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
VFirm
FCFt

t
t 0 (1  WACC )
 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



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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
simple sum of two
stand-alone firms
Optimum for Newco
showing effects of coinsurance
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
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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

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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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