Question

You have the following information on an M&A deal, between two all equity firms that operate in the same industry. The cost of equity for both firms is the same and equal to 10%. For each of the firms capital expenditures are equal to depreciation and net working capital is expected to remain constant forever. The EBIT of the acquirer is a constant perpetuity equal to £100 million per year, and the EBIT of the target is constant perpetuity of £10 million per year, both of which start in one-year time. The corporate tax rate is 20%.

1. Obtain the stand alone values of the acquirer and the target. (5 points)
2. The acquirer decided to make a cash offer for the target equal to 100 million pounds. In order to pay for the target the acquirer decided to issue perpetual debt equal to this amount, at an interest rate of 5 percent. The acquirer believes that it will be able to generate synergies from the deal that will lead to an increase in the annual EBIT of the target equal to 5 million pounds. The EBIT of the acquirer remains unchanged. Calculate the value of the merged firm? Which are the gains from the merger? (15 points)

Answer 1

a) From Gordon's zero growth model  

Value of Acquirer = Annual PAT /cost of equity = 100 million pounds*(1-0.2) /0.1 = 800 million pounds

Similarly, Value of target = 10 million pounds* (1-0.2)/0.1 = 80 million pounds

b) After merger,

Value of Meged firm = value of Acquirer firm + value of target firm + Value due to synergies + present value of tax shield

= 800 million pounds +80 million pounds +5million pounds*(1-0.2)/0.1  +100 million pounds * 0.2

=940 million pounds

So, gains from the merger = Value of firm after merger - value of firm before merger

= 940 million pounds - (800 million pounds + 80 million pounds)

= 60 million pounds