An acquiring company may be interested in acquiring entire business or just acquiring individual assets and selling off the rest of the assets. When considering a merger, companies can use capital budgeting techniques to find the value of the company. If the net present value of the relevant cash flows is positive then a merger is considered acceptable.

If the acquiring company is interested in the whole business rather than in just few assets of the target company then post-merger pro forma statements for the target company should be prepared and the cost of capital of the acquiring company must be adjusted to reflect the cost of capital of the target company.

Test yourself:

ABC Company would like to obtain assets of BCD Company. BCD Company is a loss maker, it made losses over the last 4 years. However, it has three assets which ABC needs for its operations which are assets a, b and c. BCD is not willing to sell the assets separately but willing to sell the entire company for $95,000. According to the balance sheet of BCD:

• asset a is worth $25,000
• asset b is worth $20,000
• asset c is worth $50,000
• BCD also has $5,000 in cash, $12,000 in accounts receivable, and $5,000 in relatively obsolete inventory
• ABC found out that they can sell accounts receivable and inventory of BCD for $10,000
• BCD’s liabilities account for $70,000
• After the merger, three assets of BCD will generate $15,000 in cash inflows over the next 10 years
• ABC’s cost of capital is 12%

How should ABC establish if it should undertake this investment?

Solution:

BCD requires $95,000. Out of this money, $70,000 will be used to cover liabilities and $25,000 will be going to the owners of the target company. ABC will be able to recover $10,000 from selling accounts receivable and inventory and it will also obtain $5,000 in cash. Therefore, its actual investment is $80,000 ($95,000-10,000-5,000).

Next we need to determine the net present value of the relevant cash flows. Since it is an annuity, we can calculate it very simply. We will use a financial calculator. The calculation is as follows:

PMT: 15,000

N: 10

I: 12

PV: calculate = 84,753

Since investment required is $80,000, we can find the NPV as follows:

84,753 – 80,000 = 4,753

There is another way to calculate NPV using a financial calculator. It is advisable to try them both to make sure that the answer you obtain is correct. The second way is as follows:

CF0: -80,000

CF1: 15,000

Second function Nj: 10

I: 10

Second function NPV: calculate = $4,753

Since both calculations gave us the same answer, we can be confident that the answer is correct.

Since NPV is $4,753 which is higher than zero, a merger with BCD is acceptable.