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Evaluation of a merger as a capital budgeting decision

When a firm plans to acquire any firm then it should consider the acquisition as a capital budgeting decision. Hence, such a proposal must be evaluated as a capital budgeting decision.

Framework for evaluating acquisition

It consists of the following steps

Step 1 Determine CF (X), the equity related post-tax cash flows of the acquiring firm, X, without the merger, over the relevant planning horizon period.

Step 2 Determine PV (X), the present value of CF (X) by applying a suitable discount rate,

Step 3 Determine CF (X), the equity-related post cash flows of the combined firm X which consists of the acquiring firm X and the acquired firm Y over the planning horizon. These cash flows must reflect the post merger benefits.

Step 4 Determine PV (X), the present value of CF (X)

Step 5 Determine the ownership position (OP) of the shareholders of firm X in the combined firm X, with the help of the following formula  

OP = Nx/[Nx + ER (Ny)] 

Where

Nx = number of outstanding equity shares of firm X (the acquiring firm) before the merger.

Ny = number of outstanding equity shares of firm Y (the acquired firm) before the merger.

ER = exchange ratio representing the number of shares of firm X exchanged for every share of firm Y.

Step 6 Calculate NPV of the merger proposal from the point of view of X as follows

NPV (X) = OP [PV (X)] PV (X) 

Where

NPV (X) = NPV of the merger proposal from the point of view of shareholders of X

OP = ownership position of the shareholder of firm X

PV (X) = PV of the cash flows of the combined firm X.

PV (X) = PV of the cash flows of firm X, before the merger. 

Example

Consider the firm X limited.

Step 1- Estimated equity related post tax cash flow CF (X)t of X limited are as follows-            

Year

1

2

3

4

5

CF (X) t

200

220

236

248

260

After five years, CF (X) t will grow at a compound rate of 5% per annum.

Step 2 Determination of PV of cash flows using the discount rate of 15%

PV (X) = 200/1.15 + 220/(1.15)2 + 236/(1.15)3 +248/(1.15)4 +260/(1.15)5 
+260(1.05) /[(0.15 0.05)(1.15)5] = 2123.79

The last item in the above equation represents the PV of the perpetual stream of cash flows beyond the fifth year.

Step 3 Estimation of the equity related cash flows of the combined firm X is as follows  

Year

1

2

3

4

5

CF (X) t

320

360

410

430

450

After 5 years cash flows of the combined firm is expected to grow at the compounded rate of 6% per year.

Step 4 Determination of PV of expected cash flows of the combined firm.

PV(X) = 320/1.15 + 360/(1.15)2 + 410/(1.15)3 + 430/(1.15)4
450/(1.15)5 +450(1.06) /[(0.15 0.06)(1.15)5] = 3660.6

Step 5 Determining the ownership position of the shareholders of X. the number of outstanding shares of firm X before merger are 100. The number of outstanding shares 
of firm Y are 100. The proposed exchange ratio (ER) is 0.6. The ownership position 
of the shareholders of firm X in the combined firm X will be

OP = 100 / [100 + 0.6(100)] = 0.625

Step 6 Calculation of NPV of the merger proposal from the point of view of 
shareholders X  -

NPV (X)  = (0.625) 3660.6 - 2123.79 = 164.085 

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