Introduction to Corporate Finance

21: Mergers, Acquisitions and Corporate Control

low-growth stage. Applying this multiple to

determine the terminal value in t = 3 yields 17.3 ×

$12 million = $207.6 million. This is very close to

our year 3 terminal value estimate above using

DCF ($206 million), which reinforces the terminal

value estimated in the DCF analysis.

• Precedent transactions: Given the similarities
  between the companies and transactions, to
  apply precedent transactions we identify the
  acquisition multiple ($210 million/$6.1 million =
  34.4) and multiply by W. Lee’s earnings to arrive

at an estimate: 34.4 × $5 million = $172 million.

Remember, both synergies and a control premium

are built into this valuation, which is the likely

explanation for why the multiple is so much larger

than the public comparable.

Conclusion: The public comparable is not

particularly helpful in this analysis, but gives us

comfort that our DCF terminal value is reasonable;

the DCF and the precedent transactions methods

imply a valuation range between $172 million and

$182 million.

To determine how target and bidder shareholders fare in an acquisition, we look to the market.

A  positive combined bidder plus target share market reaction implies that the market believes that a

merger creates value.^16 Of course, many things can change after the initial merger announcement: bids

may be increased, target management may respond positively or negatively to the initial bid, or the form

of payment may change (or be announced). Even with these considerations, studying short-term market

reactions provides interesting insights into the market’s perception of mergers and acquisitions.

21-3b SHAREHOLDER GAINS (OR LOSSES) IN MERGERS –

RETURNS TO BIDDER AND TARGET

Table 21.2 presents the returns earned by shareholders in each of the last three decades. The returns

are shown for the bidding company (the company making the acquisition) and also for the target company

(the company being taken over). These are two-day returns, for the day of the announcement and the

next day. The returns are expressed net of the normal return expected over those two days, so the

announcement reactions are considered abnormal returns (above and beyond what the companies would

have been expected to earn on those two days).^17

We see that targets earn significantly positive abnormal returns when a merger is announced,

reflecting the large premium usually offered for target shares. Over the past several decades, targets

have experienced abnormal returns averaging

about 15% in the two days surrounding the

takeover announcement. Not all targets

experience substantial gains though.

Table 21.2 also shows that bidders,

in contrast, lose money on average in some

decades, and barely break even in others. This

implies that any value gains created by the

merger are paid almost entirely (sometimes

16 We are assuming that no word has leaked out in advance of the merger announcement. If information leaks out in advance, the market price
may have changed prior to the announcement, and there may not be any market reaction on the day of the official announcement. In such a
case, it would not be correct to conclude that there are no valuation effects from the merger.
17 To be more precise, we use each firm’s CAPM beta to determine its expected return, which is equal to the risk-free return plus beta times the
market risk premium for a two-day interval. Abnormal return is the difference between actual return and expected return.

Can you think of a reason why

you typically would not use

an EBITDA multiple or a P/E

multiple to value a start-up?

TABLE 21.2 AVERAGE ABNORMAL RETURNS TO TARGETS

AND BIDDERS IN A TWO-DAY WINDOW

1980−89 1990−99 2000−10

Bidding company 0.30% –2.43% –1.65%

Target company 12.57% 11.69% 21.92%

Combined 5.1% 3.2% 1.19%

Source: SDC and authors’ calculations. © Reuters. Used with permission.

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