EVALUATION OF MERGER PROPOSAL

When a firm plans to acquire another firm, it should consider the acquisition as a capital budgeting decision. Hence, such a proposal must be evaluated as a capital budgeting decision from the view point of acquiring/merged firm. This requires determining the cash flows over the estimated finite time horizon during which incremental benefits of mergers will occur, determining the cost of capital and finding out the present value of incremental cash flows using the discount rate. The steps involved in the determination of NPV of mergers and acquisitions deal are as follows: 1. Determination of time period for the evaluation of the deal. The time period depends upon the period for which the benefits of the merger are expected to be available to the comb. 2. Determine CF(X), the after tax cash flows of acquiring firm X, w/o merger, over the evaluation period. 3. Determine the discount rate. 4. Determine PV(X), present value of CF(X)[cash flows of the acquiring firm X w/o merger] using the discount rate computed in step 3. 5. Determine CF (X), post-merger cash flows of the combined firm X. the cash flows consists of the cash flows of both the merging firm and the merged firm. These CF must reflect the post-merger benefit. 6. Determine PV(X), the present value of CF(X) using the discount rate determined in step 3. 7. Determine the ownership position(OP) of the shareholders of acquiring firm X in the combined firm X with the help of following formula OP = Nx/ [Nx+ER(Ny)] Where, Nx= number of outstanding equity shares of acquiring firm X before the merger. Ny= number of outstanding equity shares of firm Y(acquired firm) before the merger. ER= exchange ratio representing the number of shares of firm X exchanged for every share of firm Y.

8. Calculate NPV of the merger proposal from the point of view of X(acquiring firm) 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 shareholders of firm X. PV(X) = present value of CF of firm X, before merge. PV (X) =present value of CF of combined firm X.

BENEFITS AND COST OF MERGER

Mergers and acquisitions deals create synergy. V(A) + V(B) < V(AB) For acquiring/merged firm investment decision as requires huge capital outlay to purchase assets of the acquiring firm. For acquired/merging firm- disinvestment decision i.e release of funds tied up in the balance sheet of such companies. Mergers and acquisitions create value for both. Success when NPV is positive for both.

COMPUTATION OF COSTS AND BENEFITS

A is acquiring company. B is acquired company. AB is combined company. To calculate NPV of A, the benefit and costs to A are to be calculated

BENEFIT =(PVAB) (PVA + PVB) Cost to A (if cash is paid) = cash - PVb NPV to A = benefit cost = [PVAB (PVA+PVB)] [cash PVB] = PVAB PVA PVB cash + PVB = PVAB PVA cash NPV to A = PVAB PVA cash

NPV to B = cost of merger from the view point of A = cash - PVB

For example: FIRM A Value of firm: Rs 20 million FIRM B Rs 5 million

If 2 firm merge the cost saving will be with PV of Rs 5 million. Firm A proposes to offer 6 million as cash compensation to acquire firm B. Calculate NPV of the merger to the firms. Benefit = PVAB (PVA + PVB) 5 = PVAB - (20+5)

PVAB = 25 million Cost = cash PVB = 6-5 = 1 NPV1 to A= 25-20-1 = 4million NPV to B = 6-5 = 1million

COMPENSATION IN STOCK
Compensation is generally paid in stock. If this happens, cost component in the PV calculation needs to be calculated with care.

Cost to A = PVAB PVB Where, = fraction of shares in combined entity received by shareholders of merging company. OR = No. of shares received by merging company shareholders / total no. of shares in the combined firm ( including shares issued above). For example: firm A plans to acquire firm B. The financial details of 2 firms, prior to merger announcement are: A MP per share No. of shares MV of shares Rs 50 1000,000 50 million B Rs 20 500,000 10 million

The merger is expected to bring gains which have a present value of 10 million. Firm A offers 250000 shares in exchange of 500000 shares to the shareholders of firm B. Sol. Benefit to A = 10million Benefit = [PVAB (PVA+ PVB)] 10million= PVAB (50 + 10) PVAB= 70 million Cost to A = PVAB PVB = 250000 / (1000000 + 250000) = 250000 / 1250000 = 0.2 Cost = (0.2*70) 10 = 4million NPV to A= 10- 4 = 6million NPV to B = cost to A= 4 million

CASH Vs STOCK COMPENSATION

Whether to pay for acquisition in cash or stock is an input decision. It depends on 4 factors: 1. Overvaluation- if the acquiring firms stock are overvalued relative to acquired companies stock = paying in stock can be less costly. 2. Taxes- cash comp = taxable transaction from the point of view of shareholders of acquired firm. 3. Sharing of risk and rewards Acquired firm implies cash comp. 4. Discipline Acquisition financed by cash succeed more compared to finance by stock