Two large, publicly owned firms are contemplating a merger. No operating synergy is expected. However, since returns on the 2 firms are not perfectly positively correlated, the standard deviation of earnings would be reduced for the combined corporation. One group of consultants argues that this risk reduction is sufficient grounds for the merger. Another group thinks this type of risk reduction is irrelevant because stockholders can themselves hold the stock of both companies and thus gain the risk-reduction benefits without all the hassles and expenses of the merger. Whose position is correct?
The basis of merging the company because the combined company is not positively correlated is a good theory. In theory, the two stocks should always increase in value because either company A or B will always increase in value. This argument supports the idea of owning the individual stocks in a portfolio. Further, the cost of the merger will outweigh any gains obtained from the stocks not being perfectly correlated. ...
The solution examines risk reduction and mergers.