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The Value of Synergy: Aswath Damodaran
The Value of Synergy: Aswath Damodaran
AswathDamodaran
Aswath Damodaran
ValuingSynergy
Thekeytotheexistenceofsynergyisthatthetargetfirmcontrolsa
specialized resource that becomes more valuable if combined with
the bidding firm's resources. The specialized resource will vary
dependinguponthemerger:
Inhorizontalmergers:economiesofscale,whichreducecosts,orfrom
increased market power, which increases profit margins and sales.
(Examples:BankofAmericaandSecurityPacific,ChaseandChemical)
In vertical integration: Primary source of synergy here comes from
controllingthechainofproductionmuchmorecompletely.
In functional integration: When a firm with strengths in one functional
area acquires another firm with strengths in a different functional area,
the potential synergy gains arise from exploiting the strengths in these
areas.
Aswath Damodaran
Valuingoperatingsynergy
(a)Whatformisthesynergyexpectedtotake?Willitreducecostsasa
percentage of sales and increase profit margins (as is the case when
there are economies of scale)? Will it increase future growth (as is
thecasewhenthereisincreasedmarketpower)?)
(b) When can the synergy be reasonably expected to start affecting
cashflows? (Will the gains from synergy show up instantaneously
afterthetakeover?Ifitwilltaketime,whencanthegainsbeexpected
tostartshowingup?)
Aswath Damodaran
Sources of Synergy
Strategic Advantages
Higher returns on
new investments
More new
Investments
Higher ROC
Higher Reinvestment
Higher Growth
Rate
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Economies of Scale
More sustainable
excess returns
Cost Savings in
current operations
Longer Growth
Period
Higher Margin
Financial Synergy
Tax Benefits
Added Debt
Capacity
Lower taxes on
earnings due to
- higher
depreciaiton
- operating loss
carryforwards
Higher debt
May reduce
raito and lower cost of equity
cost of capital for private or
closely held
firm
Diversification?
Aprocedureforvaluingsynergy
(1) the firms involved in the merger are valued independently, by
discountingexpectedcashflowstoeachfirmattheweightedaverage
costofcapitalforthatfirm.
(2) the value of the combined firm, with no synergy, is obtained by
addingthevaluesobtainedforeachfirminthefirststep.
(3) The effects of synergy are built into expected growth rates and
cashflows,andthecombinedfirmisrevaluedwithsynergy.
ValueofSynergy=Valueofthecombinedfirm,withsynergyValueof
thecombinedfirm,withoutsynergy
Aswath Damodaran
Aswath Damodaran
ValuingSynergy:CompaqandDigital
In1997,CompaqacquiredDigitalfor$30pershare+0.945Compaq
sharesforeveryDigitalshare.($5360pershare)Theacquisitionwas
motivatedbythebeliefthatthecombinedfirmwouldbeabletofind
investment opportunities and compete better than the firms
individuallycould.
Aswath Damodaran
Background Data
Compaq
CurrentEBIT
CurrentRevenues
CapitalExpendituresDepreciation
Expectedgrowthratenext5years
Expectedgrowthrateafteryear5
Digital
$2,987million
$25,484mil
$184million
10%
5%
$522million
$13,046mil
$14
10%
5%
Debt/(Debt+Equity)
Aftertaxcostofdebt
Betaforequitynext5years
Betaforequityafteryear5
WorkingCapital/Revenues
Taxrateis36%forbothcompanies
10%
5%
1.25
1.00
15%
20%
5.25%
1.25
1.0
15%
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Valuing Compaq
Year
FCFF
TerminalValue PV
1
$1,518.19
$1,354.47
2
$1,670.01
$1,329.24
3
$1,837.01
$1,304.49
4
$2,020.71
$1,280.19
5
$2,222.78
$56,654.81
$33,278.53
TerminalYear $2,832.74
$38,546.91
ValueofCompaq=$38,547million
Afteryear5,capitalexpenditureswillbe110%ofdepreciation.
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TheCombinedfirmwillhavesomeeconomiesofscale,allowingittoincrease
itscurrentaftertaxoperatingmarginslightly.Thedollarsavingswillbe
approximately$100million.
CurrentOperatingMargin=(2987+522)/(25484+13046)=9.11%
NewOperatingMargin=(2987+522+100)/(25484+13046)=9.36%
Thecombinedfirmwillalsohaveaslightlyhighergrowthrateof10.50%
overthenext5years,becauseofoperatingsynergies.
Thebetaofthecombinedfirmiscomputedintwosteps:
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DigitalsUnleveredBeta=1.07;CompaqsUnleveredBeta=1.17
DigitalsFirmValue=4.5;CompaqsFirmValue=38.6
UnleveredBeta=1.07*(4.5/43.1)+1.17(38.6/43.1)=1.16
CombinedFirmsDebt/EquityRatio=13.64%
NewLeveredBeta=1.16(1+(10.36)(.1364))=1.26
CostofCapital=12.93%(.88)+5%(.12)=11.98%
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TerminalValue PV
$1,541.95
$1,521.59
$1,501.50
$1,481.68
$66,907.52
$39,463.87
=$45,511
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ValueofCombinedFirmwitSynergy
ValueofCompaq+ValueofDigital
=38,547+4532
TotalValueofSynergy
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=$45,511million
=$43,079million
=$2,432million
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=$2,110million
=$2,521million
=$4,531million
=$2,432million
=$6,963million
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Thereare146.789millionDigitalsharesoutstanding,andDigitalhad
$1,006millionindebtoutstanding.Estimatethatmaximumpriceyou
wouldbewillingtoofferonthisdeal.
AssumethatCompaqwantedtodoanexchangeoffer,whereitwould
exchangeitssharesforDigitalshares.AssumingthatCompaqstockis
valuedat$27pershare,whatwouldbetheexchangeratio?
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Citicorp + Travelers = ?
Citicorp
Travelers
Net Income
$
3,591
BV of Equity
$
20,722
ROE
17.33%
Dividends
$
1,104
Payout Ratio
30.74%
Retention Ratio 69.26%
Expected growth 12.00%
Growth Period
5
Beta
1.25
Risk Premium
4.00%
MV of Equity (bil)
Cost of Equity
11.00%
Beta - stable
1.00
Growth-stable
6.00%
Payout-stable
65.38%
DDM
$ 70,743
DDM/share
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155.84
Citigroup
$
3,104 $
6,695
$
20,736
$
41,458
14.97%
16.15%
$
587
$
18.91%
25.27%
81.09%
74.73%
12.14%
12.07%
5
5
1.40
1.33
4.00%
4.00%
81
84
165.00
11.60%
11.31%
1.00
1.00
6.00%
6.00%
59.92%
62.85%
$ 53,464
$ 124,009
1,691
46.38
16
Baseduponthesenumbers,whatexchangeratiowouldyouagreetoas
aCiticorpstockholder?
Theactualexchangeratiowas2.5sharesofTravelersforeveryshare
ofCiticorp.AsaCiticorpstockholder,doyouthinkthatthisisa
reasonableexchangeratio?
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Increase in Equity
Value
30000
25000
20000
15000
10000
5000
0
Inc rease by1%
Inc rease by 2%
Inc rease by 3%
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Financial Synergy
SourcesofFinancialSynergy
Diversification:Acquiringanotherfirmasawayofreducingriskcannot
createwealthfortwopubliclytradedfirms,withdiversifiedstockholders,
butitcouldcreatewealthforprivatefirmsorcloselyheldpubliclytraded
firms.
CashSlack:Whenafirmwithsignificantexcesscashacquiresafirm,
withgreatprojectsbutinsufficientcapital,thecombinationcancreate
value.
TaxBenefits:Thetaxpaidbytwofirmscombinedtogethermaybelower
thanthetaxespaidbythemasindividualfirms.
DebtCapacity:Bycombiningtwofirms,eachofwhichhaslittleorno
capacitytocarrydebt,itispossibletocreateafirmthatmayhavethe
capacitytoborrowmoneyandcreatevalue.
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AssumethatyouareBestBuys,theelectronicsretailer,andthatyou
wouldliketoenterthehardwarecomponentofthemarket.Youhave
beenapproachedbyinvestmentbankersforZenith,whichwhilestilla
recognizedbrandname,isonitslastlegsfinancially.Thefirmhasnet
operatinglossesof$2billion.Ifyourtaxrateis36%,estimatethetax
benefitsfromthisacquisition.
IfBestBuyshadonly$500millionintaxableincome,howwouldyou
computethetaxbenefits?
IfthemarketvalueofZenithis$800million,wouldyoupaythistax
benefitasapremiumonthemarketvalue?
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OneoftheearliestleveragedbuyoutswasdoneonCongoleumInc.,a
diversifiedfirminshipbuilding,flooringandautomotiveaccessories,
in1979bythefirm'sownmanagement.
After the takeover, estimated to cost $400 million, the firm would be
allowedtowriteupitsassetstoreflecttheirnewmarketvalues,andclaim
depreciationonthenewvalues.
Theestimatedchangeindepreciationandthepresentvalueeffectofthis
depreciation, discounted at the firm's cost of capital of 14.5% is shown
below:
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Deprec'n
before
$8.00
$8.80
$9.68
$10.65
$11.71
$12.65
$13.66
$14.75
$15.94
$17.21
$123.05
Deprec'n
after
$35.51
$36.26
$37.07
$37.95
$21.23
$17.50
$16.00
$14.75
$15.94
$17.21
$249.42
Changein
Deprec'n
$27.51
$27.46
$27.39
$27.30
$9.52
$4.85
$2.34
$0.00
$0.00
$0.00
$126.37
TaxSavings
PV
$13.20
$13.18
$13.15
$13.10
$4.57
$2.33
$1.12
$0.00
$0.00
$0.00
$60.66
$11.53
$10.05
$8.76
$7.62
$2.32
$1.03
$0.43
$0.00
$0.00
$0.00
$41.76
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Whentwofirmsindifferentbusinessesmerge,thecombinedfirmwill
havelessvariableearnings,andmaybeabletoborrowmore(havea
higherdebtratio)thantheindividualfirms.
In the following example, we will combine two firms, with optimal
debtratiosof30%each,andendupwithafirmwithanoptimaldebt
ratioof40%.
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30%
6.00%
70%
13.60%
11.32%
11.32%
11.32%
11.32%
11.32%
10.55%
FirmB
NewDebt
30%
5.40%
70%
12.50%
10.37%
10.37%
10.37%
10.37%
10.37%
10.37%
ABNo
Debt
30%
5.65%
70%
12.95%
10.76%
10.76%
10.77%
10.77%
10.77%
10.45%
ABAdded
40%
5.65%
60%
13.65%
10.45%
10.45%
10.45%
10.45%
10.45%
9.76%
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FirmB
ABNonew ABAdded
Debt
Debt
FCFFinyear1 $120.00 $220.00 $340.00
$340.00
FCFFinyear2 $144.00 $242.00 $386.00
$386.00
FCFFinyear3 $172.80 $266.20 $439.00
$439.00
FCFFinyear4 $207.36 $292.82 $500.18
$500.18
FCFFinyear5 $248.83 $322.10 $570.93
$570.93
TerminalValue $5,796.97 $7,813.00 $13,609.97 $16,101.22
PresentValue $4,020.91 $5,760.47 $9,781.38
$11,429.35
Thevalueofthefirm,asaconsequenceoftheaddeddebt,will
increasefrom$9,781.38millionto$11,429.35million.
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o Theyconcludedthat28ofthe58programsfailedbothtests,and6failedatleast
onetest.
o
o
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Whogetsthebenefitsofsynergy?
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Synergyisoftenusedasaplugvariableinacquisitions:itisthe
differencebetweenthepricepaidandtheestimatedvalue.
Evenwhensynergyisvalued,thevaluationsareincompleteand
cursory.Somecommonmanifestationsinclude:
Valuingjustthetargetcompanyforsynergy(Youhavetovaluethe
combinedfirm)
Notthinkingaboutthecostsofdeliveringsynergyandthetimingof
gains.
Underestimatingthedifficultyofgettingtwoorganizaitons(withdifferent
cultures)toworktogether.
Failuretoplanforsynergy.Synergydoesnotshowupbyaccident.
Failuretoholdanyoneresponsiblefordeliveringthesynergy.
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Closing Thoughts
Ifanacquisitionismotivatedbysynergy,makearealisticestimateof
thevalueofthesynergy,takingintoaccountthedifficultiesassociated
withcombiningthetwoorganizationsandothercosts.
Donotpaythisvalueasapremiumontheacquisition.Yourobjective
istopaylessandshareinthegains.Ifyougetintoabiddingwarand
findyouhavetopaymore,dropout.
Haveadetailedplanforhowthesynergywillactuallybecreatedand
holdsomeoneresponsibleforit.
Followupthemergertoensurethatthepromisedgainsactuallyget
delivered.
Donottrustyourinvestmentbankersoranyoneelseinthedealto
lookoutforyourinterests;theyhavetheirown.Thatisyourjob.
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