Expert Work

Expert Work

Chapter 9

9.11 Vonnegut Company and Heller Company are two identical firms that agree to merge. Both have revenues (R0) of $1,500, operating margin (m) of 15%, a tax rate (T) of 40%, investment rate (I) of 10%, growth rate (g) of 11%, 5 years of supernormal growth (n) followed by zero growth thereafter, and a 9% cost of capital (k).

a. What are the values of the firms as stand-alone companies?

b. If the combined firm increases its operating margin by 2%, revenues are combined, and the other value drivers remain unchanged, what is the value of the combined firm? (Weston 252) 

Chapter 10

Question 10.2.1

Table P10.2.1 uses Model 10-04 (from our Web sites) to calculate the premerger stand-alone values of Dow and Union Carbide. Dow had a higher net operating margin and a higher growth rate. Because of its higher credit rating it had a somewhat lower cost of capital. Analysts’ reports predicted that the combined operating margin would reflect the benefits of synergies in the total amount of $2 billion. They also predicted that the combined growth rate would raise Union Carbide’s growth rate toward the higher of Dow. In the combined column (Dow, the surviving company), of Table P10.2.1, are blanks for the operating income margins and growth rates for the initial period and the terminal period. Make your best estimate to fill in the blanks to calculate the values for the third column of the tab. (Weston 281-282) See way below:

Please note the following assumptions (explanations): 

Some of the potential gains from the merger were lost by the required divestitures to obtain the FTC approval. 

Our judgment was that the net operating margin of the combined company would move to Dow’s 10% level. 

Since some promising growth lines had to be stripped, we show an 8% growth rate for the combined company, somewhat below Dow’s standalone higher rate. 

An improvement is shown in the combined net operating margin for the terminal period to 7.5% and for the growth rate to 5%. 

The indicated combined equity value rises to $33,602 million.  This represents an indicated value per share for Dow of $50.91.  Dow closed on May 14, 2002 at $34.32 with a 52-week range of approximately $24-$40.  These numbers are well below our intrinsic value estimate of $50.91.  Intrinsic value estimates appear to be high in a weak market. 

Analysts’ reports were generally optimistic about the benefits of the merger, the progressive realization of synergies, and improved price prospects for Dow. 




Please note the following assumptions (explanations):

The indicated market value of Dow postmerger is $41.4 billion (from question 10.1.1). from this we deduct the amount paid to Union Carbide of $8.9 billion.  The remainder is the value for Dow of $32.5 billion compared to its premerger value of $27.1 billion. 

The gain from the merger was $5.4 billion divided on the basis of ownership shares in the combined company.  Thus the gain to Dow shareholders was $4.1 billion.  The gain to Union Carbide shareholders, including the $2.4 billion premium was $3.8 billion.  Therefore the gains were about evenly divided. 

Another method of showing the same results starts with the postmerger value of $41.4.  From this we deduct the total of premerger values to obtain a total gain of $7.9 billion, with $4.1 billion to Dow shareholders and $3.8 billion to the Union Carbide shareholders.

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