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Study notes

Synergy

  • Levels: A Level
  • Exam boards: AQA, Edexcel, OCR, IB, Eduqas, WJEC

Synergy is a key concept associated with external growth. Synergy happens when the value of two businesses brought together is higher than the sum of the value of the two individual businesses. in other words, when synergy happens, 1 + 1 = more than 2!

Revision Video - Synergy

There are two main kinds of synergy:

Cost synergy: where cost savings are achieved as a result of external growth

Revenue synergy: where additional revenues are achieved as a result of external growth

Cost Synergies

When two businesses are combined there is often significant scope for achieving cost savings. These might include:

Eliminating duplicated functions & services (e.g. combining the two accounting departments)

Getting better deals from suppliers - which might be possible if combining two businesses gives them improved bargaining power

Higher productivity & efficiency from shared assets: can capacity utilisation of the combined businesses be improved, perhaps by closing down spare capacity?

Example of successful cost synergies:

Back in 2004, investors and analysts were doubtful that Spanish banking giant Santander would be able to achieve its ambitious plan of stripping out £300 million of costs from Abbey National which it bought for £9.6bn. In fact, Santander delivered the £300 million of cost synergies a year ahead of schedule.

Revenue Synergies

Potential revenue synergies include:

Marketing and selling complementary products
Cross-selling into a new customer base
Sharing distribution channels
Access to new markets (e.g. through existing expertise of the takeover target)
Reduced competition

The Crucial Role of Synergy in Takeovers and Mergers

The primary objective of any takeover is to create value for shareholders that exceeds the cost of the acquisition. In fact, synergies are fundamentally the only tangible justification for a takeover.

Synergies represent the extra value that can be created from the takeover. Assuming that the buyer has to pay a reasonable price for the takeover target, then no value has been created at that point.

For example, consider a business valued at £10 million by the market (e.g. from the market capitalisation on the stock market).

A buyer comes along and, after negotiation and due diligence, agrees to pay £13 million to complete the takeover. The buyer has paid a bid premium of 30% (or £3 million) to complete the takeover.

The shareholders of the target business are happy. But the shareholders of the buyer business will need to be convinced that the price was worth paying. They have had to pay £3 million over the apparent value of the business to achieve the takeover.

How can the bid premium be justified? Only if the takeover achieves synergies worth at least £3 million in value terms (e.g. the NPV of future synergies).

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