20.8 Valuing Acquisitions

Evaluating a potential merger candidate requires a great deal of care. These acquisi-

tions generally are very large transactions which have important effects on the operat-

ing strategy and the financial structure of the acquiring firm.

Anumber of firms now have “M&A” departments devoted entirely to discovering

and analyzing acquisition candidates. Evaluating a potential acquisition is similar in

most respects to analyzing the net present value of any other investment project a firm

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may be considering. Hence, the techniques discussed in Chapters 9 through 13 also

apply to evaluating acquisition candidates. There are, however, some subtle differences.

Most importantly, publicly traded acquisition candidates have an observable stock price

that provides an estimate of the market’s evaluation of the present value of the firm’s

cash flows. This information allows the acquiring firm to estimate more accurately the

present value of the cash flows from a potential acquisition than it can for most other

investment projects.

Valuing Synergies

Obviously, an analyst cannot rely exclusively on a potential acquisition’s current stock

price to determine the company’s value. An acquiring firm will have to offer a pre-

mium over the target company’s current stock price to purchase the firm, implying that

there has to be additional value created by combining the firms. In other words, there

must be synergies that make the value of the target to the acquirer greater than the mar-

ket value of the target on its own. The present value of the synergies must be added

to the value of the firm’s cash flows, given its current operations, to arrive at the pres-

ent value of the acquisition.

In many cases, these synergies arise because of a reduction in the fixed costs of

the combined firm. If these cost savings occur with certainty or, equivalently, are deter-

mined independently of the market portfolio’s return (assuming the CAPM holds), then

valuing the target is straightforward, as Example 20.2 illustrates.

Example 20.2:Valuing Isolated Industries

Isolated Industries is currently selling for $22 a share and has 1 million shares outstand-

ing.Since analysts do not presently expect the firm to be a takeover target, $22 a share

is also its current operating value.However, United Industries is considering the acquisition

of Isolated Industries.It believes that by combining sales forces, it can eliminate 10 sales-

people at a savings of $500,000 per year.They expect this savings to be permanent and

certain.If the discount rate is 10 percent, how much is Isolated Industries worth to United

Industries?

Answer:The present value of the perpetual savings from combining the sales forces is

$5 million ($500,000.1) or $5 per share.Hence, United Industries would be willing to pay

up to $27 per share for Isolated Industries.

Example 20.2 was simple because it assumed that the synergies were certain

and thus quite easy to value. The example also assumed that the firm’s stock price

could be used to obtain a value for Isolated Industries as a stand-alone entity which,

in general, will not be the case. The target’s stock price will exceed the present

value of the firm’s future cash flows, given its current operating structure, if it

reflects the possibility that the firm may eventually be taken over at a premium.

Assuming risk neutrality and a zero discount rate, we can express the firm’s cur-

rent stock price as

Current stock priceCurrent operating value

(Expected takeover premium)(Takeover probability)

Equivalently, the current operating value of the firm can be expressed as

CurrentoperatingvalueCurrentstockprice

(Expected takeover premium)(Takeover probability)

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716Part VIncentives, Information, and Corporate Control

AGuide to the Valuation of Synergies

Valuing acquisitions draws upon the techniques for evaluating real investment projects

described in Chapters 9 to 13. However, acquisitions tend to be much larger than the

capital investments that firms typically undertake, so firms should go into more depth

in their valuation. They should evaluate a variety of scenarios and consider the various

embedded options that exist in most firms (see Chapter 12). We suggest that acquiring

firms take the following steps to evaluate prospective targets.

Step 1: Value the Target as a Stand-Alone Firm.Valuing the target as a stand-alone

entity provides the analyst with a useful reality check for determining the value cre-

ated by the acquisition. Such a valuation requires estimates of future cash flows and

the appropriate rates for discounting the cash flows. The value obtained in this manner

should be compared with the target firm’s stock price.

Step 2: Calibrate the Valuation Model.The analyst needs to explain any difference

between the estimated value of the target and the target’s preacquisition stock price. As

mentioned above, stock prices may reflect takeover probabilities and takeover premi-

ums as well as the stand-alone value of the target. Also, stock prices may not incor-

porate proprietary information that the acquiring firm’s analysts may have obtained

about the target’s asset values during the course of their investigations. In many cases,

especially in friendly takeovers, the acquiring firm has access to information that is

unavailable to other investors. For example, the target’s management may provide pro-

prietary information when negotiating a selling price. The acquirer also may have come

across new information in the course of its own investigation. When buying an entire

company, the importance of collecting accurate information is greater than it is when

buying even large numbers of shares. Hence, it is plausible that the acquirer might value

the target better than the financial markets.

If the acquiring firm’s analysts believe they do not have superior information, and

the difference between their estimated value of the target and the target stock price can-

not be explained by information about a possible takeover, they must conclude that

their valuation is flawed. In other words, analysts are valuing the firm using assump-

tions about future cash flows and discount rates that differ from the assumptions implied

by market prices. At this point, the analysts will have to revise their assumptions about

cash flows and discount rates. Getting these assumptions right at this stage of the analy-

sis is important because these assumptions also may be used to value the synergies.

Step 3: Value the Synergies.To evaluate what the target is worth to the acquiring

firm, analysts must value the synergies associated with combining the target and the

acquirer. Doing this requires estimates of the cash flows generated by the synergies

along with the appropriate discount rates. To simplify the analysis, assume that some

synergies are virtually certain while others are risky. For example, synergies that come

from tax savings or reductions in fixed costs are often of a lower-risk category—while

those related to increased sales or reductions in variable costs should be related to the

risk of either the acquirer or the target, or perhaps both.

The future cash flows and the discount rates used in the stand-alone valuation model

are likely to be used in valuing risky synergies. For example, to value a 10 percent

increase in the target’s cash flows that will be generated for the first five years fol-

lowing a takeover requires both the preacquisition discount rate and the cash flows of

the target. Valuing the synergies also may require an estimate of the acquiring firm’s

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cost of capital and expected cash flows. Hence, the acquiring firm also will want to

use the procedures outlined in steps 1 and 2 to value its own stock and calibrate its

cost of capital and cash flows.

As Example 20.3 illustrates, the synergies generated by a takeover should, in many

cases, be discounted at a weighted average of the discount rates of the two merging

organizations.

Example 20.3:Valuing the Marketing Synergies from Kraft and Philip Morris

Assume that by combining sales forces Kraft and Philip Morris both increase their pretax

profits by 10 percent per year.What discount rate should be used to value this synergy?

Answer:Since the gain in each year is proportional to the preacquisition cash flows of both

firms, the appropriate discount rate is a weighted average of the two firm’s costs of capital.

Example 20.3 illustrates a case with marketing synergies that affect both parties to

the merger equally. However, this will not always be the case. In the Gillette takeover

of Duracell, the synergy was Duracell’s use of Gillette’s distribution network. If this is

expected to result in a proportional increase in Duracell’s profits, but not Gillette’s, then

one would use Duracell’s cost of capital to value the synergy.

Because Duracell’s ability to enter new markets is the major gain from the merger,

one might want to consider valuing the synergies as a strategic option, using the real

options methodology, rather than the risk-adjusted discount rate method. Recall from

Chapter 12 that strategic options exist whenever flexibility exists in the implementa-

tion of an investment. When a firm expands into a new market, it has the option to

expand further if prospects turn out to be more favorable than originally anticipated,

and to exit if the situation turns out to be unfavorable. In these situations, an investment

may be substantially undervalued when such options are ignored.

Step 4: Value the Acquisition.The acquisition can be valued by simply adding the

stand-alone value of the target to the synergies being produced. In general, we would

suggest acquiring the target if it can be purchased for a price that is less than this sum.

However, as discussed in Chapters 9–13, we also have to take into account mutually

exclusive projects that may also have positive net present values as well as a possible

option to delay making the acquisition.

Hilton Buys Welch Hotels

Welch Hotels, a hypothetical company, is a relatively small chain with 23 hotels in Ger-

many. Of the 2 million shares outstanding, more than 30 percent are owned by the Welch

family, who started the hotel chain. The remaining 70 percent of Welch’s shares trade on

the Frankfurt Stock Exchange. On October 3, Wolfgang Welch, the hotel’s founder,

announced that he wished to retire and would seek an international hotel company to buy

the firm. Following this surprise announcement, the stock price of Welch Hotels jumped

from €60 to €72 per share, or €144 million for the entire chain, indicating that the market

believed that an international hotel would place a higher value on the firm than its stand-

alone value.

The Hilton Hotel Corporation hired Gordon Elliot, an investment banker, to evaluate

this potential opportunity. Hilton executives believe that with the unification of Europe and

the emerging markets in Eastern Europe, they would benefit from an increased presence

in Germany. Since Hilton hotels are known internationally, Hilton’s management believes

that they can create value with such an acquisition. Specifically, they believe that Hilton

is much better positioned to attract international business travelers who value the Hilton

name but know nothing about Welch. An added bonus of the acquisition would be increased

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718Part VIncentives, Information, and Corporate Control

recognition of Hilton hotels. By increasing their visibility within Germany, Hilton manage-

ment hopes to increase the number of German business travelers who stay in their hotels

when they travel outside Germany.

To value Welch Hotels, Elliot first values the hotel as a stand-alone business. To this

value, he adds the value created by its combination with Hilton. Elliot examines the pro-

jected cash flows of the corporation provided by Welch’s top management and by the stock

market analysts who follow the company. He finds that his cash flow forecasts, those of the

analysts, and those of Welch’s management are pretty much the same. These estimates sug-

gest that the unlevered cash flow that will accrue over the current year is €12 million and

that this value will increase, on average, at 2 percent per year. Based on these projected

cash flows and the company’s value of €120 million before the proposed takeover, Elliot

infers that if the company’s pretakeover value of €120 million does not capture an antici-

pated takeover premium, the WACCfor Welch Hotels is 12 percent—obtained by solving

for the discount rate in the growing perpetuity formula (see Chapter 9), PVC (r g),

where for this illustration

PVfirm value €120 million

Cend of year expected unlevered cash flow€12 million

ggrowth rate of expected cash flow 2%, and

rWACC

Elliot believes that this WACCis consistent with the hotel’s risk, which supports his assump-

tion that the value of the firm before the takeover represents the value of the hotel chain

as a stand-alone business.

Elliot estimates that because of increased occupancy rates and more aggressive pricing

generated as a result of Hilton’s reputation and its worldwide reservation network, Welch

Hotels will increase its expected unlevered cash flows more than the 2 percent per year that

it would have achieved as a stand-alone firm. He assumes that the expected unlevered cash

flows will increase 3 percent in years 2 and 3, and 5 percent thereafter. In other words, the

expected unlevered cash flows after the takeover can be expressed as follows:

Unlevered Cash Flows (in €millions) at End-of-Year

12

3

4

12	12(1.03)	12(1.03)2	2
€	€	€	€12(1.03)(1.05)

The unlevered cash flows will increase by 5 percent in each year past year 4.

Since the incremental cash flows depend on the state of the German economy, they have

the same risk as the original cash flows, so the firm’s cash flows after the takeover can be

discounted at the 12 percent WACCused to value the firm as a stand-alone business. This

assumes that the tax effects on the WACCfrom both the financing mix and the cross-border

transaction can be ignored.

To find the present value of this stream of cash flows, first calculate the end of year 4

value of the cash flows from year 4 on as

2 ² million

€12(1.03)(1.05)

V€12(1.03)²€

(1.05) million 214 million

⁴.12 .05

The present value of the Welch Hotels is thus

2

€12 million€12(1.03) million€12(1.03)million€214 million

1.121.12²³1.12⁴

1.12

€163 million.

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Strategy, Second Edition

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Valuing the spillover benefits that accrue to Hilton Hotels outside Germany is somewhat

more difficult. Elliot estimates that by buying the chain of Welch Hotels, 10,000 German

individuals will come into contact with the Hilton name every day. He estimates that the

cost of buying that sort of advertising would cost about €500,000 per year, which he expects

will remain fixed indefinitely. Since the benefits associated with that kind of publicity are

determined by the demand for Hilton’s hotels outside Germany, Elliot discounts the pro-

jected benefits of this publicity at Hilton’s weighted average cost of capital, which is 10

percent. Assuming that this €500,000 stream is perpetual, the value is €500,000 .1

€5million. Adding this to the value of the hotel after the takeover provides a value of

Welch Hotels to Hilton of €168 million. Given that this amount is substantially above the

current market price of €144 million for Welch Hotels, Elliot recommends that Hilton pro-

ceed with an offer that is slightly higher than the current market price.