Financial Synergy occurs when the joining of two companies improves financial activities to a level greater than when the companies were operating as separate entities. Usually, M&A transactions result in a larger company, which has a higher bargaining power to get a lower cost of capital. Achieving a lower cost of capital as a result of a merger or acquisition is an example of Financial Synergy.
Synergy in M&A is achieved when the value added from the joining of two companies is greater than that of the companies operating as separate entities. A good way to think about it is the formula below:
The classification of Synergy as either Financial or Operating is similar to the classification of a cash flow as either financing or operating. Synergy can arise in both operating activities and in financing activities. The main difference between the two is:
Financial Synergy arises from the improved efficiency of financing activities and is primarily linked to a reduction in the Cost of Capital.
Operational Synergy is achieved through the improvement of operating activities, such as reduced costs from Economies of Scale.
Benefits of Financial Synergy
Financial synergy can either be positive or negative. Positive financial synergy results in increased benefits in terms of tax, profitability, and debt capacity. Negative synergy is when the value of the merged firms is lower than the combined value of each separate firm.
To get the overall value of the merged company’s revenue and expenses, evaluate all the income statements together. Assess whether the combined profitability from the income statements creates positive synergy. Also, examine the debt capacity of the combined firm from the balance sheets and, finally, check whether the company’s’ cash from the cash flow statement results in a positive synergy.
Examples of positive financial synergy benefits:
1. Tax Benefits
Many tax implications arise when two or more firms merge. Tax benefits can arise from a merger, taking advantage of existing tax laws and using net operating losses to shield income. If a profitable firm acquires a loss-making company, it can manage to reduce its tax burden by using the net operating losses (NOL) of the target company. Also, a firm that can increase its depreciation charges after a merger can save on tax costs and increase in value.
The firm’s unused debt capacity, unused tax losses, surplus funds, and write-up of depreciable assets also create tax benefits.
2. Increased Debt Capacity
Debt capacity can increase because when two companies merge because their cash flows and earnings may become more steady and predictable. A merged firm may also manage to acquire more debt from lending institutions, which can help reduce the overall cost of capital. Smaller companies usually need to pay higher interest rates when taking out a loan in relation to bigger companies.
Combined firms are able to get better interest rates on loans because they achieve better capital structure and cash flow to secure their loan. Since banks base their interest rates on the liquidity and leverage of a specific company, a combined firm is able to get loans with a more favorable interest rate.
3. Diversification and Reduced Cost of Equity
A lower cost of capital through reduced cost of equity arises from diversification. It often happens when large firms acquire smaller ones or when publicly traded firms acquire private firms that are in a different industry. The diversification effect may reduce the cost of equity for the combined firm.
When firms merge, they gain a wider customer base, which can result in lower competition. The expanded customer base can also result in increased revenue, market share, and cash flows. Therefore these competitive advantages can reduce the cost of equity. However, this is highly dependent on the size and industry of the business.
Financial synergy is a commonly used in evaluating companies in the context of mergers and acquisitions. It is a type of synergy that relates to an improvement in financial performance when two firms combine. Financial synergy is often part of the argument in favor of a potential merger or acquisition.
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