Synergy 4 / 7

The combinations should be pursued if they increase the shareholder wealth

The combinations should be pursued if they increase the shareholder wealth

Synergies can be separated into three types:

  1. 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;

  2. 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.

  3. 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).

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