Acquisition Valuation

Financial Synergy
Sources of Financial Synergy
• Diversification: Acquiring another firm as a way of reducing risk
cannot create wealth for two publicly traded firms, with diversified
stockholders, but it could create wealth for private firms or closely
held publicly traded firms.
• Cash Slack: When a firm with significant excess cash acquires a firm,
with great projects but insufficient capital, the combination can
create value.
• Tax Benefits: The tax paid by two firms combined together may be
lower than the taxes paid by them as individual firms.
• Debt Capacity: By combining two firms, each of which has little or
no capacity to carry debt, it is possible to create a firm that may
have the capacity to borrow money and create value.
 Diversification
• A takeover, motivated only by diversification
considerations, has no effect on the combined
value of the two firms involved in the takeover.
• The value of the combined firms will always be
the sum of the values of the independent firms.
• In the case of private firms or closely held firms,
where the owners may not be diversified
personally, there might be a potential value gain
from diversification.
 Diversification
• If the earnings of two firms are not highly
correlated the variance in earnings of the
combined firm should be significantly lower
• Reduction in earning variance doesn’t add
value for a well diversified investor
• As the betas in such diversified businesses are
always value-weighted averages of the betas
of the two merging firms
 Cash Slack
• Managers may reject profitable investment
opportunities if they have to raise new capital to
finance them.
• It may therefore make sense for a company with excess
cash and no investment opportunities to take over a
cash-poor firm with good investment opportunities, or
vice versa.
• The additional value of combining these two firms lies
in the present value of the projects that would not
have been taken if they had stayed apart, but can now
be taken because of the availability of cash.
 Valuing Cash Slack
• Assume that Netscape had a severe capital rationing
problem, that results in approximately $500 million of
investments, with a cumulative net present value of $100
million, being rejected.
• IBM had far more cash than promising projects, and has
accumulated $4 billion in cash that it is trying to invest. It is
under pressure to return the cash to the owners.
• If IBM takes over Netscape Inc, it can be argued that the
value of the combined firm will increase by the synergy
benefit of $100 million, which is the net present value of
the projects possessed by the latter that can now be taken
with the excess cash from the former
 Tax Benefits
• Assume that a firm with expected income of
$1 billion next year acquires a firm with a net
operating loss carry forward of $1 billion
• What is the synergy from this acquisition if the
acquirer company pays tax @ 40%?
 Valuing Tax Benefits: Asset Write Up
• One of the earliest leveraged buyouts was in case of
Congoleum Inc., a diversified firm in ship building,
flooring and automotive accessories, in 1979 by the
firm's own management.
• After the takeover, estimated to cost $400 million, the
firm would be allowed to write up its assets to reflect
their new market values, and claim depreciation on the
new values.
• The estimated change in depreciation and the present
value effect of this depreciation based on the tax rate
of 48%, discounted at the firm's cost of capital of 14.5%
is shown below:
 Debt Capacity
• Diversification will lead to an increase in debt
capacity and an increase in the value of the
firm.
• Has to be weighed against the immediate
transfer of wealth that occurs to existing
bondholders in both firms from the
stockholders.
 Valuing Debt Capacity
• Basic Assumption
• When two firms in different businesses merge,
the combined firm will have less variable
earnings, and may be able to borrow more (have
a higher debt ratio) than the individual firms.
• In the following example, we will combine two
firms, with optimal debt ratios of 30% each, and
end up with a firm with an optimal debt ratio of
40%.
Effect on Costs of Capital of Added
debt
Effect on Value of Added Debt
 Accretive vs Dilutive Acquisitions
Accretive Acquisition
• General Rule: The price-earnings (P/E) ratio of the acquiring firm is greater
than that of the target firm.
• An accretive acquisition increases the acquiring company's earnings per
share
• The price paid by the acquiring firm is lower as compare to the resultant
value increase the new acquisition is expected to provide to the acquiring
company's EPS.
• An accretive acquisition is similar to the practice of bootstrapping,
wherein an acquirer purposely buys a company with a low price-earnings
ratio through a stock swap transaction in order to boost the post-
acquisition earnings per share of the newly formed combined business
and encourage a rise in the price of its shares.
• Bootstrapping is associated with an accounting practice that lowers overall
earnings quality on the other hand an accretive acquisition helps in
boosting value through combined synergies of a merger.
 Accretive vs Dilutive Acquisitions
Dilutive Acquisition
• A dilutive acquisition is a takeover transaction that decreases the acquirer's
EPS through lower (or negative) earnings contribution or if additional shares are
issued to pay for the acquisition.
• A dilutive acquisition can decrease shareholder value temporarily, but if the deal
has strategic value, it can potentially lead to a sufficient increase in EPS in later
years.
• In general, if the standalone earnings capacity of the target firm is not as strong as
the acquirer's, the combination will be EPS-dilutive to the acquirer.
• This may be true in the first one or two years post-transaction closing, but as
revenues and cost synergies take hold through scale economies, the acquisition
should become accretive to earnings.
• The market tends to punish the share price of the acquirer if the benefits are not
immediately clear.
• A lower EPS, after all, at the same trading multiple will reduce the stock price.
(Conversely, an announcement of an EPS-accretive deal in Year 1 will quickly
reward shareholders with a higher stock price.)
 Decide on payment mechanism: Cash
versus Stock
• Generally, firms which believe that their stock is under
valued will not use stock to do acquisitions
• Conversely, firms which believe that their stock is over
or correctly valued will use stock to do acquisitions.
• The premium paid is larger when an acquisition is
financed with stock rather than cash.
• There might be an accounting rationale for using stock
as opposed to cash. Use of pooling instead of purchase.
• There might also be a tax rationale for using stock.
Cash acquisitions create tax liabilities to the selling
firm’s stockholders.
The Exchange Ratio in a Stock for Stock
Exchange
• Exchange Ratio = Offer Price for the Target’s
Shares / Acquirer’s Share Price
 Example
• Company X is contemplating the purchase of Company Y,
Company X has 3,00,000 shares having a market price of Rs
30 per share, while Company Y has 2,00,000 shares selling
at Rs 20 per share. The EPS are Rs 4 and Rs 2.25 for
Company X and Y respectively. Managements of both
companies are discussing two alternative proposals for
exchange of shares as indicated below:
• in proportion to the relative earnings per share of two
companies
• 0.5 share of Company X for one share of Company Y (0.5:1)
• Calculate the EPS after merger under two alternatives
 Example- Bid Evaluation
Adagio Software, Inc. and Tantalus Software Solutions, Inc., are negotiating a friendly
acquisition of Tantalus by Adagio. The management teams at both companies have
informally agreed upon a transaction value of about $12 per share of Tantalus Software
Solutions stock but are presently negotiating alternative forms of payment. Sunil
Bansal, CFA, works for Tantalus Software Solutions’ investment banking team and is
evaluating three alternative offers presented by Adagio Software:
a. Cash Offer: Adagio will pay $12.00 per share of Tantalus stock.
b. Stock Offer: Adagio will give Tantalus shareholders 0.80 shares of Adagio stock per
share of Tantalus stock
c. Mixed Offer: Adagio will pay $6 per share and 0.40 shares of Adagio stock per share
of Tantalus stock
Bansal estimates that the merger of the two companies will result in economies of
scale with a net present value of $ 90 million. To aid in the analysis Bansal has complied
the following data:
Adagio Tantalus
Pre- Merger Stock Price ($) 15.00 10
No. of Shares Outstanding ($, millions) 75 30
Pre- Merger Market Value ($, millions) 1,125 300

Based on the information given, which of the three offers should Bansal recommend to
the Tantalus Software Solutions management team?