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BBA 3rd Year concept Of Synergy Long Question Answer

BBA 3rd Year concept Of Synergy Long Question Answer

BBA 3rd Year concept Of Synergy Long Question Answer Study material Unit Wise division of the content Solved papers Last 3 Year examination 3 mock papers for self-assessment Book code-602

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BBA 3rd Year concept Of Synergy Long Question Answer
BBA 3rd Year concept Of Synergy Long Question Answer


(Long Answer Questions),(2014, 15)

Q.1. Explain the various types of synergy.

Ans. The various types of synergy are discussed as below:

1. Operating Synergy: Operating synergies are those synergies that allow firms to increase their operating income from existing assets or increase their growth or both. We would categories operating synergies into four types:

(a) Economies of scale that may arise from the merger, allowing the combined firm to become

more cost-efficient and profitable. In general, we would expect to see economies of scales in mergers of firms in the same business (horizontal mergers)- two banks coming together to create a larger bank or two steel companies combining to create a bigger steel company.

(b) Greater pricing power from reduced competition and higher market share, which should

result in higher margins and operating income. This synergy is also more likely to show up in mergers of firms in the same business and should be more likely to yield benefits when there are relatively few firms in the business to begin with. Thus, combining two firms is far more likely to create an oligopoly with pricing power.

(c) Combination of different functional strengths, would be the case when a firm with strong

marketing skills acquires a firm with a good product line. This can be applied to wide variety of mergers since functional strengths can be transferable across businesses.

(d) Higher growth in new or existing markets, arising from the combination of the two firms. This would be case, for instance, when a US consumer products firm acquires an emerging market firm, with an established distribution network and brand name recognition and uses these strengths to increase sales of its products. Operating synergies can affect margins, returns and growth, and through these the value of the firms involved in the merger or acquisition.

BBA 3rd Year concept Of Synergy Long Question Answer

2. Financial Synergy: With financial synergies, the payoff can take the form of either higher cash flows or a lower cost of capital (discount rate) or both. Included in financial synergies are as given:

(a) A combination of a firm with excess cash, or cash slack, (and limited project opportunities) and a firm with high-return projects (and limited cash) can yield a payoff in terms of higher value for the combined firm. The increase in value comes from the projects that can be taken with the excess cash that otherwise would not have been taken. This synergy is likely to show up most often when large firms acquire smaller firms, or when publicly traded firms acquire private businesses.

(b) Debt capacity can increase, because when two firms combine, their earnings and cash flows may become more stable and predictable. This, in turn, allows them to borrow more than they could have as individual entities, which creates a tax benefit for the combined firm

This tax benefit usually manifests itself as a lower cost of capital for the combined firm.

(c) Tax benefits can arise either from the acquisition taking advantage of tax laws to write up the target company’s assets or from the use of net operating losses to shelter income. Thus, a profitable firm that acquires a money-losing firm may be able to use the net operating losses of the latter to reduce its tax burden. Alternatively, a firm that is able to increase its

depreciation charges after an acquisition will save in taxes and increase its value.

(d) Diversification is the most controversial source of financial synergy, In most publicly traded firms, investors can diversify at far lower cost and with more ease than the firm itself. For private businesses or closely held firms, there can be potential benefits from diversification. Clearly, there is potential for synergy in many mergers. The more important issues relate to valuing this synergy and determining how much to pay for the synergy.

BBA 3rd Year concept Of Synergy Long Question Answer
BBA 3rd Year concept Of Synergy Long Question Answer

3. Valuing Synergy: The key question about synergy is not whether it can be valued but how it should be valued. After all, firms that are willing to pay billions in dollars for synergy have to be able to estimate a value for that synergy.

4. Valuing Operating Synergies: There is a potential for operating synergy, in one form or the other, in many takeovers. Some disagreement exists, however, over whether synergy can be valued and if so, what that value should be. One school of thought argues that synergy is too nebulous to be valued and that any systematic attempt to do so requires so many assumptions that it is pointless. If this is true, a firm should not be willing to pay large premiums for synergy if it cannot attach a value to it. The other school of thought is that we have to make our best estimate of how much value synergy will create in any acquisition before we decide how much to pay for it, even though it requires assumptions about an uncertain future. We come down firmly on the side of the second school.

While valuing synergy requires us to make assumptions about future cash flows and growth, the lack of precision in the process does not mean we cannot obtain an unbiased estimate of value. Thus we maintain that synergy can be valued by answering two fundamental questions:

(a) What form is the synergy expected to take? Will it reduce costs as a percentage of sales and increase profit margins (eg, when there are economies of scale)? Will it increase future growth (e.g. when there is increased market power) or the length of the growth period? Synergy, to have an effect on value, has to influence one of the four inputs into the valuation process higher cash flows from existing assets (cost savings and economies of scale), higher expected growth rates (market power, higher growth potential), a longer growth period (from increased competitive advantages), or a lower cost of capital (higher debt capacity).

(b) When will the synergy start affecting cash flows? Synergies seldom show up instantaneously, but they are more likely to show up over time. Since the value of synergy is the present value of the cash flows created by it, the longer it takes for it to show up, the lesser it values.

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