BUCAS GRANDE FOUNDATION COLLEGE

Taruc, Socorro, Surigao del Norte

Lecture Notes

in

ELEC 12
MERGER AND ACQUISITION

(Bachelor of Science in Entrepreneurship)

1ST Semester, AY 2022-2023

Prepared by:

Jackylou Hingpit Canta

Instructor

ELEC 12 – MERGER AND ACQUISITION 1

 TABLE OF CONTENTS

Chapter 2 Topics Pages

The Goal of Acquisition ------------------------------------------------------------ 3

Understanding Synergy in M&A Transactions ---------------------------------- 3
Classifications of Synergy --------------------------------------------------------- 3
Synergy Can Be Positive or Negative -------------------------------------------- 4
Acquisition Strategies --------------------------------------------------------------- 4
Scale Acquisition --------------------------------------------------------------------- 4
Scope Acquisition -------------------------------------------------------------------- 5
Diversification ------------------------------------------------------------------------ 5
Strategic Disposal -------------------------------------------------------------------- 6

ELEC 12 – MERGER AND ACQUISITION 2

The Goal of Acquisition
The objective of an acquisition should be – and is usually is – an enhancement of
shareholder value. At its simplest, this means that an acquirer has to be able to
generate a better return on its capital that if would achieve otherwise. This could be
achieved through increasing revenue, cutting cost, making its assets work more
efficiently, solving problems with its suppliers or getting access to more opportunities
for growth, or it could just come about through paying a low price for good assets.

Understanding Synergy in M&A Transactions

Synergy, most commonly used in M&A, refers to the additional value created by
a transaction. When a transaction has synergy, it means that the value of the newly
created entity will be greater than the value of the separate individual parts.
For example, if Company A and Company B are worth $200m and $50m on a
stand-alone basis respectively, yet when combined through an M&A transaction are
valued at $285m, there is a synergy of $35m.
From a buyer’s perspective, synergies influence the maximum price they can
afford to pay for a company. In the example above, the value of Company B on a
stand-alone basis was only $50m. However, with synergies, it was $85m. So, Company
A could theoretically afford to pay more than $50m and still have the deal make
economic sense.
From a seller’s perspective, understanding the potential synergies that a
purchaser may be able to extract from a transaction, provides a basis for negotiating in
favor of a higher purchase price. Company B could argue that it is worth more than
$50m because of the $35m in synergies that it offers Company A.
A key point to recognize is that synergies vary from one combination of
businesses to the next. While combining Company A and Company B offered $35m in
synergies, combining Company A and Company C may offer more, less or no synergies
depending on the specifics of those businesses.
We need to, at this stage, to introduce the concept of synergies. Synergies are
benefits that can only come about when two entities are joined together so that “two
plus two equals five”. To enhance shareholder value, the value of two businesses joined
together must be greater that they were separate. If the total future earnings from the
acquisition, or total capital uplift, are less than or equal to the cost of the acquisition,
the deal is wasted exercise. The benefits from the acquisition must outweigh the cost –
and to achieve this, either the target must be “cheap” or the acquisition must be able to
generate synergies from the buyer.

Classifications of Synergy
Synergies are the benefits that can only be achieved by putting two businesses
together. They can also be classified as follows:
Commercial synergies – those benefits that come from improvements in the
underlying business of the companies. For instance, increased sales volumes,
ability to charge higher prices, reduced production or administration costs, and

ELEC 12 – MERGER AND ACQUISITION 3

 greater efficiencies. They will usually result in improved profit margins or better
return on capital statistics.
Financial synergies - those benefits that come from better use of capital. For
example, being able to reduce the cost of borrowings or the cost of equity
capital, reducing the company’s tax charge, making use of surplus cash,
improving the mix of equity and borrowings. Financial synergies are usually
reflected in lower weighted average cost of capital (WACC) and improved
earnings per share (EPS).
Asset synergies - those benefits that come from better use of acquirer’s or
targets assets. For example, combining administration functions and then selling
the spare head office building, using excess manufacturing capacity to generate
higher production volumes, and combining a distribution network. These
synergies can be measured using metrics such as return on capital employed
(ROCE) or return on assets (ROA).
Revenue synergy - is based on the premise that the two companies combined
can generate higher sales than the sum of their individual sales. It should be
noted, however, the research shows that capturing revenue synergies takes, on
average, a few years longer than capturing cost synergies. For example, Disney’s
acquisition of Pixar in 2006 is often cited as an example of value generating
M&A, and with good reason. The deal made sense on a lot of levels, creating a
series of revenue synergies that added billions of dollars in value to the Walt
Disney Company stock price.
Cost synergy - is the savings in operating costs expected after the merger of two
companies. Cost synergies are cost reductions due to the increased efficiencies in
the combined company. It is one of three major synergy types, with the other
two being revenue and financial synergies. For example, the merger of Exxon
and Mobil in 1998 to create the world’s largest oil company by market cap,
generated massive cost savings. As two US oil companies, they possessed
several assets that were essentially overlapping each other and could be sold,
including refineries and 2,400 service stations. In addition, a total of 16,000
people were laid off, allowing the company to generate cost synergies of over $5
billion.

Synergy Can Be Positive or Negative

Synergy is positive when the idea is that the combined efforts of two or more
entities are greater than those entities alone. In business terms, however, though
companies may aim to achieve synergy by joining forces, the end result often lacks
synergy, making the endeavor a wasted one.
Synergy can also be negative. Negative synergy is derived when the value of the
combined entities is less than the value of each entity if it operated alone. This could
result if the merged firms experience problems caused by vastly different leadership
styles and corporate cultures.

Acquisition Strategies
Most acquisitions come about either because the acquirer’s management has
spotted an opportunity for growth, or because they have identified an issue which is
restricting their growth. We could illustrate this using an example company – a UK
chocolate manufacturer, called Bubbles.

Scale Acquisitions

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 Bubbles may be trying to increase its market share, in a competitive and
shrinking market. It could do this by acquiring a regional competitor business, which
would give it a larger share of its existing market while at the same time eliminating an
element of competition. This type of transaction, aimed just at increasing the scale of
operations, is sometimes referred to as a scale acquisition.
Where are the synergies? These could come from economies of scale: with this
larger market share, Bubbles should have a greater purchasing power, and be able to
purchase raw materials more cheaply and perhaps extract a higher price from retailers.
Asset synergies also come from using the distribution of networks of the target
company more effectively, putting additional volumes through its production facilities
and eliminating duplicated head office or other assets. In some cases the business
could also achieve revenue synergies, if, by sharing brands or sales forces, the
combined companies can create higher revenues that they could get independently.
Another area where value can be enhanced is management. This could come
from applying management skills and expertise to problem-solve and re-energize the
target, at the same time as eliminating any duplicated roles. And finally, by increasing
the critical mass of the company, Bubbles may be able to achieve some financial
synergies, through better and cheaper access to debt and equity capital or by pooling
working capital resources.

Scope Acquisitions
As an alternative to investing in its mainstream business, Bubbles could by a
company which also sells chocolates but in different geographical markets: or it could
buy a business which sells a different, complementary products (perhaps chocolate
biscuits) in the same markets as the purchaser. This is sometimes referred to as scope
acquisition – a broadening of the scope of the acquirer - and also sometimes referred to
as horizontal integration. Either way, Bubbles is staying within its central area of
activity, but widening its geographical or product range.
Another form of scope acquisition is vertical integration. This is the term used
when company expands into different stages in its supply chain. For example, Bubbles
might want to secure its access to good quality, competitively priced cocoa beans, and
could do this by acquiring a cocoa plantation or harvesting business. Alternatively, if it
wants to have control over its end markets, it might acquire a chocolate retail business.
In this case, the synergies would come mainly from cost reduction cutting out the
margins paid to the middleman. However, the reduction of the company’s risk will also
contribute to an increase in its value.
Backward integration refers to an acquisition further back along the supply chain
- for example, a manufacturer buying a producer of raw materials. Forward integration
refers to an acquisition further on the supply chain - for example, a motor manufacturer
buying a motor retailer or after-sales service business.

Diversification
Diversification involves buying a company in unrelated business. If Bubbles
decided that there was a limited growth in the chocolate market, it might acquire
company in a completely unrelated activity (say clothing) or in a different but linked
activity (such as bakery products). The scope for synergies is far lower with this
strategy; in most cases it relies on financial and asset synergies to enhance shareholder
value. This a strategy which was popular in Europe and North America in 1980’s but fell
out of favor in 1990’s, as investors developed a preference for focused businesses.

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 In addition, diversification acquisition is a corporate action whereby a company
takes a controlling interest in another company to expand its product and service
offerings. One way to determine if a takeover comes under diversification acquisition is
to look at the two companies Standard Industrial Classification (SIC) codes. When the
two codes differ, it means that they conduct dissimilar business activities. The acquirer
may believe the unrelated company unlocks synergies that promote growth or reduce
prevailing risks in other operations. Mergers and acquisitions (M&A) often take place to
complement existing business operations in the same industry.
Diversification acquisition often occurs when a company needs to lift shareholder
confidence and believe making an acquisition can facilitate a pop in the stock or buoy
earnings growth. Takeovers between two companies that share the same SIC code are
considered related or horizontal acquisitions, whereas two different codes fit in the
framework of an unrelated takeover.

Strategic Disposals
A corporate strategic review may prompt a company to refocus its activities in a
particular direction, or to focus only those activities it considers to be core, so that the
board adopts a disposal strategy. There are many reasons that specific companies are
selected:
 Sometimes the businesses to be sold are under-performing, relative to the
group, and therefore dilute shareholder returns and EPS.
 There may be a lack of synergies between the subsidiaries and the group, so
that there is no visible logic in keeping them. The capital invested in them can be
used more profitably elsewhere.
 The parent may have acquired a company with non-core or unwanted
subsidiaries and choose to sell these off to recover some of the acquisition cost
and create a more streamlined whole.

Cash can of course be a key disposal driver; if a parent company is short of cash
and has limited or no access to credit facilities or equity funding, it may have to
resort to asset sales, including business disposals, to create liquidity. Sometimes
there is one particular subsidiary that is highly cash negative, or need substantial
cash expand, so that the decision is taken to spin it off.
In owner-managed businesses, the disposal may be motivated by personal
considerations such as the retirement of the owner-manager (with the timing often
dictated by tax planning issues) combined with lack of family succession. Other
personal motivations could include financial necessity, perhaps due to litigation or
divorce, or even boredom.
Private equity and ventures capital firms are always, by their nature, both buyers
and sellers. The classic management buy-out (MBO) model starts with the private
equity firm’s co-acquisition of a business, alongside incumbent management, from
its previous owners. This is followed by financial and management investment in
that business, in order to create a step change in its equity value. Then, after
around three to five years, comes the exit – with the private equity firm either
selling that business, or carrying out an IPO, in order to realize a capital gain and
release funds for further reinvestment in other businesses.
This three-to-five-year cycle of “find-buy-change-sell” means that private
equity firms have been major players in the M&A markets, both as acquirers and
sellers, for decades.

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 Occasionally a disposal is required for regulatory reasons. One example is where
an anti-trust competition ruling requires an acquirer to sell all or part of its
acquisition target, to avoid a monopolistic or anti-competitive situation. Equally, a
purchaser or vendor could agree to dispose of a subsidiary during the course of
negotiations, in a pre-emptive attempt to avoid a negative ruling. Sometimes,
regulatory changes within a specific industry may give rise to a wave of disposals;
for example, the privatization of the electricity industry in the UK in the 1990’s
involve the breakup of companies into transmission, supply, retail and generation.

REFERENCES:
Chase-Dunn, C., 2002. Globalization: A World-Systems Perspective, in Preyer, G., M.
Bös, 2002. Borderlines in a Globalized World: New Perspectives in a Sociology of the
World-System. Kluwer Academic Publishers.
Czinkota, M., Ronkainen, I., 2007. International Marketing, 8th Edition, Thomson Higher
Education, Thomson South-Western, Mason, USA.
Rinne, A., 2013. Young Global Leaders Sharing Economy Dialogue Position Paper 2013,
Circular Economy Innovation & New Business Models Dialogue, World Economic Forum,
Geneva.
https://courses.lumenlearning.com/boundless-business/chapter/types-of-international-
business/
https://www.investopedia.com/terms/d/diversification-acquisition
https://www.cfsg.com.au/understanding-synergies-ma-transactions/
https://dealroom.net/blog/types-of-synergies-in-mergers-and-acquisitions-with-
examples

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