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MF 0011 Mergers & Acquisitions
Unit 4 Synergy and Value Creation in Mergers
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Program : MBA
Semester : III
Subject Code : MF 0011
Subject Name : Mergers and Acquisitions
Unit Number : 4
Unit Title : Synergy and Value Creation in Mergers
Lecture Number :
Lecture Title : Synergy and Value Creation in Mergers
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Objectives:
After studying this unit, you should be able to:
Discuss the concept of Synergy
Explain different types of synergy
Describe the role of industry lifecycle
Discuss value creation in synergy
Discuss value Creation in Horizontal, Vertical andConglomerate Mergers
Describe the forces contributing to Mergers & Acquisitions
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Synergy and Value Creation in Mergers
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Introduction
Concept of Synergy Types of Synergy
Operating Synergy
Financial Synergy
Managerial Synergy
Role of Industry Life Cycle
Creating Synergy Strategic Compatibility
Organizational Compatibility
Managerial Actions
Value Creation
Forces Contributing to Mergers and Acquisitions
Summary
Glossary
Check Your Learning
Answers
Case Study
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Lecture Outline
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Identifying an acquisition opportunity and deciding upon it calls forcareful evaluation of its strategic fit with the rest of a companys
activities.
Here we shall look into the concept of synergy and its importance.
The benefits of synergy gained through a merger should exceed thecosts of the merger including the payment of premium.
Introduction
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The Concept of Synergy
Where,Value of firm A is VAValue of firm B is VB, andCombined value of the firm is VABAnd V
AB
is the value of synergy
Synergy refers to a situation where the combined value of a merger is more
than the sum of the values of merging firms. It is the phenomenon where2 + 2 = 5.
Valueof Firm
A
Valueof Firm
B
Value ofSynergy
Value ofCombined
Firm
VAB = VA+ VB+ VAB
VAB=VA+ VB+ VAB
OrVAB= VAB(VA+ VB)
It is clear from the above equation that, VABwill be positive
only when:
VAB= VA+ VB
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The Concept of Synergy (Cont.)
Synergy is also known as economic advantage or gain.
Mergers also involve cost, which is measured as cash paid for the
acquisition minus the value of the business acquired.
We now arrive at net gain or net economic advantage, and this is
calculated as:
Or, Net gain = VAB (Cash paid VB)
Or, Net gain = [VAB(VA+ VB)] (Cash paid VB)
Net Gain = Value of Synergy Cost of Merger
Gain = Economic Advantage = Value of Synergy
Click here for an illustration oncalculation of the value of
synergy, cost and new gainfrom merger
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Types of Synergy
Synergy is the additional value that is generated by the combination of two
or more than two firms creating opportunities that would not be available tothe firms independently.
Synergy
Operating Synergy
Economies of Scale
Greater Pricing Power
Higher Strength
Combination of DifferentFunctional Strengths
Financial Synergy
Managerial Synergy
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Types of Synergy: Operating Synergy
Synergies that enable companies to raise their operating income from existingassets, increased growth or both are referred to as operating synergies.
Economies ofScale
Enables the combined firm to become more cost efficient andprofitable. Economies of scales can be seen in mergers offirms in the same business (horizontal mergers).
Greater Pricing
Power
Greater pricing power resulting from reduced competitionand greater market share should lead to higher profit
margins and operating income.
Higher GrowthHigher growth in existing or new markets can result from amerger.
Combination ofDifferent FinancialStrengths
Combination of different functional strengths may enhancethe revenue and net income of the merged entity. The
phenomenon can be understood in cases where onecompany with an established brand name lends itsreputation to a company with a great new product. The latterhas products of great potential but lacks the power tocapture market and tackle competition. The merger in such acase is a win-win for both.
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Types of Synergy: Operating Synergy(Cont.)
Economies ofScale: Example
HDFC banks merger with Centurion Bank of Punjab is an
example of cost reduction through economies of scale. Themerged bank can be expected to cut costs considerably onan account of sharing of resources and avoiding duplicationof facilities.
Greater Pricing
Power: Example
Limiting competition to increase pricing power is theacquisition of Universal Luggage by Blow Plast. The twocompanies were in the same line of business and were in
direct competition with each other leading to a severe pricewar and increased marketing costs. After the acquisitionBlow Plast acquired a stronghold on the market and creatednear monopoly situation.
Higher Growth:Example
When a firm with an established distribution network andbrand name recognition acquires an emerging market firm,and uses these strengths to increase sales of its products.
Combination ofDifferent Financial
Strengths:Example
Consider a situation where there are two firms A and B. FirmA has substantial surplus cash to be invested while firm Bhas profitable investment opportunities but no cash. If A andB merge, both can utilise each others strengths. A caninvest in the opportunities available to B.
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Types of Synergy: Financial Synergy
Benefits that are in the form of either greater cash flows or a lower cost ofcapital or both, give rise to financial synergies.
When two firms combine, of which one has surplus cash but noinvestment opportunities and the other has excellent investmentopportunities but is facing a cash crunch, the combination can resultin higher value for the combined firm from the profitable investmentprojects that can be invested in with the surplus cash.
One with SurplusCash and Other with
Cash Crunch
When firms with wide variation in monthly earnings merge, thecombined firm may experience much lower variation and become lessrisky. It will then be perceived as a safer investment and haveincreased debt capacity. This, in turn, allows the combined firm toborrow more than the individual firms could have. The lower after-taxcost of debt reduces cost of capital for the combined firm.
Reduction invariability of
Earnings
By writing up the target firms assets or using net operating losses toshelter income, tax benefits can be reaped. Thus, a profitablecompany that takes over a loss-making company may reduce its taxburden by using the net operating losses of the latter. Hence, thepresent value of the tax savings resulting from this merger is thevalue of the synergy.
Shelter Income toReap Tax Benefits
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Types of Synergy: Managerial Synergy
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Click here for an exampleof Managerial Synergy
These synergies are typically gained when competitively relevant skills thatwere possessed by managers in the formerly independent companies orbusiness units can be transferred successfully between units within thenewly formed firm.
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Role of Industry Life Cycle
FragmentationStage
In the firststage, the newindustrydevelops thebusiness.
Shake-out
Here, thecompetitorsbegin realisingbusinessopportunities inthe emergingindustry.
Maturity
At this stage, thedominantbusiness models
efficiency givescompanies acompetitiveadvantage overcompetition
Decline
It is a stage atwhich there ispossibility of awar of slowdestructionbetween
businessesresulting in thefailure of thosewith heavybureaucracies.
Click here for a detailed explanationon the activities in different stages
of the industry life cycle
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Synergy is not created automatically, it requires a lot of work on part ofmanagers at corporate and business levels
Does not require the material resources of the two companies Demands effective integration of human resources, physical assets and
operations
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Creating Synergy
Synergy
StrategicCompatibility
OrganizationalCompatibility
ManagerialActions
Value Creation
When all the four exist then the chances of the firm being able to create synergyare substantially higher.
Building Blocks for Creation of Synergy
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Creating Synergy: StrategicCompatibility
Strategic compatibility refers to the matching of organisations strategic
capabilities.
There are various ways in which capabilities can be matched through a
merger.
When combined firms or business organisations are both strong and/or
weak in the same business activities, the newly created combined firm
displays the same capabilities (or lack of capabilities), although the
magnitude of the strength or weakness is greater, and no synergy
results.
MF 0011 M & A i i i
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Creating Synergy: OrganisationalCompatibility
Organisational compatibility occurs when two organisations have similarmanagement processes, cultures, systems and structures.
Organisational compatibility from an operational point of view suggests thatthe integration processes that are developed and used to combine theoperations can be expected to bring about desired results effectively andefficiently.
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Creating Synergy: Managerial Actions
The third building block for the creation of synergy is related to the actionsand initiatives that managers take for their firms to actually realisethe competitive benefits.
Creation of synergy requires active involvement and participation of themanagement.
Managers must recognise the importance and magnitude of integrationissues and the need to involve human resources in implementing acombination.
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Creating Synergy: Value Creation
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The focus here is on deriving benefits from synergy in excess of the costs tobe incurred.
Studies have shown that in the last two decades, premiums paid for acquired firmshave averaged between 40% and 50%.
Value creationinvolvescontrolling costsassociated with:
Financing of the transaction
Premium paid for purchase. (Premiums sometimes exceedthe market value of the target firm by 100% or more. )
Value Creation inHorizontal,Vertical andConglomerateMergers involvescontrolling ofcosts associatedwith:
Purchasing Premium
Financing of the transaction
Implementation actions to integrate the acquired unit intothe existing organisational structure.
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Forces Contributing to Mergers andAcquisitions
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Mergers and acquisitions have become more popular in the era of increasedcompetition, free flow of capital across geographical boundaries andglobalisation of business.
Safeguarding the sources of raw material
Achieving economies of scale by combining production facilities through efficientutilisation of resources
Standardizing product specifications and improving product qualityAchieving improved technical know-how from the combined entity to cut cost,improve quality and produce better products to retain and improve market share.
Reducing competition and protecting existing market
Obtaining new markets
Enhancing borrowing power of the combined entity on better and enhanced assetbacking
Reducing tax liability because of the provision of setting off accumulated losses andunabsorbed depreciation of one company against the profits of another
Achieving diversification
Offering enhanced satisfaction to consumers
Utilising under-utilised manpower
Reasons attributed to the rise in business combinations:
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MF 0011 Mergers & Acquisitions
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Summary
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The objective for any business combination is long-term growth and
sustainability. The combination must provide gain in terms of synergy, be it operational or
financial.
Synergy is a very important concept that gives insights into the understandingof the reasons and rationale behind business combinations.
Synergistic gain depends on so many factors that it is a challenge for thecombining organisations to contend with each of these. This is the reason thatmany mergers are not able to achieve what they set out to.
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MF 0011 Mergers & Acquisitions
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Glossary
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Synergy:Synergy refers to a situation where the combined value of a firm is
more than the sum of the values of individual firms
Strategic compatibility:Strategic compatibility refers to the matching oforganisations strategic capabilities.
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Check Your Learning
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1. Synergy refers to a situation where the combined value of a firm is morethan the sum of the values of individual firms. (True/False)
2. Operating synergy means increasing the operating income from existingassets. (True/ False)
3. Acquisition of Tomco by Hindustan Lever is a part of financial synergy.(True/False)
4. Synergy results from complementary activities. (True/False)
5. When a firm that has surplus funds merges with another with good investingopportunities financial synergy results. (True/False)
6. Operating synergies include economies of sale, increased pricing power,higher growth potential and affect the operations of the combinedcompanies. (True/False)
7. Tax benefits, a higher debt capacity and diversification are part of financialsynergies. (True/False)
8. Merger of HDFC bank with Centurion bank of Punjab is an example of costreducing financial synergy. (True/False)
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Answers
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1. True
2. True
3. False
4. True
5. True
6. True
7. True
8. False
9. Emerging industry
10. Aggressive
11. Synergy
12. Managerial capabilities
13. Operating synergy
14. Benefits
15. Corporate-level strategy
16. Borrowing power
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Case Study
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Answer the following questions, based on the
given case:
QuestionDiscuss the strategy of LDFO.
Hint answer:
LDFO creates synergy under cluster-basedmarketing strategy. LDFO encompasses differentproduct categories like menswear, ladies wear,kids wear, shawls, home furnishings andaccessories and member brands.
Click on the icon besides, to analysethree mini-cases on Synergy and
Value Creation in Mergers