Question

Present a framework for estimating the value of operational synergies from a merger. Identify different potential sources of such synergies. Explain possible difficulties in making estimates of the value of operational synergies and methods of mitigating the difficulties.

Answer 1

operational synergy is the value of two firms is higher when combined than the value when the both firms are apart which results in growth of firms.

The following framework is implemented in estimating the value of operational synergies from a merger:

1. We should value the fims involved in the merger independently by way of discounting cash flows for the each firm at the weighted average cost of capital for that firm.

2. We estimate the value of merged firm by adding the value of each firm that was obtained in the first place.

3. We build in the effects of synergy into expected growth rates and cash flows and we revalue the combined firm with synergy. The difference between the value of the combined firm with synergy and the value of the combined firm without synergy provides a value for synergy.

It is important at this stage that we keep the value of the synergy apart from the value of the control. The value of the control is the incremental value that an acquirer believes can be created by running a target firm more efficiently.

The following are the potential sources of synergy:

1. Revenue enhancements
2. Cost reductions
3. Process improvements
4. Financial economies

1. Revenue enhancements can be achieved when the combined company offers a broader line of products and services by leveraging the the distribution system of the new entity.The expanded or improved product line also may qualify the combined company to compete for business that was not available to either the ac­quirer or the target operating as stand-alone businesses.

2. To succeed with cost reductions, particular attention must be paid in advance to job titles. Since these tend to vary among companies, identifying which specific functions can be eliminated becomes more difficult. In particular salaries require vigilance because while removed from the position, the individuals who held them sometimes survive in the new entity in a different department.

3. Process improvements occur when the combined entity adopts the most effective practices employed by the target or ac­quirer. These enhancements frequently result from process improvements that can be leveraged over the broader base of the combined entity. The improvements can create en­hanced revenues or cost reductions and more efficient oper­ations.

4. Financial economies will raise the investment value of the target company but not its own fair market value.The combination also may lower the combined en­tity’s financing costs and may allow for efficiencies in lease terms, cash management. The value of a target, however, cannot be enhanced by at­tributing to it a lower cost of capital through use of more debt fi­nancing.