Value Creation in Mergers and Acquisitions

Value Creation in Mergers and Acquisitions

The primary motive should be the creation of synergy.

          Synergy value is created from economies of integrating a target and acquiring a company; the amount by which the value of the combined firm exceeds the sum value of the two individual firms.

Creation of Synergy Motive for M&As

Synergy is the additional value created (∆V) :

∆V = V_{A-T –}  (V_A + V_T)

Where:

V_T         =       the pre-merger value of the target firm

V_{A - T}  =       value of the post merger firm

V_A     =       value of the pre-merger acquiring firm

Value Creation Motivations for M&As

Operating Synergies

1.     Economies of Scale

·        Reducing capacity (consolidation in the number of firms in the industry)

·        Spreading fixed costs (increase size of firm so fixed costs per unit are decreased)

·        Geographic synergies (consolidation in regional disparate operations to operate on a national or international basis)

2.     Economies of Scope

·        Combination of two activities reduces costs

3.     Complementary Strengths

·        Combining the different relative strengths of the two firms creates a firm with both strengths that are complementary to one another.

Efficiency Increases

–       New management team will be more efficient and add more value than what the target now has.

–       The combined firm can make use of unused production/sales/marketing channel capacity

Financing Synergy

–       Reduced cash flow variability

–       Increase in debt capacity

–       Reduction in average issuing costs

–       Fewer information problems

Tax Benefits

–       Make better use of tax deductions and credits

•         Use them before they lapse or expire (loss carry-back, carry-forward provisions)

•         Use of deduction in a higher tax bracket to obtain a large tax shield

•         Use of  deductions to offset taxable income (non-operating capital losses offsetting taxable capital gains that the target firm was unable to use)

•         New firm will have operating income to make full use of available CCA.

Strategic Realignments

–       Permits new strategies that were not feasible for prior to the acquisition because of the acquisition of new management skills, connections to markets or people, and new products/services.

Managerial Synergies

Managers may have their own motivations to pursue M&As.   The two most common, are not necessarily in the best interest of the firm or shareholders, but do address common needs of managers

1.     Increased firm size

–       Managers are often more highly rewarded financially for building a bigger business (compensation tied to assets under administration for example)

–       Many associate power and prestige with the size of the firm.

2.     Reduced firm risk through diversification

–       Managers have an undiversified stake in the business (unlike shareholders who hold a diversified portfolio of investments and don’t need the firm to be diversified) and so they tend to dislike risk (volatility of sales and profits)

–       M&As can be used to diversify the company and reduce volatility (risk) that might concern managers.

3.     Target shareholders gain the most

Through premiums paid to them to acquire their shares

15 – 20% for stock-finance acquisitions

25 – 30% for cash-financed acquisitions (triggering capital gains taxes for these shareholders)

4.     Gains may be greater for shareholders will to wait for  ‘arbs’ to negotiate higher offers or bidding wars develop between multiple acquirers.