Exercises
Exercises
1. Synergy Valuation
a. Cost and revenue synergies
Managers of an acquiring company anticipate cost savings pretax of $50 million in the first year of the deal and $100 million the next and that thereafter the savings would grow @ inflation, 2%. Marginal tax rate is 30%. The firm must invest $1 billion to achieve these savings and starting in the third year must spend 5% of the pre-tax savings to sustain the rate of savings. As part of rationalization of operations, some assets will be sold generating a positive cash flow of $20 million net of tax in years 1 and 2 and $10 million in year 3. The analyst judges that these costs savings are rather certain, reflecting a degree of risk consistent with the variability in the firm’s EBIT. Accordingly, the analyst decides to discount the cash flow at the firm’s cost of debt of 6%.
The merger will expand revenues through cross-selling of products, efficient exploitation of brands and geographic and product line extensions. They forecast revenue growth of $100 million in the first year and $200 million in year 2 and thereafter. The COGS underlying these new revenues is 45% of the revenue. This forecast s in constant dollar terms and needs to reflect expected inflation of 2% p.a. To achieve these synergies will require an investment of $400 million initially and 5% of the added revenue each year to fund working capital growth. The target’s cost of equity is 15%
b. Financial Synergies
Managers believe that a combination of the two firms will reduce the risk of the combined enterprise more than investors could achieve through simple portfolio diversification. This belief springs from the fact that one of the firms holds secret proprietary processes that are unknown to public investors. These processes will dampen the volatility of earnings. Analysts believe that this volatility reduction equates to a reduction in the asset beta of the new company (formed by merging two existing entities) by 0.10 from a simple
1. Synergy Valuation
a. Cost and revenue synergies
Managers of an acquiring company anticipate cost savings pretax of $50 million in the first year of the deal and $100 million the next and that thereafter the savings would grow @ inflation, 2%. Marginal tax rate is 30%. The firm must invest $1 billion to achieve these savings and starting in the third year must spend 5% of the pre-tax savings to sustain the rate of savings. As part of rationalization of operations, some assets will be sold generating a positive cash flow of $20 million net of tax in years 1 and 2 and $10 million in year 3. The analyst judges that these costs savings are rather certain, reflecting a degree of risk consistent with the variability in the firm’s EBIT. Accordingly, the analyst decides to discount the cash flow at the firm’s cost of debt of 6%.
The merger will expand revenues through cross-selling of products, efficient exploitation of brands and geographic and product line extensions. They forecast revenue growth of $100 million in the first year and $200 million in year 2 and thereafter. The COGS underlying these new revenues is 45% of the revenue. This forecast s in constant dollar terms and needs to reflect expected inflation of 2% p.a. To achieve these synergies will require an investment of $400 million initially and 5% of the added revenue each year to fund working capital growth. The target’s cost of equity is 15%
b. Financial Synergies
Managers believe that a combination of the two firms will reduce the risk of the combined enterprise more than investors could achieve through simple portfolio diversification. This belief springs from the fact that one of the firms holds secret proprietary processes that are unknown to public investors. These processes will dampen the volatility of earnings. Analysts believe that this volatility reduction equates to a reduction in the asset beta of the new company (formed by merging two existing entities) by 0.10 from a simple