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

Acquiring

Firm

Target

Firm

Debt-to-capital ratio 10% 10%

Revenues ($ millions) $1,000 $500

Operating income (EBIT) ($

millions)

$50 $25

Pretax return on capital 12% 30%

Reinvestment rate 50% 80%

Length of growth period 5 years 5 years

Valuingthesecompaniesasindependentcompaniesyieldsthe
estimatesofvalueinTable15.5(assumingarisk-freerateof
4.25percent,a riskpremiumof 4 percent,and zeroexcess
returnsinperpetuityafteryear5).Theacquiringfirm,withan
expectedgrowthrateof4.20percent,isclearlybuyinggrowth
sincethetargetcompanyhasanexpectedgrowthrateof16.8
percent. While this will translate into higher expected
earningsgrowthfortheacquiringfirmaftertheacquisition,it
willnotnecessarilytranslateintoanincreaseinvalueforits
stockholders.Thatwilldependonwhethertheacquiringfirm
paidmorethantheestimatedvalueofthetarget($332.49)or
less.Ifitpaysmore,itsstockholderswilllosevalue,whereas
ifitpaysless,itsstockholderswillgain.Thegain,though,is
notbecausethefirmwasabletobuygrowthbutbecauseit
wasabletobuythetargetcompanyforlessthanitsestimated
value.

TABLE 15.5 Acquiring and Target Company Valuations:
Growth Merger