Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

VIII. Topics in Corporate

Finance

25. Mergers and
    Acquisitions

© The McGraw−Hill^873

Companies, 2002

GAINS FROM ACQUISITION

To determine the gains from an acquisition, we need to first identify the relevant incre-
mental cash flows, or, more generally, the source of value. In the broadest sense, ac-
quiring another firm makes sense only if there is some concrete reason to believe that
the target firm will somehow be worth more in our hands than it is worth now. As we
will see, there are a number of reasons why this might be so.

Synergy

Suppose Firm A is contemplating acquiring Firm B. The acquisition will be beneficial if
the combined firm will have value that is greater than the sum of the values of the sep-
arate firms. If we let VABstand for the value of the merged firm, then the merger makes
sense only if:

VABVAVB

where VAand VBare the separate values. A successful merger thus requires that the value
of the whole exceed the sum of the parts.
The difference between the value of the combined firm and the sum of the values of
the firms as separate entities is the incremental net gain from the acquisition, V:

VVAB
(VAVB)

When Vis positive, the acquisition is said to generate synergy. For example, when
Walt Disney bought Capital Cities/ABC for $4 billion in 1995, Disney chairman
Michael Eisner predicted the combined companies would find synergies “under every
rock,” adding that in this case, “1 and 1 will add up to 4.” That’s a lot of synergy!
If Firm A buys Firm B, it gets a company worth VBplus the incremental gain, V.
The value of Firm B to Firm A (VB*) is thus:

Value of Firm B to Firm AVB*VVB

We place an on VBto emphasize that we are referring to the value of Firm B to Firm A,
not the value of Firm B as a separate entity.
VBcan be determined in two steps: (1) estimating VBand (2) estimating V. If B is a
public company, then its market value as an independent firm under existing manage-
ment (VB) can be observed directly. If Firm B is not publicly owned, then its value will
have to be estimated based on similar companies that are. Either way, the problem of de-
termining a value for VBrequires determining a value for V.
To determine the incremental value of an acquisition, we need to know the incre-
mental cash flows. These are the cash flows for the combined firm less what A and B
could generate separately. In other words, the incremental cash flow for evaluating a
merger is the difference between the cash flow of the combined company and the sum
of the cash flows for the two companies considered separately. We will label this incre-
mental cash flow as CF.

CHAPTER 25 Mergers and Acquisitions 849

25.4

Try the “M & A” link at

http://www.thedeal.comfor

current news.

synergy

The positive incremental

net gain associated with

the combination of two

firms through a merger

or acquisition.

Synergy

Firms A and B are competitors with very similar assets and business risks. Both are all-equity

firms with aftertax cash flows of $10 per year forever, and both have an overall cost of capi-

tal of 10 percent. Firm A is thinking of buying Firm B. The aftertax cash flow from the merged

firm would be $21 per year. Does the merger generate synergy? What is VB*? What is V?

EXAMPLE 25.1