OPTIMAL TIMING AND TERMS IN A VERTICAL MERGER WITH TWO SOURCES OF UNCERTAINTY

• Author: Sijia Zhang,Zhuming Chen,Tao Lin
• Date: 01 May 2020
• Published date: 01 May 2020
• DOI: http://doi.org/10.1111/jfir.12209

The Journal of Financial Research Vol. XLIII, No. 2 Pages 345–372 Summer 2020

DOI: 10.1111/jfir.12209

OPTIMAL TIMING AND TERMS IN A VERTICAL MERGER WITH TWO

SOURCES OF UNCERTAINTY

Zhuming Chen

Sun Yat‐sen University

Sijia Zhang

Credit Agricole Corporate and Investment Bank

Tao Lin

University of Hong Kong

Abstract

In this article we provide the optimal timing and equilibrium terms of a vertical

merger with two sources of uncertainty in the production chain, namely, marginal

cost of raw material and price level of final product. By eliminating monopoly power

and transaction cost in the production process between upstream and downstream

firms, a vertical merger can increase social welfare, which is consistent with the

literature. The optimal threshold of a vertical merger is negatively correlated with

transaction cost in the intermediate product market. Vertical mergers also accelerate

when merging provides natural hedging for the postmerger firm, that is, when the

correlation between the two uncertainties increases.

JEL Classification: D23, G13, G34

I. Introduction

Mergers and acquisitions (M&As) are important and efficient strategies for firms to use

to increase their capital, gain access to technology, and improve their competitiveness.

Mitchell and Mulherin (1996) demonstrate that they are the least costly means for firms

to respond to industry shocks. Although there is a considerable amount of research in

financial economics on M&As, including vertical mergers, how different factors affect

the optimal timing and equilibrium terms of vertical mergers remains unclear.

Transaction cost theory, which is one widely used approach to study vertical mergers,

suggests that eliminating transaction cost is an important incentive for vertical

integration. However, further theoretical work is required.

There are many examples demonstrating the benefit of lower transaction costs

and associated risks from vertical integration. For example, hot metal is produced in

blast furnaces and is used to make crude steel. Trading of hot metal in its liquid form at

about 2,500 degrees exists but is very rare. Vertical integration of the two processes

The authors thank Yan Zeng and an anonymous reviewer for the helpful suggestions.

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© 2020 The Southern Finance Association and the Southwestern Finance Association

can reduce the negotiation costs and exploitation risk between these tightly bound pairs

of buyers and sellers (Stuckey and White 1993).

Apart from reducing costs, vertical integration may enable firms to capture

more economic surplus. For example, high‐quality needle coke is the main material for

the production of large (super) high‐power graphite electrodes, which in turn are

needed in electric steelmaking. Because of increased market demand for high‐quality

steel in China, the demand for graphite electrodes and high‐quality needle coke has

gone up. At the same time, most domestic needle coke could not meet the quality

requirement in key performance measures.

In 2017, Fangda Carbon New Material Co. Ltd. (Fangda), a company that

produces graphite‐related products, acquired a 51% stake in C‐Chem (Jiangsu) Needle

Coke Technology Co. Ltd, a high‐quality needle coke producer whose production

technology and equipment plan are from Nippon Steel & Sumitomo Metal Corporation

(NSSMC), a world leader in the field and C‐Chem’s parent company at the time.

1

The

move allowed Fangda to expand into the upstream industry value chain, improve its

technical position, ensure a stable supply of high‐quality material, reduce reliance on

imports, and save on procurement costs.

In this article we extend the literature by building an equilibrium model to

study the impact of monopoly power and transaction cost on the timing and terms of a

vertical merger between upstream and downstream firms. In our model, the upstream

firm produces an intermediate product that the downstream firm uses as input to the

final product. The upstream firm has monopoly power to set the price of this

intermediate product, whereas the downstream firm faces perfect competition in the

final product market. A production transaction cost is involved in the intermediate

product market that has a constant component and a variable component proportional

to the sales of the intermediate product.

Based on Lambrecht (2004) and Tarsalewska (2015), we construct a real

option model in which the downstream firm has a permanent American call option to

merge with the upstream firm, and the upstream firm has an option to sell out. Our

model examines how the motivation of eliminating transaction cost and monopoly

power through vertical merger balances out the merger cost. Before the merger, the

monopolistic upstream firm sets the price above the economically efficient price,

which lowers the quantity of intermediate goods traded and consequently reduces final

output from the downstream firm. In addition, the transaction cost in the procurement

process further creates economic losses. Vertical integration allows the integrated firm

to capture bigger amount of economic surplus, which can be shared between the two

firms.

We also examine how comovement in different uncertainties affects the

merger decision. In our model, the upstream firm faces the random production cost of

the intermediate product, and the downstream firm faces the random price of the final

product. The two prices may correlate differently across industries. For example,

industries that require imports from other countries may have a lower correlation

1

Progress Report on C‐Chem share acquisition, Fangda Carbon Press Release No. 2017‐028.

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