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
