Advanced financial management revision question and answer

Advanced Financial Management Block Revision Mock Exams

You have been asked to produce a briefing memo for senior management at your company on the subject of mergers and acquisitions. Your memo should identify and discuss:

(a) Possible synergies that might occur in mergers and acquisitions.

(b) Potential problems in the achievement of synergies.

(c) Whether or not mergers and acquisitions should be undertaken to achieve corporate diversification only.
Briefing Memo: Mergers and acquisitions

(a) The motive for many mergers and acquisitions is to create incremental value through the existence of synergy when two entities are combined. Synergy means that the value of the new whole is greater than the sum of the previous values of the component parts. Synergy may exist for several reasons:

Operating synergy:
Operating synergies arise from improved productivity, or from cost cutting as a result of the merger. Economies of scale or scope might exist in the larger merged entity. Such economies may relate to production, marketing or finance, the latter including access to capital markets on improved terms. There might also be increased market power, allowing some advantage to be taken of an oligopolistic position.

If the victim company was relatively badly managed it might be possible to eliminate inefficiencies that previously existed. Alternatively better use may be made of talented managers who were not previously utilised to their full potential.

Where a victim company is „cash rich‟ more efficient use might be made of such cash.

Gains may occur from horizontal mergers where competitors are purchased. Gains occur through rationalization of research and development, sales and distribution, duplicated facilities and sales outlets, computer facilities etc. Vertical mergers between customers and suppliers can create value eliminating various co-ordination, security of supply and bargaining problems.

Synergy may exist though the greater ability to transfer from one division to another.

Financial synergy:
Financial synergy may exist after a merger as the new entity may be more diversified. Diversification reduces the risk of cash flows, making the company more attractive to investors and reducing the company‟s cost of capital.

There may also be tax synergies, wherethe combined entity is able to fully utilize tax allowances or tax losses that could not previously be utilised.

(b) Evidence suggests that many mergers and acquisitions do not achieve the forecast synergies, and that shareholders in the target firm reap most benefits from any additional value created. Reasons for not achieving expected synergy include:

• The acquisition decision is based upon incomplete or incorrect information
• Synergies are difficult to value
• Unexpected costs and problems exist when combining two organizations with different organizational structures, cultures and managerial styles.
• Managers are not given suitable incentives to achieve maximum synergies.

(c) Mergers purely for diversification may be beneficial as they may reduce the cost of capital explained above. Other possible benefits from diversification are:

• The flexibility of the company may be enhanced
• Debt capacity is normally increased
• The risk of corporate failure is often reduced
• Competitors may find it more difficult to access relevant information about a diversified company, as it is not immediately clear how individual sections of the company are performing, and what is their strategy.

However, it is usually considered that investors can diversify far more efficiently through their portfolios than can company managers.

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