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
- WACC = Weighted average cost of capital
- Capital Invested = The amount of capital that has been invested in the firm
In this case, the NOPAT of G & P is calculated as follows:
NOPAT = (Return on Capital * Capital Invested) - Taxes
= (13% * $ 2 billion) - (40% * $ 2 billion)
= $ 1.44 billion
The WACC of G & P is calculated as follows:
WACC = (Weight of Equity * Cost of Equity) + (Weight of Debt * Cost of Debt)
= (0.6 * 13%) + (0.4 * 5%)
= 10.2%
The capital invested in G & P is $ 2 billion.
Therefore, the EVA of G & P is $ 1.44 billion - ($ 10.2% * $ 2 billion) = $ 1.03 billion.
Value BandAdd using the EVA approach:
The EVA of BandAdd is calculated in the same way as the EVA of G & P. The only difference is that the NOPAT, WACC, and capital invested are different for BandAdd.
The NOPAT of BandAdd is calculated as follows:
NOPAT = (Return on Capital * Capital Invested) - Taxes
= (16% * $ 500 million) - (40% * $ 500 million)
= $ 400 million
The WACC of BandAdd is calculated as follows:
WACC = (Weight of Equity * Cost of Equity) + (Weight of Debt * Cost of Debt)
= (0.6 * 12%) + (0.4 * 6%)
= 10%
The capital invested in BandAdd is $ 500 million.
Therefore, the EVA of BandAdd is $ 400 million - ($ 10% * $ 500 million) = $ 350 million.
Synergy in the merger:
The synergy in the merger is the additional EVA that the merged company will generate over the two companies operating separately. The synergy is calculated as follows:
Synergy = EVA of Merged Company - (EVA of G & P + EVA of BandAdd)
The EVA of the merged company is calculated as follows:
EVA of Merged Company = (NOPAT of Merged Company) - (WACC of Merged Company * Capital Invested of Merged Company)
The NOPAT of the merged company is calculated as follows:
NOPAT of Merged Company = NOPAT of G & P + NOPAT of BandAdd
= $ 1.44 billion + $ 400 million
= $ 1.84 billion
The WACC of the merged company is calculated as follows:
WACC of Merged Company = (Weight of G & P * WACC of G & P) + (Weight of BandAdd * WACC of BandAdd)
= (0.6 * 10.2%) + (0.4 * 10%)
= 10.1%
The capital invested in the merged company is $ 2.5 billion (the sum of the capital invested in G & P and BandAdd).
Therefore, the EVA of the merged company is $ 1.84 billion - ($ 10.1% * $ 2.5 billion) = $ 1.31 billion.
Therefore, the synergy in the merger is $ 1.31 billion - ($ 1.03 billion + $ 350 million) = $ 180 million.
Conclusion:
The synergy in the merger is $ 180 million. This means that the merged company will generate an additional $ 180 million in EVA over the two companies operating separately. This is a significant amount of synergy, and it is one of the reasons why mergers and acquisitions are often done.