MERGERS & ACQUISITIONS

LECTURE 14,15
M&A SYNERGY
 Main content

 What is Synergy?
 Sources of Synergy
 Synergy Valuation
“Suppose you are running at 3 mph, but are required to run 4 mph
next year and 5 mph the year after. Synergy would mean running even
harder than this expectation while competitors supply a head wind.
Paying a premium for synergy – that is, for the right to run harder – is
like putting on a heavy pack. Meanwhile, the more you delay running
harder, the higher the incline is set. This is the acquisition game.”
MARK SIROWER, Boston Consulting Group

3
 What is synergy?
“Synergy is the additional value that is generated by
combining 2 firms, creating opportunities that would not
been available to these firms operating independently.”

---Damodaran---

Synergy
Operating synergies Financial synergies reason
is the
why
the acq
uirer
willing
to pa
premiu y
m
 Operating Synergy
 Operating synergies are those synergies that allow firms to increase their
operating income from existing assets, increase growth or both.

 Sources:
• Economies of scale (horizontal mergers)
• Greater pricing power
• Combination of different functional strengths
• Higher growth in new or existing markets
 Financial Synergy
 Financial synergies are synergies relate to improvement in the financial metric
of a combined business such as revenue, debt capacity, cost of capital,
profitability, etc.
 Sources:
• A combination of a firm with excess cash, or cash slack, (and limited project
opportunities) and a firm with high-return projects (and limited cash)
• Debt capacity increases
• Tax benefits
• Diversification
 Sources of Synergy
Synergy is created when two firms are combined and can be
either financial or operating

Operating Synergy accrues to the combined firm as Financial Synergy

Added Debt
Strategic Advantages Economies of Scale Tax Benefits Capacity Diversification?

Higher returns on More new More sustainable Cost Savings in Lower taxes on Higher debt May reduce
new investments Investments excess returns current operations earnings due to raito and lower cost of equity
- higher cost of capital for private or
depreciaiton closely held
- operating loss firm
Higher ROC Higher Reinvestment carryforwards
Longer Growth Higher Margin
Higher Growth Higher Growth Rate Period
Rate Higher Base-
year EBIT
 Synergy Valuation
• Generally, using DCF method:

Sy =

∆CF: additional Cash Flow

r: expected return of combined firm
A procedure for valuing synergy
(1) the firms involved in the merger are valued independently, by
discounting expected cash flows to each firm at the weighted average
cost of capital for that firm.
(2) the value of the combined firm, with no synergy, is obtained by
adding the values obtained for each firm in the first step.
(3) The effects of synergy are built into expected growth rates and
cashflows, and the combined firm is re-valued with synergy.
Value of Synergy = Value of the combined firm, with synergy
- Value of the combined firm, without synergy
 Example 1: Compaq and Digital
• In 1997, Compaq acquired Digital for $ 30 per share + 0.945 Compaq
shares for every Digital share. ($ 53-60 per share) The acquisition was
motivated by the belief that the combined firm would be able to find
investment opportunities and compete better than the firms
individually could.
 Background Data
Compaq Digital
Current EBIT $ 2,987 million $ 522 million
Current Revenues $25,484 mil $13,046 mil
Capital Expenditures - Depreciation $ 184 million $ 14
Expected growth rate -next 5 years 10% 10%
Expected growth rate after year 5 5%5%
Debt /(Debt + Equity) 10% 20%
After-tax cost of debt 5%5.25%
Beta for equity - next 5 years 1.25 1.25
Beta for equity - after year 5 1.00 1.0
Working Capital/Revenues 15% 15%
Tax rate is 36% for both companies
 Valuing Compaq
Year FCFF Terminal Value PV
1 $1,518.19 $1,354.47
2 $1,670.01 $1,329.24
3 $1,837.01 $1,304.49
4 $2,020.71 $1,280.19
5 $2,222.78 $56,654.81 $33,278.53
Terminal Year $2,832.74 $38,546.91
• Value of Compaq = $ 38,547 million
• After year 5, capital expenditures will be 110% of depreciation.
 Combined Firm Valuation
 The Combined firm will have some economies of scale, allowing it to increase its current operating
margin slightly. The dollar savings will be approximately $ 100 million.
• Current Operating Margin = (2987+522)/(25484+13046) = 9.11%
• New Operating Margin = (2987+522+100)/(25484+13046) = 9.36%

 The combined firm will also have a slightly higher growth rate of 10.50% over the next 5 years,
because of operating synergies.

 The beta of the combined firm is computed in two steps:

• Digital’s Unlevered Beta = 1.07; Compaq’s Unlevered Beta=1.17
• Digital’s Firm Value = 4.5; Compaq’s Firm Value = 38.6
• Unlevered Beta = 1.07 * (4.5/43.1) + 1.17 (38.6/43.1) = 1.16
• Combined Firm’s Debt/Equity Ratio = 13.64%
• New Levered Beta = 1.16 (1+(1-0.36)(.1364)) = 1.26
• Cost of Capital = 12.93% (.88) + 5% (.12) = 11.98%
 Combined Firm Valuation
Year FCFF Terminal Value PV
1 $1,726.65 $1,541.95
2 $1,907.95 $1,521.59
3 $2,108.28 $1,501.50
4 $2,329.65 $1,481.68
5 $2,574.26 $66,907.52 $39,463.87
Terminal Year $3,345.38
Value of Combined Firm = $ 45,511
 The Value of Synergy
• Value of Combined Firm wit Synergy = $45,511 million
• Value of Compaq + Value of Digital
= 38,547 + 4532 = $ 43,079 million
• Total Value of Synergy = $ 2,432 million
 Empirical Evidence on Synergy
• If synergy is perceived to exist in a takeover, the value of the
combined firm should be greater than the sum of the values of the
bidding and target firms, operating independently.
V(AB) > V(A) + V(B)
• Bradley, Desai and Kim (1988) use a sample of 236 inter-firm tender
offers between 1963 and 1984 and report that the combined value of
the target and bidder firms increases 7.48% ($117 million in 1984
dollars), on average, on the announcement of the merger.
• Operating synergy was the primary motive in one-third of hostile
takeovers. (Bhide,1993)
 Operational Evidence on Synergy
o A stronger test of synergy is to evaluate whether merged firms improve their performance
(profitability and growth), relative to their competitors, after takeovers.
o McKinsey&Co examined 58 acquisition programs between 1972 and 1983 for evidence on 2
questions:
• Did the return on the amount invested in the acquisitions exceed the cost of capital?
• Did the acquisitions help the parent companies outperform the competition?
They concluded that 28 of the 58 programs failed both tests, and 6 failed one test.
o KPMG in a more recent study of global acquisitions concludes that most mergers (>80%) fail - the
merged companies do worse than their peer group.
o Large number of acquisitions that are reversed within fairly short time periods. bout 20.2% of
the acquisitions made between 1982 and 1986 were divested by 1988. In studies that have
tracked acquisitions for longer time periods (ten years or more) the divestiture rate of
acquisitions rises to almost 50%.
 Who gets the benefits of synergy?
• In theory: The sharing of the benefits of synergy among the 2 players will depend in
large part on whether the bidding firm's contribution to the creation of the
synergy is unique or easily replaced.
• If it can be easily replaced, the synergy benefits will accrue to the target firm.
• If it is unique, the sharing of benefits will be much more equitable.

• In practice: Target company stockholders walk away with the bulk of the gains.
Bradley, Desai and Kim (1988) conclude that the benefits of synergy accrue
primarily to the target firms when there are multiple bidders involved in the
takeover. They estimate that the market-adjusted stock returns around the
announcement of the takeover for the successful bidder to be 2%, in single bidder
takeovers, and -1.33%, in contested takeovers.
 Why is it so difficult to get synergy?
• Synergy is often used as a plug variable in acquisitions: it is the difference between
the price paid and the estimated value.
• Even when synergy is valued, the valuations are incomplete and cursory. Some
common manifestations include:
o Valuing just the target company for synergy (You have to value the combined firm)
o Not thinking about the costs of delivering synergy and the timing of gains.
o Underestimating the difficulty of getting two organizaitons (with different cultures) to work
together.
• Failure to plan for synergy. Synergy does not show up by accident.
• Failure to hold anyone responsible for delivering the synergy.
 Closing Thoughts
• If an acquisition is motivated by synergy, make a realistic estimate of the value of
the synergy, taking into account the difficulties associated with combining the
two organizations and other costs.
• Do not pay this value as a premium on the acquisition. Your objective is to pay
less and share in the gains. If you get into a bidding war and find you have to pay
more, drop out.
• Have a detailed plan for how the synergy will actually be created and hold
someone responsible for it.
• Follow up the merger to ensure that the promised gains actually get delivered.
• Do not trust your investment bankers or anyone else in the deal to look out for
your interests; they have their own. That is your job!
CHAPTER SUMMARY

 What is Synergy?
 Sources of Synergy
 Synergy Valuation