Synergies in M&A

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 • 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)]/0.1025 = $48.78m. • Q: Why does the WACC change? 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: 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? P.V. Viswanath