The Portable MBA in Finance and Accounting, 3rd Edition

Profitable Growth by Acquisition 575

The deal would destroy $200,000 of value. Note that this is in spite of the fact
that there are $2 million of positive synergies created by the acquisition. The
reality is that this synergy is more than offset by the costs of the transaction
and the premium paid for the target, a typical problem in acquisitions. For ex-
ample, consider Coca-Cola’s recent interest in Quaker Oats, which Coke CEO
Douglas Daft felt “fit perfectly into Coke’s strategy of boosting growth by in-
creasing its share of non-carbonated drinks.”^7 Even Coke’s directors felt that
the strategic rationale behind the transaction was sound. But the deal was
ultimately rejected because of the price. Warren Buffett, a major Coca-Cola
shareholder, said “Giv ing up 10% of the Coca-Cola Company was just too much
for what we would get.”^8
Note that the bracketed term in equation 2 is just the synergy as defined
in equation 1. Where does this synergy or incremental value originate? From
above, we know that value can only come from two places—increased cash
f lows or reduced risk. In this case, the synergy can be computed as follows:

where ∆CFtis the incremental cash f low in period t,and ris the appropriate
risk-adjusted discount rate. The total synergy is just the present value of all fu-
ture incremental cash f lows. Equation 3 makes it clear that changes in future
cash f lows or their risk are at the root of any M&A synergies. Before consider-
ing how a merger might impact cash f lows, recall how they are computed:

With this in mind, we can look more closely at potential sources of incremental
cash f lows—and therefore, value—in acquisitions. We focus on the following
three areas:

1. Incremental revenue.


2. Cost reductions.


3. Tax savings.

Incremental Revenue More revenue for the combined firm can come from
marketing gains, strategic benefits, or market power. Increased revenue
through marketing gains result from improvements in advertising, distribution
or product offerings. For example, when Citicorp and Travelers Inc. announced
their merger in 1998, incremental revenue was a key factor:

Incremental Revenues

−Incremental Costs

−Incremental Taxes

−Incremental Investment in New Working Capital

−Incremental Investment in Fixed Assets

=Incremental Cash Flow

Synergy= (3)

= ()+

∞

∑

∆CF

r

t

t t

(^01)
Net advantage of merging = 1[] 4 −+()$ 10 $ 2 −− ×$.1 5 () 35 % $ 2 =−$.0 2 million