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V AB - (V A + V B ), is the incremental value created by the acquisition, sometimes called the synergy. That
is,
(1)
Clearly, positive synergy would be a prerequisite to going forward with the acquisition. In practice,
things are a bit more complicated for two reasons: the costs of an acquisition and the target premium.
The acquisition process carries significant direct costs for lawyers, consultants, and accountants. There
is also the indirect cost caused by the distraction of the bidder‟s executives from their day-to-day
operation of the existing business. Finally, the data presented earlier in the track record section shows
that target shareholders in acquisitions typically receive a 30% to 40% premium over market price.
Some transactions have smaller premiums, but in almost all cases, the acquirer pays a price above the
preacquisition market value. All of these costs can be factored into the evaluation as follows:
(2)
Example 3 Midland Motorcycles Inc. is considering the acquisition of Scotus Scooters. Midland‟s
current market capitalization is $10 million, while Scotus has a market capitalization of $2 million.
The executives at Midland feel the combined firm would be worth $14 million due to synergies.
Current takeover premiums average 35%, and the total cost of the acquisition is estimated at $1.5
million. Should Midland proceed with the deal?
Using equation 2,
The deal would destroy $200,000 of value. Note that this is in spite of the fact that there are $2
million of positive synergies created by the acquisition. The reality is that this synergy is more than
offset by the costs of the transaction and the premium paid for the target, a typical problem in
acquisitions. For example, consider Coca-Cola‟s 2001 interest in Quaker Oats, which Coke CEO
Douglas Daft felt “fit perfectly into Coke‟s strategy of boosting growth by increasing its share of noncarbonated
drinks. . . .” 10 Even Coke‟s directors felt that the strategic rationale behind the transaction
was sound. But the deal was ultimately rejected because of the price. Warren Buffett, a major Coca-
Cola shareholder, said, “Giving up
would get.” 11
of the Coca-Cola Company was just too much for what we
Note that the bracketed term in equation 2 is just the synergy as defined in equation 1. Where does
this synergy or incremental value originate? From the earlier discussion, we know that value can come
from only two places—increased cash flows or reduced risk. In this case, the synergy can be computed
as follows:
(3)