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 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. There may be various sources for this extra value arise i.e., the increase in wealth of the shareholders as a result of merger. 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 costs, or from increased 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. Eliminating similar research efforts and repetition of work already done by the target firm will also substantially reduce the research and development expenditures in the new set up. 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 others 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 in various types of operating costs. These resultant economies arc known as synergistic operating economies. There is no denying the fact that there is a potential for operating synergy, in one form or the other, in most of take-over. Some disagreement exists however, over whether synergy can be valued, and if so, how much that value should be. Some argue that the synergy is too nebulous to be valued and that any attempt to do so requires so many assumptions that it is point less. Although valuing synergy requires assumptions about future cash flows and growth, the lack of precision in the process does not mean that an unbiased estimate of value cannot be made. The synergy can be valued by answering fundamental questions: What form is the synergy expected to take? Will it reduce costs as a percentage of sales and increase profit margins? Will it increase future growth?