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The following example summarizes the sources of value discussed in this section and illustrates how
we might assess value creation in a potential acquisition.
Example 5: MC Enterprises Inc. manufactures and markets value-priced digital speakers and
headphones. The firm has excellent engineering and design staffs and has won numerous awards from
High Fidelity magazine for its most recent wireless bookshelf speakers. MC wants to enter the market
for personal computer (PC) speakers, but does not want to develop its own line of new products from
scratch. MC has three million outstanding shares trading at $30 per share.
Digerati Inc. is a small manufacturer of high-end speakers for PCs, best known for the technical
sophistication of its products. However, the firm has not been well managed financially and has had
recent production problems, leading to a string of quarterly losses. The stock recently hit a three-year
low of $6.25 per share, with two million outstanding shares.
MC‟s executives feel that Digerati is an attractive acquisition candidate that would provide them
with quick access to the PC market. They believe an acquisition would generate incremental after-tax
cash flow from three sources:
1. Revenue enhancement: MC believes that Digerati‟s technical expertise will allow it to
expand its current product line to include high-end speakers for home theater equipment. MC
estimates these products could generate incremental annual cash flow of $1.25 million. Because
this is a risky undertaking, the appropriate discount rate is 20%.
2. Operating efficiencies: MC is currently operating at full capacity with significant
overtime. Digerati has unused production capacity and could easily adapt its equipment to
produce MC‟s products. The estimated annual cash flow savings would be $1.5 million. MC‟s
financial analysts are reasonably certain these results can be achieved and suggest a 15% discount
rate.
3. Tax savings: MC can use Digerati‟s recent operating losses to reduce its tax liability. The
tax accountant estimates $750,000 per year in cash savings for each of the next four years.
Because these values are easy to estimate and relatively safe cash flows, they are discounted at
10%.
The premerger values of MC and Digerati are computed as follows:
Assume that MC pays a 50% premium to acquire Digerati and that the costs of the acquisition total
$3 million. What is the expected impact of the transaction on MC‟s share price?
Solution: We first compute the total value created by each of the incremental cash flows. 13