Posted in Finance Articles, Total Reads: 14293
, Published on 26 June 2013

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Mergers and acquisitions industry being a trillion dollar industry attracts many faces across the world. Leading investment banks like Goldman Sachs, JP Morgan, Nomura and many others strive hard to capture M&A deals around the world. Many people aspire to go into this industry by becoming investment bankers. But when we talk about the companies and bankers involved in the deal, what do they look for and how do they assess the deal? Is there anything called synergy to look or evaluate for a M&A deal? And if yes, how is that done? Through this article we will try to find out the answers to these questions.

Now why do the companies go for M&A at first? There can be many reasons like:

- Combining the strengths of each company to promote growth.
- Creating monopoly by decreasing competition and taking advantage of it.
- Enhancing productivity by increasing revenues through reduced capital requirements and cost reduction of operations.
- Political factors which requires it to enter a market only through collaboration.
- Increasing the range of its markets.
- Improving the brand name or organizational structure.
- Tax gains through use of surplus funds or unused debt capacity.

But looking at the above factors does the company after M&A deal is really benefited at all occasions?

Does it generate revenues greater than what the individual companies would have generated if not merged?

Are they generating any benefit for the shareholders?

Statistics show that about half or 50% of the deals does not result in success for the M&A deal. In spite of this abysmal success rate, the companies are looking for these deals to gain strategic competitive advantage over others. Worldwide M&A deals are on an increase after a small decline in 2012. Recent ones would be $6.6 billion offer from biotechnology firm Royalty Pharma for Elan and warren buffet backed takeover of Heinz.

If we go by Synergy theory, companies strike M&A deals because it creates synergies for their combined businesses. So what is this synergy? If we simply describe it in simple terms defying mathematics, it means 1+1>2 where both 1’s signifies the individual companies and their combination would be greater than expected number 2 which is due to the synergy between the companies. It means the merged company generates higher shareholder value through increasing income or decreasing costs than what the individual companies would have done. Other than synergy, there could be another factor which is manager interest involved in the deal. The bidder’s manager would look to wrap up a deal even it doesn’t create synergies. This is because even if shareholders value is not created but compensation would increase as he is required to manage a bigger firm. And for the target firm, the reverse happens and managers tend to oppose the takeover even if there is a positive synergy created through the merger.

But these synergies are calculated pre-deal and wrong analysis of these synergies can lead to the failure of the deal. Hence, it is very important to calculate correctly the synergies of the deal in process. Now both the parties of the deal would calculate different valuations of the company to be acquired or merged. The bidder would try to acquire the target company at lowest cost possible and the target company would inflate its value to gain most out of the process. But first we would look onto the methods to calculate synergies which are:

** Free cash flow method** : In this method we divide synergies into two components viz. revenue based synergies and cost based synergies.

Three types of scenarios are considered which signifies pessimistic, normal and optimistic approaches. Cross selling potential of a company due to merger would be calculated as a percentage of targeted sales. Cross selling means that a bidder or target company would be able to target the customers and regions of each other and hence increase sales. Also the revenues would increase due to combined media and advertising efforts, improved product mix, and enhanced distribution network and monopoly power increased due to reduced competition. After taking all these factors into account, revenue increase is calculated as a percentage of target sales.

Now, cost based synergies arises due to decreased production costs through horizontal integration as production volume increases. Also sharing of corporate offices, computer systems and management staff reduction leads to saving of costs to the company. Cost reduction takes place also in case of vertical integrations as coordinating of closely related operations becomes easier. Example of this can be airline companies purchasing hotels and car rental companies to better serve their customers and hence expect a premium for their service. Another reason could be reduction in research and development costs by acquiring or merging with a company which already has that technology. Tax based cost reduction would also be incorporated in all the three scenarios.

In the end, these cost based synergies can be broadly classified into manufacturing cost synergies, R&D synergies, selling, general and administrative cost synergies and sourcing synergies. Another factor could be considered would be planned sale of some assets which would produce future cash flows after merger.

We can see that we have considered all the factors behind synergies and their cost advantages taken into consideration, we would be able to calculate the future cash flows and hence net present value of the firm.

But what are the factors on which future sales of a company are dependent? Hence we should incorporate in our calculations also the change in market size in coming years which will determine the market share of the company in consideration. Hence cumulative annual growth rate of the industry over the pertinent past years and future expected growth rate should be taken into consideration. The firm’s growth stage would be very helpful in determining the future expected growth rates.

Another point in consideration would be the time required for the company to reach its target market share or sales. Definitely more time would suggest more adjustments to the calculations as there could be new players entering the market or competitors gaining some competitive edge in these years. If we calculate the above parameters, then cash flows could be calculated as following:

**Total sales of the market (total demand) x (Market share of the target company )****.****= Stand-alone sales of the target company ****X (EBIT margin i.e. less operative costs).**

**= Earnings before interest and taxes****- Taxes****+/- Cash flow adjustments.**

**= Free cash flows**

These future cash flows could be then discounted for the years calculated for all the three probable situations.

Now, if we say that we can determine the probability at which these three types of scenarios would occur by considering past data of the market and expected scenario of the market by drawing a probability distribution curve, we can determine the expected net present value for the firm by multiplying each probability with the NPV of each scenario and adding them.

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**Expected value of the firm= {probability of pessimistic scenario * NPV (pessimistic)} + {probability of normal scenario * NPV (normal)} + {probability of optimistic scenario * NPV (optimistic)}**

If this expected value of the firm after M&A deal exceeds the NPV of the individual firms before the deal, then definitely the deal would be beneficial. But in real case scenario, the target company would also be able to calculate these figures and may demand a premium which could reduce the synergy value. Hence the premium given to the target company should be subtracted from the synergy value calculated to get the fair synergy value for the bidder. Sometimes a bidder may go for an M&A even if the synergy value is negative just to gain a strategic advantage or it thinks it can reorganize the target company to give better than expected sales or help increase its own sales and create shareholder value. This could also happen if the M&A adds to the goodwill of the company or it wants to eliminate competition.

Even after we calculate the NPV’s of the merged firm and the individual firms and think that the deal is beneficial, we are forgetting that this can apply only to the private firms. As for public firms, shares are traded in the market and hence to acquire or merge a company, the bidder has to pay an amount which is greater than the market capitalization of the target company. And in most cases, price of the share would be greater than of the true value of the firm calculated through its earnings. Hence a firm has to pay a greater value than the present worth of the company as its shareholders consider the company to grow more in the future. And definitely the value of synergy would be affected because of the increase in bidding value for the M&A.

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** Enterprise value method or relative valuation**:

We calculate a value known as enterprise value which is calculated as given below:

EV= Market value of equity + market value of debt – cash

Value of equity and debt is at market value as it s the figure which the bidder has to compensate presently. Now this enterprise value is divided by EBITDA to get EV/EBITDA. If this value is greater than the industry average, that means that the stock is overvalued and should not be bought and if it is below, the deal should be done taking into consideration the premium given to the target company by the bidder.

Now we have seen the different methods of calculating synergies and the contributing factors. But I feel that these methods simply ignore one factor which could alter the value of synergy i.e. the change in organizational structure. Whenever there is an M&A, there is an amalgation of two organizations which could either increase or decrease the synergy value. There could be many factors such as conflicts between the staff of both companies which could deteriorate the working environment and hence decrease the operational efficiency of the workers. Also the management would spend precious time in resolving conflicts than to focus on their core job. Although this factor is highly descriptive to calculate but should always be considered while taking M&A decisions. Best example would be unsuccessful acquisition of Montgomery securities by Nations Bank Corp. in 1997 due to too aggressive culture integration. Less than a year and half later Montgomery securities founder Thomas Wiesel left, taking 100 of his best investment bankers with him.

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**Summary**

Through this article, I tried to analyze the factors behind synergy and their calculation through cash flow method and relative valuation. We also considered the management influence on the M&A deal. Mergers and acquisitions is an alternative to organic growth and hence require careful consideration and calculation to get a fair deal out of it. At last I would like to say that keeping calculations aside, the deal should also be evaluated on the basis of human and psychological factors, the industry per se and the government regulations currently and expected changes in the future.

*The article has been authored by Saket Sourabh, MDI Gurgaon.*

**References**

Stephen A Ross, 2009, corporate finance-eighth edition, pp 963-1010

Bruner, R., 2004a, "Where M&A Pays and Where It Strays; A survey of the

Research," Journal of Applied Corporate Finance*, *16, pp. 63-76

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