Damodaran on Valuation_ Security Analysis for Investment and Corporate Finance ( PDFDrive )

Acquiring FirmTarget Firm

Pretax cost of debt 5% 5%

Tax rate 30% 30%

Debt-to-capital ratio 10% 10%

Revenues $1,000 $500

Operating income (EBIT)$50 $25

Pretax return on capital 15% 15%

Reinvestment rate 70% 70%

Length of growth period 5 years 5 years

Notethatbothfirmshavethesamecostofcapital,expectthe
same growth in the future, and earn the same operating
margin.Therisk-freerateis4.25%,andtheriskpremiumis
4%. Forpurposes of simplicity, we willassume that both
firmswillbeinstablegrowthafteryear5,growing4.25%a
yearinperpetuityandearningnoexcessreturns(i.e.,return
on capital equals cost of capital).
3

The first step in the process is to value the two firms
independently.Thefollowingtablesummarizesthevaluations
andconfirmsthatthevalueofthecombinedfirmisthesum
of the two independent firm values.