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The positive incremental net gain associated with the combination of two firms through a merger or acquisition.


Firms A and B are competitors with very similar assets and business risks. Both are all-equity firms with aftertax cash flows of $10 per year forever, and both have an overall cost of capital of 10 percent. Firm A is thinking of buying Firm B. The aftertax cash flow from the merged firm would be $21 per year. Does the merger generate synergy? What is V'B? What is A V?

Ross et al.: Fundamentals I VIII. Topics in Corporate I 25. Mergers and I I © The McGraw-Hill of Corporate Finance, Sixth Finance Acquisitions Companies, 2002

Edition, Alternate Edition

850 PART EIGHT Topics in Corporate Finance

The merger does generate synergy because the cash flow from the merged firm is ACF = $1 greater than the sum of the individual cash flows ($21 versus $20). Assuming that the risks stay the same, the value of the merged firm is $21/.10 = $210. Firms A and B are each worth $10/.10 = $100, for a total of $200. The incremental gain from the merger, A V is thus $210 - 200 = $10. The total value of Firm B to Firm A, V*, is $100 (the value of B as a separate company) plus $10 (the incremental gain), or $110.

From our discussions in earlier chapters, we know that the incremental cash flow, ACF, can be broken down into four parts:

ACF = AEBIT + ADepreciation — ATax — ACapital requirements = ARevenue — ACost — ATax — ACapital requirements where ARevenue is the difference in revenues, ACost is the difference in costs, ATax is the difference in taxes, and ACapital requirements is the change in new fixed assets and net working capital.

Based on this breakdown, the merger will make sense only if one or more of these cash flow components are beneficially affected by the merger. The possible cash flow benefits of mergers and acquisitions thus fall into four basic categories: revenue enhancement, cost reductions, lower taxes, and reductions in capital needs.

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