Page 22 - CIMA SCS Workbook November 2018 - Day 2 Suggested Solutions

SUGGESTED SOLUTIONS

Operating economies

Economies of scale - Horizontal combinations (acquisitions of a company in a similar line of
business) can reduce costs and therefore increase profits due to economies of scale. As
mentioned above, this will be a key factor in the pharmaceutical industry where overheads are so
large.

Complementary resources - by combining the strengths of two companies a synergistic gain can
be obtained. For example, Novak has been successful in the past at making and patenting new
products, but it has no experience of manufacturing or marketing generics. Acquiring a firm that
has experience in this area would give Novak an additional competitive advantage.

Elimination of inefficiency - If the victim company is badly managed, its performance and hence its
value can be improved by the elimination of inefficiencies. Improvements could be obtained
particularly in the areas of research and production, where Novak has traditionally been very
strong.

Financial synergy

Diversification - Diversification normally reduces risk, so even if the earnings of the combined
companies stay the same (i.e. no operating economies are obtained), there could still be an
increase in value of the company due to the lower risk and lower cost of capital.

Diversification and financing - If the future cash flow streams of the two companies are not
perfectly positively correlated (i.e. if they are forecast to fluctuate in different ways) then, by
combining the two companies, the variability of their operating cash flow may be reduced. A
more stable cash flow is more attractive to creditors and this could lead to cheaper financing.

Boot-strapping - Companies with high P/E ratios are in a good position to acquire other companies
as the market will often apply the higher P/E ratio to both companies’ earnings after the
acquisition, thus increasing the value. Unfortunately we don’t know how many shares Novak has
in issue, or what its P/E ratio is, so it is not clear whether this would be possible for Novak.

Other synergistic effects

Market power – A horizontal combination could give Novak increased market power (e.g. greater
bargaining power with customers and suppliers). However, if this power created a monopoly
situation in the industry, which was not in the best interests of customers, it could attract the
attentions of the competition authorities, e.g. the Competition and Markets Authority in the UK.
The authorities could block the acquisition or only allow it to proceed under certain conditions.

Surplus cash – Novak has C$ 7,456 million of cash in its most recent statement of financial
position. Admittedly that is less than in the previous year, so Novak may not have any surplus
cash at the moment. However, in theory any spare cash should always be either invested in new
projects to increase shareholder wealth or alternatively paid out to shareholders so they can
make better use of the cash.
Speed – As mentioned above, acquisition may be far faster than organic growth in obtaining a
presence in a new and growing market, although there could be extra costs involved such as
paying for the goodwill and intangible assets of the target company.

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