Synergies in M&A

P.V. Viswanath

Class Notes for FIN 648: Mergers and Acquisitions

 Framework for Synergy Analysis

 Synergies can be thought of as bundles of two

types:

 Vsynergies = Vin-place-synergies + VReal-option-synergies

 Parallels the decomposition of firm value into

“assets-in-pace” and “growth options.”

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 Synergies in Place

n
FCFt
VFirm 
t 0 (1  WACC)
t

 This formula implies that synergies in place can

arise from improvements in any of the Free Cash
Flow components or in WACC.
 Implied in FCF or WACC are improvements in
timing.

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 Sources of Synergies in Place

 Revenue Enhancement Synergies

 For example, the new firm may sell more product than the existing
firms would have sold independently – perhaps because of a more
efficient marketing force or because of cross-branding.
 Cost Reduction Synergies
 Economies of scale from higher capacity utilization of existing P&E
 Greater purchasing power vis-à-vis suppliers
 Elimination of intermediaries in a supply chain
 Improvement in logistics and distribution
 Closing the targets’ headquarters
 Transfer of technology or know-how from one firm to the other.

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 Sources of Synergies in Place

 Asset Reduction Synergies

 Disposal of idle assets, such as a redundant headquarters building,
unused plant capacity, excess inventories, receivables, or cash
balances. These are typically one-shot benefits, and so it is useful to
separate them from the cost reduction synergies that might be
associated with these asset reduction synergies
 Tax Reduction Synergies
 Exploitation of increase in depreciation tax shields deriving from the
step-up in basis following a purchase transaction.
 Transfer of Net Operating Losses from a target to a buyer through
merger or acquisition.
 Financial Synergies
 Reducing WACC by Optimizing the Use of Debt Tax Shields (?)
 Coinsurance Effects

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 Optimizing WACC

WACC

Optimum
Debt/(Debt+Equity)

 Caution: Investors may be able to optimize WACC on their

own, through homemade leverage

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 Coinsurance Effects

WACC

Optimum for Newco as Optimum for Newco

simple sum of two showing effects of co-
stand-alone firms insurance

Debt/(Debt+Equity)

 Combination of the buyer and seller could cause the WACC

curve to shift in advantageous ways
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 Real Option Synergies

 Growth option synergies

 Combination of resources in a transaction that creates the right to
grow, but not the obligation. For example, the matching of licenses
to enter new markets with the resources to do so.
 Exit option synergies
 The combined company might be more flexible and be able to move
out of current strategies and into new ones in response to evolving
conditions.
 Options to defer
 The combined firm might have greater flexibility in waiting on
developing a new technology, perhaps by incumbency advantages.
 Options to alter operating scale
 The new firm could exit or enter a business more readily.

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 Real Option Synergies

 Options to switch
 The combined firm might be able to switch production
from large plants to smaller plants as required
 To switch production from one plant in a given high cost
location (country) to another in response to changing
labor costs or exchange rates.
 To change the mix of inputs or outputs of the firm, or its
processes.
 To switch from one source of supply to another.

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 Estimating Synergy Value

 Discount synergistic improvements in FCF at the correct

discount rate.
 Keep in mind
 Factor in tax effects
 Choose a discount rate consistent with the risk of the synergy
 Reflect inflation, real growth and a reasonable life.
 Use a Terminal Value to reflect extended life of synergies.
 Perform Sensitivity Analysis

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 Estimating the impact of a lower WACC

 Suppose Va is the pre-acquisition value of the

acquirer and Vt, the pre-acquisition value of the
target.
 Suppose ra and rt are the corresponding WACCs.
 Suppose the WACC of the combined firm is rc.
 The value of the change in WACC can be estimated
as [raVa+rtVt) – rc(Va+Vt)]/rc

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 Impact of a lower WACC: Example

 Va = $800m., Vt = $400m.
 ra = 10%; rt = 12%.
 With no synergies, the WACC of the combined firm is
(8/12)(10%) + (4/12)(12%) = 10.67%
 Suppose the WACC of the combined firm is 10.25%.
 The savings are [(800)(.1) + (400)(.12) –
(.1025)(1200)]/0.1025 = $48.78m.

 Q: Why does the WACC change?

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 Valuing Real Option Synergies

 Sirius Technologies, a manufacturer of PDAs, is looking to

buy Leonid Co. Leonid is working on a technology that
would allow PDAs to measure body temperatures and pulse
rates. Sirius estimates the PV of cash flows from this new
technology to be $388 million. Leonid is 8 months away
from bringing this technology to market. To launch the
product, Sirius would need to spend $272m. The new
technology could give Sirius a first mover advantage, but it
could be easily copied by competitors. He thinks the
projected $871 in cashflows may have a s.d. of 90%.
 If the risk-free rate is 4.5%, what is the value of the
technology?

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 Valuing Real Option Synergies

 This could be thought of as an option on uncertain product

development activities, and valued as a European option.
 Underlying asset value: $388m.
 Exercise price: $272m.
 Term: 0.667 years
 Volatility: 90%
 Risk-free rate: 4.5%

 This yields a Black-Scholes value of $167.3m.

 Q: What makes this a real option synergy?

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