Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVIII. Topics in Corporate
Finance- Mergers and
Acquisitions
(^878) © The McGraw−Hill
Companies, 2002
1.Do not ignore market values.There is no point to and little gain from estimating the
value of a publicly traded firm when that value can be directly observed. The
current market value represents a consensus opinion of investors concerning the
firm’s value (under existing management). Use this value as a starting point. If the
firm is not publicly held, then the place to start is with similar firms that are
publicly held.
2.Estimate only incremental cash flows.It is important to estimate the incremental
cash flows that will result from the acquisition. Only incremental cash flows from
an acquisition will add value to the acquiring firm. Acquisition analysis should thus
focus only on the newly created, incremental cash flows from the proposed
acquisition.
3.Use the correct discount rate.The discount rate should be the required rate of
return for the incremental cash flows associated with the acquisition. It should
reflect the risk associated with the use of funds, not the source. In particular, if
Firm A is acquiring Firm B, then Firm A’s cost of capital is not particularly
relevant. Firm B’s cost of capital is a much more appropriate discount rate because
it reflects the risk of Firm B’s cash flows.
4.Be aware of transactions costs.An acquisition may involve substantial (and
sometimes astounding) transactions costs. These will include fees to investment
bankers, legal fees, and disclosure requirements.
A Note on Inefficient Management
There are firms whose value could be increased with a change in management. These
are firms that are poorly run or otherwise do not efficiently use their assets to create
shareholder value. Mergers are a means of replacing management in such cases.
The fact that a firm might benefit from a change in management does not necessar-
ily mean that existing management is dishonest, incompetent, or negligent. Instead, just
as some athletes are better than others, so might some management teams be better at
running a business. This can be particularly true during times of technological change
or other periods when innovations in business practice are occurring. In any case, to the
extent that corporate “raiders” can identify poorly run firms or firms that, for other rea-
sons, will benefit from a change in management, these raiders provide a valuable service
to target-firm shareholders and society in general.
SOME FINANCIAL SIDE EFFECTS OF
ACQUISITIONS
In addition to the various possibilities we have discussed thus far, mergers can have
some purely financial side effects, that is, things that occur regardless of whether the
merger makes economic sense or not. Two such effects are particularly worth mention-
ing: EPS growth and diversification.
CONCEPT QUESTIONS
25.4a What are the relevant incremental cash flows for evaluating a merger candidate?
25.4bWhat are some different sources of gain from acquisition?
854 PART EIGHT Topics in Corporate Finance