574 Making Key Strategic Decisions
significant number destroy shareholder value, some spectacularly. In this sec-
tion, we more closely examine the issue of value creation, focusing on its
sources in mergers and acquisitions. We begin the discussion with an assump-
tion that the objective of managers in initiating these transactions is to increase
the wealth of the bidder ’s shareholders. We will ignore the reality that man-
agers may have personal agendas and ulterior motives for pursuing mergers and
acquisitions, even those harmful to their shareholders. A discussion of these is-
sues is beyond the scope of this chapter.^6
To be very clear, recall the source of all value for holders of corporate eq-
uity. Stock prices are a function of two things: expected future cash f lows and
the risk of those f lows. These cash f lows may come as dividends, share price
increases, or some combination of the two, but the important thing to under-
stand is that changes in share prices simply ref lect the market’s expectations
about future cash f lows or their risk—nothing more and nothing less. If in-
vestors believe a company’s cash f lows in the future will be smaller or riskier,
ceteris paribus, the share price will decline. If the expectation is for larger or
less risky cash f lows, the share price goes up. Thus, when we talk about M&A
decisions creating value, there can only be two sources of that value: more cash
f low or less risk. Our discussion focuses primarily on the former.
Consider two independent firms, A and B, with respective values VAand
VB.Assume that the managers of firm Afeel that the acquisition of firm B,that
is, the creation of a merged firm AB,would create value. That is, they believe
VAB>VA+VB. The difference between the two sides of this equation, VAB−(VA
+VB),is the incremental value created by the acquisition, sometimes called the
synergy.That is,
Clearly, positive synergy would be a prerequisite to going for ward with the ac-
quisition. In practice, things are a bit more complicated for two reasons: the
costs of an acquisition and the target premium. The acquisition process carries
significant direct costs for lawyers, consultants, and accountants. There is also
the indirect cost caused by the distraction of the bidder ’s executives from their
day-to-day operation of the existing business. Finally, the data presented in the
section on mergers and acquisitions shows that target shareholders in acquisi-
tions typically receive a 30% to 40% premium over market price. Some trans-
actions have smaller premiums, but in almost all cases, the acquirer pays a
price above the pre-acquisition market value. All of these costs can be factored
into the evaluation as follows:
Example 3 Midland Motorcycles Inc. is considering the acquisition of Scotus
Scooters. Midland’s current market capitalization is $10 million, while Scotus
has a market capitalization of $2 million. The executives at Midland feel the
combined firm would be worth $14 million due to synergies. Current takeover
premiums average 35% and the total cost of the acquisition is estimated at $1.5
million. Should Midland proceed with the deal?
Net advantage of merging = V[]AB−+()VVA B −−Merger costs Premium (2)Synergy=−+VVVAB ()A B (1)