Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVIII. Topics in Corporate
Finance- Mergers and
Acquisitions
(^874) © The McGraw−Hill
Companies, 2002
From our discussions in earlier chapters, we know that the incremental cash flow, CF,
can be broken down into four parts:
CF EBITDepreciation Tax Capital requirements
Revenue Cost Tax Capital requirements
where Revenue is the difference in revenues, Cost is the difference in costs, Tax is
the difference in taxes, and Capital requirements is the change in new fixed assets and
net working capital.
Based on this breakdown, the merger will make sense only if one or more of these
cash flow components are beneficially affected by the merger. The possible cash flow
benefits of mergers and acquisitions thus fall into four basic categories: revenue en-
hancement, cost reductions, lower taxes, and reductions in capital needs.
Revenue Enhancement
One important reason for an acquisition is that the combined firm may generate greater
revenues than two separate firms. Increases in revenue may come from marketing gains,
strategic benefits, and increases in market power.
Marketing Gains It is frequently claimed that mergers and acquisitions can produce
greater operating revenues from improved marketing. For example, improvements
might be made in the following areas:
- Previously ineffective media programming and advertising efforts
- A weak existing distribution network
- An unbalanced product mix
For example, when Microsoft purchased tiny Vermeer in 1996, Vermeer’s FrontPage
software (used to create web pages) was selling at a snail’s pace. When the software was
rebadged as Microsoft FrontPage, however, sales took off, reflecting Microsoft’s mar-
keting muscle.
Strategic Benefits Some acquisitions promise a strategic advantage. This is an op-
portunity to take advantage of the competitive environment if certain things occur or,
more generally, to enhance management flexibility with regard to the company’s future
operations. In this latter regard, a strategic benefit is more like an option than a standard
investment opportunity.
For example, suppose a sewing machine manufacturer can use its technology to en-
ter other businesses. The small-motor technology from the original business can provide
opportunities to begin manufacturing small appliances and electric typewriters. Simi-
larly, electronics expertise gained in producing typewriters can be used to manufacture
electronic printers.850 PART EIGHT Topics in Corporate Finance
The merger does generate synergy because the cash flow from the merged firm is CF
$1 greater than the sum of the individual cash flows ($21 versus $20). Assuming that the risks
stay the same, the value of the merged firm is $21/.10 $210. Firms A and B are each worth
$10/.10 $100, for a total of $200. The incremental gain from the merger,V, is thus $210
200 $10. The total value of Firm B to Firm A,VB*, is $100 (the value of B as a separate
company) plus $10 (the incremental gain), or $110.