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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.

MF 0011 M & A i iti

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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.

MF 0011 M & A i iti

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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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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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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

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