Company ABC intends to take over XYZ. One of the arguments propounded by the CEO

Question

Company ABC intends to take over XYZ. One of the arguments propounded by the CEO of ABC is that it intends to undertake the merger as a means to diversification to reduce risk. The present value of ABC is given as $300 million. The present value of XYZ on the other hand is $ 80 million. It is estimated that due to the merger, annual savings of $6 million will be made. After several rounds of negotiations, ABC has agreed to pay a price of $120 million for XYZ. Assume a post merger cost of capital of 10%

a) Calculate the cost of the merger to ABC
b) Calculate the NPV of the merger to ABC

c) What will be the gain to the shareholders of XYZ?

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d) Determine the total value of this company assuming the merger takes place.

e) Comment on the argument propounded by the CEO of ABC.

Explanation / Answer

a.) Value of annual savings upto perpetuity due to merger =$6,000,000/0.10 =$60,000,000

Cost of merger to ABC =$120,000,000 - $60,000,000 =$60,000,000

b.) NPV of Merger for ABC =$300 - $120 + $60 = $240 million

c.) Gain to Shareholders of XYZ =$120 - 80 =$40 million

d.) Total Value of the company assuming the merger takes place = $300 + $80 - $120 + $60 =$320 million

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