Synergy

Synergy

Popular definition of synergy is 2 + 2 = 5!

Synergy is ability of combined company to generate higher shareholders wealth than the standalone entities. It is the additional value that would not be generated if the firms operated independently. To be successful in M & A, it is important to understand the credible sources of synergies and the dubious ones.

Synergy = PV after – PV before (Optimal)

Value of change of control = PV before (Optimal) - PV before (Status quo)

Drivers of Synergy

Operating Synergy – The M & A of related businesses may lead to operating synergy due to the economy of scope, the economy of scale, higher growth in revenue and greater pricing power. The economy of scope lead to reduction in per unit fixed cost and the economy of scale lead to reduction in per unit variable cost. This way operating synergy affects the free cash flows of the combined firm.

Financial Synergy – affects the cost of capital The M & A of diversified businesses (i.e. backward/upward) may lead to financial synergy. Such M & A reduces the portfolio risk and can lead to reduction in cost of capital due to increased debt capacity, tax benefits leading to the Financial Synergy

Synergy Valuation

Enterprise Value = Summation of (Cash Flows) / (1+r)

FCF = EBIT (1-t) + Depreciation – Capex – Delta (WC)

School of thoughts on discount rate for FCF 

1. Cost of equity as discount rate: Operating synergy goes only to the equity and so Cost of equity should be used for discounting. 

2. Different discounting rate for cost and revenue: Split operating synergy into cost and revenue synergy. Cost synergy is more in company’s control whereas revenue synergy is market driven. So, cost synergy should be discounted by lower rate i.e. cost of debt and revenue synergy by higher rate i.e. cost of equity. 

3. WACC as discount rate

Limitation of Synergy Valuation

1. Revenue synergy is in any case is out of control (as dependent on market). Secondly revenue synergy is predicted to realize only after certain number of years (not realized immediately) 

2. Cost synergy is overestimated 

3. Time is crucial and can undermine even well prepared transactions if not considered