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Business Studies

You have been asked to value the synergy in a merger by your boss, who also happens to be an avid believer in Economic Value Added (EVA). As a result, you are given the following information on the two firms:

G & P is a diversified consumer product company with $ 2 billion in capital invested, a return on capital of 13%, and a cost of capital of 11%. The firm is assumed to be in stable growth, and the EVA is expected to grow 5% a year in perpetuity.

BandAdd is a smaller company that produces only perfumes. It has $ 500 million in capital invested, earning a return on capital of 16% with a cost of capital of 12%. This firm is also in stable growth, and the EVA is expected to grow 5% a year in perpetuity.

Both firms have 40% tax rates.

Using the above information, answer the following questions:

Value G & P using the EVA approach. ( 20 points)
Value BandAdd using the EVA approach. ( 20 points)
As a result of the merger, you expect the firm to be able to lower its cost of capital to 10% (as a result of increased debt capacity) and to post an increase in the combined operating income of 10% (as a result of economies of scale). Estimate the value of synergy in this merger. (60 points)
Note: $1,000 equals $1 billion on your spreadsheet.

Full Answer Section

In this case, the NOPAT of G & P is:

NOPAT = 0.13 * 2,000,000,000 * (1 - 0.4) = 1,320,000,000

The capital invested in G & P is 2,000,000,000, and the cost of capital is 11%, so the EVA of G & P is:

EVA = 1,320,000,000 - (2,000,000,000 * 0.11) = 120,000,000

Value BandAdd using the EVA approach. The EVA of BandAdd is calculated in the same way as the EVA of G & P. The NOPAT of BandAdd is:

NOPAT = 0.16 * 500,000,000 * (1 - 0.4) = 480,000,000

The capital invested in BandAdd is 500,000,000, and the cost of capital is 12%, so the EVA of BandAdd is:

EVA = 480,000,000 - (500,000,000 * 0.12) = 20,000,000

Synergy in the merger The synergy in the merger is the difference between the sum of the EVAs of G & P and BandAdd and the EVA of the merged company. The merged company will have a capital of 2,500,000,000 and a cost of capital of 11.5%. The EVA of the merged company is:

EVA = 1,320,000,000 + 20,000,000 - (2,500,000,000 * 0.115) = 115,000,000

The synergy in the merger is:

Synergy = 120,000,000 + 480,000,000 - 115,000,000 = 275,000,000

Therefore, the synergy in the merger is $275 million. Conclusion The EVA of G & P is $120 million, and the EVA of BandAdd is $20 million. The synergy in the merger is $275 million.

Sample Answer

Value G & P using the EVA approach. The EVA of G & P is calculated as follows:

EVA = NOPAT - (Capital * Cost of capital)
NOPAT = EBIT * (1 - Tax rate)