Mergers and Diversification

Elsewhere in our book, we discuss mergers and acquisitions. There we mention that diversification is frequently cited as a reason for two firms to merge. Is diversification a good reason to merge? It might seem so. After all, in an earlier chapter, we spent a lot of time explaining why diversification is very valuable for investors in their own portfolios because of the elimination of unsystematic risk.

To investigate this issue, let's consider two companies, Sunshine Swimwear (SS) and Polar Winterwear (PW). For obvious reasons, both companies have very seasonal cash flows, and, in their respective off-seasons, both companies worry about cash flow. If the two companies were to merge, the combined company would have a much more stable cash flow. In other words, a merger would diversify away some of the seasonal variation and, in fact, would make bankruptcy much less likely.

Notice that the operations of the two firms are very different, so the proposed merger is a purely "financial" merger, which means that there are no "synergies" or other value-creating possibilities except, possibly, gains from risk reduction. Here is some pre-merger information:

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