Synergies and Valuation

Synergies and Valuation
Determining the Synergy from an

Acquisition
• Most acquisitions fail to create value for the acquirer.
• The main reason why they do not lies in failures to
integrate two companies after a merger.
• Intellectual capital often walks out the door when
acquisitions aren't handled carefully.
• Traditionally, acquisitions deliver value when they
allow for scale economies or market power, better
products and services in the market, or learning from
the new firms.
Synergy
• Suppose firm A is contemplating acquiring firm B.
• The synergy from the acquisition is
Synergy = VAB – (VA + VB)
• The synergy of an acquisition can be determined
from the usual discounted cash flow model:
S
DCFt
T
Synergy = (1 + r)t
t=1
where
DCFt = DRevt – DCostst – DTaxest – DCapital Requirementst
Source of Synergy from Acquisitions
• Revenue Enhancement
• Marketing gains
• Strategic benefits
• Market or monopoly power
• Cost Reduction
• Economies of scale
• Economies of vertical integration
• Complementary resources
• Replacement of ineffective managers.
Source of Synergy from Acquisitions
• Tax Gains
• Net operating losses
• Unused debt capacity
• Surplus funds
• Incremental new investment required in working
capital and fixed assets
DCFt = DRevt – DCostst – DTaxest – DCapital Requirementst

Calculating the Value of the Firm after
an Acquisition
• Avoiding Mistakes
• Do not Ignore Market Values
• Estimate only Incremental Cash Flows
• Use the Correct Discount Rate
• Don’t Forget Transactions Costs
A Cost to Stockholders from
Reduction in Risk
• The Base Case

• If two all-equity firms merge, there is no transfer of
synergies to bondholders, but if…
• One Firm has Debt
• The value of the levered shareholder’s call option falls.
• How Can Shareholders Reduce their Losses from the
Coinsurance Effect?
• Retire debt pre-merger.
Two "Bad" Reasons for Mergers
• Earnings Growth
• Only an accounting illusion.
• Diversification
• Shareholders who wish to diversify can accomplish this at
much lower cost with one phone call to their broker than
can management with a takeover.
The NPV of a Merger
• Typically, a firm would use NPV analysis when

making acquisitions.
• The analysis is straightforward with a cash offer, but
gets complicated when the consideration is stock.
The NPV of a Merger: Cash
NPV of merger to acquirer = Synergy – Premium
Synergy  VAB  (VA  VB )
Premium = Price paid for B - VB
NPV of merger to acquirer = Synergy - Premium

 VAB  (VA  VB )  [Price paid for B  VB ]
 VAB  VA  VB  Price paid for B  VB

 VAB  VA  Price paid for B
The Ingredients that determine value.
Estimating Cash Flows
Expected Growth
Expected Growth
Net Income Operating Income
Retention Ratio= Return on Equity Reinvestment Return on Capital =

1 - Dividends/Net X Net Income/Book Value of Rate = (Net Cap X EBIT(1-t)/Book Value of
Income Equity Ex + Chg in Capital
WC/EBIT(1-t)
Ways of changing value…
Are y ou investing op timally for
future growth? Is there scop e for more
efficient utilization of
Growth from new investments Efficiency Growth exsting assets?
How well do y ou manage y our Growth created by making new Growth generated by
existing investments/assets? investments; function of amount and using existing assets
quality of investments better
Cashflows from existing assets

Cashflows before debt p ay ments,
but after taxes and reinvestment to Exp ected Growth during high growth p eriod
Stable growth firm,
maintain exising assets with no or very
limited excess returns
Length of the high growth period
Since value creating growth requires excess returns,
Are y ou building on y our
comp etitive advantages? this is a function of
- M agnitude of comp etitive advantages
- Sustainability of comp etitive advantages
Cost of capital to apply to discounting cashflows

Are y ou using the right Determined by
amount and kind of - Op erating risk of the comp any
debt for y our firm? - Default risk of the comp any
- M ix of debt and equity used in financing
The NPV of a Merger: Common Stock
• The analysis gets muddied up because we need to
consider the post-merger value of those shares we’re
giving away.
Target firm payout    New firm value
New shares issued


Old shares  New shares issued
Cash versus Common Stock
• Overvaluation
• If the target firm shares are too pricey to buy with cash,
then go with stock.
• Taxes
• Cash acquisitions usually trigger taxes.
• Stock acquisitions are usually tax-free.
• Sharing Gains from the Merger
• With a cash transaction, the target firm shareholders are
not entitled to any downstream synergies.

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Synergies and Valuation

Determining the Synergy from an

DCFt = DRevt – DCostst – DTaxest – DCapital Requirementst

• The Base Case

• Typically, a firm would use NPV analysis when

Synergy  VAB  (VA  VB )

Premium = Price paid for B - VB

NPV of merger to acquirer = Synergy - Premium

 VAB  VA  VB  Price paid for B  VB

Net Income Operating Income

Retention Ratio= Return on Equity Reinvestment Return on Capital =

Cashflows from existing assets

Cost of capital to apply to discounting cashflows

Target firm payout    New firm value

New shares issued

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