Summary

Acquisitions take several forms and occur for different reasons. Acquisitions can be categorized, based upon what happens to the target firm after the acquisition. A target firm can be consolidated into the acquiring entity (merger), create a new entity in combination with the acquiring firm or remain independent (buyout).

There are four steps in analyzing acquisitions.

First, we specify the reasons for acquistions and list five: the undervaluation of the target firm, benefit from diversification, the potential for synergy, the value created by changing the way the target firm is run and management self-interest.

Second, we choose a target firm whose characteristics make it the best candidate, given the motive chosen in the first step.

Third, we value the target firm, assuming it would continue to be run by its current managers and then revalue it assuming better management. We define the difference between these two values as the value of control. We also value each of the different sources of operating and financial synergy and considered the combined value as the value of total synergy.

Fourth, we look at the mechanics of the acquisition. We examine how much the acquiring firm should consider paying, given the value estimated in the prior step for the target firm, including control and synergy benefits. We also look at whether the acquisition should be financed with cash or stock, and how the choice of the accounting treatment of the acquisition affects this choice. Buyouts share some characteristics with acquisitions, but they also vary on a couple of important ones.

The absence of an acquiring firm, the fact that the managers of the firm are its acquirers and the conversion of the acquired firm into a private business all have implications for value. If the buyout is financed predominantly with debt, making it a leveraged buyout, the debt ratio will change in future years, leading to changes in the costs of equity, debt and capital in those years.

Prof. Aswath Damodaran