Valuation of Merger Target

Corporate Financial Decisions

Timothy A. Thompson
Basics
Valuation of merger target is from
the perspective of acquiring
company´s shareholders
Net present value of acquisition is
the „value of the target to
acquirer“ minus the „effective
cost“
Value of target to acquirer
Value of the target to the acquirer
is made up of:
• Stand alone value of the target plus
• Value of improvements at target made by
acquirer management plus
• Value of pure synergies between target
and acquirer
Valuations must make a capital
structure assumption
The valuations (stand alone,
improvements, and synergies) must
make a capital structure assumption
• WACC model or APV model
Be careful!
• The capital structure assumption should not be
reflective of the financing used to buy the
target per se, but should reflect the degree to
which owning the target incrementally affects
your debt capacity
What?!
For example, suppose you bought
the target with debt
• If you are using WACC to value target,
the weights should reflect the debt
capacity of the target, not 100% debt
• If you are using APV, the tax shields
should only reflect the contribution of the
target firm towards affording those tax
shields
What is the „effective cost“?
Acquirer pays cash ($100M)
• Cash price is the effective cost of the acquisition
Acquirer must raise the cash ($100M)
• Assume borrow the money from government with a
subsidized rate
– Loan is $100M, but PV of loan payments is $95M
– „Purchase price“ is $100M, but acquirer makes $5M
NPV on loan. „Effective cost“ of acquisition is $95M
• Assume sell shares of combined firm ($100M)
– „Purchase price“ is $100M, but suppose shares are
actually worth $60M. NPV on share sale is $40M.
„Effective cost“ of acquisition is „$60M“.
Deal NPV and NPV to original
shareholders
Deal NPV is the NPV of the deal to all capital
contributors
• Original target shareholders
• And new purchasers of stock or debt
If new securities are not zero NPV
• This is a redistribution among capital providers
Decision should be made from perspective
of original target shareholders
Actual NPV = Deal NPV – NPV of financing
issues
Valuation of Merger Target
Value of
synergies

„Purchase
Value of
price“
improve
Value of ments

Target to
Stand
Acquirer Valone
value of
target
NPV to acquirer shareholders NPV of
financing
issues

Value of
synergies

Value of Value of
„Purchase
price“
Target to improve
ments
Acquirer´s
Share- Stand
alone V
holders value of
target
Where was „effective cost“?
The „purchase price“ minus the NPV of
financing is the „effective cost“
Real world situations
• Debt plus warrants or equity of private firm
(like John Case)
• Debt may be cheap to „make it up on equity“
• Subsidized loans
• Using overvalued stock to make acquisitions