The Role of Acquisitions

As firms mature and increase in size, they are often confronted with a quandary. Instead of being cash poor and project rich, they find that their existing projects generate far more in cash than they have available projects in which to invest. This can be attributed partly to size and partly to competition. As they face up to their new status as cash-rich companies, with limited investment opportunities, acquiring other firms with a ready supply of high-return projects looks like an attractive option, but there is a catch. If these firms are publicly traded, the market price already reflects the expected higher

14 It is estimated that Intel spent between $3 billion and $5 billion developing the Pentium chip.

returns not only on existing projects but also on expected future projects. In terms of present value, the value of a firm can be written as

Value of Firm = Present Value of Cash Flows from Existing Projects

+ Net Present Value of Cash Flows from Expected Future Projects Thus, firms that are earning super-normal returns on their existing projects and are expected to maintain this status in the future will sell at prices that reflects these expectations. Accordingly, even if the cash-rich firm pays a "fair" price to acquire one of these firms, it has to earn more than the expected super normal returns to be able to claim any premium from the acquisition. To put all this in perspective, assume that you are considering the acquisition of a firm that is earning 25% on its projects, when the hurdle rate on these projects is 12%, and that it is expected to maintain these high returns for the foreseeable future. A fair price attached to this acquisition will reflect this expectation. All this implies that an acquisition will earn super-normal returns for the acquirer if, and only if, one of the following conditions holds:

• The acquisition is done at a price below the fair price (i.e., the company is significantly undervalued).

• The acquisition is done at a price that reflects the expectation that the firm will earn 25% but the acquirer manages to earn an even higher return, say 30%, on future projects.

• The acquisition enables the firm to take on projects that it would not have taken on as an independent firm; the net present value of these additional projects will then be a bonus that is earned by the acquiring firm. This is the essence of synergy.

• The acquisition lowers the discount rate on projects, leading to an increase in net present value, even though the returns may come in as expected.

Overall, it is clear that internally generated projects have better odds of success than do acquisitions since no premium is paid for market expectations up front.

Super Normal Returns: These are returns which are greater than the returns that would normally be earned for an investment of equivalent risk.

Synergy: This is the increase in the value that results from combining two firms.

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