perfectlycorrelated.Thedebtcapacitybenefitsincreaseasthe
earnings of the two firms become less correlated and as
investors become more risk averse.
Thereisone finalpointto bemade inthecontext ofdebt
capacity.Thedebtcapacityargumentassumesthatboththe
acquiring firm and target firms were at theiroptimal debt
capacitiespriortothemerger.Themergerreducedtheoverall
risk in thecombined firmand increased the optimal debt
capacity.Thisargumentcannotbeusedwhenthetargetfirm
ortheacquiringfirmisunderleveredtobeginwithanduses
theacquisitiontomoveuptoitsoptimaldebtcapacities.In
thatcase,thereisnosynergyvalueinthemergersinceeither
firmcouldhavemovedtotheoptimaldebtcapacityonits
own and generated the increase in value.
ILLUSTRATION15.7:ValuingAdditionalDebtCapacityin
a Merger
Consider again the merger of Lube & Auto and Dalton
Motors.Thevalueofthecombinedfirmwasthesameasthe
sumofthevaluesoftheindependentfirms.Thefactthatthe
two firms were in different business lines reduced the
varianceinearnings,butvaluewasnotaffected,becausethe
debtratiosofthefirmsremainunchangedafterthemerger,
andthecostsofequityanddebtweretheweightedaverages
of the individual firms’ costs.
The reduction in variance in earnings can increase debt
capacity, which canincrease value.If, after themerger of
thesetwofirms,thedebtcapacityforthecombinedfirmwere
increasedto20%from10%(leadingtoanincreaseinthebeta