1. Synergies in M&A P.V. Viswanath
Class Notes for FIN 648: Mergers and Acquisitions

2. 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.”
P.V. Viswanath

3. 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.
P.V. Viswanath

4. 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 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.
P.V. Viswanath

5. 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
P.V. Viswanath

6. Optimizing WACC
Caution: Investors may be able to optimize WACC on their own, through homemade leverage
P.V. Viswanath

7. Coinsurance Effects
Combination of the buyer and seller could cause the WACC curve to shift in advantageous ways
P.V. Viswanath

8. Real Option Synergies Growth option synergies Exit 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.
P.V. Viswanath

9. 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.
P.V. Viswanath

10. 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
P.V. Viswanath

11. 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
P.V. Viswanath

12. 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)]/ = $48.78m.
Q: Why does the WACC change?
The debt capacity might increase
P.V. Viswanath

13. 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?
P.V. Viswanath

14. 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: 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?
If Leonid could not sell the rights to this option or did not have the access to funds to exploit it directly, this might be thought of as an option. Or perhaps the estimated cashflows would be higher if the technology were exploited by Sirius.
P.V. Viswanath