Valuation of Synergies

NIHAR DALAL
BE MBA(FIN) MS(FIN) CFA
The Idea of Synergy

• When two companies A and B combine, the combined value V(AB)

is higher than the value of the companies independently ie
V(A)+V(B)
• Synergy is often the rationale given by acquiring companies
Types of Synergies

1. Operational Synergies
2. Financial Synergies
1. Operational Synergies

a) Economies of scale leading to a cost advantage

b) Pricing Power due to the increased firm size/elimination of
competition
c) Differing skillsets
d) Higher growth due to geographic expansion and/or extended
product line
2. Financial Synergies

a) Excess Cash/Cash Slack

b) Increased debt capacity
c) Tax benefits
d) Diversification
Valuing Operating Synergies (Cost Synergy)

1) Value the firms independently

2) Add these two values to obtain the value of the combined firm
without synergies
3) Build the effect of synergy into growth rates and cash flows and
value the combined firm with synergy
4) The difference in the value between step 3 and step 2 is the
value of synergy
Illustration

Firm A Firm B
beta 0.9 0.9
Pre tax cost of debt 5% 5%
Tax rate 30% 30%
Debt/Total Capital 10% 10%
Revenues 1000 500
EBIT 50 25
RoIC (after tax) 10.5% 10.5%
Reinvestment Rate 70% 70%
Growth Period 5 5
Illustration (contd..)

• The WACC for both the firms is 7.42% based on a beta of 0.9, a
long bond rate of 4.25% and a risk premium of 4%
• The growth rate in the explicit period is arrived at by multiplying
the reinvestment rate (70%) by the RoIC(15%)
Illustration (contd..)

• In the terminal phase both firms are expected to grow at 4.25%.

Based on the RoIC=Cost of capital in terminal phase we arrive at
the reinvestment rate as g/RoIC=4.25/7.42=57.28
• Using these inputs, we value the firm A at 542 and firm B at 271
• The value of the combined firm is 542+271=813
Illustration (contd..)

• To value synergy, assume that the combined firm will be able to

lower operating expenses (cost synergy) by 15 increasing the EBIT
from the current 75(50+25) to 90
• Now with a EBIT of 90, the combined firm with all the other
assumption being same is valued at 977 (see calculations in
following slides)
• The value of synergy is therefore 977-813=164
Combined Firm

• Cost of capital stays same at 7.42%

• RoIC stays at 10.5% (although the base year EBIT goes to 90) and
growth rate in explicit period stays at 7.35% based on the
reinvestment rate staying same at 70%
Valuing Synergy

1 2 3 4 5
EBIT@7.35% 96.61 103.71 111.33 119.52 128.30
Tax Rate 30% 30% 30% 30% 30%
NOPAT 67.62 72.59 77.93 83.66 89.81
Reinvest Rate 70% 70% 70% 70% 70%
FCFF 20.28 21.77 23.37 25.09 26.94
DF@7.415% 0.93 0.866 0.8067 0.7510 0.6991
Valuing Synergy

• The PV(FCFF) in growth stage is 94.23

• The terminal value is calculated at the end of year 5 assuming
that the RoIC in terminal phase equals the cost of capital of
7.415% leading to a reinvestment rate of 4.25/7.415=57.27%
• Growing the year 5 NOPAT of 89.81 by 4.25% and taking r=7.415,
we get TV=1261.95 which when discounted to present gives the
PV(TV)=882.22
• The combined firm is worth 94.23+882.22=976.45 or 977
Valuing Operating Synergies (Growth Synergy)

• With the same two companies earlier, if synergy instead of showing up in

lowering of operating expenses had instead showed up in RoIC going
from 10.5%(pre-merger) to 12.6% post merger the value of the combined
firm would be 869 keeping all other assumptions same.
• The value of synergy in this case would be 869-814=55
• If instead the combined firms saw increased investment opportunities we
would have changed the reinvestment rate to reflect this scenario.
• In reality, more than one variable is likely to change which can be
modeled using the same process
Valuing Financial Synergies

• Tax benefits lead to synergy if a profitable firm acquires a money

losing firm with tax loss carryforwards. The combined firm ends up
lowering its tax rate and increasing its value
• If two firms with cash flows that are not correlated combine then
the combined firm can increase its debt lowering its WACC and
creating value
Illustration

Acquiring Firm Target Firm Combined Firm

• The following data is REVENUES 1500 1000 2500
provided on the acquiring EBIT(1-T) 150 75 250
and target companies.
Evaluate whether the COST OF CAPITAL 8% 10% 9%
merger makes sense? RoIC 12% 10% 14%
Expected Growth Rate 3% 3% 4%
Solution

• V(A)=150-0.25(150)/0.08-0.03=2250
• V(T)=75-0.3(75)/0.10-0.03=750
• Value of V(A)+V(T)=3000
• Value of Combined firm (with synergies)=250-0.285(250)/0.09-
0.04=3575
• Value of Synergy=3575-3000=575
Valuing Synergies

• What if the synergies are likely to spread equally over a 5 year

period?