Table of Contents Rationale of the Merger 2 Overview of the Banks History2 Analysis of the Banking Market2 Motives behind Merger and Acquisition Transactions2 Rationale behind the Chase-Chemical Merger 4 Relative Merits of a Merger and an Acquisition 5 Present Value of the Gains from the Merger 6 Estimating the Exchange Ratio 8 Overview:8 Problem Definition:8 The Expected Market Exchange Ratio:8 The Acquiring Premium:9 The Expected Value Added of the Merger:9 The Expected Value Added of the Focus Program:10
Proposed Solution:10 Ex-Post Analysis:11 Literature12 List of Tables Table 1 Estimated Impact of Merger between Chemical and Selected Banks4 Table 2 Beta Calculation7 Table 3 Banks merger premium multipliers in the US during 19959 List of Figures Figure 1 Projected Growth in Online Banking4 ? Rationale of the Merger Overview of the Banks History In 1955 Chase National Bank and the Manhattan Company merged with Chase Manhattan Bank.
David Rockefeller, who became Chairman of Chase in 1969, was significantly involved in the merger. By the end of the 1979s Chase evolved to the third largest Bank in the United States (U.
S. ). In the 80s Chase saw itself confronted with difficulties, which were caused by investments in bad real estate loans. In the year of 1990 Chase suffered from a record loss of $1 billion. The company however managed to regroup and presented a solid balance sheet in the next four years leading to the merger (Gilson and Escalle, 1998). Chemical Banking Corporation was formed in 1824. In 1844 it became the Chemical Bank of New York and eventually completely left the manufacturing business seven years later. During the period from 1946 to 1972 Chemical was able to seriously increase its assets (from $1. 5 billion to $15 billion). At the same time Chemical acquired several banks, enabling it to expand into new markets, offer new products and services and therefore diversify (Gilson and Escalle, 1998). Whereas during the financial crisis of 1991 Chemical had to book a loss of $1 billion, Chemical Banking Corporation and Manufacturers Hanover Corporation merged, giving life to the first major bank merge amongst equals (Gilson and Escalle, 1998) in the history of the U. S. . The resulting bank became the second largest bank, in terms of assets, in the U. S. (Gilson and Escalle, 1998).
Analysis of the Banking Market Between 1991 and 1995 U. S. commercial banks increased their net-profit from $20 billion to $80billion. At the same time the industry was marked by several mergers, which led to an increase in the average total value of bank equity acquired in acquisitions per year by over 300%. This trend resulted in a consolidation of the U. S. banking industry, in which a few banks were holding a great deal of total bank assets, for instance the top 50 banks now held 65% of the total assets compared to 53% in 1985 (Gilson and Escalle, 1998).
This period of mergers created new competitors. As a result Chemical and Chase were both under pressure to react to the rise in competition for national and international market shares in order to hold their market position. Despite the leading position Chemical had achieved thanks to its merger in 1991, the bank had fallen by late 1994 to fourth place in terms of size (Gilson and Escalle, 1998). Motives behind Merger and Acquisition Transactions As Brealy and Meyers (2005; pp. 55) mentioned mergers can be divided into different categories: horizontal, vertical or conglomerate. A horizontal merger is defined as a merger between two firms of the same line of business. Hence the merger between Chase and Manhattan would clearly belong to this category as they both are commercial banks. In contrast a vertical merger takes place between companies in different stages of product (Brealy and Meyers, 2005) and conglomerates are mergers or more usually acquisitions where the two firms are engaged in different lines of business (Brealy and Meyers, 2005).
Another kind of distinction, closely related to the above described one, can be made: in-market mergers and market extension mergers. In in-market mergers, as the one between Chase and Chemical would be described, the merging companies do business in the same markets, the merger rationale is mainly to eliminate overlapping activities and consolidate market positions. In contrast a market extension merger is done to enter new markets and diversify production (Gilson and Escalle, 1998).
M&A often goes along with globalization and deregulation, which increase the competitive situation in world markets and therefore forces companies to react with structural changes. The inability of some companies’ respectively their management to grow under their own power can also lead to M&A transactions (Volkart, 2007; pp. 1083). Although it is worth mentioning that intern growth can be accompanied by high costs (Berger and Humphrey, 1994). Different motives behind Mergers & Acquisition (M&A) exist. Expanding the business is definitely one of them.
However the dominant goal of an M&A activity is the improvement of a firm’s financial performance and efficiency. Volkart (2005; pp. 1084-1086) mentioned numerous theoretical approaches for the explanation of the existence of M&A as there are: Synergy theories: financial, operational and competitive synergies potential. Market power and competition: possibility of eliminating competitors through acquisitions. Corporate taxes: possibility of buying loss makers and thus reducing tax liabilities. Inefficient management: in a merger a weak management can be replaced by a new one.
Diversification: since inefficiency in markets often exists, diversification through acquisition can be achieved (in addition to diversification through securities). Eat or be eaten: especially in markets with a lot of structural changes and diverging sizes of companies the question arises, whether one wants to make an acquisition or be acquired. Nevertheless Shim and Siegel (2006; pp. 230) stated that mergers have several disadvantages as well: Earnings per share: Should be greater or equal as after the merger, which often is not the case.
Market price per share: should be bigger or equal after the merger, which often is not the case. The culture within the two companies can be totally different, making integration difficult and costly. Need, in order to succeed, of a reduction of the labor force, which potentially can cause reputational damage and lower employee morale for the new company. Numerous econometric studies of bank scale and scope economies, efficiency and mergers in U. S. banking have been conducted (Berger and Humphrey, 1994).
Berger and Humphrey (1994) stated that economies of scale, economies of scope and x-efficiency are generally able to increase the efficiency of a company, whereby x-efficiency is much more important than scale and scope economies. The academic studies have come to the result that economies of scales indeed allow average costs to fall with increases in bank size. Additionally there are minor economies of scope that reduce costs by around 5%. Furthermore the studies have shown that x-efficiency in banking has to potential to lower costs as well (Berger and Humphrey, 1994).
In their empirical study Michtell and Onvural (1995) find that bigger commercial banks often profit from economies of scale and economies of scope and consequently have a high degree of efficiency. While mergers have the potential to improve x-efficiency, this potential is generally not realized (Michtell and Onvurla, 1995). In conclusion we can say that mergers may have the potential to increase the efficiency of a bank. However in most empirical studies, on average, mergers have had no significant, predictable effect on costs and efficiency.
While some mergers have reduced costs, others have raised costs (Berger and Humphrey, 1994). Besides an increase in efficiency through scale and scope economies can be achieved through many different approaches. Internal organic growth, although cost intensive, gives companies another possibility to expand. In addition further agreements (i. e. joint ventures) can help to improve the efficiency as well Rationale behind the Chase-Chemical Merger Within the trend towards deregulation which had mainly started in the 80s, several non-financial institutions began to offer financial products (e. . loans, credit-card business, and mortgages). Hence the pressure Chemical and Chase were confronted with further increased. As a consequence of the broader supply from the new players in the market the households changed their allocation of financial assets, whereby the percentage amount of conventional bank deposits (of the financial assets) decreased from 49% in 1980 to 35% in 1994. Under the changed market situation Chemical considered a merger as an option for dealing with the pressure resulting from the new competitors and the trends leading to deregulation.
Another reason for the merger, were the big investment costs in technology that the companies were preparing to sustain in order to stay or emerge as leaders. These investments could only be achieved by big banks. To show how important technological improvements would be in the future, Figure 1 presents the evolution of online banking in the 90’s (Gilson and Escalle, 1998). Figure 1 Projected Growth in Online Banking Source: (Gilson and Escalle, 1998) On merger completion, Chase Manhattan Corporation would create America’s largest- and the world’s fourth largest commercial bank.
In addition the merger would create value in at least two different ways. First of all the banks would save operating and overhead costs. According to an analysis of Chemical the saving potential of a merger with Manhattan would be $1. 5 billion, as seen in Table 1 (Gilson and Escalle, 1998). Table 1 Estimated Impact of Merger between Chemical and Selected Banks Source: (Gilson and Escalle, 1998). However, 12’000 employees would need to be fired and over 100 branches would have to be closed to achieve the planned cost reductions.
As mentioned before the reduction of the labor force could cause serious reputational problems. Second of all, the leading position of both banks and especially Chemical would help the new company to increase its profit from the higher revenue growth. Furthermore the leading position and a greater equity should enable the bank to enter new markets and better satisfy the individual needs of customers. Since Chase had suffered losses in the past and was under pressure, it needed to increase its efficiency (Gilson and Escalle, 1998).
Chemical however, had a solid financial record and was not under any pressure to immediately cut costs; hence the possibility to wait presented itself, in this case however Chemical incurred the risk of losing attractive merger opportunities. As mentioned before we can say that mergers have the potential to increase the efficiency of a bank trough scale and scope economies and x-efficiency. Relative Merits of a Merger and an Acquisition It is not always simple to distinguish a merger from an acquisition, because in both cases it is possible that a new firm is established.
In case of a merger, the stockholders of the acquiring company will become stockholders of the new company while by contrast they will no longer be stockholders in case of an acquisition (Volkart, 2007; pp. 1069-1079). In practice there are only few actual “merger of equals”, as usually one of the two companies takes control over the new established company and clearly runs the business. Yet, in the case of Chase Manhattan Corporation and Chemical Banking Corporation a “merger of equals” would be possible, as the needed preconditions are fulfilled.
First, Chase Manhattan is willing to merge and a hostile takeover (acquisition) is therefore not needed. Second, the size of the two companies is similar, thus a joint management and leadership of the new established company could be possible. The choice of a merger over an acquisition could lead to some considerable advantages. First of all, through a joint management a lot of motivational employees’ problems could be solved, as the employees of the acquiring company would not feel so much betrayed and under pressure as in the case of an acquisition and therefore be less hostile.
Second, it seems realistic to assume that the acquiring company (both its management and its stockholders) does prefer a merger over an acquisition (Gilson and Escalle, 1998; pp. 6). With an acquisition, the stockholders of the acquiring company will find themselves with a new management they haven’t really chosen and can’t expect to control. The purchasing price demanded by the acquiring company is therefore likely to be much higher with an acquisition, as the stockholders must be compensated for giving up control of the firm.
Third, in case of an acquisition Chemical Banking Corporation would first have to make sure that its equity is sufficient, because in case of an acquisition the debt to equity ratio is likely to increase significantly, (Volkart, 2007; pp. 1077) leading the new established company to important financial problems if the initial equity amount were too low. Last, but surely not least, a merger, because of the advantages mentioned above, could be perceived by the market as more valuable and value-adding than an acquisition, leading to an increase in stocks’ price.
Yet, a merger of equals, with none of the companies taking control over one another, can also lead to important problems. In the case of Chase Manhattan Corporation and Chemical Banking Corporation, the presence of strong corporate cultures within both companies could lead to considerable difficulties. A compromise might never take place between the two companies, creating unrest and inefficiency inside the new firm. Moreover, a merger wouldn’t allow Chemical Banking Corporation to avoid redundancy and cut costs by selectively maintaining only the most profitable assets of Chase Manhattan Corporation like in case of an acquisition.
In case of a merger, the integration costs are likely to be higher, as additional effort is needed in order to achieve a joint decision on whom and what to is to maintain inside the two firms and on how the different technologies are to be integrated (Gilson and Escalle, 1998; pp. 9 – 12). To conclude, it must be mentioned, that one of the main dangers of mergers and acquisition is paying too much for the acquiring firm (beside the integration problems, which are anyway present both in the case of an acquisition as well as in the case of a merger) leading to the result that the premium paid is higher than the additional value created.
This problem, particularly considering the banking trend at the time of the merger, with rising premiums, leads to the conclusion that in this case a merge is better than an acquisition since it allows the buying firm to pay a smaller premium on the acquisition. Present Value of the Gains from the Merger Data forecasts, source: (Gilson and Escalle, 1998): Cost savings: 0. 6$ bil. (1. year) 1. 05$ bil. (2. year) 1. 7$ bil. /year (afterwards) Revenue enhancement: 0. 02$ bil. (2. year) 0. 12$ bil. /year (afterwards) Negative impact of overlapping businesses: -0. 125$ bil. (1. year) Restructuring charge: -1. 9$ bil. (0. year)
PV(merger gains)=? (-1. 9+0. 6/(1+R)+(1. 05+1. 7/R)/((1+R^2 ) )+(0. 12/r+0. 02)/(1+r)^2 -0. 125/((1+r) ))*? (1-TR) Taking into account the different nature of the risks associated to savings and revenues it is appropriate to use two different discount rates R and r. These should be modeled on the basis of the required return on assets (rROA). We set the revenue discount rate slightly lower than the rROA because the level of profitability of 1990-95 in U. S banking sector is considered difficult to sustain in the future (Gilson and Escalle, 1998) and this fact should be reflected in a lower required return on assets on future gains.
Notice however that the correction in this second rate will have a small impact on the final result. Indeed as expected for a predominantly in-market merger as the one considered here (notice how revenues are much smaller than the forecasted savings) the PV will presumably be mostly influenced by the savings factor. The saving discount rate is set lower than the discount rate for revenues, since it is generally accepted, see for example: (Houston et al, 2001) that cost reductions are less risky than the average businesses of the bank.
The rROA is determined using CAPM where we will derive the equity beta by regressing each company’s monthly stock returns against market returns between January ’94 and March ’95, taking the data from Exhibit 12: (Gilson and Escalle, 1998) and Yahoo Finance. Following (Houston et al, 2001) the rROA is then obtained by multiplying the average beta with the market risk premium (rp) of 7% as proposed in (Ibbotson and Associates, 1996) and adding the risk free rate (rf) assumed to be the 10-year U. S treasury bond as of July 1995, equal to 6. 45%, (U. S. Dept. Of Treasury). In this way we obtain the rROA, equal to 12. 1 (see table 2). Notice that we used the average beta of the two banks betas since we are considering a merger between equals. rROA=rf+1/2*?? (?? _Chemical+? _Chase ? )*rp Source: own calculation modeled after Exhibit 12 (Gilson and Escalle, 1998) and Bloomberg Database The discount rates for the gains are chosen to be r = 11. 7% and R = 10%. The final result for the present value of merger gains is then PV(merger net gains)=9. 57$ bil. Where, to compute the net value, we used the tax ratio 33% calculated on the 1995 taxation, taken from Exhibit 11 (Gilson and Escalle, 1998) TR=1/2(? taxes (Chemical,^’ 95))/(Income before provision (Chemical,^’ 95) )+(taxes (Chase,^’ 95))/(Income before provision (Chase,^’ 95) )? )=0. 5(1141/3445+695/2068)=0. 33 Estimating the Exchange Ratio Overview: The typical way to execute a merger or an acquisition is for the acquiring company to swap stocks with the acquiring firm at a fixed exchange ratio. Determining the exchange ratio in these cases is crucial, since it directly determines the relative wealth distribution for the stockholders of the two firms after the merge/acquisition.
From the point of view of a stockholder of the acquiring firm the exchange ratio is inversely proportional to the gains or losses achieved by the merger or acquisition, since a higher exchange ratio will: “cause the combined entity to have a greater number of shares outstanding” (Larson and Gonedes, 1969) “cause the acquired company’s stockholders to own a larger portion of the combined entity” (Larson and Gonedes, 1969) The acquiring firm usually compensates the stockholders of the acquired firm by setting the exchange ratio higher than the expected market ratio, paying a premium on the acquired stocks.
The more the acquiring firm whishes to control the new firm, for instance by removing the acquired firm’s management, the higher the premium it usually has to pay. Problem Definition: The real exchange ratio ER can be defined as: ER=MER(T)*MP Source: own representation modeled after: (Gilson and Escalle, 1998) Where: MER(T) is the market exchange ratio of the two stocks on the day of the merger T before the merger announcement. MP is the merger premium multiplier paid by the acquiring firm. Therefore in order to estimate the exchange ratio E(ER) of the Chemical-Chase merger the following economical variables have to be estimated:
The expected market exchange ratio E(MER(T)). The expected market premium multiplier E(MP). The Expected Market Exchange Ratio: Under the efficient market assumption the future allocation of the merger’s gains/losses is reflected in the present stock price, the ratio between the Chemical and Chase stock prices right before the exchange ratio announcement will therefore reflect the expected exchange ratio. In practice speculation over mergers often leads to “abnormal returns during announcement period” (Mitchell et al, 2004) which would lead to a biased market exchange ratio expectation.
Another way to determine the exchange ratio is to use a stochastic model to first assess the post- merger wealth allocation based on the current assets and liabilities of the two firms and to fix the exchange ratio accordingly (Giacomelli, 2008) For the purpose of this study we will use the simplified assumption that the stock ratio before the exchange ratio announcement and the expected exchange ratio don’t differ. Furthermore since the last available data on the stock prices is the 31sth of July we will use this day’s exchange ratio to estimate the market exchange ratio on the day of the merger.
The Acquiring Premium: Without pertinent information a possible way to estimate the premium multiplier is to look at the previous mergers in the same period, as shown in Table 1: Table 3 Banks merger premium multipliers in the US during 1995 TargetAcquiring bankMerger Value ($ bil. )Market Premium Multiplier First UnionFirst Fidelity5. 41. 3 First ChicagoNBD5. 31. 1 Fleet Shawmut3. 71. 5 PNCMidantic21,3 US BancorpWest One21. 4 NABMichigan National1. 91. 2 BoatmensFourth Financial1. 81. 1
Source: own representation modeled after: (Comsa et al, 2002) Derived from the above table, the market premium multiplier should vary between 1. 1 and 1. 5, with an average value of 1. 26. In this case more precise information are provided on how to calculate the expected merger premium multiplier; even so the above collected data is still useful as a reality check once the proposed solution has been computed. In the case study (Gilson and Escalle, 1998) there are various indications that the possible returns/losses of the merger should be divided equally between the two firms, the most pertinent being: The desire of the senior management … was to structure the deal so that shareholders and employees … would share equally in both the rewards and the risks of the merger. ” Assuming this is the case then the merger premium multiplier will automatically be enclosed in the solution obtained by equally dividing the expected merger gains/losses between the two firms and rebalancing their stock prices to reflect the new wealth allocation. In order to solve the problem in this way, the expected gains/losses of the merger have to be estimated.
The Expected Value Added of the Merger: Under the standard market efficiency assumption, the expected value of the merger can be derived by comparing the difference in the stock price of the two banks before and after the merger’s proposition were made public. The added/lost stock value should then reflect the expected gains/losses per stock of the merge . In the case study (Gilson and Escalle, 1998) the following reference was found as to when the merging proposition started: “Takeover speculation intensified in April 1995 …. “.
The last available data before the merger is the 31sth of July, the last available data before the merger speculation was made known is the 31sth of march; the difference between those two stock prices for both companies will therefore be used as a proxy for the gains/losses per stock expected on the market once the merger prospective becomes common knowledge. Since in the same period of time Chase started a stock enhancement program named “Focus” (Gilson and Escalle, 1998), Focuses value has to be estimated and subtracted from the estimated merger value.
The Expected Value Added of the Focus Program: The “Focus” program was announced in June, therefore using the same mechanism that was applied to the expected value of the merger, the difference between the Chase stock price on the 31sth of June and of March was used to estimate the expected value per stock of the program, the 31sth of March was chosen to remain consistent with the time interval used for the expected value of the merger calculation. Proposed Solution: The expected market exchange ratio ER was:
E(ER(07/31))=(S” ” Chase (07/31))/(S Chemical (07/31))=53. 630$/51. 630$? 1. 039 Source: own calculation modeled from Exhibit 12: (Gilson and Escalle, 1998) The estimated expected value added of the merger E(M) was: E(M)=N Chemical*? S Chemical+N Chase*? S Chase=244. 5 mil. *(51. 63$-37. 75$)+ 181. 2 mil. *(53. 63$-35. 63$)? 3. 39366 bil. +3. 21616$ bil. =E(Chemical)+ E (Chase)= 6. 65526$ bil. Source: own calculation modeled from Exhibit 6, 12: (Gilson and Escalle, 1998) The estimated expected the value of the “Focus” program was: E(F)=N Chase*?
S Chase=181. 2 mil. *(47$-35. 63$)= 2. 060244$ bil. Source: own calculation modeled from Exhibit 6, 12: (Gilson and Escalle, 1998) The estimated exchange ratio ER, assuming the merger rewards/risks were evenly split, was: E(ER)=(S Chase (03/31)+[(E(M)-E(F))/2+E(F) ]/(N Chase))/(N Chemical*S Chemical (03/31)+[(E(M)-E(F))/2]/(N Chemical))? 59. 68$/47. 15$? 1. 266 Source: own calculation modeled from Exhibit 6, 12: (Gilson and Escalle, 1998) The expected merger premium multiplier E(MP) is: E(MP)=(E(ER))/(E(MER))=1. 266/1. 039 ? . 22 Source: own calculation This value seems reasonable if compared with the yearly average of 1. 26, however it looks a little too high if compared to the only other merger of equals in 1995 between First Chicago and NDB with a multiplier of 1. 1. Ex-Post Analysis: The market expectation was that Chemical would profit more from the merger than Chase, observable by the overvalued Chemical and undervalued Chase stock prices under the equal division of gains assumption. Since the real exchange rate was afterwards fixed at 1. 4 and the merger premium multiplier paid was 1. 1 (Comsa et al, 2002) the market was probably right. Literature Berger, N. A. , Humphrey, D. B. (1994). „Bank Sale Economies, Mergers, Concentration and Efficiency”. Working paper 94-25, Wharton School Centre for Financial Institutions, University of Pennsylvania. Brealey, R. A. , Myers, S. C. (2003). „Corporate Finance: Capital Investment and Valuation”. New-York: McGraw-Hill. Brewer, E. I. , Jackson III, W. E. , Jagtiani, J. A. , & Nguyen, T. (2000). “The Price of Bank Mergers in the 1990’s”.
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