Mergers and Acquisitions – Synergies through Consolidation

Synergy implies a situation where the combined firm is more valuable than the sum of the individual combining firms. It is defined as ‘two plus two equal to five’ (2+2>4) phenomenon. Synergy refers to benefits other than those related to economies of scale. Operating economies are one form of synergy benefits. But apart from operating economies, synergy may also arise from enhanced managerial capabilities, creativity, innovativeness, R&D and market coverage capacity due to the complementarily of resources and skills and a widened horizon of opportunities.

An under valued firm will be a target for acquisition by other firms. However, the fundamental motive for the acquiring firm to takeover a target firm may be the desire to increase the wealth of the shareholders of the acquiring firm.  This is possible only if the value of the new firm is expected to be more than the sum of individual value of the target firm and the acquiring firm. For example, if A Ltd. and Ltd. decide to merge into AB Ltd. then the merger is beneficial if

V (AB)> V (A) +V (B)


V (AB)    =     Value of the merged entity

V (A)      =     Independent value of company A

V (B)       =    Independent value of company B

A merger which results in meeting the test of increasing the wealth of the shareholders is said to contain synergistic properties. Synergy is the increase in the value of the firm combining two firms into one entity i.e., it is the difference value between the combined firm and the sum of the value of the individual firms. Igor Ansoff (1998) classified four different types of synergies. These are:

1. Operating synergy:

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 sources of synergy of specialized resources will vary depending upon the merger. In case of horizontal merger, the synergy comes from some form of economies of scale which reduce the cost or from increase market power which increases profit margins and sales. There are several ways in which the merger may generate operating economies. The firm might be able to reduce the cost of production by eliminating some fixed costs. The research and development expenditures will also be substantially reduced in the new set up by eliminating similar research efforts and repetition of work already done by the target firm. The management expenses may also come down substantially as a result of corporate reconstruction.

The selling, marketing and advertisement department can be streamlined. The marketing economies may be produced through savings in advertising (by reducing the need to attract each other’s customers), and also from the advantage of offering a more complete product line (if the merged firms produce different but complementary goods), since a wider product line may provide larger sales per unit of sales efforts and per sales person. When a firm having strength in one functional area acquires another firm with strength in a different functional area, synergy may be gained by exploiting the strength in these areas. A firm with a good distribution network may acquire a firm with a promising product line, and thereby can gain by combining these two strength. The argument is that both firms will be better off after the merger. A major saving may arise from the consolidation of departments involved with financial activities e.g., accounting, credit monitoring, billing, purchasing etc.

Thus, when two firms combine their resources and efforts, they will be able to produce better results than they were producing as separate entities because of savings various types of operating costs. These resultant economies are known as synergistic operating economies.

In a vertical merger, a firm may either combine with its supplier   of input (backward integration) and/or with its customers (forward integration). Such merger facilitates better coordination and administration of the different stages of business stages of business operations-purchasing, manufacturing and marketing –eliminates the need for bargaining (with suppliers and/or customers), and minimizes uncertainty of supply of inputs and demand for product and saves costs of communication.

An example of a merger resulting in operating economies is the merger of Sundaram Clayton Ltd. (SCL) with TVS-Suzuki Ltd. (TSL).By this merger, TSL became the second largest producer of two –wheelers after Bajaj. The main objective motivation for the takeover was TSL’s need to tide over its different market situation through increased volume of production. It needed a large manufacturing bas to reduce its production costs. Large amount of funds would have been required for creating additional production capacity. SCL also needed to upgrade its technology and increase its production. SCL’s and TCL’s plants were closely located which added to their advantages. The combined company has also been enabled to share the common R&D facilities.

2. Financial synergy:

Financial synergy refers to increase in the value of the firm that accrues to the combined firm from financial factors. There are many ways in which a merger can result into financial synergy and benefit. A merger may help in:

  • Eliminating financial constraint
  • Deployment surplus cash
  • Enhancing debt capacity
  • Lowering the financial costs
  • Better credit worthiness

Financial Constraint: A company may be constrained to grow through internal development due to shortage of funds. The company can grow externally by acquiring another company by the exchange of shares and thus, release the financing constraint.

Deployment of surplus cash: A different situation may be faced by a cash rich company. It may not have enough internal opportunities to invest its surplus cash. It may either distribute its surplus cash to its shareholders or use it to acquire some other company. The shareholders may not really benefit much if surplus cash is returned to them since they would have to pay tax at ordinary income tax rate. Their wealth may increase through an increase in the market value of their shares if surplus cash is used to acquire another company. If they sell their shares, they would pay tax at a lower, capital gains tax rate. The company would also be enabled to keep surplus funds and grow through acquisition.

Debt Capacity: A merger of two companies, with fluctuating, but negatively correlated, cash flows, can bring stability of cash flows of the combined company. The stability of cash flows reduces the risk of insolvency and enhances the capacity of the new entity to service a larger amount of debt. The increased borrowing allows a higher interest tax shield which adds to the shareholders wealth.

Financing Cost: The enhanced debt capacity of the merged firm reduces its cost of capital.  Since the probability of insolvency is reduced due to financial stability and increased protection to lenders, the merged firm should be able to borrow at a lower rate of interest. This advantage may, however, be taken off partially or completely by increase in the shareholders risk on account of providing better protection to lenders. Another aspect of the financing costs is issue costs. A merged firm is able to realize economies of scale in flotation and transaction costs related to an issue of capital. Issue costs are saved when the merged firm makes a larger security issue.

Better credit worthiness: This helps the company to purchase the goods on credit, obtain bank loan and raise capital in the market easily.

RP Goenka’s ceat tyres sold off its type cord division to Shriram Fibers Ltd. in 1996 and also transfer’s its fiber glass division to FGL Ltd., another group company to achieve financial synergies.

3. Managerial synergy

One of the potential gains of merger is an increase in managerial effectiveness. This may occur if the existing management team, which is performing poorly, is replaced by a more effective management team. Often a firm, plagued with managerial inadequacies, can gain immensely from the superior management that is likely to emerge as a sequel to the merger. Another allied benefit of a merger may be in the form of greater congruence between the interests of the managers and the shareholders.

A common argument for creating a favorable environment for mergers is that it imposes a certain discipline on the management. If lackluster performance renders a firm more vulnerable to potential acquisition, existing managers will strive continually to improve their performance.

4. Sales synergy

These synergies occurs when merged organization can benefit from common distribution channels, sales administration, advertising, sales promotion and warehousing.

The Industrial Credit and Investment Corporation of India Ltd. (ICICI) acquired Tobaco Company, ITC. Classic and Anagram Finance to obtain quick access to a well dispersed distribution network.

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