Solid Metal is a fairly large-sized manufacturing firm which produced unique metal products for households and commercial use. Formed in 1980, the company had performed better. At the time of its inception, the industry was in its infancy stage and there was virtually no competition. As a result, the firm enjoyed significant growth in the early years and cumulated a significant amount of cash. Over the past few years, due to intense competition and an economic downturn, the firms growth has dried up. Managers were in pursuit of alternative ways of growth. The companys stock price had recently dropped to $45 per share. The company decided to look for suitable acquisition opportunities to better utilize its assets and diversify its risk.

Using the formula for free cash flow, explain the various reasons why firms undertake mergers and acquisitions? Which of these reasons are most likely to apply to the acquisition that Solid Metal is considering?

Answer: Free Cash Flow = NOPLAT + Depreciation Change in Invested Capital Where NOPLAT = Revenue operating costs depreciation operating cash taxes

Firms undertake mergers and acquisitions to increase NOPLAT, either by enhancing revenues or reducing costs;

lower taxes; and Reduce capital needs or more efficient use of capital. Solid Metal is considering the acquisition of Everyday Products to try and boost their earnings via a reduction in production and marketing costs. They also feel that they could achieve some diversification benefits since Everyday Products involved in a totally different industry. The above formula (1) shows that firms undertake mergers and acquisitions in order to increase NOPLAT, either by enhancing revenues or reducing costs; lowering taxes; and by reducing capital needs. Solid Metal is considering the acquisition of Everyday products to try and boost their earnings via a reduction in production and marketing costs. They also feel that they could achieve some diversification benefits since Everyday products is involved in a totally different industry. Solid Metal is looking at the Synergy that they will receive after the acquisition of Everyday Products, when businesses acquire other businesses or operations that were previously competitors, suppliers, buyers, or sellers, they are engaging in a strategy known as integration. This strategy is based on the possibility of synergy, the idea that the sum of two entities will be greater than their individual parts. We know that Synergy comes from either improved FCFs after the acquisitions and the opportunities to improve future cash flows of the acquirer are called synergies. Possible sources for the value of synergies is derived from growth, ROIC, capital efficiency, and WACC. A higher growth, higher ROIC, more efficient use of capital, or lower WACC (or any combination of these) as a result of the acquisition can lead to synergy value. In this scenario Solid Metal is acquiring Everyday Products which is a vertical integration and the acquirer is doing a vertical integration by consolidating the suppliers, then the likely result is lower operating costs and better use of capital.

2. Using the free cash flow method of valuation calculate the maximum offer price that Solid Metal would be justified in making for Everyday Products

Value of Everyday to Solid Metal = Value of Everyday + PV of Synergy Value of Everydays equity = number of shares * price per share = 50 million shares * EPS * P/E ratio = 50 million shares * $1.20 * 12.5 = $750 m PV of Synergy = Incremental cash flows/WACC = $45m/0.16 =$281.25m Value of Everyday to Solid Metal = $750m+$281.25m = $1031.25m The maximum offer price = V of Everyday to Solid Metal/# of shares of Everyday = $1031.25/50m =$20.625 per share *Assume zero growth perpetuity model.