580 Making Key Strategic Decisions
annual cash f low savings would be $1.5 million. MC’s financial analysts
are reasonably certain these results can be achieved and suggest a 15%
discount rate.- Tax savings: MC can use Digerati’s recent operating losses to reduce its
tax liability. Their tax accountant estimates $750,000 per year in cash sav-
ings for each of the next four years. Because these values are easy to esti-
mate and relatively safe cash f lows, they are discounted at 10%. The
values of MC and Digerati premerger are computed as follows:
Number of
Company Shares Price/Share Market Value
MC Enterprises 3,000,000 $30.00 $90 million
Digerati Inc. 2,000,000 6.25 12.5 million
Assume that MC pays a 50% premium to acquire Digerati and that the
costs of the acquisition total $3 million. What is the expected impact of the
transaction on MC ’s share pr ice?
Solution: We first compute the total value created by each of the incremental
cash f lows:
Annual Cash Discount
Source Flow Rate Value
Revenue enhancement $1.25 million 20% $6.25 million
Operating efficiencies 1.5 million 15 10.0 million
Tax savings $750,000 10 2.38 million
Total Value=$18.63 million
The total value created by the acquisition is $18.63 million. A 50% pre-
mium would give $6.25 million of this incremental value to Digerati’s share-
holders. After $3 million of acquisition costs, $9.38 million remains for MC’s
three million shareholders. Thus, each share should increase by $3.13 ($9.38
million divided by the 3 million shares outstanding) to $33.13.
Note that the solution to Example 5 assumes the market knows about and
accepts the value creation estimates described. Investors will often discount
management’s estimates of value creation, believing them to be overly opti-
mistic or doubting the timetable for their realization. In practice, estimating
the synergistic cash f lows and the appropriate discount rates is the analyst’s
most difficult task.
Summary The sole motivation for initiating a merger or acquisition should
be increased wealth for the acquirer ’s shareholders. We know from the em-
pirical evidence presented in section III that many transactions fail to meet
this simple requirement. The main point of this section is that value can only
come from one source—incremental future cash f lows or reduced risk. If we
can estimate these parameters in the future, we can measure the acquisition’s