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Evaluating Mergers

If you are given the responsibility for evaluating a proposed merger, you must think hard about the following two questions:

1. Is there an overall economic gain to the merger? In other words, is the merger valueenhancing? Are the two firms worth more together than apart?

2. Do the terms of the merger make my company and its shareholders better off? There is no point in merging if the cost is too high and all the economic gain goes to the other company.

Answering these deceptively simple questions is rarely easy. Some economic gains can be nearly impossible to quantify, and complex merger financing can obscure the true terms of the deal. But the basic principles for evaluating mergers are not too difficult.

MERGERS FINANCED BY CASH

We will concentrate on a simple numerical example. Your company, Cislunar Foods, is considering acquisition of a smaller food company, Targetco. Cislunar is proposing to finance the deal by purchasing all of Targetco`s outstanding stock for $19 per share. Some financial information on the two companies is given in the left and center columns of Table 6.3.

Question 1. Why would Cislunar and Targetco be worth more together than apart? Suppose that operating costs can be reduced by combining the companies` marketing, distribution, and administration. Revenues can also be increased in Targetco`s region.

The rightmost column of Table 6.3 contains projected revenues, costs, and earnings for the two firms operating together: annual operating costs postmerger will be $2 million less than the sum of the separate companies` costs, and revenues will be $2 million more. Therefore, projected earnings increase by $4 million.5We will assume that the increased earnings are the only synergy to be generated by the merger. The economic gain to the merger is the present value of the extra earnings. If the earnings increase is permanent (a level perpetuity), and the cost of capital is 20 percent,

Economic gain = PV (increased earnings) = 4 = $20 million .20

This additional value is the basic motivation for the merger.

Question 2. What are the terms of the merger? What is the cost to Cislunar and its shareholders?

Targetco`s management and shareholders will not consent to the merger unless they receive at least the stand-alone value of their shares. They can be paid in cash or by new shares issued by Cislunar. In this case we are considering a cash offer of $19 per Targetco share, $3 per share over the prior share price. Targetco has 2.5 million shares outstanding, so Cislunar will have to pay out $47.5 million, a premium of $7.5 million over Targetco`s prior market value. On these terms, Targetco stockholders will capture $7.5 million out of the $20 million gain from the merger. That ought to leave $12.5 million for Cislunar.

This is confirmed in the Cash Purchase column of Table 6.4. Start at the bottom of the column, where the total market value of the merged firms is $492.5 million. This is derived as follows: Cislunar market value prior to merger $480 million Targetco market value 40 Present value of gain to merger 20 Less Cash paid out to Targetco shareholders 47.5 Post merger market value $492.5 million

The post merger share price for Cislunar will be $49.25, an increase of $1.25 per share. There are 10 million shares now outstanding, so the total increase in the value of Cislunar shares is $12.5 million.

Now let`s summarize. The merger makes sense for Cislunar for two reasons. First, the merger adds $20 million of overall value. Second, the terms of the merger give only $7.5 million of the $20 million overall gain to Targetco`s stockholders, leaving $12.5 million for Cislunar. You could say that the cost of acquiring Targetco is $7.5 million, the difference between the cash payment and the value of Targetco as a separate company.

Cost = cash paid out Targetco value = $47.5 40 = $7.5 million

Of course the Targetco stockholders are ahead by $7.5 million. Their gain is your cost.

As we`ve already seen, Cislunar stockholders come out $12.5 million ahead. This is the merger`s NPV for Cislunar:

NPV = economic gain cost = $20 7.5 = $12.5 million

Writing down the economic gain and cost of a merger in this way separates the motive for the merger (the economic gain, or value added) from the terms of the merger (the division of the gain between the two merging companies).