MF0011 Slides Unit 04

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 and
Conglomerate 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 for
careful 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 the
costs of the merger including the payment of premium.
Introduction
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The Concept of Synergy
Where,
Value of firm A is V
A

Value of firm B is V
B
, and
Combined value of the firm is V
AB
And 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 where
2 + 2 = 5.
Value
of Firm
A
Value
of Firm
B
Value of
Synergy
Value of
Combined
Firm

VAB = VA + VB + VAB
V
AB
=V
A
+ V
B
+ V
AB

Or
V
AB
= V
AB
(V
A
+ V
B
)
It is clear from the above equation that, V
AB
will be positive
only when:
V
AB
= V
A
+ V
B
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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 = V
AB
(Cash paid V
B
)
Or, Net gain = [V
AB
(V
A
+ V
B
)] (Cash paid V
B
)
Net Gain = Value of Synergy Cost of Merger
Gain = Economic Advantage = Value of Synergy
Click here for an illustration on
calculation of the value of
synergy, cost and new gain
from 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 to
the firms independently.

Synergy

Operating Synergy
Economies of Scale
Greater Pricing Power
Higher Strength
Combination of Different
Functional Strengths

Financial Synergy

Managerial Synergy
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asdad
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Types of Synergy: Operating Synergy
Synergies that enable companies to raise their operating income from existing
assets, increased growth or both are referred to as operating synergies.
Economies of
Scale
Enables the combined firm to become more cost efficient and
profitable. Economies of scales can be seen in mergers of
firms in the same business (horizontal mergers).
Greater Pricing
Power
Greater pricing power resulting from reduced competition
and greater market share should lead to higher profit
margins and operating income.
Higher Growth
Higher growth in existing or new markets can result from a
merger.
Combination of
Different Financial
Strengths
Combination of different functional strengths may enhance
the revenue and net income of the merged entity. The
phenomenon can be understood in cases where one
company with an established brand name lends its
reputation to a company with a great new product. The latter
has products of great potential but lacks the power to
capture market and tackle competition. The merger in such a
case is a win-win for both.
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Types of Synergy: Operating Synergy
(Cont.)
Economies of
Scale: Example
HDFC banks merger with Centurion Bank of Punjab is an
example of cost reduction through economies of scale. The
merged bank can be expected to cut costs considerably on
an account of sharing of resources and avoiding duplication
of facilities.
Greater Pricing
Power: Example
Limiting competition to increase pricing power is the
acquisition of Universal Luggage by Blow Plast. The two
companies were in the same line of business and were in
direct competition with each other leading to a severe price
war and increased marketing costs. After the acquisition
Blow Plast acquired a stronghold on the market and created
near monopoly situation.
Higher Growth:
Example
When a firm with an established distribution network and
brand name recognition acquires an emerging market firm,
and uses these strengths to increase sales of its products.
Combination of
Different Financial
Strengths:
Example
Consider a situation where there are two firms A and B. Firm
A has substantial surplus cash to be invested while firm B
has profitable investment opportunities but no cash. If A and
B merge, both can utilise each others strengths. A can
invest 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 of
capital or both, give rise to financial synergies.
When two firms combine, of which one has surplus cash but no
investment opportunities and the other has excellent investment
opportunities but is facing a cash crunch, the combination can result
in higher value for the combined firm from the profitable investment
projects that can be invested in with the surplus cash.
One with Surplus
Cash and Other with
Cash Crunch
When firms with wide variation in monthly earnings merge, the
combined firm may experience much lower variation and become less
risky. It will then be perceived as a safer investment and have
increased debt capacity. This, in turn, allows the combined firm to
borrow more than the individual firms could have. The lower after-tax
cost of debt reduces cost of capital for the combined firm.
Reduction in
variability of
Earnings
By writing up the target firms assets or using net operating losses to
shelter income, tax benefits can be reaped. Thus, a profitable
company that takes over a loss-making company may reduce its tax
burden by using the net operating losses of the latter. Hence, the
present value of the tax savings resulting from this merger is the
value of the synergy.
Shelter Income to
Reap Tax Benefits
Types of Synergy: Managerial Synergy
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Click here for an example
of Managerial Synergy
These synergies are typically gained when competitively relevant skills that
were possessed by managers in the formerly independent companies or
business units can be transferred successfully between units within the
newly formed firm.
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Role of Industry Life Cycle
Fragmentation
Stage
In the first
stage, the new
industry
develops the
business.
Shake-out
Here, the
competitors
begin realising
business
opportunities in
the emerging
industry.
Maturity
At this stage, the
dominant
business models
efficiency gives
companies a
competitive
advantage over
competition
Decline
It is a stage at
which there is
possibility of a
war of slow
destruction
between
businesses
resulting in the
failure of those
with heavy
bureaucracies.
Click here for a detailed explanation
on the activities in different stages
of the industry life cycle
Synergy is not created automatically, it requires a lot of work on part of
managers 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
Strategic
Compatibility
Organizational
Compatibility
Managerial
Actions
Value Creation
When all the four exist then the chances of the firm being able to create synergy
are substantially higher.
Building Blocks for Creation of Synergy
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Creating Synergy: Strategic
Compatibility
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.
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Creating Synergy: Organisational
Compatibility
Organisational compatibility occurs when two organisations have similar
management processes, cultures, systems and structures.

Organisational compatibility from an operational point of view suggests that
the integration processes that are developed and used to combine the
operations can be expected to bring about desired results effectively and
efficiently.
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Creating Synergy: Managerial Actions
The third building block for the creation of synergy is related to the actions
and initiatives that managers take for their firms to actually realise
the competitive benefits.

Creation of synergy requires active involvement and participation of the
management.

Managers must recognise the importance and magnitude of integration
issues and the need to involve human resources in implementing a
combination.
Creating Synergy: Value Creation
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The focus here is on deriving benefits from synergy in excess of the costs to
be incurred.
Studies have shown that in the last two decades, premiums paid for acquired firms
have averaged between 40% and 50%.
Value creation
involves
controlling costs
associated with:
Financing of the transaction
Premium paid for purchase. (Premiums sometimes exceed
the market value of the target firm by 100% or more. )
Value Creation in
Horizontal,
Vertical and
Conglomerate
Mergers involves
controlling of
costs associated
with:
Purchasing Premium
Financing of the transaction
Implementation actions to integrate the acquired unit into
the existing organisational structure.
Forces Contributing to Mergers and
Acquisitions
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Mergers and acquisitions have become more popular in the era of increased
competition, free flow of capital across geographical boundaries and
globalisation of business.
Safeguarding the sources of raw material
Achieving economies of scale by combining production facilities through efficient
utilisation of resources
Standardizing product specifications and improving product quality
Achieving 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 asset
backing
Reducing tax liability because of the provision of setting off accumulated losses and
unabsorbed 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 understanding
of the reasons and rationale behind business combinations.
Synergistic gain depends on so many factors that it is a challenge for the
combining organisations to contend with each of these. This is the reason that
many 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 of
organisations 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 more
than the sum of the values of individual firms. (True/False)
2. Operating synergy means increasing the operating income from existing
assets. (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 investing
opportunities financial synergy results. (True/False)
6. Operating synergies include economies of sale, increased pricing power,
higher growth potential and affect the operations of the combined
companies. (True/False)
7. Tax benefits, a higher debt capacity and diversification are part of financial
synergies. (True/False)
8. Merger of HDFC bank with Centurion bank of Punjab is an example of cost
reducing financial synergy. (True/False)

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9. During the shake-out stage, competitors start to realise business
opportunities in the ____________.
10.In the stage of maturity the competition in the industry is rather
___________ because there are many competitors and product substitutes.
11.The creation of _______________ is not automatic.
12.Synergy may arise from enhanced _____________.
13.Mergers between two firms having different functional strengths can create
_____________.
14.Value creation means the ___________ of the synergy must exceed the
costs.
15.M & A decisions are an important part of the firm's overall ___________.
16.M & A enhances ______________ of the combined entity on better and
enhanced asset backing.
Check Your Learning
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:

Question
Discuss the strategy of LDFO.

Hint answer:
LDFO creates synergy under cluster-based
marketing strategy. LDFO encompasses different
product categories like menswear, ladies wear,
kids wear, shawls, home furnishings and
accessories and member brands.
Click on the icon besides, to analyse
three mini-cases on Synergy and
Value Creation in Mergers

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