Synergy in Acquisitions

Synergy is often a motive in acquisitions, but it is used as a way of justifying huge premiums and seldom analyzed objectively. The framework that we developed for valuing synergy in projects can be applied to valuing synergy in acquisitions. The key to the existence of synergy is that the target firm controls a specialized resource that becomes more valuable when combined with the bidding firm's resources. The specialized resource will vary depending upon the merger. Horizontal mergers occur when two firms in the same line of business merge. In that case, the synergy must come from some form of economies of scale, which reduce costs, or from increased market power, which increases profit margins and sales. Vertical integration occurs when a firm acquires a supplier of inputs into its production process or a distributor or retailer for the product it produces. The primary source of synergy in this case comes from more complete control of the chain of production. This benefit has to be weighed against the loss of efficiency from having a captive supplier, who does not have any incentive to keep costs low and compete with other suppliers.

When a firm with strengths in one functional area acquires another firm with strengths in a different functional area (functional integration), synergy may be gained by exploiting the strengths in these areas. Thus, when a firm with a good distribution network acquires a firm with a promising product line, value is gained by combining these two strengths. The argument is that both firms will be better off after the merger.

Most reasonable observers agree that there is a potential for operating synergy, in one form or the other, in many takeovers. Some disagreement exists, however, over whether synergy can be valued and, if so, how much that value should be. One school of thought argues that synergy is too nebulous to be valued and that any systematic attempt to do so requires so many assumptions that it is pointless. While this philosophy is debatable, it implies that a firm should not be willing to pay large premiums for synergy if it cannot attach a value to it.

While it is true that valuing synergy requires assumptions about future cash flows and growth, the lack of precision in the process does not mean that an unbiased estimate of value cannot be made. Thus we maintain that synergy can be valued by answering two fundamental questions:

(1) What form is the synergy expected to take? Will it reduce costs as a percentage of sales and increase profit margins (e.g., when there are economies of scale)? Will it increase future growth (e.g., when there is increased market power)?

(2) When can the synergy be expected to start affecting cash flows — instantaneously or over time?

Once these questions are answered, the value of synergy can be estimated using an extension of discounted cash flow techniques. First, the firms involved in the merger are valued independently, by discounting expected cash flows to each firm at the weighted average cost of capital for that firm. Second, the value of the combined firm, with no synergy, is obtained by adding the values obtained for each firm in the first step. Third, the effects of synergy are built into expected growth rates and cash flows, and the combined firm is re-valued with synergy. The difference between the value of the combined firm with synergy and the value of the combined firm without synergy provides a value for synergy.

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