|
Master plan for Merger Negotiations |
|
|
Havard Business Review |
|
|
Jan - Feb 1970 |
|
|
By Gary E. MacDougal and Fred V. Malek |
|
|
Page 1 2 3 4 5 6 7 8 9 10 11 |
|
|
Assessing ROI target
|
|
|
Discounted cash flow return analysis, now in use by a number of sophisticated companies, offers several important advantages. For one thing, it provides a means of determining value that is independent of the financial terms involved. If only EPS impact is measured, an all cash acquisition of a slowly growing company, for example, can be made to look good on a straight earnings per share basis because the effect of leveraging the company, through the use of cash, is confused with the acquisition evaluation.
|
|
|
For another thing, the present-value ROI approach also gives full recognition to the fact that earnings received in, say, ten years are less valuable than those received in two, three, or four years. In addition, management can easily decide by assessing the ROI in terms of present value whether acquiring a given company is preferable to using the same capital for internal projects or for other acquisitions.
|
|
|
The essence of this discounted cash flow ROI approach is to estimate cash inflows for each year of a given period (often a ten-year period is appropriate). These inflows include the capitalized increases in earnings per share. In addition, cash outflows are estimated for the same period—outflows which include the initial purchase price of the acquisition and the amount by which capital investment exceeds depreciation. The initial value of the company acquired is then treated as a cash inflow in the final year of the period under consideration.
|
|
|
In the case of the Synergetics Corporation, assume that management’s calculations show that investing new capital at a discounted cash flow ROI rate of 12% or better will produce an annual return on shareholders’ equity of 14% or better—thus meeting two of the goals approved by Synergetics’ board of directors. (Note that the 12% discounted cash flow is on total capital, whereas the 14% return on shareholders’ equity covers only the equity portion.)
|
|
|
Therefore, in contemplating the purchase of HFE, the first task for Synergetics’ executives is to project a range of possible compound after- tax earnings per share growth rates for HFE, and then to ask:
|
|
|
What is the maximum price we can pay at each of the various HFE growth levels if we are going to meet our 12% discounted cash flow ROI target?
|
|
|
Exhibit I shows graphically this relationship between purchase price, projected HFE growth rate, and Synergetics’ return on investment. (See Appendix which describes in detail the assumptions underlying this exhibit. A financial analyst familiar with basic present-value techniques can easily construct a similar chart.)
|
|
|
If an annual HFE growth rate of 10% seems probable, then Synergetics’ can pay $20.75 million for the company and get a 12% return on investment. However, if HFE is expected to grow at a rate of 12% annually, a price as high as $25.25 million can be paid without falling below the ROI criterion set by Synergetics’ board of directors.
|
|
|
Synergetics’ management, therefore, knows that negotiations on the purchase price should stay within a range of $20 million to $25 million, and that the critical factor is the HFE projected earnings per share growth rate.
|
|
|
Page 4 Page 6
|
|
