A well-designed merger can offer operational synergy, a competitive edge or cost savings to the post-merger organization. On the other hand, unstrategic mergers often don't create a true economic gain for the company. Financial managers can use the bootstrap game to create a false appearance of economic gain from merger. However, the bootstrap effect generally becomes apparent after a few years.
The Bootstrap Game
The bootstrap game refers to a merger that has no economic benefits to a company. Despite the fact that these mergers have no economic benefit, a bootstrap game merger can still produce increased earnings per share. Financial experts contend that the "bootstrap effect" occurs when earnings per share rise while there is no real gain created by the merger, and the combined value of the two firms is equal to the sum of the separate values.
How It Works
The bootstrap game can produce increased earnings per share despite no economic benefit because of the exchange of stock involved in the merger. For example, consider two companies with 100 shares that have the same earnings per share ratio. If there is no exchange of stock, the ratio remains the same. However, if the acquiring company acquires the target company through stock, there will be fewer combined shares outstanding after the merger. Since earnings remain the same but there are fewer shares of stock, the earnings per share ratio increases favorably.
If financial managers play their cards right, the bootstrap game can increase the postmerger company stock price. Investors who aren't carefully watching the actions of the company may not understand why earnings per share has increased. Instead of identifying an artificial increase, investors may believe the earnings per share increased because of real growth and gain created through the merger. This in turn increases the value of the post-merger stock.
Companies that play the bootstrap game may garner a temporary boost in stock price. However, the bootstrap effect generally becomes apparent in future years. To keep the earnings-per-share ratio at an artificially high level, the company would have to continue to expand by merger at the same rate. Once the company stops mergers and expansions, earnings per share will decrease and the stock price along with it.