CIMA F3 Syllabus D. Business valuation - Synergy - Notes 4 / 7
The combinations should be pursued if they increase the shareholder wealth
Synergies can be separated into three types:
Revenue synergy:
- which result in higher revenues for the combined entity,
- higher return on equity and
- a longer period when the company is able to maintain competitive advantage;Cost synergy:
- which result mainly from reducing duplication of functions and related costs, and from taking advantage of economies of scale;
Sources of which include:
o Economies of scale (arising from eg larger production volumes and bulk buying);
o Economies of scope (which may arise from reduced advertising and distribution costs where combining companies have duplicated activities);
o Elimination of inefficiency;
o More effective use of existing managerial talent.
Financial synergy:
- which result from financing aspects such as the transfer of funds between group companies to where it can be utilised best, or from increasing debt capacity.
Sources of which include:
o Elimination of inefficient management practices;
o Use of the accumulated tax losses of one company that may be made available to the other party in the business combination;
o Use of surplus cash to achieve rapid expansion;
o Diversification reduces the variance of operating cash flows giving less bankruptcy risk and therefore cheaper borrowing;
o Diversification reduces risk (however this is a suspect argument, since it only reduces total risk not systematic risk for well diversified shareholders);
o High PE ratio companies can impose their multiples on low PE ratio companies (however this argument, known as “bootstrapping”, is rather suspect).