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 posttax
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 equityrelated
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
= N_{x}/[N_{x} + ER (N_{y})]
Where
–
N_{x}
= number of outstanding equity shares of firm X (the acquiring
firm) before the merger.
N_{y
}= 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