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Mergers & Acquisitions Questions

Q.3 The following are the details on two potential merger candidates, Northrop and Grumman, in 1993:

Northrop
Grumman
Revenues
\$4,400.00
\$3,125.00
Cost of Goods Sold (w/o Depreciation)
87.50%
89.00%
Depreciation
\$200.00
\$74.00
Tax Rate
35.00%
35.00%
Working Capital
10% of Revenue
10% of Revenue
Market Value of Equity
\$2,000.00
\$1,300.00
Outstanding Debt
\$160.00
\$250.00
Both firms are in steady state and are expected to grow 5% a year in the long term. Capital spending is expected to be offset by depreciation. The beta for both firms is 1, and both firms are rated BBB, with an interest rate on their debt of 8.5%. (The treasury bond rate is 7% and risk premium is 5.5%)
As a result of the merger, the combined firm is expected to have a cost of goods sold of only 86% of total revenues. The combined firm does not plan to borrow additional debt.
a. Estimate the value of Grumman, operating independently.
b. Estimate the value of Northrop, operating independently.
c. Estimate the value of the combined firm, with no synergy.
d. Estimate the value of the combined firm, with synergy.
e. How much is the operating synergy worth?
Solution:

Synergy Gain = \$7,479 - \$5,879 = \$1,600 (Firm Value = FCFF1/(WACC - g)
Q.4. In the Grumman-Northrop example, described in the previous example, the combined firm did not take on additional debt after the acquisition. Assume that, as a result of the merger, the firm's optimal debt ratio increases to 20% of total capital from current levels. (At that level of debt, the combined firm will have an A rating, with an interest rate on its debt of 8%.) If it does not increase debt, the combined firm's rating will be A+ (with an interest rate of 7.75%.)
a. Estimate the value of the combined firm, if it stays at its existing debt ratio.
b. Estimate the value of the combined firm, if it moves to its optimal debt ratio.
c. Who gains this additional value if the firm moves to the optimal debt ratio?

Solution: a & b.

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