CalculatingThe Value-Creation Potential of a Deal: The shareholder value approach enables management to determine whether a merger or acquisition can truly add value to the company.

Alfred RappaportThe basic objective of making acquisitions is identical to any other investment associated with a company’s overall strategy, namely, to add value. The shareholder value approach enables management to evaluate all investments, whether they be dedicated to internal growth or to external growth, such as mergers and acquisitions, with an economically sound and consistent measurement system. Indeed, mergers and acquisitions may be seen as a special case of a strategy or, perhaps more realistically, as an important component of a company’s corporate and business strategies. The three basic steps of competitive analysis to assess industry attractiveness, to evaluate the business’s competitive position within the industry, and to identify sources of competitive advantage are equally relevant for evaluating presently owned businesses and businesses that are candidates for purchase. After all, immediately following the acquisition, the target company becomes part of the “presently owned businesses” of the buyer. Therefore, the basic calculations for valuing acquisitions closely parallel those for valuing strategies. There are, however, two distinct features associated with mergers and acquisitions that need to be acknowledged. First, when a company makes capital investments in connection with its internal development, it is adding real assets to the productive capacity of the industry and may well be affecting the competitive structure. In contrast, a merger per se does not alter productive capacity but simply transfers ownership rights from one set of shareholders to another. While there are often substantial advantages associated with acquisitions when compared with internal development, the price of an acquisition is set in a highly competitive market for companies, which tends to limit extraordinary value-creating opportunities. This leads to the second distinct feature of mergers and acquisitions. Investments such as machines and plant made in connection with a company’s internal development typically are purchased in relatively active markets with quoted prices. While publicly traded companies also have quoted trading prices, the price required to obtain a controlling interest in the target company ordinarily will be materially higher than the trading price. Thus, price is more negotiable in acquisitions than in the normal process of directly acquiring real assets. Integrating the organizational assets, particularly the commitment of employees, is by far a more compelling task in the case of acquisitions than for expansion via internal development. While mergers and acquisitions involve a considerably more complex set of managerial problems than the direct purchase of ordinary assets, the economic substance of these transactions is the same. In each case, there is a current outlay made in anticipation of a stream of future cash flows. To estimate the value-creating potential of an acquisition to the buying company’s shareholders, assessments must be made of the stand-alone value of the seller, the value of acquisition benefits, and the purchase price. The respective roles of these factors in the value creation framework can be gleaned from the three fundamental equations shown below. The value created by an acquisition depicted in the first equation is the difference between the postmerger value of the combined company and the sum of the stand-alone values of the buyer and seller. This difference represents the acquisition benefits generated by operating, financial, and tax synergies. These synergies will either increase cash flow returns or decrease the riskiness of the cash flow stream. It is important to emphasize that this is the total value created by combining the two companies and not the value created for the buyer. The respective amounts of value transferred to the buyer and seller ultimately will be determined by the purchase price. The stand-alone value of the selling company ordinarily would be the seller’s minimum acceptable, or floor, price because it usually has the option of continuing to operate the business. In this event it would be reasonable for the seller to expect the price to be greater than the present value of continuing to operate the business. In most cases it will take a substantial premium over the stand-alone price to persuade the target company to sell. As the premium increases, more of the value created by the acquisition goes to selling shareholders and the more difficult it becomes for the buyer to achieve a rate of return exceeding the minimum acceptable rate. At this point, two questions need to be answered: What measure ought to be used in establishing the seller’s stand-alone value? Under what circumstances will the seller depart from stand-alone value as a floor price? When the target company is publicly traded, market value is the best basis for establishing stand-alone value. For some companies, however, market value may not be a particularly good proxy for stand-alone value. These are companies whose stocks have been bid up in anticipation of a takeover bid. To estimate stand-alone value, the “takeover premium” impounded in the current market price should be deducted from the current market price. We now turn to the question of when the seller is likely to depart from using stand-alone value as a floor or minimum acceptable price. The seller’s floor price is determined by the attractiveness of alternative opportunities. If the seller already has a credible offer above the current market price, then this competing offer will in fact be the floor price. On the other hand, if the seller is not optimistic about the future prospects of the business or perceives major capital or managerial constraints in realizing the company’s potential, the floor price likely will be lower. To negotiate effectively, buyers need to recognize that the floor price depends on the seller’s perceptions and not those of the buyer. The second equation defines the maximum acceptable price to pay for the seller as the sum of the stand-alone value of the seller plus the value of acquisition synergies. The maximum price may be characterized equivalently as the difference between the postmerger value of the combined firm and the premerger stand-alone value of the buyer. If the maximum price actually is paid, then all value created by the acquisition goes to the seller. Thus, from the buyer’s perspective, the maximum price is an economic break-even price, that is, the investment is expected to yield the risk-adjusted cost of capital rate. Ordinarily this price truly will represent the maximum offering price. There are, however, circumstances in which the buyer may be willing to pay even more and also circumstances in which alternative opportunities enable the buyer to set the maximum acceptable price at a considerably lower level. There are times when an acquisition is simply a necessary investment as part of a more global long-term strategy to attain a competitive advantage in a selected product market. The relevant entity for analysis thus would be the total strategy or, organizationally, the business unit. The acquisition can be viewed as a project that is an integral part of the strategy. What is important is that the overall strategy creates value and that the supporting projects represent the most efficient and effective means of implementing the strategy. In such a situation an acquisition per se may not meet conventional discounted cash-flow hurdle rates, but it simply may be the only feasible way to execute the long-term strategy. Such an acquisition represents not an end in itself but rather it provides the option to participate in the future opportunities in the industry. There are circumstances under which a buying company’s maximum acceptable price would be considerably less than the sum of the stand-alone value of the seller and the value created by the acquisition. All of these circumstances involve the availability of less costly alternatives. In the simplest case, there is an equally attractive seller available at a lesser price. Alternatively, the strategic imperatives can be achieved by other collaborative means, such as joint ventures, a wide range of strategic alliances, or a minority investment. Finally, there is the alternative of internal development. When this is a viable choice, management is essentially engaged in a make (internal development) versus buy (acquisition) decision. The increasing tilt toward acquisitions reflects several important advantages of acquisitions over internal growth. * Entry in a product market via acquisition may take weeks or months while internal development typically takes years. * Acquiring a business with a strong market position is often less costly than a competitive battle to achieve market entry. * Strategic assets such as brand image, distribution channels, proprietary technology, patents, trademarks, and experienced management are often difficult, if not impossible, to develop internally. * An existing, proven business is typically less risky than developing a new one. The third equation defines the value created for the buyer as the difference between the maximum acceptable price and the price paid for the seller. In light of the competitive nature of the market for corporate control, an acquisition is likely to create value for the buyer only if the buyer has a distinctive ability to generate significant economic benefits as a result of the combination. It is important to emphasize that the acquiring company needs to value not only the target company but also itself. Two fundamental questions posed by a financial self-evaluation are: How much is my company worth? How would its value be affected by each of several scenarios? The first question involves generation of a “most likely” estimate of the company’s value based on management’s detailed assessment of its prospects and plans. The second calls for an assessment of value based on a range of plausible scenarios that enable management to test the effect of hypothesized combinations of product market strategies and environmental forces. Corporate self-evaluation, when conducted as an assessment of the value created for shareholders by various strategic planning options, promises potential benefits for all companies. In the context of the acquisition market, self-evaluation takes on special significance. First, while a company might view itself as an acquirer, few companies are totally exempt from a possible takeover. Self-evaluation provides management and the board with a continuing basis for responding to tender offers or acquisition inquiries responsibly and quickly. Second, the self-evaluation process might well call attention to strategic divestment or other restructuring opportunities. Finally, financial self-evaluation offers acquisition-minded companies a basis for assessing the comparative advantages of a cash versus an exchange-of-shares offer. Buying companies commonly value the purchase price for an acquisition at the market value of the shares exchanged. This practice is not economically sound and could be misleading and costly to the buying company as well as the selling company. A well-conceived analysis for an exchange-of-shares acquisition requires sound valuations of both buying and selling companies. If the buyer’s management believes the market is undervaluing its shares, then valuing the purchase price at market might well induce the company to overpay for the acquisition or to earn less than the minimum acceptable rate of return. Conversely, if management believes the market is overvaluing its shares, then valuing the purchase price at market obscures the opportunity to offer the seller’s shareholders additional shares while still achieving the minimum acceptable return. Consider the following example. The buying company management values its own company at $150 million. The buyer’s value is $15 per share with 10 million shares outstanding for a total market value of $150 million. The buyer values the target (including synergies) at $45 million. What is the maximum number of shares the buyer can issue in exchange for all of the seller’s outstanding shares? The answer is clearly 3 million shares valued at $15 per share, and can be demonstrated as follows: Now suppose all the facts remain the same except that the buyer’s market value is $9 per share for a total market value of $90 million. What is the maximum number of shares the buyer can issue under these circumstances? The correct answer is once again 3 million shares because the buying company management continues to value itself at $150 million. Management, in fact, believes it is being undervalued by $6 per share. If the shares exchanged were valued at the market price of $9 per share, then the buyer would be willing to exchange up to 5 million shares in exchange for the seller’s $45 million value. But this will lead to the buyer overpaying by $20 million for the acquisition, as is shown below: Determining whether mergers and acquisitions create shareholder value is challenging. This is true because the more successful the postmerger integration the more difficult it is to measure the value added by the merger. Moreover, as time passes, other investments and strategic events are likely to overtake and mask the effects of the merger. Thus, an acquirer’s postacquisition shareholder return performance cannot be confidently attributed to past acquisitions. As a consequence, most empirical studies conducted by financial economists focus on the stock market response a few days before and after the announcement date of the merger. Mergers and acquisitions are highly visible, strategic, and megadollar events. The buying company’s stock price is established by investors with substantial dollars at risk and strong incentives to develop accurate estimates of the long-term consequences of the acquisition. Thus, while the research window is short, the measured price response, like the market itself, is based on long-term expectations. While the market’s short-term response to a merger announcement provides a reasonably reliable barometer of the likely consequences of the transaction, there is, of course, the possibility that with hindsight the market assessment will turn out to be incorrect. There is, however, evidence that the market’s assessments are unbiased. This means that, on average, the market neither overvalues or undervalues the transaction. There is an approximately 50-50 probability that the market assessment will be too low or too high in estimating the eventual value created by the merger. The collective judgment of competitive investors thus can be viewed as an objective assessment of the value of the merger to buying and selling shareholders. In brief, the immediate price reaction is the market’s best guess about the long-term implications of the transaction. Should the market err in its assessment of the likely consequences of the merger, the resulting mispricing would offer market participants trading opportunities that would move market prices to a more reasonable level. What do these so-called “event studies” reveal? Acquisition announcements in the 1980s, on average, decreased the value of the acquiring company. In about two-thirds of the cases the market response was negative. Why do disappointing results persist for acquiring companies? The price of an acquisition is set in a highly competitive market for companies, which tends to limit extraordinary value-creating opportunities. Acquisition candidates available at a price that enables the acquiring company to earn an acceptable risk-adjusted rate of return are difficult to find. This is the case because invariably the acquisition price includes a premium over the market value of the selling company. According to Mergers & Acquisitions, premiums, based on the seller’s share price one month before deal announcement, have averaged between 40% and 50% during the first half of the 1990s. If the buying company is going to create value for its shareholders, the acquisition price must be no greater than the stand-alone value of the selling company plus the value created by acquisition synergies. These synergies increase the cash flows for the combined company over the expected level of cash flows for the two companies operating separately. At an economic break-even, that is, when the acquiring company shareholders earn just their risk-adjusted rate of return, the following holds true: This formula captures the difficulty that buying companies have in creating value from mergers and acquisitions. To create value, the present value of synergies must be greater than the premium paid. Remember, the buyer pays the premium up front and buys an option on uncertain future synergies. In other words, the premium is an advance payment on a speculative synergy bet. Those who have participated in the challenges arising after the acquisition undoubtedly will agree that synergy is a concept desperately searching for successful execution. When the buyer’s stock price decreases upon the announcement of an acquisition, this signals that investors believe that the expected present value of synergies is less than the premium paid. With premiums averaging 40% to 50% and sometimes reaching 100% it should come as no surprise that the buying company’s stock falls so often after the merger is announcement. The greater the premium percentage is, and the greater the selling company’s stand-alone value relative to the buying company’s is, the more vulnerable the buying shareholders are. For example, suppose that the stand-alone values for the acquiring company and the target are $800 million and $400 million, respectively. The acquisition price of $640 million represents a 60% premium of $240 million over the target’s stand-alone value. The $240 million synergy bet places 30% of the acquiring company’s $800 million value at risk. Table 1 shows how the percentage of the buyer’s premerger market value at risk varies with premium percentages and the stand-alone value of the target company relative to the acquiring company. In brief, even if a merger creates value it may not be value-creating for the acquirer if the premium paid exceeds the value added. In this circumstance all the value created is captured by the selling shareholders. Acquirers are often doomed well before the price is established. They buy without a clear strategy. They buy with inadequate knowledge of the target company and sometimes no “cultural” due diligence. They buy with no postmerger integration plan that would quickly convert synergies from wishful projections to operational realities. They buy because they are compensated on such shareholder-value unfriendly measures as return on tangible net assets. Consequently, operating managers have an incentive to make acquisitions, even those with large premiums, because they add to operating income and goodwill is excluded from the denominator. These misjudgments lead to payment of excessive premiums and value destruction. In these settings, merger success is likely to be as rare as sightings of Haley’s Comet. To minimize the risk of buying an economically unattractive business or paying too much for an attractive one, management must go beyond standard acquisition analysis. Because of the difficulty of forecasting the value of synergies, management sometimes justifies paying substantial premiums by recourse to such comfortable qualitative labels as “strategic fit,” “market share opportunity,” or “technological imperative.” Such unwillingness to face uncertainty squarely can be costly. To establish a maximum price, management can use market signals analysis in conjunction with the standard acquisition analysis detailed here. Rather than beginning with value driver forecasts to estimate the maximum acceptable price, start with a figure that is much easier to determine the price it will take to make a successful bid. The required bid then can be used to establish the market’s minimum expectations for the target company’s postmerger performance. At this level of performance the acquirer will earn its cost of capital or minimum acceptable rate of return. To illustrate, let’s look at the 1988 acquisition of Sterling Drug by Eastman Kodak. Kodak purchased Sterling for $5.1 billion, or a 70% premium over its $3 billion market capitalization 30 days prior to announcement. Within days of the announcement Kodak market value declined by $2.2 billion, which represented about 15% of its total market value. Remarkably, the $2.2 billion market decline was even greater than Kodak’s $2.1 billion premium to purchase Sterling Drug. The market signal was clear. It simply did not believe that Kodak would be able to generate any synergies to recoup the premium paid over Sterling’s premerger stand-alone value. A market signals analysis performed beforehand surely would have made Kodak a more reluctant bidder. Value Line’s long-term projections for Sterling just before the acquisition called for 13% sales growth and pretax operating margins of 15%. Coupled with estimates of investment requirements, tax rates, and cost of capital, these projections suggested that to justify Sterling’s premerger price of $53 per share, the company would have to perform at these levels for the next six years. Thereafter, the company would invest at its cost of capital. Figure 1 shows the various combinations of sales growth and operating profit margins needed to justify Sterling’s $53-per-share stand-alone value and those to justify the $89.50-per-share purchase price. It illustrates the tradeoff between profit margins and sales growth. It also shows the dramatic difference between market expectations for growth and profitability before the acquisition and the much higher performance required to justify the $89.50-per-share purchase price. For example, assume that the premerger sales growth expectation of 13% is also reasonable after the acquisition. To justify the Kodak purchase price, pretax operating profit margin would have to increase from 15% to 21%. This is a profit margin level not achieved historically, not achieved by competitors, and not forecast by even the most euphoric equity analysts. Indeed, any growth and profitability combination at or above the acquisition price curve is implausible at best. What about the executive who will have postmerger operating responsibility for the target and insists that this acquisition is a “strategic imperative”? Offer this individual a highly leveraged compensation package that pays for value-added performance above the acquisition price curve. In too many organizations threshold performance targets are established at premerger stand-alone levels. When this happens the company is rewarding managers for a level of performance that destroys value because the acquisition premium is ignored. Acquirers increasingly are using stock rather than cash. In 1996, over 60% of transactions valued at more than $100 million were for stock or a combination of stock and cash. CEOs consistently contend that their company’s shares are undervalued. Yet these same CEOs will not hesitate to pay for a major acquisition with stock. Paying for an acquisition with truly undervalued shares makes the acquisition more expensive. This becomes abundantly clear when the purchase price is computed using management’s per-share value times the number of shares exchanged. If management incorrectly values the purchase price at the undervalued market price, the company is likely to overpay for the acquisition or, even worse, earn less than the minimum acceptable rate of return. On Sept. 12, 1996, Gillette Co. agreed to purchase battery maker Duracell International, ending a five-year search for a new business venture. Terms called for Gillette to issue 0.904 of a share of its common stock for each share of Duracell, thus valuing Duracell shares at $7.2 billion, approximately a 20% market premium. On Dec. 30, 1996, shareholders approved Gillette’s purchase of Duracell. The purchase price was significantly higher than KKR Associates’ purchase of Duracell from Kraft for $1.9 billion in 1988. Duracell became a public company in May 1991 when KKR issued 34.5 million shares at $15 per share. At the time of Gillette’s purchase, KKR owned 34% of Duracell. Market reaction to the acquisition, which was the largest ever by Gillette, was very positive, with Duracell’s and Gillette’s stock prices up 27% and 8%, respectively, within two days of the September 12 announcement. The S&P 500 was up 2% during the same two days. The market’s reaction remained positive through the transaction’s close, with net of market returns for Duracell and Gillette of over 30% and 7%, respectively. Alkaline batteries, the largest component of the battery market, accounted for approximately $4.7 billion in 1996 sales, with 10% historical annual growth. However, by the year 2000, the worldwide alkaline battery market is estimated to nearly double in size, prompted by consumers’ demand for longer-lasting batteries needed in portable devices. Between 1977 and 1995 the U.S. alkaline battery market grew from 25% to more than 80% of all batteries sold. However, alkaline batteries have yet to experience this penetration internationally. Alkalines are only 40% of the European market, 30% of the Latin American market, and 14% of the Asian market. Duracell and Ralston Purina’s Energizer control 50% and 35% shares in the U.S. alkaline market, respectively. A new battery market with large growth potential is the rechargeable batteries market. Rechargeable lithium-ion and nickel-metal-hydride cells are forecasted to grow from $2 billion in 1995 to $5 billion in 2000, fueled by the growth of cellular phones and laptop computers. Today, Japanese computer manufacturers, including Sony, Sanyo, Matsushita, and Toshiba, dominate the production of high-end rechargeables. Advertising economics and capabilities, shelf-space leverage, and new-product development are critical success factors for consumer-branded product companies like Gillette and Duracell. On the issue of shelf-space leverage, manufacturers will need the clout to deal with increasingly large consumer retailing entities. Retailers like Wal-Mart require manufacturers that can deal with the sophistication of just-in-time inventory management and high-level customer support and service. Prior to the addition of batteries, the 95-year-old Boston-based Gillette specialized mainly in the manufacturing and marketing of grooming aids. Major product groupings included razors (e.g., Sensor, SensorExcel, Trac II, Atra, and Good News), toiletries (e.g., Gillette Series, Adorn, Right Guard, Soft and Dri, Foamy, and Dry Idea), stationery products (e.g., Paper Mate, Parker, and Waterman), Braun appliances and electric shavers, and Oral-B oral care products. Total 1996 revenues, excluding Duracell, were $7.4 billion, with blades and razors accounting for 38%; toiletries and cosmetics, 19%; stationery products, 12%; Braun, 24%; and Oral-B, 7%. As presented in The Wall Street Journal’s Shareholder Scoreboard (Feb. 27, 1997) Gillette’s shareholders fared well when compared with peers within the cosmetics and personal care industry. For the five years ended Dec. 31, 1996, Gillette’s average annual shareholder returns were over 24%, 12% over the industry average. Gillette attributes its strong historic stock price performance to an intense focus on its mission: “to achieve or enhance clear leadership, worldwide, in the core consumer product categories in which we choose to compete.” Under the leadership of Chairman and CEO Alfred M. Zeien and President Michael Hawley, there has been a continued emphasis on research and development, capital spending, and advertising. These forces have driven increased capacity across all product lines, geographic expansion, and the development of more efficient production methods to launch new products. The acquisition of Duracell was seen as a long-sought “new leg” to Gillette’s business portfolio. Gillette prides itself on only developing new products that represent significant tangible consumer improvements. Gillette’s strategy has had the desired effect on its sales mix. Approximately 70% of its sales are generated outside of North America. In 1996, 81% of total sales came from the 13 product categories in which they hold the world leadership position. In contrast, these categories represented only 56% of total sales five years ago. Attesting to the success of Gillette’s product development, 41% of total sales come from products introduced in the last five years. Analysts support this positive outlook on Gillette, sighting it as one of the major multinationals with a significant percentage of profits generated in high-growth emerging markets. Gillette is acknowledged commonly as an exceptional company and a core holding in the cosmetics and household products industry. Its global marketing reach and in-house technical capabilities are regarded highly by competitors and industry analysts. Gillette’s considerable cash flow also eases the market acceptance of its aggressive approach to growth, product expansions, and, in particular, its announcement to acquire Duracell. Duracell International is a Bethel, Conn.-based manufacturer of alkaline batteries (83% of sales) under the Copper Top, Activair, and Durabeam names. Products also include primary lithium, zinc air, zinc carbon-type, and rechargeable nickel-metal-hydride batteries as well as a lighting products line. With fiscal 1996 total revenues of $2.3 billion, Duracell is the world’s largest producer of alkaline batteries. Duracell’s batteries are sold both domestically and internationally, through consumer channels, to industrial users and to manufacturers of battery-powered consumer, industrial, medical, and military equipment. Approximately 45% of Duracell’s sales are outside of the United States. In the fast-growing rechargeable market, analysts say that rechargeables could account for $500 million, or 10%, of Duracell’s business by 2000. By 1992 Duracell already had started to set up a joint venture with Toshiba and Varta for the manufacturing and marketing of nickel-metal-hydride batteries. Duracell also led the charge on manufacturing facilities by setting up the first U.S. lithium-ion battery factory in August 1996. Duracell shares many operational characteristics with Gillette, including strong new product programs, superior technology, top-quality manufacturing skill and strength, global presence, and strong consumer brand loyalty worldwide. There are four major potential operating synergies. First, there are significant global distribution synergies. Duracell, as the leading producer of alkaline batteries, has the potential to increase the penetration of alkaline batteries in international markets. Gillette generates 70% of its sales overseas, while Duracell generates only 45%. This is a result of Gillette’s significantly more developed international distribution. Enhanced growth rates are possible by taking Duracell’s products into new international markets through Gillette’s established distribution networks. Duracell is a globally recognized brand with room for international expansion that would be aided by Gillette’s international marketing power. Second, there are interesting opportunities from a new-product development perspective. The unique combination of Gillette and Duracell results in a company that makes battery-operated devices as well as the batteries that power them. Gillette’s renowned research-and-development shop could be put to work on new battery-operated products and could help advance Duracell’s technological leadership. R&D could likely focus on the new and growing area of rechargeable batteries and their respective portable products, which have considerable market growth opportunities in developing countries. Third, the combined entity would have impressive leverage with retailers and could likely increase shelf space for all products. Gillette and Duracell’s size and product breadth position them to participate in the growing practice of category management. This growing marketing practice involves retailers and manufacturers working together to improve profitability. The more space a company’s products can fill, the more they can learn about consumer behavior and the more they have to offer the retailer, the link to the end user. Fourth, integrating some of Duracell’s operations with Gillette’s could reduce the overall costs of the combined operation. In addition, Gillette is recognized as an efficiency leader in manufacturing. In developed markets, merchandising, distribution, finance, and administration functions can be combined. In emerging markets, batteries can be treated as an additional product to Gillette’s existing operations, resulting in significant distribution, administration, and manufacturing and packaging efficiencies. In this section the potential synergies are translated into financial forecasts for the value drivers: sales growth, profit margins, incremental fixed and working capital investment, taxes, the cost of capital, and the forecast period or the value growth duration. Sales. Duracell’s 1996 sales were $2.3 billion. Without the merger Duracell’s sales growth were forecasted at 13.5% annually versus 8.5% annual growth over the past five years. With the merger, Gillette’s international presence would enable Duracell to accelerate the international growth of alkaline batteries. The increased international distribution of alkaline batteries and enhanced, further development of rechargeables could improve the growth rate to 20%. Operating Profit Margins. Without the merger, Duracell’s operating profit margins were expected to remain at just over 20%. Margins could improve to 23% due to the cost savings realized from integrating operations and speedier development of Duracell’s high-margin rechargeable batteries. Investment. Both incremental working and fixed capital investments have been at historic levels of 20% each, or 20 cents for every dollar of increased sales each year. The consolidation of some Gillette and Duracell manufacturing facilities could improve incremental fixed capital investment to 15%, while incremental working capital likely would remain close to its historic level. Taxes. Without the merger, the cash tax rate was estimated at 39%. The overlapping geographies of the two companies could result in some tax savings, reducing the cash tax rate to an estimated 38%. Cost of Capital. The cost of capital was estimated at 10%, before and after the acquisition. Value Growth Duration. Duracell’s value growth duration used in establishing the forecast period is estimated to be 10 years. Estimating Duracell’s value growth duration involves: * Establishing estimates of market expectations for value drivers just before the announcement date; * Translating the value drivers into cash flows; and * Extending the forecast period until the discounted value of cash flows and residual value equals Duracell’s preannouncement stock price. Duracell’s share price represented the present value of a 10-year cash flow projection plus the present value of the residual value at the end of 10 years. The value driver forecasts are used to estimate the annual cash flows that appear in column one of Table 2. Column two shows each of the cash flows discounted by the 10% cost of capital. Column three presents the cumulative present value of those cash flows. Column four takes the capitalized value of the sustainable cash flows at the end of each year and discounts it back to the present. Column five is the sum of columns three and four. Assuming that Duracell’s cash balance is required for operations, the $6.4 billion present value of cash flows and residual value is the company’s corporate value. Finally, the portion of the company that belongs to debt holders is subtracted, which results in the equity holders’ portion. This stand-alone shareholder value for Duracell is $5.9 billion, or almost $49 per share. Next, the value of Duracell to Gillette is calculated incorporating into the projections the effects of synergies. The value of Duracell, with synergies, increases to almost $94 per share, as shown in Table 3. This indicates that based on the set of assumptions used for this analysis, Gillette could pay a maximum of $94 per share for Duracell before taking into account any costs associated with the deal. If Gillette’s estimated shareholder value per share is greater than its current stock price, the company may be better off using its debt capacity and offering cash for the seller’s stock rather than issuing additional shares. Keep in mind that comparing shareholder value per share and the current stock price provides only one criterion for determining deal structure. Other factors in the final determination include tax effects of the structure, the funds available from investments and borrowing, capital structure, and whether the buyer wants the seller to participate in the ownership of the new company. For this case, it is assumed that the market is pricing Gillette’s stock fairly at the time of the analysis. The Gillette-Duracell deal was an exchange-of-shares transaction and was accounted for under pooling-of-interest rules. How much value is created for Gillette? Is more value being acquired than surrendered? The amount of value acquired consists of the shareholder value of Duracell plus the anticipated synergies that would arise from the merger. The value surrendered consists of the purchase price and the total costs of completing the deal. All of this is presented in Table 4. The shareholder value of Duracell of $5.9 billion comes from Table 2. After adding to this the amount of anticipated synergies of $5.4 billion and then deducting the purchase price and fees, the estimated Shareholder Value Added (SVA) for Gillette in September 1996 is $4 billion. Even though the deal appears to create significant value for Gillette, relatively small changes in the forecast data could affect the analysis materially. Thus, it is important to determine how the value drivers might change and which value drivers have the greatest impact on value. To do this, a variety of relative impact and sensitivity analyses can be performed on the value drivers. For example, the sensitivity matrix in Table 5 shows what can happen to Gillette’s value added from the acquisition if synergies, and therefore margin improvements and forecasted sales growth, are not realized fully. If Duracell’s expected operating profit margins decrease by 1% (from 23% to 22%), Gillette’s value creation from the transaction would decline from $4 to $3.4 billion. However, the lower operating profit margin coupled with a 3% reduction in the sales growth rate (from 20% to 17%) would reduce Shareholder Value Added to $1.4 billion. The sensitivity analysis shows that the transaction can add value for Gillette’s shareholders even if synergies are not realized fully. However, management also is interested in knowing how far sales growth and operating profit margins can decline before the transaction begins to destroy value. Figure 2 shows the various combinations of sales growth and operating profit margins needed to justify the exchange ratio at the time of the analysis in September 1996. The striped “triangle” on Figure 2 is bound by operating profit margin with synergies (23%) on the top, sales growth with synergies (20%) on the side, and the value break-even line on the bottom. It can be thought of as the safety zone for how far the drivers can decline before the transaction destroys value. If operating profit margin assumptions remain at 23%, sales growth can decline to just under 11%, and if sales growth assumptions remain at 20%, operating profit margin can decline to just under 15%. While buying companies find value creation challenging, that certainly is not the case for selling shareholders. The market premium paid by the acquirer represents an immediate gain for the seller. Acquisition premiums are a two-sided coin. Paying a large premium often leads to a decrease in the buyer’s value. On the other hand, when the target company rejects a large premium, selling shareholders may be foreclosed from realizing substantial gains. Therefore, acquisition premiums are a critical issue to the board of directors of both acquirers and targets. To illustrate, consider a target company whose shares were trading at about $125 per share before receiving an all-cash offer of $200 per share. The offer represents a 60% premium over the $125 trading price. Assuming a cost of equity capital of 12%, what is the estimated value over the next five years of reinvesting the $200 proceeds in the market? Compounding the $200 at an annual rate of 12% yields the following values: To reject the $200-per-share bid, the target board must believe that the company can grow value faster as an independent company. The board must consider the likelihood that, given current plans, the share price will outdistance the above benchmark values. It must also take into account that the $200 is a bird in the hand. There is another useful question that the target board might ask. If the bid is rejected, what is the minimum required annual rate of appreciation on the “stand-alone” price of $125 per share to match the value created by accepting the bid? The rates of share price appreciation are as follows: 79% for one year, 42% for two years, 31% for three years, 26% for four years, and 23% for five years. These daunting minimum returns would make it improbable that any board would reject the $200-per-share all-cash offer. Nevertheless, as a shareholder of the target company you are surprised to read the following newspaper quotes from the chairman and the president respectively: “We are not for sale, haven’t been for sale, and don’t plan to be for sale.” “It is not our duty to liquidate Corporate America, beginning with our own company….This company is not for sale.” Unfortunately, the above example is real and, yes, the target company was able to ward off the would-be acquirer’s offer. You may have guessed correctly that this case is, in fact, the infamous Paramount Communications bid for Time. This case has been analyzed extensively in legal and corporate governance literature. For present purposes, only a few brief observations are pertinent. On March 3, 1989, Time announced a $14-billion stock offer for Warner Communications, a deal that required no approval from Time shareholders. On June 6, 1989, Paramount announced a $175-per-share cash bid for Time and filed suit in the Delaware Court of Chancery to stop the Time-Warner merger. Paramount raised its cash bid to $200 per share on June 23. In July the Delaware court ruled in favor of Time. Paramount then withdrew its offer. Why did the Time board reject the Paramount bid? The board believed that Paramount presented a threat to the retention of the “Time culture” and that a combination with Warner offered better long-term returns to shareholders. Time’s financial advisers projected that Time-Warner stock would be valued at $208 to $402 per share by 1993. In the words of Delaware’s Chancellor William Allen, this is “a range that a Texan might feel at home on.” The market certainly was not convinced. At the announcement of the Time-Warner merger, Time shares were trading at $109. Time-Warner shares traded in the range of $109 to $187 (adjusted for the four-for-one stock split in 1992) during 1993, well below the projections made by Time’s financial advisers. Finally, if shareholders had been able to sell their shares in June 1989 and reinvest the $200-per-share proceeds in the market, that is, Standard & Poor’s 500, their total wealth at the end of 1996 would be $579. If shareholders had decided to rebalance their portfolio and invest in Walt Disney, another entertainment stock, their wealth at the end of 1996 would be $617. On the other hand, shareholders who continue to hold their Time-Warner shares would have a total wealth (with reinvested dividends) of only $161 at the end of 1996, an amount less than the $200 offered seven and a half years earlier. If shareholders had been able to accept the Paramount offer and reinvest the proceeds in the market, the value of their investment would be an incredible 3.6 times the value of continuing to hold Time-Warner shares. Stated another way, a holding of 500 shares in June 1989 would be worth $80,400 at the end of 1996, while reinvestment in the market or in Walt Disney shares would be valued at $290,000 and $308,000, respectively. Target companies that initially resist takeovers as a means of inviting higher bids are, of course, acting in the best interests of their shareholders. Companies with poison pills and other antitakeover provisions can use them as bargaining tools to extract a better price. Today’s boards of directors are much less likely to follow the route of the Time board and deny shareholders the opportunity to cash in on generous premiums. Nonetheless, the urge to remain independent, even at a substantial cost to shareholders, is still alive. The Value YardstickThe basic aim of making acquisitions is the samefor any other investment associated with a company’s overall growth strategy – to add value. While mergers and acquisitions involve a more complex set of considerations than otherkinds of asset purchases, such as machinery, theeconomic substance of these transactions is thesame. In each case, a current price is paid inanticipation of a stream of future cash flows. For the acquirer to estimate the value-creatingpotential of an acquisition to its shareholders, itmust make assessments of the stand-alone valueof the seller, the value of acquisition benefits, and the purchase price. Value of Stand-alone Stand-aloneValue created = combined – value of + value ofby acquisition company buyer seller Stand-alone Value ofMaximum acceptable = value of + acquisitionpurchase price seller synergies MaximumValue created = acceptable – Price paidfor buyer purchase price for seller<\TBL> Shares Outstanding (millions)Premerger 10New shares issued 3Postmerger 13 ($ millions)Postmerger: Buyer’s shareholders own 10/13 of ($150 million + $45 million) $150Premerger value of buyer $150Value created for buyer $0<\TBL> Shares Outstanding (millions)Premerger 10New shares issued 5Postmerger 15 ($ millions)Postmerger: Buyer’s shareholders own 10/15 of ($150 million + $45 million) $130Premerger value of buyer $150Value created for buyer $(20)<\TBL> Table 1: Percentage of Buyer’s Market Value at Risk Stand-Alone Value of Seller to Stand-Alone Value of Buyer (%) 25% 50% 75% 100% 30 7.5 15 22.5 30Premium % 40 10 20 30 40 50 12.5 25 37.5 50 60 15 30 45 60<\TBL> Table 2: Cash Flows and Shareholder Value For Duracell Stand-Alone* ($ in millions) Present Cumulative Cumulative Value of PV + PV of Cash Present Present Residual ResidualYear Flow Value Value Value Value1997 $214 $195 $195 $3,149 $3,3441998 243 201 396 3,250 3,6451999 276 207 603 3,353 3,9562000 313 214 817 3,460 4,2762001 355 221 1,037 3,570 4,6072002 403 228 1,265 3,683 4,9482003 458 235 1,500 3,801 5,3012004 520 242 1,742 3,922 5,6642005 590 250 1,992 4,046 6,0392006 669 258 2,250 4,175 6,426Corporate value $6,426 Market value of debt 564Shareholder value $5,862Shareholder value per share $48.6Current stock price $48.9*Cost of capital equals 10%<\TBL> Table 3: Cash Flows and Shareholder Value For Duracell With Synergies* ($ in millions) Present Cumulative Cumulative Value of PV + PV of Cash Present Present Residual ResidualYear Flow Value Value Value Value1997 $250 $228 $228 $3,834 $4,0621998 300 248 476 4,183 4,6581999 360 271 746 4,563 5,3092000 432 295 1,042 4,978 6,0202001 519 322 1,364 5,430 6,7942002 623 352 1,716 5,924 7,6402003 747 383 2,099 6,463 8,5622004 897 418 2,517 7,050 9,5672005 1,076 456 2,974 7,691 10,6652006 1,291 498 3,472 8,390 11,862Corporate value $11,862 Market value of debt 564Shareholder value $11,298Shareholder value per share $93.7Current stock price $48.9*Cost of capital equals 10%<\TBL> Value perYear share 1 $224 2 251 3 281 4 315 5 352<\TBL> Table 4: Shareholder Value Added for Gillette-Duracell Acquisition* ($ in billions) AmountCumulative present value of cash flows: Duracell $2.3Present value of residual value: Duracell 4.2Corporate value: Duracell 6.4 Market value of debt: Duracell 0.6Shareholder value: Duracell 5.9Synergies acquired 5.4 Purchase price of shares and fees 7.3Shareholder Value Added for Gillette 4.0*0.904 share exchange ratio<\TBL> Table 5: Sensitivity of Shareholder Value Added * Sales Growth -3% 0% +3%Operating -1.0% 1.4 3.4 5.8Profit 0 1.9 4.0 6.6Margin +1.0 2.4 4.6 7.4*From acquisition to changes in the operating profit margin and sales growth rate of Duracell with synergies<\TBL>