The Pros And Cons Of Financial Synergy

In modern finance theory (Manne, 1965), shareholder wealth maximization that are in line with a company’s business strategy is stated as the rational for investment and financing decisions made by managers. This means that firms should invest when the sum of the present values of future cash flows exceeds the initial project outlay. With M&A, the shareholder wealth maximization criterion is satisfied from the bidder’s perspective when the added value by the acquisition of a target company exceeds the cost of acquisition i.e. the transaction costs and the acquisition premium.

Likewise, managers of targets would engage in M&A activity only if it results in gains to the target shareholders. The result is synergy: positive gains to the bidder and

This stands in sharp contrast to the early view of Miller and Modigliani (1958), who argued that in a well-functioning efficient market without taxes, informational asymmetries, and default costs no financial synergy can be found because the market value of company does not depend on its capital structure. However, a firm’s capital structure decision can matter if these assumptions are not true.

The theory has two important caveats concerning its applicability; first, one of the merging firms must be experiencing financial distress. The theory is most directly applicable to marginally profitable start-up companies and existing companies that are financially distressed. Second, theory only applies when severe agency problems exist between the manager and the claim holders of the distressed firm. The theory for this reason is more applicable to mergers where one of the merging firms is small (Fluck and Lynch,

The higher valuation of the bidders, compared to the true value of the target, would not have been made by rational bidders. Thus, managerial motives are important determinants for the outcome of the M&A as manager may act to maximize their own utility and engage in ‘empire building’ (Trautwein, 1990) instead of their shareholders’ value. Managers may invest the free cash flow in projects such as acquisitions with negative net present value if that would lead to increased personal utility rather than maximize shareholder value. These free cash flows, which are generally found in the reserves, should rather be paid out as to shareholders in the form of dividends if the firm is to be effective and to maximize the stock price (Jensen,