In chapter 25, we developed value enhancement strategies for Boeing, the Home Depot and InfoSoft. Using the estimates of value for each firm that we obtained based on these strategies, and comparing them to the status quo valuations in chapter 24, we can estimate the value of control at each of these firms:
The value of control is greatest at Boeing and InfoSoft, albeit for different reasons. It is large at Boeing because of its poor investment returns and potential for improvement, whereas it is significant at InfoSoft because it is a small, private firm, constrained in terms of capital and expansion possibilities.
c. Valuing Operating Synergy
There is a potential for operating synergy, in one form or the other, in many takeovers. Some disagreement exists, however, over whether synergy can be valued and, if so, what that value should be. One school of thought argues that synergy is too nebulous to be valued and that any systematic attempt to do so requires so many assumptions that it is pointless.
If this is true, a firm should not be willing to pay large premiums for synergy if it cannot attach a value to it. While valuing synergy requires us to make assumptions about future cash flows and growth, the lack of precision in the process does not mean we cannot obtain an unbiased estimate of value. Thus we maintain that synergy can be valued by answering two fundamental questions:
(1) What form is the synergy expected to take? Will it reduce costs as a percentage of sales and increase profit margins (e.g., when there are economies of scale)? Will it increase future growth (e.g., when there is increased market power) or the length of the growth period? Synergy, to have an effect on value, has to influence one of the four inputs into the valuation process – cash flows from existing assets, higher expected growth rates (market power, higher growth potential), a longer growth period (from increased competitive advantages), or a lower cost of capital (higher debt capacity).
(2) When will the synergy start affecting cash flows? –– Synergies can show up instantaneously, but they are more likely to show up over time. Since the value of synergy is the present value of the cash flows created by it, the longer it takes for it to show up, the lesser its value.
Once we answer these questions, we can estimate the value of synergy using an extension of discounted cash flow techniques. First, we value the firms involved in the merger independently, by discounting expected cash flows to each firm at the weighted average cost of capital for that firm. Second, we estimate the value of the combined firm, with no synergy, by adding the values obtained for each firm in the first step.
Third, we build in the effects of synergy into expected growth rates and cash flows, and we value the combined firm with synergy. The difference between the value of the combined firm with synergy and the value of the combined firm without synergy provides a value for synergy.
Figure 26.4 summarizes the effects of synergy and control in valuing a target firm for an acquisition. Notice the difference between figure 26.2, which is based upon the market price of the target firm before and after the acquisition, and figure 26.4, where we are looking at the value of the target firm with and without the premiums for control and synergy. A fair-value acquisition, which would leave the acquiring firm neither better nor worse off, would require that the total price (in figure 26.2) be equal to the consolidated value (in figure 26.4) with the synergy and control benefits built in.
Figure 26.4: Valuing an Acquisition
In Practice 26.4: Valuing Synergy: Compaq and Digital
Returning to the Compaq/Digital merger, note that synergy was one of the stated reasons for the acquisition. To value this synergy, we needed to first value Compaq as a stand-alone firm. To do this, we made the following assumptions:
· Compaq had earnings before interest and taxes of $2,987 million on revenues of $25,484 million. The tax rate for the firm is 36%.
· The firm had net capital expenditures of $ 184 million and working capital is 15% of revenues.
· The firm had a debt to capital ratio of 10%, a beta of 1.25, and an after-tax cost of debt of 5%.
· The operating income, revenues and net capital expenditures are all expected to grow 10% a year for the next 5 years.
· After year 5, operating income and revenues are expected to grow 5% a year forever, and capital expenditures are expected to be 110% of depreciation. In addition, the firm will raise its debt ratio to 20%, the after-tax cost of debt will drop to 4% and the beta will drop to 1.00.
Based upon these inputs, the value of the firm can be estimated as follows:
The value of Compaq is $38.547 billion.
The value of the combined firm (Compaq+ Digital), with no synergy, should be the sum of the values of the firms valued independently. To avoid double counting the value of control, we add the value of Digital, optimally managed, that we estimated in illustration 26.2, to the value of Compaq to arrive at the value of the combined firm:
Value of Digital (optimally managed)= $ 4,531.59 million
Value of Compaq (status quo)= $38,546.91 million
Value of combined firm = $43,078.50 million
This would be the value of the combined firm in the absence of synergy. To value they synergy, we made the following assumptions about the way in which synergy would affect cash flows and discount rates at the combined firm:
· The combined firm will have some economies of scale, allowing it to increase its current after-tax operating margin slightly. The annual dollar savings will be approximately $ 100 million. This will translate into a slightly higher pre-tax operating margin:
· Current Operating Margin = (EBITCompaq+EBITDigital)/(SalesCompaq+SalesDigital) = (2987+522)/(25484+13046) = 9.11%
· New Operating Margin = (2987+522+100)/(25484+13046) = 9.36%
· The combined firm will also have a slightly higher growth rate of 10.50% over the next 5 years, because of operating synergies.
· The beta of the combined firm was computed in three steps. We first estimated the unlevered betas for Digital and Compaq: Digital’s Unlevered Beta = 1.25/(1+ (1-.36)(.25)) = 1.07 Compaq’s Unlevered Beta=1.25/(1 + (1-.36) (.10/.90)) = 1.17
Figure 26.5: Valuing Compaq for Digital
We then weighted these unlevered betas by the values of these firms to estimate an unlevered beta for the combined firm; Digital has a firm value[7] of $ 4.5 billion and Compaq’s firm value was $ 38.6 billion. Unlevered Beta for combined firm= 1.07 * (4.5/43.1) + 1.17 (38.6/43.1) = 1.16 We then used the debt to equity ratio for the combined firm to estimate a new levered beta and cost of capital for the firm. The debt to equity ratio for the combined firm, estimated by cumulating the outstanding debt and market value of equity at the two firms is 13.64%:
3. New Levered Beta = 1.16 (1+(1-0.36)(.1364)) = 1.26
4. Cost of Capital = 12.93% (.88) + 5% (.12) = 11.98% Based on these assumptions, the cash flows and value of the combined firm, with synergy, can be estimated:
The value of the combined firm, with synergy, is $ 45,510.58 million. This can be compared to the value of the combined firm, without synergy, of $43,078.50 million, and the difference is the value of the synergy in the merger.
Value of combined firm (with synergy) = $45,510.58 million
Value of combined firm (with no synergy) = $43,078.50 million
Value of Synergy = $ 2,422.08 million
This valuation is based on the presumption that synergy will be created instantaneously. In reality, it can take years before the firms are able to see the benefits of synergy. A simple way to account for the delay is to consider the present value of synergy. Thus, if it will take Compaq and Digital three years to create the synergy, the present value of synergy can be estimated, using the combined firm’s cost of capital as the discount rate: Present Value of Synergy = $2,422 million/(1.1198)3 = $1724.86 million
--> synergy.xls: This spreadsheet allows you to estimate the approximate value of synergy in a merger or acquisition.
d. Valuing Financial Synergy
Synergy can also be created from purely financial factors. We will consider three legitimate sources of financial synergy - a greater “tax benefit” from accumulated losses or tax deductions, an increase in debt capacity and therefore firm value, and better use for “excess” cash or cash slack. We will begin the discussion, however, with diversification, which though a widely used rationale for mergers, is not a source of increased value by itself.
7 The values that we used were the values immediately before the acquisition announcement. This is to prevent the biases that may be created when target prices increase once an acquisition is announced.
Prof. Aswath Damodaran
Next: Diversification
Summary: Index