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How are synergies calculated in the merger model?
Consider the following table −
Company 1 | Company 2 | |
---|---|---|
Revenue ($) | 1000000 | 500000 |
Cost of goods sold ($) | 750000 | 270000 |
EBIR ($) | 250000 | 125000 |
Growth Rate (Expected) | 5% | 9% |
Cost of capital | 11% | 14% |
Assume the following −
- Cost of goods sold is reduced from 75% to 60% of revenues.
- Tax rate = 32%.
- Weighted average cost of capital = 14%.
- Weighted average growth rate = 6%.
Solution
The solution is as follows −
Before merger
Company 1
Cash flows = (1000000 – 750000) * 0.68 >= $170000
Value of firm = $ 170000 * 1.05/ (0.11-0.05)
= 178500/0.06 => $ 2975000Company 2
Cash flows = (500000 – 270000) * 0.6 => $156400
Value of firm = $ 156400 * 1.09/ (0.14-0.09)
= 170476/0.05 => $ 3409520Combined (company 1 + company 2)
Combined value = $ 297500 + $3409520
= $ 3707020
After merger
Revenue = $1000000 + $500000 => $1500000
After merger cost of goods sold revenue reduced to 60% => $1500000 * 0.60 => $900000EBIT => $1500000 − $900000 => $600000
Post tax => $600000 * 0.68 => $408000
Value of firm = 408000 * 1.06/ (0.14-0.06) => 432480/0.08 => 5406000
Value after post-merger = $ 5406000 - $3707020 = $1698980 (increased)