344 Int. J. Financial Services Management, Vol. 2, No.

4, 2007

Identifying synergies ahead of mergers and

acquisitions

Dodo zu Knyphausen-Aufsess*
Otto-Friedrich University of Bamberg, Feldkirchenstrasse 21,
96045 Bamberg, Germany
E-mail: dodo.knyphausen@uni-bamberg.de
*Corresponding author

Jens Koeppen
AlixPartners GmbH, KoÈnigsallee 53-55, 40212 DuÈsseldorf, Germany
E-mail: jkoeppen@alixpartners.com

Lars Schweizer
Johann-Wolfgang-Goethe-University Frankfurt &
Grenoble Ecole de Management, Mertonstr. 17, D-60325
Frankfurt am Main, Germany
E-mail: l.schweizer@em.uni-frankfurt.de

Abstract: Most merger and acquisition activities destroy value. One reason
for this is that acquisition premiums tend to be too high in relation to the
synergies that motivated the premiums paid. In this paper, we illustrate the
performance implications of overstated synergies and develop a ten-step
reference model for the calculation of synergies in order to avoid
overestimating their potential. After that, we present three case studies in
which we assess how synergies are determined in practice and compare this
to our reference model.

Keywords: acquisition premium; mergers and acquisitions; synergies.

Reference to this paper should be made as follows: Knyphausen-Aufsess, D. zu,

Koeppen, J. and Schweizer, L. (2007) `Identifying synergies ahead of
mergers and acquisitions', Int. J. Financial Services Management, Vol. 2,
No. 4, pp.344±360.

Biographical notes: Dodo zu Knyphausen-Aufsess is a professor of Human

Resource Management and Organisation at the University of Bamberg,
Germany. His research interests are in strategic management, organisation
theory, corporate venture capital, venture capital and entrepreneurship, as
well as human resource management.

Jens Koeppen works as a consultant for AlixPartners. He has extensive

experience in restructuring situations and in delivering significant
performance improvement for clients in various industries with a focus
on set up and validating restructuring concepts, pre-merger studies,
financial analysis and modelling.

Copyright # 2007 Inderscience Enterprises Ltd.

 Identifying synergies ahead of mergers and acquisitions 345

Lars Schweizer holds the UBS-endowed Professorship for Management at

the Johann-Wolfgang-Goethe University in Frankfurt/Germany and is
visiting professor at Grenoble Ecole de Management in France. His research
interests are in strategic management, organisation theory, and M&A.

1 Introduction
Mergers and acquisitions (M&A) are a popular strategy for many firms and are
considered to be a key element of economic activity causing industrial change and
rationalisation in the modern industrial era (Jensen, 1993). However, failure rates of
M&A are reported as high as 50±75% (Marks and Mirvis, 1998) and many acquiring
companies paid far more than the market value for their purchases. To justify these
`acquisition premiums', they pointed to potential synergies they said they would reap
as the companies grew together (Brush, 1996; Harrison et al., 1991). However, the
realistic potential for synergies often falls short of these expectations (Chatterjee,
1986, 1992; Lubatkin, 1983; Ravenscraft and Scherer, 1989; Reed and Luffman,
1986; Sirower, 1997). Ex post, it therefore turns out that the purchase prices were too
high. This points to the important role the correct calculation of synergies is
supposed to play as a linking pin (Kode et al., 2003; Sirower and Stark, 2001)
between the M&A strategy (Bower, 2001; Trautwein, 1990), on the one hand, and the
subsequent post-acquisition integration phase (Haspeslagh and Jemison, 1991), on
the other hand.
The synergies calculated as a result of the applied M&A strategy during the
acquisition planning phase determine the necessary amount of synergy realisation,
e.g. either in terms of cost savings or revenue improvements. Thus, they have a
significant influence on the post-acquisition integration phase in which value creation
is supposed to take place (Haspeslagh and Jemison, 1991; Larsson and Finkelstein,
1999; Shrivastava, 1986). Because of that, synergy calculation can be considered as
one very important and indispensable step in the M&A process connecting M&A
strategy and post-acquisition integration.
However, the issue of synergy calculation is still considered to lack sufficient
empirical research. In this context, Javidan et al. (2004, p.254) ask the question `how
do firms define synergy . . . and how do they measure it?' In a similar vein, Sirower
(1997) raises in his `synergy limitation view' two important questions that need to be
analysed in more detail in order to improve our knowledge concerning the
calculation of M&A synergies and, by this, making M&A more successful:
* What can companies do to realistically calculate synergies ahead of a merger or
acquisition?
* What do companies actually do in practice?
The purpose of this paper is to provide an answer to the questions raised by Javidan
et al. (2004) and Sirower (1997) by developing a theoretical-driven reference model
that will be compared with the description of real synergy calculation cases, thus
pursuing an exploratory approach. Firstly, we discuss the impact that overblown
synergy estimates can have on the expected performance of the acquiring company
after the merger, before outlining one possible way of doing so. This procedure serves
346 D. zu Knyphausen-Aufsess, J. Koeppen and L. Schweizer

as the benchmark for three case studies, which we performed to illustrate the `nuts
and bolts' of applying the procedure in corporate practice. Finally, we present some
conclusions.

2 Synergies and the need to improve performance

The word synergy is synonymous with `economies of scope'. Synergies are often
spoken of in the same breath as the much vaunted `2 ‡ 2 ˆ 5' equation (Ansoff,
1965; Brealey and Myers, 2002; Panzar and Willig, 1981; Teece, 1980). More
accurately, synergies can be understood as merger-induced improvements in cash
flow that go beyond cash flow improvements which the two companies would be
expected to generate in their current (`stand-alone') constellation and which are
therefore already priced in their share valuations (Sirower, 1997). Distinctions can be
drawn between financial synergies (e.g. the ability to raise the level of gearing),
operational synergies (e.g. scale effects in purchasing) and management synergies (e.g.
the introduction of efficient management processes). These synergies are the pivotal
argument used to substantiate the efficiency of corporate mergers (Seth et al., 2000;
Trautwein, 1990). Another important distinction is between sales synergies and cost
synergies. While sales synergies increase profits as a result of additional sales, cost
synergies improve the bottom line as a result of cost cuts in the wake of the merger.
When a company is acquired, the purchase price is initially expected to reflect the
present value of future cash flows. However, in order to buy a company an
acquisition premium above the company's market capitalisation is usually paid. The
size of this premium is based on the expected synergies which are by definition
uncertain and can only be realised in the future during and after the post-acquisition
integration phase (Haspeslagh and Jemison, 1991). Figure 1 illustrates three
scenarios concerning this uncertainty for the shareholders of both the acquiring
company and the acquired company.

Figure 1 Relationship between the acquisition premium and the net present value

If the acquisition premium is paid in cash, shareholder value will increase for the
target company in all three scenarios. However, the shareholder value of the bidding
company will increase only if the net present value of the synergies associated with
the acquisition is greater than the premium paid to the shareholders of the target
 Identifying synergies ahead of mergers and acquisitions 347

company. If not, shareholder value will be destroyed. If the present value of the
synergies is equal to the acquisition premium, positive synergies will indeed be
realised. However, cash payment of the equivalent premium would transfer all added
value to the shareholders of the acquired company. The acquisition premium is
therefore deemed ex post to have been estimated accurately. It will thus increase the
net present value for the shareholders in the amount of the acquisition premium,
provided that the net present value of future synergies is at least equivalent to the
acquisition premium paid, i.e. if:

Synergies
NPV ˆ ÿ Acquisition premium  0 …1†
X
N
t
…1 ‡ r†
tˆi

where r is the cost of capital; N is the number of years to be planned; i is the year in
which performance begins to improve; and NPV is the net present value.
Owing to the time value of money, performance improvements that are farther
off in the future have a lower present value than improvements that occur shortly
after an acquisition. Thus, synergies have to be realised quickly. In other words, the
value of the synergies needed increases exponentially with every year by which their
realisation is delayed. Consequently, the necessary synergies can be calculated as
follows:
Acquisition premium
Synergies ˆ N   : …2†
X 1
tˆi …1 ‡ r†t

For the sake of simplicity, this equation assumes that potential synergies remain
constant in each planning year. The need to improve the return on capital employed
(ROCE) resulting from payment of the acquisition premium can be expressed as the
ratio of the necessary synergies to the capital employed (P0), i.e. the price that must
be paid to acquire the company.
Acquisition premium
Synergies P0
ROCE ˆ ˆ N   : …3†
P0 X 1
tˆi …1 ‡ r†t

This dynamic correlation between the acquisition premium, the speed of synergy
realisation and the need to improve performance during the integration phase is
illustrated in Figure 2. The figure assumes a 10-year lifespan for the potential
synergies. In the case of Exxon/Mobil, if the estimated synergy potential can be
realised in the first year after the merger, performance must improve by USD 2.4
billion per annum to break even in respect of the acquisition premium. This is
equivalent to a ROCE of 3.0%. Should the identified synergies only be realised in the
second year, performance must improve by USD 2.8 billion or a ROCE of 3.5%.
However, should the merger only deliver the desired synergies in the sixth year, the
348 D. zu Knyphausen-Aufsess, J. Koeppen and L. Schweizer

company must earn an extra USD 5.8 billion or an ROCE of 7.3%. If an

improvement of, say, 3% was already anticipated from the stand-alone business, the
initial requirement climbs a full 7.3 to 10.3%.

Figure 2 Required performance improvements (Bill. USD); required ROCE improvements

(%) in parenthesis

The dynamic correlation with the acquisition premium becomes even clearer if one
varies this premium (ceteris paribus). Given an acquisition premium of 26.2% and
assuming that potential synergies are realised within two years, it is necessary to
improve ROCE by 3.5%. By contrast, the need for improvement rises to 6.2% for an
acquisition premium of 56.1%, to 7.8% for a premium of 77.4% and ± in the case of
Mannesmann/Vodafone (104.6%) ± to as much as 8.3%. The lower cost of capital
(6.8%) in the Mannesmann/Vodafone example (relative to a discount factor of 8.3%
for MCI/WorldCom) moderates the requisite improvements in performance and
ROCE. If one observed only the effect of increasing the acquisition premium from
77.4 to 104.3% (ceteris paribus), this would require a greater increase in ROCE.
These scenarios illustrate the difficulty of dynamic performance improvement if an
acquisition premium is paid.
Moreover, it is important to know for how long a company will realistically be
able to tap the synergies. It has a major influence on the present value of potential
synergies and, hence, on the maximum amount that should be paid as an acquisition
premium. The discounted cash flow (DCF) method of corporate valuation assumes
that detailed plans can be drawn up only for a few years. Beyond this planning
horizon, it assumes a constant, sustainable net cash flow (Rappaport, 1986). Based
on these assumptions, the net present value method can be used to calculate a
terminal value.
It is, however, questionable whether similar assumptions can be made in relation
to potential synergies. Along similar lines to company valuation methods, the present
value of synergies would largely derive from their terminal value. The effect of
assumed lifespan on the present value of synergies can be illustrated by computing
alternative scenarios. To do so, let us refer back to the example of the Exxon/Mobil
merger. In Figure 3, the improvements in free cash flow that would be needed to
justify an acquisition premium of USD 16.7 billion (26.2% of the transaction price)
are shown for assumed lifespans of four, seven, ten years and infinity.
 Identifying synergies ahead of mergers and acquisitions 349

Figure 3 Effect of lifespan on the net present value of potential synergies

It is fair to assume that the lifespan of potential synergies depends critically on the
vitality of the industry concerned. If the company operates in a dynamic
environment, the lifecycle theory (Porter, 1980) must be assumed, which states that
customers' needs, technologies, products and markets will continue to change.
Technological changes may lead customers to prefer other combinations of
resources, resulting in a shift in the definition of competitive advantages (Gort,
1969). Synergies associated with products and production processes must be
questioned whenever products and their underlying technologies are replaced by
new products and technologies. Alongside industry cycles, however, the attributes of
the combinations of resources from which potential synergies derive are also very
significant to their projected duration.
When quantifying synergies, it is therefore not realistic to generally assume that
companies will be able to tap the competitive advantages resulting from synergies for
an indefinite period. This is also in line with the argumentation of Shaver (2006) who
demonstrates that an inherent element of M&As is that actions taken to facilitate
synergy realisation might amplify threats and might inhibit the companies' ability to
respond to favourable conditions in the business environment. Moreover, Croson
et al. (2004) show in their experimental study that positive and negative externalities
for a specific industry may arise as a consequence from the M&As.

3 A method of identifying potential synergies

Shareholders are interested in more than just the net present value of potential
synergies. They also want to understand the process by which this potential has been
calculated. The more information is provided about the methods used to calculate
synergies and the more structured this method is, the less capital market players will
remain uncertain about the possible consequences of a merger.
350 D. zu Knyphausen-Aufsess, J. Koeppen and L. Schweizer

This section aims to develop a method that can facilitate the structured
calculation of the net present value of potential synergies. For instance Gupta and
Gerchak (2002) have developed a mathematical modelling concerning the
quantification of operational synergies in M&As. Our method breaks down into
10 steps (see Figure 4) and it is derived from several years consulting practice of one
of the authors combined with the input taken from academic publications (e.g.
Sirower, 1997). Each step is explained in detail below.

Figure 4 Steps in the process of quantifying potential synergies

3.1 Step 1 ± define a baseline

The process of identifying synergies begins by defining a baseline in order to draw a
line against which potential savings generated by realised synergies can be measured.
Existing medium-term planning figures for the company in its present form can be
used. It is also possible to use stand-alone business plans drawn up specially to
prepare for the merger. To avoid synergies being counted twice, it is important to
ensure that the selected baseline does not already contain any of the synergies
targeted. Moreover, the stand-alone plans should cover the whole period for which
potential synergies must be calculated. Furthermore, the baseline figures are to be
cleansed of any extraordinary effects.

3.2 Step 2 ± identify and calculate cost synergies for the individual years in the
forecast period
The levers of synergies and the action programmes needed to activate these levers in
each business area have to be identified as well. In this step, potential synergies are
 Identifying synergies ahead of mergers and acquisitions 351

actually identified with the help of a creative/rational process that draws on annual
financial statements, checklists, interviews and workshops. Once synergy levers and
action programmes have been identified, their in-year and full-year effects must be
calculated. The full-year effect of a potential synergy is the effect that would have
been realised if the corresponding action programme had been applied from the
beginning of the year. This effect is distinct from the in-year effect, which only states
the savings that would be achieved by taking said actions for the remainder of the
current fiscal year.
The calculated in-year and full-year effects are then distributed across the
individual years in the relevant forecast period. One option is to enter the calculated
effect of each lever and for each business area in a separate table. Effects can then be
assigned to the individual expense items in the income statement. This practice
ensures that only those effects are considered that have a quantifiable impact in the
income statement. Any one-off costs incurred in the process of realising potential
synergies should also be stated together with the amount calculated for each synergy.
At the end of the second step, all potential synergies have been identified for each
cost item in the income statement.

3.3 Step 3 ± identify new cost ratios

The potential synergies calculated are now set off against the stand-alone business
planning data for the forecast period. This creates a new business plan for the merged
corporate unit. The result is a new return on sales (ROS) ratio after cost synergies for
each year in the forecast period. Once the stand-alone business data has been
enriched by the identified cost synergies, new cost ratios become apparent. This step
is important because it is necessary to know the costs associated with each additional
revenue item. Moreover, since cost synergies affect each additional unit of revenue, it
is essential to calculate the cost synergies before the revenue synergies.

3.3 Step 4 ± identify and calculate revenue synergies for the individual years in
the forecast period
The calculation of potential revenue synergies involves identifying the synergy levers
in all business areas, calculating the associated revenue potential and then spreading
this over the individual years in the forecast period. The one-off costs incurred in
generating these extra revenues must then be calculated. Potential revenue gains must
be based on the new cost structure after considering cost synergies. To identify value
added, the costs incurred in generating extra revenues must be deducted from these
revenues.

3.5 Step 5 ± calculate the tax burden on potential synergies

The tax expenses carried in the income statement should be stated in order to deal
with the issue of taxation. Once all potential synergies have been calculated, it is
possible to isolate those before-tax earnings that would derive solely from the
identified potential synergies. Of the gross amount calculated for potential synergies,
the merged company will only have what is left after taxes. To simplify the
352 D. zu Knyphausen-Aufsess, J. Koeppen and L. Schweizer

calculation of the tax rate, one can take the average rate for the two stand-alone
companies. EBIT derived from the income statement should serve as the basis for tax
assessment. This approach assumes that the company will pay the tax bill out of its
own financial resources and ignores that interest on debt capital is tax-deductible.
The cost of capital is therefore applied to correct this simplification.

3.6 Step 6 ± calculate the change in working capital and provisions

Revenue and cost synergies also affect the balance sheet. It is therefore necessary to
adjust balance sheet items to accommodate the effect of additional revenues and
lower costs caused by realised synergies. The effect that these balance sheet items
have on corporate financing is recorded in the form of a change in working capital
and must be calculated for the whole of the forecast period. The familiar ratios used
in stand-alone planning ± such as the term of receivables/payables and inventory
coverage ± can be used to calculate these balance sheet items. Then, once the revenue
synergies, cost synergies and stand-alone ratios are known, it is possible to calculate
the impact on working capital.

3.7 Step 7 ± calculate free cash flows from investing activities

It may be necessary to invest money to create conditions that will enable synergies to
be realised. To merge production technologies, for example, it may be necessary to
build a new production facility. The effect of this required investment on corporate
financing must be considered when calculating free cash flow. Similarly, if a merger
means that machinery, buildings or other assets are no longer needed, it is also
necessary to record the cash flows that result from the corresponding divestments.
Investments that would have been necessary but can be avoided thanks to the merger
must likewise be taken into account.

3.8 Step 8 ± calculate free cash flows for the whole of the forecast period
In a next step, it is necessary to calculate the cash flow that will be generated by
potential synergies and will be available in each year of the forecast period. To this
end, free cash flow generated by the items in the income statement and on the balance
sheet must be determined. The result indicates the free cash flows generated by
synergies for the individual years in the forecast period.

3.9 Step 9 ± identify the cost of capital

Once free cash flows have been calculated, the next step in the process of determining
the present value of synergies is to identify the cost of capital that the company must
discount from its free cash flow. The cost of capital for the merged company
…WACCA‡B † is the average cost of capital for both companies …WACCA ; WACCB †
weighted for the market value of either company …MWA ; MWB † before the merger:

MWA MWB
WACCA‡B ˆ  WACCA ‡  WACCB : …4†
MWA‡B MWA‡B
 Identifying synergies ahead of mergers and acquisitions 353

3.10 Step 10 ± discount the free cash flows

The final step is to use the net present value (NPV) method to calculate the present
value of potential synergies:
Xn
FCFt
C0 ˆ ˆ APmax : …5†
tˆ1 … 1 ‡ r† t

The free cash flows (FCFs) calculated for the individual years of the forecast period
(n) are discounted by the calculated cost of capital (1 ‡ r). The present value of
potential synergies (C0 ) calculated in this way indicates the maximum acquisition
premium (APmax ) that should be paid if, assuming all identified potential synergies
are realised in full, the shareholders of the acquiring company do not want to see the
value of their company erode. It is then up to the management of the acquiring
company to determine the acquisition premium that must be paid to secure the
merger of the two companies.

4 How real companies calculate synergies ± three case studies

Having outlined one theoretical way to identify potential synergies, we now examine
how synergies are actually identified in practice. We use three brief case studies
(Eisenhardt, 1989; Yin, 1984) to answer this question. It is particularly interesting to
note the deviations between the practices applied in the case studies and the method
outlined above. It is likewise important to see what happens to the calculated value of
synergies ± and hence to the maximum acquisition premium ± if individual steps in
the method are omitted. The three case studies we use to examine the practice of
identifying and calculating synergies are the RWE/VEW, Shell/DEA and Austrian
Airlines (AUA)/Lauda Air mergers.
The case studies were chosen because they contain many aspects that are useful
for refining the reference model. These aspects include significant size and market
capitalisation. Moreover, the cases cover different industries. We examined successful
cases (Shell/DEA±Petroleum), moderately successful mergers (REW/VEW±Utilities)
and failures (AUA/Lauda Air±Civil aviation). In 2002, Shell Deutschland GmbH
acquired RWE-DEA AG with expected synergies of EUR 150 million. In 2001,
RWE AG acquired VEW AG and calculated expected synergies of EUR 725 million.
Austrian Airlines AG acquired Lauda Air AG in 2001 and aimed at the realisation of
EUR 73 million in term of synergies.

4.1 Data collection and research design

The data collection for the case studies comprised 12 semi-structured interviews with
the people involved in the process of quantifying synergies. This semi-structured
approach enabled us to make the individual interviews and case studies largely
comparable and to focus on the key problem areas. Each interview was conducted
personally and took from 1.5 to 2 hours. Transcriptions of the recordings were
returned to the interviewees for approval in order to ensure that their responses were
fairly and accurately represented.
354 D. zu Knyphausen-Aufsess, J. Koeppen and L. Schweizer

Documentation provided by the companies themselves served as the second main

source of information: it complemented the interview data, it helped us analyse the
same information from multiple perspectives, and it enabled a `triangulation' of the
various data sources. We also made use of scientific papers, articles in management
magazines, websites, company documentation, annual financial statements and
company presentations supplied by the external consultants concerned. Analysts'
reports produced by various investment banks served as an additional source of
information.
Our research design was validated by the use of multiple sources and by the
triangulation of these sources. Furthermore, the case study drafts and analyses were
reviewed by our interview partners to ensure that their statements had been faithfully
reproduced. External validity was ensured by references to literature dealing with the
same and related phenomena. To guarantee the internal validity of the case studies,
the empirical data was compared with the reference model in an iterative process.
Further substantiation was ensured by repeating the interviews with different
individuals and by introducing additional and supplementary questions. The
reproducibility of the method is guaranteed by its transparency and the detailed
documentation provided. Records of the individual case studies were produced and a
case study database was created.

4.2 Case study findings

During the interviews with the company representatives, we examined which of the
steps described in the previous section were used in practice in order to quantify
synergies and which were omitted. Figure 5 provides a list of the steps taken.

Figure 5 Steps taken in the case studies analysed

 Identifying synergies ahead of mergers and acquisitions 355

4.2.1 Step 1
In all three case studies, a baseline was defined to calculate potential synergies.
However, the baselines selected differed considerably. RWE/VEW based their
calculations on actual and forecast figures. Shell/DEA used only actual data,
whereas Austria Airlines/Lauda Air quantified potential synergies on the basis of
budget planning figures. It is only possible to measure and verify real improvements
in performance if actual numbers are used as the basis for calculation.
It is generally impossible to verify potential synergies that are based on forecasts,
because these figures represent moving targets. Having said that, deviations from the
use of actual figures as the baseline (in line with our reference model) only affect
calculated synergies if the actual figures ultimately deviate from the budgeted or
forecast figures used for the calculation. If the forecasts or budgets used are prepared
shortly before the end of a fiscal year, i.e. if it is fair to assume that they will deviate
only marginally from the actual figures, then deviant procedures will probably only
lead to a minimal effect. Moreover, in isolated cases, it is worth investigating whether
the use of forecasts that are inaccurate in places might not deliver better synergy
calculations than the use of actual data that is no longer up to date. This decision
should depend on the extent to which the data material used reflects current business
developments, and on whether operational and/or structural changes in the past
fiscal year preclude the use of actual figures.
Both Shell/DEA and RWE/VEW went to a lot of trouble to adjust their baseline
data. These adjustments were designed to eliminate extraordinary effects, to make
due provision for stand-alone actions that had already been initiated, and to make
the items in the two companies' income statements comparable. AUA/Lauda Air did
not adjust their baseline figures. Furthermore, the use of different terminology by the
two companies meant that key data could not readily be compared.
These cases show that both the calculated value of potential synergies and the
quality of the calculation depend heavily on the quality of the assumed baseline,
which sets the standard against which synergies are quantified.

4.2.2 Step 2
In all three mergers, the companies involved calculated the cost synergies. However,
they considered contrary effects in different ways. In the RWE/VEW case, the
contrary effects were dissynergies arising from one-off effects that had no impact on
recurrent annual cost synergies. Moreover, gross recurrent annual synergies were
equivalent to net recurrent annual synergies. In the Austrian Airlines/Lauda Air case,
not all dissynergies were quantified. Regardless of whether these dissynergies were
one-off effects or recurrent annual effects, neither was deducted from the calculated
cost synergies. The gross synergies stated were therefore too high. By contrast, Shell/
DEA split identified dissynergies into one-off effects and recurrent effects and
deducted recurrent dissynergies from calculated gross synergies.

4.2.3 Step 3
Another step in the reference model is the calculation of cost ratios. Whereas the
Austrian Airlines/Lauda Air and Shell/DEA mergers factored in the new cost ratios,
the RWE/VEW merger assumed a constant ROS of 5%. This pragmatic approach
356 D. zu Knyphausen-Aufsess, J. Koeppen and L. Schweizer

had no significant impact given that, owing to the nature of the two companies'
business, revenue synergies were only of secondary importance. No material
deviation therefore arose from the methodology proposed in our reference model.

4.2.4 Step 4
All three companies calculated revenue synergies as a separate step in a conservative
way. Even so, the figures calculated for revenues synergies varied in each case, as did
revenue synergies as a proportion of total synergies. At RWE/VEW, revenue
synergies were negligible. Moreover, no revenue synergies were assumed to derive
from future business expansion plans. Shell and DEA likewise refrained from
calculating volume-based revenue synergies. Instead, improved margins for new
products were assumed. It was also assumed that dissynergies arising from the early
stages of the merger would offset any performance gains. By contrast, Austrian
Airlines and Lauda Air calculated that performance would improve substantially as
a result of revenue synergies. In all three deals the step of quantifying revenue
synergies took place, although both the amount of these synergies and their
contribution to overall synergies varied considerably.

4.2.5 Step 5
The next step is to make due allowance for taxes. In all three cases potential
synergies before taxes were calculated. Thus, the recurrent annual effect of calculated
synergies on performance had to satisfy not only the demands of shareholders and
creditors but also those of the fiscal authorities. If taxes are omitted from this
calculation, there is the danger that the NPV stated for potential synergies will be too
high.

4.2.6 Step 6
None of the companies involved in our three case studies calculated free cash flow
from the change in working capital and the change in provisions. This is due to the
definitions of synergies that they used. Assumptions were based on recurrent annual
effects on performance, so no provision was made for changes in balance sheet items
that affected cash flows. Whether or not ignoring this step increases or reduces the
calculated synergies can be determined only on a case-by-case basis. Extra cash is
likely to be tied up if substantial revenue synergies are calculated, causing inventories
and receivables to rise to an extent that cannot be offset by an increase in liabilities.
Both RWE/VEW and Shell/DEA calculated only small increases in revenues.
Compared with cost synergies, these were only of minor significance.

4.2.7 Steps 7 and 8

The three case studies present no clear picture as far as the calculation of free cash
flows for the entire forecast period is concerned. These free cash flows were not
calculated at all for the RWE/VEW merger. For the Shell/DEA merger, cash flows
were calculated for the specific forecast period. Cash flows from improved
performance were identified together with cash flows from investing activities for
the individual years in the forecast period. Conversely, Austrian Airlines/Lauda Air
did not calculate free cash flows for the entire forecast period.
 Identifying synergies ahead of mergers and acquisitions 357

4.2.8 Steps 9 and 10

The Shell/DEA merger was the only case in which the last two steps ± calculation of
the cost of capital and the discounting of synergies to give a NPV ± were carried out.
The RWE/VEW and Austrian Airlines/Lauda Air mergers neither calculated the cost
of capital nor discounted it from synergies to arrive at a NPV. Although all six
companies stressed the importance of realising synergies quickly, only Shell and
DEA actually made provision for the time value of money. In the other two mergers,
synergies were quantified based on a static model that fails to reflect the dynamic
nature of performance improvements.

4.3 Cross-case analysis

The case studies reveal significant differences relative to the synergy quantification
method proposed herein: allowance for taxes, and allowance for changes in balance
sheet items that will affect cash flow after the merger. Further gaps are apparent in
the calculation of a NPV for potential synergies. Neither RWE/VEW nor Austrian
Airlines/Lauda Air bothered to calculate the present value of their potential
synergies. The mergers focused their synergy quantification activities on identifying
recurrent annual performance improvements, instead of on the economic value that
such synergies add for shareholders. To this extent, they did not line up with the
principle of maximising shareholder value. Nor was it possible to calculate a
maximum acquisition premium.
Synergies were mostly calculated on the basis of static views that do not
adequately reflect the dynamic nature of the performance improvements needed.
Many of the omissions in the calculation of potential synergies are attributable to the
way the companies concerned chose to define synergies. Two of the steps discussed in
our reference model were ignored entirely in all three case studies. However, the
failure to take into account working capital and taxes had more to do with the
definition of synergies than with a perception that these steps were not feasible. Tax
liabilities can be calculated by assuming a weighted average of the two stand-alone
companies' tax rates. The impact of calculated synergies on working capital can be
estimated on the basis of inventories and the maturity terms of receivables and
payables. It thus becomes evident that the omission of individual steps in the process
does indeed influence the calculation of potential synergies. Both the method of
valuation and the process itself affect the validity of the potential synergies
calculated. Where deviations relative to the reference model were identified, they
tended to overestimate potential synergies.
The dynamic need for cash flow improvement resulting from the payment of an
acquisition bonus does not allow for the use of a statistic, yield-based concept to
determine synergies. Application of statistical models to determine synergy potentials
bears the risk of overestimating synergies. Assumptions concerning the lifespan of
synergies and the duration of the implementation period determine the value of the
synergy potentials and thus the success of the merger. The longer the presumed
lifespan of synergies is, the higher their cash value will be. When assuming unlimited
duration of synergies, the cash value of the synergy potentials is overstated by the
synergies' terminal value. Different assumptions concerning the speed of synergy
implementation lead to a different cash value of the synergy potentials and, thus,
358 D. zu Knyphausen-Aufsess, J. Koeppen and L. Schweizer

different general value of the synergies determined. An overly optimistic assumption

concerning the implementation speed may lead to an overestimation of synergy
potentials as well.
For two of the three case studies, a discounting of determined synergies to a cash
value of the synergy potentials was not carried out. Cost of capital evaluation and the
discounting of synergies to a cash value were only executed when determining
synergies in the Shell±DEA case study. As for the RWE±VEW and Austrian
Airlines±Lauda Air mergers, an evaluation and subsequent discounting of synergies
to a cash value were not conducted. In conclusion, it can be stated that the disregard,
especially, of the actual cash value leads to an overestimation of synergy potentials.

5 Discussion and conclusion

The success of M&As has for many years been a focal point for various lines of
business research. Little attention has been paid to how companies go about
quantifying synergies ahead of M&As as an important linking pin between M&A
strategy and post-acquisition integration, the latter being responsible for synergy
realisation. Although previous works have acknowledged the importance of the
acquisition premium to the success of mergers (Javidan et al., 2004; Larsson and
Finkelstein, 1999; Sirower, 1997), there appears to be a lack of understanding of how
the potential synergies that underpin acquisition premiums are quantified in practice.
The reference model for quantifying potential synergies depicted here is not a
universally valid model or approach. It has, however, key elements that practitioners
should use to determine synergies in order to avoid overestimating their potential.
The synergy limitation view (Sirower, 1997) pinpoints the acquisition premium as
one of the most important parameters in management decisions about M&As. This
view therefore rates the acquisition premium as extremely important to the success or
failure of such transactions. Based on the synergy limitation view, this paper develops a
reference model to calculate the NPV of potential synergies as the maximum viable
acquisition premium. The development of this reference model has also drawn on the
insights presented in theoretical works on the preconditions for, causes of, and
classification of synergies. The reference model has been broken down into 10
structured steps. The focus remains on the nature of this model as a process ± a process
that involves clear links to valuation issues. The omission of individual steps in the
process of quantifying synergies influences the calculated value of the synergies.
Case studies were used to compare the reference model-based method of
quantifying synergies with the approaches pursued in business practice. The cases
examined mostly used static models that are unable to identify the economic value
which synergies add for shareholders. Payment of an acquisition premium requires
dynamic performance improvements. However, a static profitability-based approach
to synergy calculation can make no allowance for such dynamic developments. The
use of static models to quantify potential synergies bears the risk that synergies will
be overestimated as the acquiring company seeks to determine a suitable purchase
price.
The differences identified in the way companies approach synergy calculation and
differences in the provision they make for various synergy components cause them to
 Identifying synergies ahead of mergers and acquisitions 359

value synergies differently. Logically, this also leads to differences in the extent to
which synergies are then realised in practice. It follows that the success or failure of
mergers is significantly influenced by the method used to quantify synergies.

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