Valuation of Merger Target
Corporate Financial Decisions
Timothy A. Thompson
Basics
Valuation of merger target is from the
perspective of acquiring company´s
shareholders
Net present value of acquisition is the
„value of the target to acquirer“ minus
the „effective cost“
Value of target to acquirer
Value of the target to the acquirer is
made up of:
• Stand alone value of the target plus
• Value of improvements at target made by
acquirer management plus
• Value of pure synergies between target and
acquirer
Valuations must make a capital
structure assumption
The valuations (stand alone,
improvements, and synergies) must
make a capital structure assumption
• WACC model or APV model
Be careful!
• The capital structure assumption should not be
reflective of the financing used to buy the
target per se, but should reflect the degree to
which owning the target incrementally affects
your debt capacity
What?!
For example, suppose you bought the
target with debt
• If you are using WACC to value target, the
weights should reflect the debt capacity of the
target, not 100% debt
• If you are using APV, the tax shields should
only reflect the contribution of the target firm
towards affording those tax shields
What is the „effective cost“?
Acquirer pays cash ($100M)
• Cash price is the effective cost of the acquisition
Acquirer must raise the cash ($100M)
• Assume borrow the money from government with a
subsidized rate
– Loan is $100M, but PV of loan payments is $95M
– „Purchase price“ is $100M, but acquirer makes $5M NPV
on loan. „Effective cost“ of acquisition is $95M
• Assume sell shares of combined firm ($100M)
– „Purchase price“ is $100M, but suppose shares are actually
worth $60M. NPV on share sale is $40M. „Effective cost“
of acquisition is „$60M“.
Deal NPV and NPV to original
shareholders
Deal NPV is the NPV of the deal to all capital
contributors
• Original target shareholders
• And new purchasers of stock or debt
If new securities are not zero NPV
• This is a redistribution among capital providers
Decision should be made from perspective of
original target shareholders
Actual NPV = Deal NPV – NPV of financing
issues
Valuation of Merger Target
Value of
synergies
Value of
Target to
Acquirer
Value of
improve
ments
Stand
Valone
value of
target
„Purchase
price“
NPV to acquirer shareholders
NPV of
financing
issues
Value of
synergies
Value of
Target to
Acquirer´s
Stand
Sharealone
value of
holders
target
„Purchase
price“
Value of
improve
ments
V
Where was „effective cost“?
The „purchase price“ minus the NPV of
financing is the „effective cost“
Real world situations
• Debt plus warrants or equity of private firm
(like John Case)
• Debt may be cheap to „make it up on equity“
• Subsidized loans
• Using overvalued stock to make acquisitions