Profitable Growth by Acquisition 579of financial distress. Because most acquisitions provide some degree of diversi-
fication, that is, they reduce the variability of profits for the merged firms,
they can also reduce the probability of financial distress. This diversification
effect is illustrated in the previous example, where the postmerger net income
is constant. The result is a higher debt-to-equity ratio, more interest payments,
lower taxes, and value creation.
Many firms are in the enviable position of generating substantial operat-
ing cash f lows and over time, large cash surpluses. At the end of 1999, for ex-
ample, Microsoft and Intel held a combined $29 billion in cash and short-term
investments. Firms can distribute these funds to shareholders via a dividend or
through a stock repurchase. However, both of these options have tax conse-
quences. Dividends create substantial tax liabilities for many shareholders and
a stock repurchase, while generating lower taxes due to capital gains provisions
cannot be executed solely to avoid tax payments. A third option is to use the ex-
cess cash to acquire another company. This strategy would solve the surplus
funds “problem” and carry tax benefits as no tax is paid on dividends paid from
the acquired to the acquiring firms. Again, the acquisition must have a busi-
ness rationale beyond just saving taxes.
The following example summarizes the sources of value discussed in
this section and illustrates how we might assess value creation in a potential
acquisition.
Example 5 MC Enterprises Inc. manufactures and markets value-priced digi-
tal speakers and headphones. The firm has excellent engineering and design
staffs and has won numerous awards from High Fidelitymagazine for its most
recent wireless bookshelf speakers. MC wants to enter the market for personal
computer (PC) speakers, but does not want to develop its own line of new prod-
ucts from scratch. MC has three million outstanding shares trading at $30/share.
Digerati Inc. is a small manufacturer of high-end speakers for PCs, best
known for the technical sophistication of its products. However, the firm has
not been well managed financially and has had recent production problems,
leading to a string of quarterly losses. The stock recently hit a three-year low of
$6.25 per share with two million outstanding shares.
MC’s executives feel that Digerati is an attractive acquisition candidate
that would provide them with quick access to the PC market. They believe an
acquisition would generate incremental after-tax cash f low from three sources.
- Revenue enhancement:MC believes that Digerati’s technical expertise
will allow it to expand their current product line to include high-end
speakers for home theater equipment. They estimate these products
could generate incremental annual cash f low of $1.25 million. Because
this is a risky undertaking, the appropriate discount rate is 20%. - Operating efficiencies:MC is currently operating at full capacity with
significant overtime. Digerati has unused production capacity and could
easily adapt their equipment to produce MC’s products. The estimated