The theory of mergers and divestitures is developed in this article. This theory does not depend on taxes or the buyer's huge surpluses. The inability of short-term projects or marginally profitable enterprises to finance themselves as independent entities due to agency problems between managers and potential claimants is given as a reason for mergers. The good performance of the once marginally profitable projects allows them to be sold in the future. There are two preconditions for this theory to be applicable. The first states that one of the merging firms must be in financial difficulty and the other that there must be serious agency problems between the managers and beneficiaries of the distressed firm. Therefore this theory is more applicable to mergers where one of the merging firms faces cash flow verifiability and is small in size. Say no to plagiarism. Get a tailor-made essay on "Why Violent Video Games Shouldn't Be Banned"? Get an original essay It is well known that projects with positive net present value can be denied financing where cash flows can be manipulated by management. Marginally profitable firms are sometimes unable to support external capital because the manager's incentive constraint requires that he/she receive a cut of the project's cash flow. Therefore a merger can serve as an instrument through which such businesses can survive their period of difficulty since the merged entity can obtain full financing more easily than a stand-alone entity. According to the authors' theory and empirical evidence, shareholder value increases as mergers allow marginally profitable firms to obtain financing. However, this financial synergy may not persist. Once the project has reached a stage where it can raise funding on its own, there are coordination costs associated with mergers. This pushes companies to divest. This paper measures the vertical relationship between two merging firms using industry raw material flow information in the input-output table. A merger is classified as a vertical merger when one firm can use the services or products of others as inputs to its final production or its output is the input to the other firm. A significant positive wealth effect is generated through vertical mergers. During the 3 days surrounding the merger announcement, the combined average wealth effect is approximately 2.5%. The paper measures vertical correlation using a cross-industry vertical correlation coefficient. The merger is qualified as a vertical merger if the coefficient is greater than 1% (lenient criterion) or 5% (strict criterion). Furthermore, those companies that show vertical correlation with the lenient criteria (1%) and belong to different input-output sectors are identified by the author as pure vertical mergers. To measure the wealth effect of mergers, the authors use the value-weighted CRSP index as a market proxy.