Synergies in M

1
Synergies in MA

• P.V. Viswanath

Class Notes for EDHEC course on Mergers and
Acquisitions
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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

• 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 PE
• 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

• Caution Investors may be able to optimize WACC
  on their own, through homemade leverage

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Coinsurance Effects

• 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 raVartVt) rc(VaVt)/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?