Summary: The Widget Company

Once the target firm is chosen the bidding firm’s next step is calculating the target firm’s worth. This is done through the process called valuation. The motive for acquisition will guide the bidder on the method used to evaluate the target firm. Some common reasons for acquisitions are that the target firm is undervalued, the bidding firm is looking to diversify, create economies of scales, poorly managed firms, or managerial self-interest. If the bidding firm is acquiring the firm due to it being undervalued or being used for diversification, the value will be its stand-alone value. When the target firm is being targeted to create a benefit such as economies of scale the bidding company is looking at a characteristic called synergy. Synergy
This lets the bidder see where the firm currently stands. For simplicity purposes the widget Company example by Ben McClure will be used to discuss this method. Let's say operating costs will hold at 65% of revenues over the first three projected years, but will increase to 70% in Year 4 and Year 5. The Widget Company paid 30% income tax, spent $10 million last year on capital expenditures, with depreciation of $3 million, giving net investment of $7 million, or 7% of total revenues, 7.6% of sales in Year 1, 8.2% in Year 2, 8.8% in Year 3, 9.4% in Year 4, and 10% in Year 5. The company also has current assets of $25 million and current liabilities of $16 million, giving net working capital of $9 million. The Widget Company has a capital structure of 40% debt and 60% equity, borrowing rate on the company's debt is 5%, risk-free rate is 5%, beta is 1.3 and the risk premium is 8%. The cash flows will grow in perpetuity by 4% per year. The first step in calculating the value of Widget Company will be to calculate the free cash flow of the firm. This is calculated by subtracting operating costs, taxes, net investment, and change in working capital from revenues. Calculation results can be found in the Valuation Table 1.1. For the first year, revenue will be $120 million because there will be a 20% growth rate. This is calculated by multiplying the prior year’s revenue by 1+ growth
Companies that have an overvalued stock will use it for the acquisition as opposed to companies who have undervalued stock. Companies will typically lean towards the usage of stock even if the premium paid is larger because cash acquisitions create a tax liabilities and the company is allowed to use the pooling method instead of the purchase one. In the purchase method the bidding firm records assets and liabilities of the target company at market value with the difference being goodwill or negative goodwill also known as a gain. Pooling on the other hand combines the book values of the assets and liabilities of the merging firms and no goodwill is