So now let's develop the tools and framework that are necessary if we want to be able to work out whether an acquisition makes sense from the point of view of either the acquiring or target firm shareholders. Firstly, let's get our thinking straight and demonstrate that merging with another firm does not in and of itself necessarily create value for shareholders in the acquiring company. To do so, let's consider the following example where we begin with two companies, Bidder Limited, with assets of $100 million, and Target Limited, with assets of $20 million. Now, let's assume that the Bidder Limited successfully acquires Target Limited for $20 million. As you can see, all that has happened here is that Bidder Limited has simply converted $20 million of cash into $20 million of assets, previously owned by Target Limited, and no value is being created at all. In fact, from the bidding shareholder's point of view, it's probably going to be even worse than that. You see, in reality, shareholders in Target Limited will demand a price over and above the current value of the company in order to pass over control to Bidder Limited. This extra amount demanded is what's known as a control premium. So, in this example, let's assume that Bidder Limited are forced to pay control premium of $5 million. So they are paying $25 million for assets that are only worth $20 million. This will result in a straight transfer of $5 million in wealth from Bidder shareholders, to Target shareholders. So in what situation might Bidder shareholders actually be better off? We need the presence of some additional benefit to ensure that a deal is value enhancing to both Bidder and Target shareholders. Let's call them synergies. That is where the value of the assets of the two firms combined, is greater than the sum of the value of assets of the two firms operating independently. So in this example let's assume, once again, that the Bidder is required to pay $25 million for the Target firm that was previously worth only $20 million. But having merged the firm into the Bidder's operations, an additional $10 million in synergistic benefits is being created. Increasing the market value of the Bidder to $105 million in total. Where did the synergies come from? Well it might have been from removing duplicate costs from the combined organization. Or alternatively utilizing assets that were complimentary between both firms, much more efficiently so as to create that additional $10 million in value. Now let's define the key variables that will assist us in our analysis. We define VB as the present value of the bidding firm's cash flows on a stand alone basis. That is assuming that the acquisition is not going to go ahead. Similarly, we define VT as the present value of the Target firm's cash flows once again on a stand alone basis. VBT is the combined value of the merged firms, but this time allowing for the acquisition to proceed. We can then define the gain from the acquisition as the difference between the merged firm's value, and the sum of the value of each of the firms operating as an independent entity. This gain represents the increased value that can be created by bringing together complementary assets. And they're often referred to as the merger synergies. Now, let's consider the cost of the deal to the bidding firm. For a cash offer, it is simply the price offered per target share multiplied by the number of target shares on issue. It's a little trickier when we turn to a share-based offer, because now we're promising shareholders in the Target firm, part ownership of the new merged company. The cost, therefore, is simply the proportion of the new company that will be owned by Target shareholders. We designate that proportion as alpha. We multiply that by the total value of the merged company VBT. The net cost of an acquisition represents the total value of the controlled premium paid by the bidder firm. So this is simply the difference between the cost of the acquisition and the value of the target operating as an independent entity, VT. The NPV of the deal simply reflects the value created by the deal for Bidder shareholders. And an easy way to think about that is that it's the share of the synergies from the acquisition that are not paid out to Target shareholders in the form of a control premium. That is gain minus net cost. Okay, let's demonstrate these concepts with an example based on our flourishing coffee delivery service, Cafebike. It's five years since the inception of the company and we've finally decided to expand into Chicago. To do so, we've identified a listed coffee delivery business for us to take over, Brews-are-us. And we collect the following information relating to share prices, number of shares, and the product of the two, the market capitalization of both companies. We do some due diligence work, and we work out that there are potential synergies from the deal to the tune of $400,000. Where did they come from? All sorts of places, but let's say in this instance that we know that if we acquired Brews-are-us, we can sack the currency of that organization who happens to have a salary package whose present value is $400,000. Let's assume we make a cash offer of $24 per share for each of the 40,000 shares on issue. The net cost of the acquisition is simply the difference between the total consideration paid $960,000. And the value of the Brews-are-us without the acquisition, so $800,000. Therefore $160,000 represents the control premium paid. The NPV of the deal to Cafebike shareholders is simply what's left over from the synergistic benefits after the control premium is paid. So the leftover amount of cost is $240,000. A final question that might be of interest, especially in a hostile acquisition, is what is the maximum price that we might be willing to pay for the Target firm's shares? Now, intuitively, that's simply going to be the price, that if paid, would result in an NPV equal to zero. That is, where all of the gains are captured by Target shareholders. In this instance, that occurs when the price paid per Target share is equal to $30. Okay so that's all pretty straight forward, but what about a share offer? Let's say that you offer Brews-are-us shareholders three Cafebike shares in return for every ten shares they hold in their firm. Now it's very tempting to fall into the trap of saying, well, CBK shares are currently trading at $80 each. So we're paying three times that, or $240 in value. In return, BAU shareholders are giving up ten shares that are currently trading at $20 each, so they're giving up $200 in value, leaving them $40 ahead. Now $40 a head over 10 shares equates to a control premium of $4 per share just like the cash offer we went through previously. But that analysis confuses the fact that we're offering BAU shareholders is not shares in CBK as it was prior to the takeover, but instead shares in CBK following the merger of the two firms. Now why might these shares be worth different amounts before and after the takeover? Well, two reasons. Firstly, the impact of synergies, and then secondly the impact of passing over partial control of the firm to BAU shareholders. So let's work out what the real net cost of this share acquisition is. In redoing our analysis, let's assume that the offer remains the same, that is it's a three for ten offer. The first step is to work out the total value of the merged firm post-acquisition. That is, the sum of the values of each of the firms operating independently, plus the value of the synergistic benefits. So in this case that equates to $9.2 million. Next, we're going to work out the total number of shares that will be on issue post merger. If we issue three new shares in CBK, for every 10 shares on issue in BAU, then we'll issue 12,000 new shares to BAU shareholders. Add these 12,000 to the 100,000 shares that were already on issue, and we have 112,000 shares in CBK following the acquisition. Now, it's very simple to work out the share price. We simply divide the total value of the merged each company, $9.2 million dollars, by the total number of shares, 112,000, and we arrive at a post-acquisition share price of $82.14 per share. So what does the cost of the share offer? It's simply the proportion of the merged entity that will be owned by BAU shareholders, which is about 10.71% multiplied by the total market value of the firm, $9.2 million. So it ends up being $985,714. The net cost of the deal is the control premium paid, which is simply the cost less the value of BAU operating independently, which ends up being $185,714. Finally, the NPV of the acquisition is the share of the synergistic benefits retained by CBK shareholders. In this instance, it's simply going to be $214,286. Let's pause for a sec here. As an aside, if you divide that gain by the 100,000 shares held by CBK shareholders, you get $2.14 per share which of course matches the increase of the share price documented earlier. All right, I admit that was a little trickier than the straight cash offer but if you follow these steps carefully, you really can't go wrong. But where might we get tripped up? Well let's pause for a second. In order for a bidder to accurately measure the value created by the deal for their own shareholders, they need to estimate both the gain and the net cost of the acquisition. The gain could be estimated using standard DCF techniques. But to estimate the net cost we need two items, firstly the cost of the deal, well that's pretty easy. But then secondly, an estimate of the value of the target operating as an independent entity. Now that can be trickier to measure. Consider this graph of the price of a target firm in the period leading up to and then following the announcement of a takeover bid. Let's work from the right of the graph to the left. The first thing we notice coming from the right, and this is a common observation for takeovers, is that there's a significant positive share price reaction on the day of the takeover announcement. This reflects the fact that the market now builds in an expectation that, if the acquisition proceeds, there'll be a control premium paid. Now look what happened in the period leading up to the announcement. See how the share price was climbing in the ten days leading up to that announcement? That's consistent with either information about the impending bid being leaked to the market, or alternatively, the market simply recognizing that hey, this company might be a good target for bidders generally in the market. So why is this a problem? Well, the problem is that if you were to use the share price in this period immediately prior to the announcement, then you'd be using a price that does not reflect the value of the target as an independent entity. That is, you'd be overstating the value of the target as an independent entity. Which would understate the net cost of the acquisition, which in turn would lead to over stating the NPV of the deal to bidder shareholders. How do you avoid this trap? By careful examination of target share price histories in the lead up to a bid. By making sure that you go back far enough to remove any anticipatory effects. So, in summary, we have worked out how to estimate the following. The value of an acquisition to a target firm, the maximum price that a bidder should be willing to pay target shareholders, and how to estimate the value created for bidder shareholders via either a cash or share offer. What we haven't really discussed yet, is how can value be created by a merger? That's the topic of our next session together.
