How are synergies calculated in the merger model?

Consider the following table −

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 => $ 2975000

• Company 2
  Cash flows = (500000 – 270000) * 0.6 => $156400
  Value of firm = $ 156400 * 1.09/ (0.14-0.09)
  = 170476/0.05 => $ 3409520

• Combined (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 => $900000

• EBIT => $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)

Nagasravan Tamma

Updated on: 19-Jul-2021

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