviewing proposed mergers and acquisitions to determine whether they will diminish competition. In discharge of this mandate, FTC is principally guided by 3 laws which are the Clayton Act, the Hart-Scott-Rodinho Act and the Federal Trade Commission (FTC) Act.

The Clayton Act was enacted in 1914 and forbids any merger or acquisition which may lead to elimination of competition between companies in any sector and which may result in a monopoly. The Celler-Kefauver Act sought to amend section 7 of the Clayton Act so as to better regulate mergers and acquisitions. The Federal Trade Commission Act forbids the use of unfair practices in trade. Finally, the Hart - Scott Rodinho Act contains an amendment to section 7A of the Clayton Act and establishes waiting requirements and pre-merger notification for any individual or firm seeking to make an acquisition or take part in a merger. Amended in 2001, the law increased the threshold for statutory sizes and transaction amounts

Merger waves
According to ILO (2001), merger waves are durations of intense merger activity. The United States has had several merger waves since 1897. The first ever documented merger wave in the country took place at the end of the nineteenth century and continued until 1905. This wave arose as a result of a bullish stock market and the enactment of the Sherman Antitrust Act. According to Owen (2006), the act led to the creation of monopolies and as Sudarsaman (2003) asserts, led to the dissolution of more than 2,000 firms and the creation of about 70 monopolies.

The second merger wave to hit the United States was witnessed in 1916 and continued until 1929. This particular wave arose as a result of the 1914 Clayton Act and was enhanced by a buoyant stock market and the availability of equity.  Enactment of the Celler-Kefauver Act helped to limit merger waves and the next wave was observed almost 4 decades after the end of the second wave. This third wave took place between 1965 and 1969 and was largely attributed to a bullish stock market and a resurgent economy. Merger and acquisition activity was largely driven by the availability of excess liquidity and the preference by firms to buy out other companies rather than to give out money to their shareholders. As the Celler-Kefauver Act was largely against horizontal mergers, conglomerate mergers were observed mostly and very few hostile takeovers were carried out. The wave ended due to the oil crisis in the early seventies (Melicher, Ledolter,  DAntonio, 1983 Kolasky, n.d).

The fourth wave hit the country in 1984 and persisted until 1989 (ILO, 2001). Compared to the earlier waves, this was the biggest of them all and was characterized by a large number of hostile takeovers. The wave arose because of wide availability of debt financing, poor management of many companies, rapid specialization of firms and the government move to remove a number of controls limiting mergers and acquisitions.

There was yet another big merger which occurred in the nineties. Larger in scope and characterized by very few horizontal mergers, this particular wave featured a large number of friendly takeovers. According to Owen (2006) close to 95 of all the mergers witnessed were friendly takeovers and the main medium of exchange was stocks.

Studies on the economic impacts of mergers and acquisitions
The economic impact of merger and acquisition can be studied using share price data or studies of profits. The main objective of studies which use share price data is to analyze how the gains or losses to shares following the merger and or acquisition activity are distributed among the shareholders. These studies are often based on event study methodologies and the data used is associated with specific announcement periods. A number of studies which utilized share price data in order to evaluate whether mergers and acquisitions create value have been documented.  Majority of the studies show that the value of shareholder wealth of target companies is increased following mergers and acquisitions. On the other hand, there is a general decrease in the wealth of shareholders of the acquiring firms.

Using daily data of 196 companies, Asquith (1983) looked at the performance of companies which had taken part in mergers and acquisitions between 1962 and 1976. Results of this study showed that acquiring firms achieve positive returns 16 and 8 months before and after the merger announcement respectively. Their results also show that after these periods have elapsed, the companies attain negative returns which further decline 90 days after the end of the specified duration.

Dodd  Ruback (1977) found out that acquiring companies generally have reduced returns in the post acquisition period. According to their studies, such firms had a mean CAAR of -0.0591. Even so, the t-statistic was not significant. Their results also suggest that shareholders of target companies generally attain huge gains in their stocks, the mean of which is 20.58 for successful transactions. On average, their stocks also rise by nearly 19 for transactions which are not successful. Lagetieg (1978) assessed 149 mergers which involved firms listed in the New York Stock Exchange (NYSE). Their findings show that acquiring companies have large negative returns. These findings were corroborated by the study carried out by Malatesta (1983). In his study, Malatesta assessed 256 acquiring firms which took part in mergers and acquisitions for a period of 5 years beginning in 1969. As their results show, acquiring firms in the US generally have negative returns during the post acquisition period.

Dodd (1980) utilized the market model to evaluate 150 merger proposals made between 1970 and 1977 and discovered that shareholders of target firms benefit greatly on the day prior to the announcement and on the day when the actual announcement is made. On the day before the announcement, he found out that the stocks of shareholders of the target firms increased by up to 4.3. On the actual announcement day, the stocks of the shareholders of the target firm rose by 8.74.
Yet another study which demonstrated negative returns for acquiring firms in the post acquisition period was carried out by Magenheim  Mueller (1988). Besides demonstrating negative returns for the acquiring companies, their results also show that acquiring firms benefit more from tender offers than they do for mergers and acquisitions. Similar findings are reported by Bradley and Jarrell (1988). Negative returns for acquiring companies in the post acquisition period are also reported by Franks, Harris and Mayer (1988) who looked at 519 firms which took part in mergers and acquisitions in the US between 1955 and 1984.

Similarly, Frank, Harris and Titman (1991) evaluated 399 mergers and tender offers which were carried out for a 9 year period beginning in 1975. Their findings are consistent with other results as they show negative returns for acquiring companies and positive gains averaging 28 for shareholders of target firms.

A 10 decline in the value of shares of acquiring companies within the initial 5 years of the acquisition period was demonstrated by Agrawal, Jaffe and Mandelker (1992). They carried out a 32 year study and evaluated 1,164 samples. Whereas the shareholders experienced huge losses during the entire study period, the losses were more pronounced for transactions which were carried out before 1975 and after 1979. Even though the findings of the study by Loderer  Martins (1992) were not statistically significant, they pointed towards the same trend indicating large negative returns for shareholders of acquiring companies and positive returns for shareholders of target companies in the US. Their conclusion however is that shareholders of acquiring companies do not gain nor lose during mergers and acquisitions.

Jensen  Ruback (1993) records average gains of 17 to 34 for shareholders of target companies one month after the transaction. Loughran  Vijh (1997) utilized the buy-and-hold return technique of calculating the value of stocks and found out that there are positive gains associated with tender offers while losses are associated with mergers. The bias adjusted cumulative abnormal return (BCAR) method was used by Rau  Vermaelen (1998) to investigate a total of 3,500 mergers and tender offers transacted between 1980 and 1991. Their results show that shareholders attained negative abnormal returns 36 months into the post acquisition period. More recent studies which affirm these outcomes were conducted by Leth  Borg (2000), Mulherin (2000) and Kohers  Kohers (2000), DeLong (2001), and Houston et al (2001).

Studies utilizing profitability make use of accounting data and have also been extensively documented. Whereas there is considerable disagreement on the effect of mergers and acquisitions on the profitability of the companies involved, most studies find that mergers and acquisitions are associated with enhanced profitability of firms in the US. Studies by Healy, Palepu  Ruback (1997), Lev  Mandelkar (1972), and Weston  Masinghka (1971), show that mergers and acquisitions result in enhanced profitability for the firms involved. Results of the study by Healy, Palepu  Rubeck (1997) also demonstrate that hostile takeovers generally result in poorer outcomes than do friendly takeovers. Stated differently, companies which take part in friendly takeovers generally exhibit higher profitability than those which take part in hostile takeovers. However, different results are found by Ravencraft  Scherer (1988). Their results show that firms which take part in mergers and acquisitions generally have reduced profits. These findings corroborate earlier findings obtained from the studies by Mandelker (1974), Smiley (1976) and Ellert (1976).

The impact of Mergers and acquisitions on employment in the US
The effects of mergers and acquisition on employment levels in the United States have been extensively studied by many investigators. In a 7 year study of companies located in Michigan, Medoff (1988) demonstrated a 2 rise in employment levels following mergers. At the same time, their findings indicated that the marginal rise in employment was accompanied an average wage decline of 4. On the other hand, asset mergers were associated with a 5 increase in the average wages. In another study, Bhagat et al (1990) evaluated the impacts of 62 hostile takeovers in the US between 1984 and 1986. Their results show that nearly 6 of the employees of the companies involved the hostile takeovers were declared redundant.

Findings by Lichtenberg  Siegel (1990) indicate that mergers and acquisitions mostly affect central office workers. McGuckin  Nguyen (2000) carried out a decade long study which evaluated the effect of mergers and acquisitions on the employment levels of the US manufacturing industry. Their findings show that mergers and acquisitions are associated with an increase in the number of employees. These findings suggest a positive correlation between merger and acquisition activity and employment. Similar findings were reported by Gugler  Yartoglu (n.d.) who show an increased demand for labour in the post-acquisition period. The positive effect of mergers and acquisitions in the US labour market contrasts sharply with the impact of mergers and acquisitions on the labour markets of many European nations such as the UK. This is because the US has some of the most liberal employment protection laws. According to Arellano  Bond (1991) and Abraham  Houseman (1989), the cost involved in the adjustment of labour markets in the country is relatively small compared to that in these European states.

Factors Associated with the Failure of Mergers
According to estimates, close to a half of all mergers and acquisitions do not succeed. Similar outcomes are presented by Porter who studied 33 Fortune 500 companies involved in acquisitions and concluded that more than a half of these firms were unsuccessful. According to Chandra (2001), mergers and acquisitions are invariably associated with falling productivity and lesser profits. A report by McKinsey (cited in Hubbard, 1999) demonstrates that 75 of companies engaged in mergers and acquisitions are unable to recover the expenses spent in the activity. Reportedly also, the performance indices of more than 50 of the companies which take part in mergers and acquisitions are below those of industry averages. Schweiger (2003) reports that between 5 and 7 out of every 10 companies engaged in mergers and acquisitions fail.

This high failure rate has been attributed to several factors. These factors include hubris (Moeller, Schlingemann  Stulz, 2004 Sundarsaman, Holl  Salami, 1997 Gregory, 1997 Roll, 1986) and poor leadership (Mallikarjunappa  Nayak, 2007). Others are poor communication (Schweiger, 2003), obsession with bigness (Gregory, 1997) Malatesta, 1983), and strict antitrust legislation (Asquith, Brunner  Mullins 1983 Eckbo, 1983 Weir, 1983 Jarrell  Bradley, 1980). Other factors blamed for the high failure rate of mergers are poor strategic fit between the companies involved and lack of focus (Maitra, 1996). Rau  Vermaelen (1998b) explain that acquisitions that are made solely on the basis of glamour rather than value are bound to fail. Unsuitable partners, lack of follow up and lateness in taking over control of the merged firm are also factors associated with failure of mergers and acquisitions (Harihan, 2005 Chakravarty, 1998).

Firms which fail to conduct a due diligence on the target company also exhibit high failure rates as do those which fail to carry out a detailed financial appraisal of the targets (Harihan 2005). Poorly managed integration (Zainulbhai, 2006) and the type of exchange medium that is used also have an effect on the success of mergers and acquisitions. Generally, the use of stocks as a payment medium is associated with greater success than the use of cash Yook, 2000 Asquith, Bruner  Mullins, 1987 Huang  Walkling, 1987 and Travlos, 1987).

Size may also determine whether a particular merger or acquisition will be successful (Hubbard, 1999). Moeller, Schlingenmann  Stulz (2004) asserts that less successful outcomes are obtained with larger companies than with smaller ones. High failure rates are also associated with firms which primarily take part in mergers and acquisitions in order to strengthen their market power (Eckbo (1992 Ravenscraft and Scherer, 1987). Studies by Abyankar, Ho  Zhao (2005), Moeller, Schlingemann  Stulz, (2005) and Variaya  Ferris (1987) also demonstrate that overpayment can lead to the failure of mergers and acquisitions. Further, companies which have no prior experience in mergers and acquisitions have also been shown to have high degrees of failure (Hubbard, 1999).
Diversification of the firms is yet another issue that has profound effect on the success of mergers and acquisitions. According to Sudarsanam (2003) and Dash et al (1987), firms which purchase other companies which are engaged in the same line of business are more successful than those which buy into unrelated businesses. Similarity in organization fit as manifested by comparable human resources, managerial and cultural features is also associated with more successful outcomes (Hubbard, 1999 Jemison  Sitkin, 1986).

Summary of the literature review and gaps in literature
Mergers and acquisitions are accompanied by high failure rates. Most studies which assess the effect of acquisition and merger in the US indicate that shareholders of target firms benefit from higher stock values and hence increase their wealth. On the other hand, the studies show that shareholders of the acquiring companies attain losses in their stock values hence see a decline in their wealth. Additionally, most studies reviewed conclude that mergers and acquisitions enable the target companies to attain increased profitability. Conversely, gains by acquiring companies are quite uncommon. Studies also indicate that mergers and acquisitions have little effect on employment levels in the country and that shareholder returns are slightly positive or break even.

Gaps  more recent data is missing
Statistically significant outcomes are needed
 CHAPTER 3 RESEARCH METHODS
Nature of study
This study was conducted using the Meta analysis approach. Event studies were used to examine the impact on shareholder wealth of mergers and acquisitions.

Why the Meta Analysis Approach Was Chosen
The Meta analysis approach was deemed to be the most suitable research approach for this particular study because of the following reasons

Replication. With Meta analysis, replication of the study by other investigators is entirely possible. Since the study can be easily replicated, the validity and reliability of the conclusions made are enhanced

The meta analysis method enables the investigator to authoritatively evaluate dissimilarities across studies and diminishes the probability of over-interpretation of the differences

The meta analysis approach is suitable because it allows the investigator to discover correlations between different variables, something which may be entirely impossible with other kinds of research methods

Unlike the less tractable record review studies, meta analysis enables the investigator to study huge amounts o data

Event studies
As explained in the literature review chapter, event studies are powerful tools which are primarily used to assess the gains and or losses obtained by shareholders of companies involved in mergers and acquisitions during a specified announcement period.

Why event studies were used
Event studies were preferred over accounting studies for the following reasons Unlike accounting studies which are highly unreliable because they change constantly due to changes in accounting decisions, event studies are more reliable as they are unaffected by such decisions

Event studies are usually premised on larger data sets and therefore offer a more credible approach and allow the generalization of the outcomes obtained

Event studies are largely devoid of measurement errors which encumber many large studies
Event studies are consistent with the meta analysis method chosen for this study as they facilitate the determination of any association between mergers and acquisitions and creation of shareholder value
Event studies primarily assess cumulative abnormal returns of shareholders associated with firms engaging in mergers and or acquisitions. The main objective of this study was to evaluate the impact of these activities on the cumulative abnormal returns and by extension determine whether they are associated with value creation. Evidently therefore, event studies are best suited to fulfil the stated objective

Research questions
What impact have mergers and acquisitions conducted between 2000 and 2006 in the U.S had on shareholder wealth
What impact have mergers and acquisitions carried out between 2000 and 2006 in the U.S had on profitability of the companies involved
Statistical tests
Correlation between the dependent and independent variables was assessed using multivariate regression analysis
Number and description of literature
Source of literature
Securities Data Corporations (SDC) database
IRRC Database
Databases  JSTOR, Sagepub, Gogle Scholar
COMPUSTAT
Snowball technique
Sampling method - Clustered weighted sampling
Inclusion criteria

The following criteria were used to select data for use in this study
only studies reviewing merger and acquisition activity which took place between 2000 and 2006 were considered for this research
only peer reviewed articles were used
the research utilized only those studies which were published in English
the merger and acquisition activity must have taken place in the US or where both the target and acquiring companies are incorporated in the US
Longer period studies were utilized for this research and this was done so as to overcome the effect of differences in time period
Exclusion criteria
Poor quality and incomplete studies were not used in this research
Non-published articles were excluded from this research
Variables
Independent variables
The following independent variables were used in this study

Dependent variables
Shareholder wealth  CAAR
Profitability
ROA
Leverage
Tobins Q
Validity and reliability
Validity
Reliability
Research strategy
Data entry and management
Ms Access
Codebook
Verification of data
Summary

With the change in business environment, it has become necessary for organizations to focus on sustainable wealth creation. Some organizations have invested substantially in risk management and internal control measures. Risk management is the identification and assessment of risks and the application of resources to prevent, monitor and control the chance, and impact of an eventuality. It is very clear that appropriate responses must be prepared to counter any risk that would affect business strategies or earnings. There are various methods used to manage risk for SMEs. These range from avoidance, diversification via monitoring and insurance coverage. This paper will critically examine risk management and internal control for SMEs. The paper will also examine the contradictions and limitations of risk management as highlighted in studies on risk management for SMEs.

The benefits of risk management and internal control
Every enterprise operates in an environment that exposes its business activities to potential risks. For business to survive the increasingly uncertain business environment, they must implement effective risk management strategies. It is therefore clear that strategic business planning efforts must encompass risk management strategies. This should enable the small and medium-sized enterprises to respond swiftly and effectively to any changes in the business environment. Through risk management and internal control, the Small and Medium-sized Enterprises are able to identify potential threats and challenges and hence prepare in advance on how to meet those challenges (Stern, 1996). SMEs derive value from internal control measures. One of the benefits of internal control measures include improved business operations and risk management assessments. Internal control efforts play a vital role in enhancing business performance through reduced operational costs, minimizing regulatory impediments, and enhancing revenue predictability. Another benefit of internal control is that it gives confidence to the shareholders, local and foreign investors since they are aware that any investment is secured of internal frauds.

Special legal regulations for Small and Medium-sized Enterprises
Small and Micro Enterprises have to comply with several regulatory frameworks. The United Kingdom Government has formulated a special regulatory framework to regulate and control the operations of SMEs. The growing concern for environmental impact assessment and harsh economic situation has prompted the government to implement technical regulations pertaining to environmental conservation. In addition, Health and safety regulations ensure that SMEs operate under the required health standards and safe business conditions. These regulations help to protect workers and encourage business managers to expand their business operations without the limitation of increased risk exposure. Capital regulation ensures that SMEs comply with the government financial requirements. Interestingly, human resource surveys in the UK indicate that most SMEs within the market struggle to comply with the legislative requirements. This has created the need to evaluate the existing legislation to attract investments in the SME market.

Risk reporting and management comparison between SMEs and large corporations in the UK market
Small and medium enterprises have for a long time been ignored despite their imperative role in both national and international developments. This section of the paper gives candid information on the implications of regulations on SMES as compared to large corporations.

The international financial reporting standard for small and medium size enterprises (IFRS for SMEs) has simplified and relaxed the accounting requirements and reduced disclosure provisions. The accounting standard board (ASB) has developed new standards for accounting in UK. The history of risk management in the UK dates back to 1992. During this time, there was a substantial increase in high profile corporate frauds and financial scandals pushing the London Stock Exchange to introduce new regulations for companies listed. Recent surveys show that more than 98 of companies in the UK are SMEs. There contribution to the UK economy is therefore significantly high. The recent economic slump down exposed SMEs to the risk of insolvency and necessitated a change in planning management. Reports show that the UK SMEs rely more on package products for their cover. The risk management for SMEs is diverse and comprises of a wide range of products. Most small businesses utilize recognized insurance brokers to cover their business. Although SMEs are loyal to their insurance providers, studies have revealed that more SMEs changed their provider in 2009 than in the previous year. Traditionally, SMEs have established affinity partnerships targeting trade associations. Several insurance providers have therefore come up with tailor made broker offerings for SMEs. Apart from the usual insurance coverage, providers offer small businesses with legal advice. It is also evident that banks have a bad reputation among the SMEs, as they are expensive alternatives. Some studies have suggested that for banks to capture the lucrative SME market, they need to change their pricing strategy and reinvent their image. On the other hand, research has revealed that banks are not willing to lend to small business units and hence the banking conditions are not favorable to SMEs. This has led business owners to borrow from friends and personal credit especially during hard economic times. It is therefore notable that about 28 of SMEs used this kind of funding to finance their business activities. This has led to increased insolvency levels and personal risk thus discouraging small business owners from investing in the UK market. Security for UK SMEs is very crucial due to the contribution of these business units to the UK economy. It is also very clear that SMEs need simple and flexible cost effective security solutions tailored for them.

They need differently treatment from the large corporate organizations to lower their capital investments and realize efficiency and productivity. Many large corporations are adopting Enterprise Risk Management (ERM) to increase their risk management profile. According to the Institute of Chartered Accountants (ICA) in England and Wales 2006 report, some SMEs have integrated risk management to overall business management practices. Large corporate have developed risk control systems that are capable of assessing potential risk factors. Some of the risk areas covered by large corporations include strategic, operational, financial, compliance and environmental risk. Risk management studies have not focused on developing appropriate credit risk models to reflect the specific needs and peculiarities for SMEs. These studies need to focus on provision of qualitative information to gauge credit worthiness for the SMEs, ensure good flow of finance and develop adequate risk management models. To determine the business environment, Non-financial data need to supplement accounting data. This is especially important due to the lack of adequate data for private companies and unlisted firms. According to studies by Everett and Watson (1998), the reason why SMEs fail is due to inadequate capitalization and poor planning. The study also revealed that there is no relationship between failure rate and size of company as measured by asset value.

Influence of family board members on corporate governance issues
According to a 2008 report by the Institute for Family Business (IFB), family businesses account for approximately 65 of the total private sector enterprises in the UK economy. The report showed that most family enterprises are SMEs while 56 operate as sole traders (Abor and Adjasi 2007). These family businesses vary in size and level of family involvement in corporate governance. The UK policy environment is supportive of family businesses. For example, these businesses benefit from inheritance tax exemption since 1992. The government has also introduced capital allowances and research and development tax credits and incentives to family enterprises. In 2000, the UK government introduced enterprise management incentives scheme to help small firms recruit by giving tax-free incentives to employees. Family firms are therefore important governance structures for business organizations in the UK. It has been reported that human resource development activities for owner-managed SMEs where based mainly on succession planning. It is notable that the owner solely does decision making in SMEs particularly on training and human resource development. Even in those SMEs with human resource personnel, the ultimate decision lies with the business owner or influential family member. Most family enterprises are reluctant to hire outsiders hence they cannot utilize external knowledge leading to weak corporate governance. That is why most family owned SMEs are conservative, lack professionalism and are slow in acquiring new technology (Cadbury, 2000).

Studies that have examined the risk management practices for SMEs
Several studies have examined the risk management practices among SMEs. Some of the studies have identified barriers to risk management in the supply chains for SMEs. These are strategic risks for SMEs (Gorrod, 2004). Other studies have focused on the Basel Capital Accord and its impact on SMEs. These studies have also focused on the operational definition applied by major lenders. Some other studies have examined the credit risk models and their application in risk management for SMEs. All these risk management studies seem to raise several questions.

Methods and Key question arising from risk management studies
Some of the questions raised by these studies include concern over the availability of data for unlisted companies. According to studies by Watson and Everett (1996), there is limited data on both financial and non-financial fronts making business environment analysis and calculation a difficult task.

Recent literature has raised the question of including qualitative variables in making analysis for risk management models. Researchers and academicians have raised questions on the appropriate modeling methods that can be applied to predict the failure of SMEs. Globally, there is no universal definition of an SME and this has posed a bigger challenge to business managers who are keen on internationalizing their business. In the European Union for instance, the criteria for definition uses the number of employee and the annual turn over rate of the business. In the United States, the Small Business Administration (SBA) deals with defining SMEs to reflect the North American Classification System. The current SBA requirement differs for each industry but the number of employees is 500 and an average annual receipt of less than 28 million (Thomsen, 2000).

Generalizations, Contradictions and limitations of the studies
Risk management for UK SMEs operating in the international market is one of the areas that have elicited controversies and contradictions among academicians and researchers. The controversies have centered on risk management at market entry level for SMEs. Risk management for these SMEs is based on the use of resource models, cost theory and organizational capability theories. However, the studies have generalized some issues. Generalized issues include the need to develop specific regulations and risk management tools for SMEs. Risk managers agree that risk assessment and management for SMEs need to address the unique business issues specifically for SMEs. Management experts also agree that SMEs need Government support through the provision of incentives to encourage economic growth and creation of employment and wealth.

These studies have also raised several limitations. Definition of SMEs is one of the limitations highlighted by the studies. Different countries have different requirements and definitions on the criteria of classification of business entities. There is limited data on both financial and non-financial fronts making business environment analysis and calculations a difficult task. Recent literature has raised the question of including qualitative variables in making analysis for risk management models. Several studies have also tried to come up with modeling methods that predict the failure of SMEs (Begley, 1995). One of the limitations affecting all studies is that risk management is about preparing for uncertainties. It is therefore clear that the process will require complex management strategies that may not appeal to small business managers.

Conclusion
Based on the above analysis of SMEs, it is evident that for small and medium-sized enterprises to create wealth sustainably, they need to make risk management an integral part of the overall strategic planning management. It is also notable that to ease the pressure on SMEs, governments and other stakeholders should come up with specific regulations that meet unique needs and peculiarities of SMEs.