FI 561 MERGERS & ACQUISITIONS

WEEK 4 HOMEWORK ANSWER KEY

Question 9.11 (Chapter 9 p. 252)

9.11(a)
9.11 Vonnegut Company and Heller Company are two identical firms that agree to merge.
Both have revenues (R0) of $1,500, operating margin (m) of 15%, a tax rate (T) of 40%,
investment rate (I) of 10%, growth rate (g) of 11%, 5 years of supernormal growth (n) followed
by zero growth thereafter, and a 9% cost of capital (k).
a.

What are the values of the firms as stand-alone companies?

b.
If the combined firm increases its operating margin by 2%, revenues are combined, and
the other value drivers remain unchanged, what is the value of the combined firm?
a.
b.

What are the values of the firms as stand-alone companies?

If the combined firm increases its operating margin by 2%, revenues are combined, and the other value drivers re

R0 =
m=
T=
I=
g=
k=
n=
h=

initial revenues
net operating income margin
tax rate
investment as a ratio of revenues
growth rate of revenues
cost of capital
years of supernormal growth
calculation relationship = ((1+g)/(1+k))-1

m ( 1

$1,500
15.0%
40.0%
10.0%
11.0%
9.0%
5
0.0183

(1 h ) n 1
R 0 ( m ) (1 T )
(1 h ) n

h
k

T ) I ( 1 h )

(9.3a)

V 0 = 1500[0.15(1-0.4)-0.1](1+0.018)[(((1+0.018)^5)-1)/0.018]
<-- PV of cash flows during supernormal growth
+[(1500(0.15)(1-0.4))/0.09](1+0.0183)^5
<-- present value of terminal value

9.11(b)

The sum of the values of the independent firms is $3,128. Because of

synergies which increase the operating margin by two percentage points, the
value of the combined firms is $3,755. Hence, if one firm bought the other,
paying a premium of 25% of its intrinsic value of $1,564, or $391, then $236
of the increase in value would remain. This would be divided between the
two firms on the basis of their ownership in the new companies.
Problem 10.2.1 (Chapter 10 pp. 280-282)
Some of the potential gains from the merger were lost by the required divestitures to obtain the
FTC approval. Our judgment was that the net operating margin of the combined company would
move to Dows 10% level. Since some promising growth lines had to be divested we show an
8% growth rate for the combined company, somewhat below Dows standalone higher rate. We
show an improvement in the combined net operating margin for the terminal period to 7.5% and
for the growth rate to 5%. The indicated combined equity value rises to $33,602 million. This
represents an indicated value per share for Dow of $50.91. Dow closed on May 14, 2002 at

$34.32 with a 52-week range of approximately $24-$40. These numbers are well below our
intrinsic value estimate of $50.91. Intrinsic value estimates appear to be high in a weak market.
Analysts reports were generally optimistic about the benefits of the merger, the progressive
realization of synergies, and improved price prospects for Dow.

Solution Table PA10.2.1 (Model 10-04)

Problem 10.2.2 (Chapter 10, pp. 280-282)

Use Model 10-02 shown below as a framework inserting the Dow / Union Carbide (drawing on
the data in Model 10-01 presented in the problem statement).
Solution Table PA10.2.2
Test of Merger Performance for Dow / Union Carbide (Model 10-02)
(in $ billion)

From the solution to question 10.1.1, the indicated market value of Dow postmerger is $41.4
billion. From this we deduct the amount paid to Union Carbide of $8.9 billion. The
remainder is the value for Dow of $32.5 billion compared to its premerger value of $27.1
billion. The gain from the merger was $5.4 billion divided on the basis of ownership shares
in the combined company. Thus the gain to Dow shareholders was $4.1 billion. The gain to
Union Carbide shareholders, including the $2.4 billion premium was $3.8 billion. Thus the
gains were about evenly divided. Another method of showing the same results starts with the
postmerger value of $41.4. From this we deduct the total of premerger values to obtain a
total gain of $7.9 billion, with $4.1 billion to Dow shareholders and $3.8 billion to the Union
Carbide shareholders.