Presented by:Ankit Gupta, 6BAnmol Chopra, 7BPrachi Mukhija, 33BRumjhum Shukla, 42BVipul Agarwal, 50B

What is Synergy in M&A Context

may be defined as two or more things functioning together to produce a result not independently obtainable

Corporate synergy refers to a financial benefit that a corporation expects to realize when it merges with or acquires another corporation. This type of synergy is a nearly ubiquitous feature of a corporate acquisition and is a negotiating point between the buyer and seller that impacts the final price both parties agree to.

This magic ingredient has allowed acquirers to pay billions of dollars in premiums in acquistions.

Tata Steel paid a 100% premium to Corus Plc market price in landmark 2006 acquistion.

Breaking down the Acquisition Price

Acquistion Premium

Goodwill

Book Value of Equity

Acquistion Premium

Goodwill

Book Value of Equity

Acquisition Price of the Target Firm

Market Price of Target firm prior to acquisition

Book Value of Equity of Target Firm

Operating Synergies

Allow firms to increase their operating income from existing assets, increase growth or both

• Economies of scale that may arise from the merger, allowing the

combined firm to become more cost-efficient and profitable

• Greater pricing power from reduced competition and higher market

share, which should result in higher margins and operating income

• Combination of different functional strengths

• Higher growth in new or existing markets

Financial Synergies

With financial synergies, the payoff can take the form of either higher cash

flows or a lower cost of capital or sometimes both.

•A combination of a firm with excess cash (and limited project

opportunities) and a firm with high-return projects (and limited cash) can

yield a payoff in terms of higher value for the combined firm

•Debt capacity can increase

•Tax benefits can arise

•Diversification (also the most controversial form)

Valuing Synergy

• Quite controversial as synergy is quite nebulous and intangible to be valued.

• But if one is ready to pay a price for synergy valuation is warranted.

But two questions which need to be answered when valuing synergies?

• What form is the synergy expected to take?• When will the synergy start affecting cash flows?

Steps in valuing Operating Synergy

• Value the firms independently

• Estimate the value of the combined firm

• Value the combined firm with synergy

Valuing Cost SynergiesAll Figures in lacs

Acquiring Firm

Target Firm

Beta 0.9 0.9Pre-Tax Cost of Debt 5.00% 5.00%Tax Rate 30.00% 30.00%Debt to Capital Ratio 10.00% 10.00%

Revenues 1000.00 500.00Operating Income (EBIT) 50.00 25.00

Pre-Tax Return on Capital 15 15.00%Reinvestment Rate 70 70.00%

Length of Growth Period 5 5.00%

Summary of Financial Characteristics of Independent Firms

Acquiring Firm

Target Firm

Beta 0.9 0.9Pre-Tax Cost of Debt 5.00% 5.00%Tax Rate 30.00% 30.00%Debt to Capital Ratio 10.00% 10.00%

Revenues 1000.00 500.00Operating Income (EBIT) 50.00 25.00

Pre-Tax Return on Capital 15 15.00%Reinvestment Rate 70 70.00%

Length of Growth Period 5 5.00%

Summary of Financial Characteristics of Independent Firms

Assumptions

•Both Firms have the same cost of capital, expect the same growth in future and earn the same operating margin. The riskfree rate is assumed to be 4.25% and the risk premium is 4%.

•Both firms will be in stable growth after year 5 growing 4.25% in perpetuity and earning no excess returns.

Assumptions

•Both Firms have the same cost of capital, expect the same growth in future and earn the same operating margin. The riskfree rate is assumed to be 4.25% and the risk premium is 4%.

•Both firms will be in stable growth after year 5 growing 4.25% in perpetuity and earning no excess returns.

The valuation is done using the DCF

framework

•The after-tax return on capital is multiplied with the reinvestment rate to get the expected growth rate.•After year 5 operating income and revenues are expected to grow at 4.25% which will make the reinvestment rate to be 57.82%.•Based on this FCFF to firm for 5 years and the terminal value is calculated.•Further the expected free cash flows are discounted at the cost of capital to get the present value of the firm.

The valuation is done using the DCF

framework

•The after-tax return on capital is multiplied with the reinvestment rate to get the expected growth rate.•After year 5 operating income and revenues are expected to grow at 4.25% which will make the reinvestment rate to be 57.82%.•Based on this FCFF to firm for 5 years and the terminal value is calculated.•Further the expected free cash flows are discounted at the cost of capital to get the present value of the firm.

Acquiring Firm

Target Firm

Combined Firm

ValueCost of Equity 7.85% 7.85% 7.85%After-tax cost of Debt 3.50% 3.50% 3.50%Cost of Capital 7.42% 7.42% 7.42%

After-tax return on capital 10.50% 10.50% 10.50%Reinvestment Rate 70% 70.00% 70.00%Expected Growth Rate 7.35% 7.35% 7.35%

Value of FirmPV of FCFF in high growth 52.4 26.2 78.61Terminal Value 701.53 350.76 1052.29Value of firm today 542.99 271.5 814.49

Independent Fir m Val uat ions

Acquiring Firm

Target Firm

Combined Firm

ValueCost of Equity 7.85% 7.85% 7.85%After-tax cost of Debt 3.50% 3.50% 3.50%Cost of Capital 7.42% 7.42% 7.42%

After-tax return on capital 10.50% 10.50% 10.50%Reinvestment Rate 70% 70.00% 70.00%Expected Growth Rate 7.35% 7.35% 7.35%

Value of FirmPV of FCFF in high growth 52.4 26.2 78.61Terminal Value 701.53 350.76 1052.29Value of firm today 542.99 271.5 814.49

Independent Fir m Val uat ions

All Figures in lacs

Acquiring Firm

Target Firm

Value of Synergy

Cost of Equity 7.85% 7.85%After-tax cost of Debt 3.50% 3.50%Cost of Capital 7.42% 7.42%

After-tax return on capital 10.50% 10.50%Base-year Pre-Tax Operating Income 75.00 90.00Expected Growth Rate 7.35% 7.35%

Value of FirmPV of FCFF in high growth 78.61 94.33Terminal Value 1052.29 1262.75Value of firm today 814.49 977.39 162.9

Val uing Syner gy with Cost SavingsAcquiring

FirmTarget Firm

Value of Synergy

Cost of Equity 7.85% 7.85%After-tax cost of Debt 3.50% 3.50%Cost of Capital 7.42% 7.42%

After-tax return on capital 10.50% 10.50%Base-year Pre-Tax Operating Income 75.00 90.00Expected Growth Rate 7.35% 7.35%

Value of FirmPV of FCFF in high growth 78.61 94.33Terminal Value 1052.29 1262.75Value of firm today 814.49 977.39 162.9

Val uing Syner gy with Cost Savings

All Figures in Lacs.

Assume that the combined firm will save 15 lacs in operating expenses each year pushing up the combined firm’s pre-tax operating income by 15 lacs .

Assume that the combined firm will save 15 lacs in operating expenses each year pushing up the combined firm’s pre-tax operating income by 15 lacs .

Errors in valuing Synergy

• Subsidizing Target Firm Stockholders

• Wrong Discount Rate

• Mixing Control & Synergy

Dubious Synergies

• Accretive Acquistions – The PE ratio rationale

• Quick Growth – The Growth illusion

Conclusion

Even there is sufficient evidence of synergy in the aggregate across all acquisitions most mergers fail in delivering any synergy. Stockholders usually end up overpaying for synergy in most

acquisitions.

• Managerial Hubris

• Bias in the estimation Process

• Failure to plan for Synergy

References

• http://www.amazon.com/Valuation-Building-Value-Private-Companies/d

p/0471411019

http://www.gazhoo.com/doc/200905172359506671/Synergy+Valuation

• http://www.clerestoryconsulting.com/mergers/ma-alert.pdf

• http://www.investopedia.com/university/mergers/

mergers2.asp#axzz1ewFXISRL

Thank YouQuestions?