Financial Synergy

5 min readApr 24, 2020

The next topic in our Merger Strategy chapter is all about Financial Synergy. The financial synergy is all about the impact of a business merger or acquisition on the costs of capital to the acquiring firm or the combined partners.

The costs of the capital may be decreased significantly depending on the level to which financial synergy exists in a corporate merger. Now, you may ask yourself if the benefits of a specific financial synergy are reasonable. This is a matter of discussion among corporate finance theorists.

The Effect in Terms of Debt Coinsurance

As previously mentioned, the merger of the two firms may reduce risk. But this is only if both firms’ cash flow streams are not perfectly tied in. The suppliers of capital may view or consider the firm less risky if the acquisition or merger lowers the volatility of the cash flows.

Presumably, the risk of a firm getting bankrupt will significantly decrease. This is because of the fact that there will be fewer chances of wild ups and downs on the merged firm’s cash flow. This was explained in detail by Higgins and Schall. They called this effect in terms of debt coinsurance.

For instance, the risk of getting bankrupt that’s associated with the merging of the two firms will be significantly reduced if this result has no general agreement, too. Now, there is a chance that one of the firms could experience certain conditions or circumstances that will force them into bankruptcy. It can be a little bit tricky to know ahead of time which one of the two firms will experience bankruptcy.

That also means that creditors may suffer a loss should one of the firms fail. However, let’s say that both firms were merged ahead of certain financial problems. There is a chance that the excess cash flow of the solvent firm can cushion the decline in the other firm’s cash flow.

Now, in order to prevent the combined or merged firm from falling into bankruptcy. The offsetting earnings of the firm that is in good condition should be sufficient. This will also be helpful when it comes to preventing the creditors to suffer losses.

Debt-Coinsurance Effect

Like with most things in life, there is also a downside to this debt-coinsurance effect. The downside is that the benefits accrue to debtholders at the expense of the equity holders. Remember, these debtholders gain by holding debt in a much less risky firm.

In their observation, Higgins and Schall noted that these gains come at the expense of stockholders. These stockholders are the ones who lose in the acquisition. According to Higgins and Schall, the total returns or the RT that can be provided by the merged firm are constant. Now, if the bondholders (RB) are provided with more of these returns, then the returns must come at the expense of stockholders or (RS). Check the formula below:

RT = RS + RB

Moreover, Higgins and Schall maintain that the debt-coinsurance effect does not make room for any new value. However, it does redistribute the gains amongst the providers of capital to the firm. This result has no generic understanding, too.

For instance, Lewellen has concluded that stockholders gain from these types of mergers or firms’ combinations. However, there is a lot of other research that fails to indicate that the debt-related motives are relevant for the conglomerate acquisitions as opposed to the non-conglomerate acquisitions.

Research Studies

There are also a lot of studies that have proven the existence of a coinsurance effect on bank mergers. In their research, Penas and Unal examined 66 bank mergers. This research looked into the effects of these deals on 282 bonds.

In their research, Penas and Unal found positive bond returns for both targets that are approximately at 4.3%, and for acquiring banks at 1.2%. Some would argue that this is because larger banks may be too big to fail. And that plays a large role in this because regulators would not want to allow a larger bank to fail outright. These regulators would step in to offer their assistance instinctively.

In another research, Billet, King, and Mauer looked into the wealth effects for both the target and acquirer returns. They looked at these wealth effects in the 1980s and 1990s. This specific research concluded that the target company bonds that were less than investment grade right before the deal has earned significantly positive announcement period returns.

On the other hand, they found that acquiring company bonds earned negative announcement period returns. More importantly, Billet, King, and Mauer has found that these announcement period returns were far greater in the decade of the 1990s as opposed to the 1980s. These results provide further more proof and support for the coinsurance effect.

Higgins and Schall also showed that the losses of the stockholders may be offset through the means of issuing a new debt after the merger. In return, the stockholders may gain through the tax savings on the payments of debt interest. This result was greatly demonstrated by Galai and Masulis.

The debt-equity ratio of the post-merger firm will also be increased because of the additional firm. It was increased to a level that stockholders must have found good, or at least acceptable, before the merger.

The firm also becomes a higher risk-higher return investment because of the higher debt-equity ratio. As previously mentioned, there will come a point when a company may experience economies of scale through acquisitions.

Production Cost

Usually, these economies are thought to come from production cost decreases. These are attained by operating at a higher capacity level. Similarly, these can also be attained through a reduced sales force or a shared distribution system. These acquisitions may result in the possibility of financial economies scale in the form of lower flotation and transaction costs.

A larger company also has certain advantages that can possibly lessen the firm’s cost of capital in financial markets. This means larger companies enjoy the advantage of better access to financial markets. Another advantage is that they tend to experience lower costs of raising capital. Because it is considered less risky than a smaller firm. This means that the costs of borrowing by issuing bonds are significantly less because a larger firm would be able to issue bonds offering a lower interest rate than a smaller company.