University of Durham

Mergers and Acquisitions
Summative Assignment
Samuel Tedjasukmana
April 2007
I. Introduction
Targeting private firms seems to be the current trend in mergers and acquisitions. In
the US alone, the year 1996 saw 84% increase of takeover deals involving private
firms as the target compared to the previous year (Ang and Kohers, 2001). The total
value of these transactions reached £40 billion.
This paper seeks to investigate the issues surrounding mergers and acquisitions, both
in general and specifically of a privately owned business, as the following: estimating
the value of a privately owned business, determining the value of an acquisition deal
settlement, how to eliminate a competitive bidder, and how asymmetric information
influences company’s corporate financing policies, including those involving merger.
These issues are observed from the acquirer’s point of view, which in this study is
London Globe. The target company is Murdoch Incorporated, and for the purpose of
valuation, McIntosh Corporation (a public company similar to Murdoch in terms of
industry) is used as a comparable company.
London Globe is a construction company, and has been blessed by the current boom
in the housing market. The industry classification for this company is assumed as
Building – residential and commercial (see appendix for details). Murdoch the target
company has the core business of gas pipeline construction and related equipment,
which is similar to a public company, McIntosh Corporation.
II. The value of the target company and the maximum price of the acquisition
Murdoch Incorporated (Murdoch) is a privately owned business. It does mean that in
the process of searching for its value, some basic principles of comparable method of
valuation should be used. The following analysis uses the information gathered from
the comparable public company, which is the McIntosh Corporation (McIntosh).
Murdoch McIntosh
Shares outstanding 25 millions 30 millions
Share price - £25
Market value of equity - £750 million
Debt £500 million £80 million
β - 1.20
Tax rate 35% 35%
Risk-free rate 8% 8%
Risk premium 8% 8%
Table 1. Preliminary review
There are three main components of valuation: the weighted average cost of capital
(WACC), the free cash flow (FCF), and the expected growth of cash flow items
(Damodaran, 2002). The first step in valuing Murdoch would be to determine the
cost of equity – as a part of WACC calculation – by using McIntosh’s data, both firm-
specific as well as its market information.
The basic assumption underlying this calculation is that both companies are within
the same industry, which also means being in the same market. Therefore, both of
them will have the same risk-free rate, corporate tax rate, and utterly the same risk
premium. Finally, to estimate the β for Murdoch, the calculation should assume that
Murdoch’s β will eventually converge to its industry average β (using McIntosh’s β
as proxy) by the time it goes public (Damodaran, 2002). The detailed calculation
process and results are presented in the following table.
McIntosh Murdoch Details
β (levered) 1.20 -
β (un-levered) 1.12 -
β (private entity) - 1.41 Debt-equity
B/S = 0.4
( ) ( )
1 £80 1 0.35
1 1
u u u
B T m
S m
þ þ þ · ÷ · ÷ ·

+ +
] ]
] ]
] ]
( ) ( ) 1 1 1.12 1 1 0.35 0.4 1.41
p u p
þ þ þ
· + × ÷ · + × · ]
] ]
Cost of equity 19.28%
( ) ( ) 8% 1.41 8% 19.28%
e f m f e e
k R R R k k þ · + ÷ · + ÷ ·
Cost of debt 8.85%
CR = Interest
( ) ( )
int £50 £357.69
1 1 0.35
NI m
EBIT erest m m
· + · + ·

Interest m
· · ·  Bond rating A  Cost of borrowing = 0.85%
above the risk-free rate
Cost of debt after tax 5.75%
8% 0.85% 8.85%
b f
k R spread · + · + ·
( ) ( ) 1 8.85% 1 0.35 5.75%
d b
k k T · · ·
WACC 15.42%
1 0.4
19.28% 5.75% 15.42%
1.4 1.4
e d
WACC k k
· + · + ·
+ +
Net Income (projected) £200.00m
EBIT £357.69m
Contingent loss £40.00m
EBIT (corrected) £317.69m
EBIT (1-tax) £206.50m
Investment £50.00m
FCF £156.50m
Expected growth (g) 2%
Equity value
Equity value/share
( ) ( ) 1 £156.50 100% 2%
15.59% 2%
FCF g m
Value m
+ +
· · ·

£1,177.67 £500 £677.67 Equity Value Debt m m m · · ·
/ £27.11
EV m
EV share
shares m
· · ·
Table 2. Calculation for Murdoch’s (target company) value
See appendix for more details on the synthetic bond rates
Comments on results
Since London Globe is a public company, the deal of acquiring Murdoch is not a
private deal. In that sense, the calculation of Murdoch’s cost of capital would have
been different if the deal was private. This very much affects the assumption of what
borrowing rate should be used. Given that Murdoch is a private business, it cannot
generate debt from the market. Instead, it raises debt from bank loans. The interest
rate for this loan is 10 percent for Murdoch [50m/500m x 100%]. This rate does not
resemble Murdoch’s credit rating in the market. Since the nature of the deal is public,
the calculation should use the appropriate rate, which is the bond rate (Damodaran,
2002). Taking into the account the interest coverage ratio, provided as the company’s
information, the bond rate can be estimated to reflect the company’s credit rating in
the market.
Moreover, the fact that Murdoch, with certainty will incur contingent loss, i.e.
lawsuit liability amounting £40 million, and the event is assumed will take place after
the acquisition; London Globe is entitled to get a tax deduction (Maples, 2003).
London Globe saves £14 million worth of tax due to the inclusion of lawsuit liability
(contingent loss) in the valuation of Murdoch.
To convert the information of net income into earnings before interest and tax (EBIT),
the fixed charge of interest should be included as the standard accounting procedure.
However in the next step of determining the FCF, the direct taxation of EBIT is
justified (Damodaran, 1997). The value of FCF estimated is assumed to grow in
perpetuity, which is why the growth rate becomes a multiplying factor of FCF.
Reliability of the method used, and other methods could have been used
Comparable method used in the calculation carries some limitations. Since only one
company used as a comparison to estimate Murdoch’s cost of equity, assuming they
are in the same field of business, it raises a concern over the estimation’s reliability.
Moreover, the danger of misestimating becomes more apparent when it assumes
McIntosh as the proxy for the industry average. Such method, namely comparable
company method, has less accuracy than the comparable transaction or comparable
industry transaction method (Kaplan and Ruback, 1995). Either method would give
more accurate results in estimating Murdoch’s cost of capital at market rate, since
they consider information from several – or all – companies within the industry.
The discounted cash flow method (DCF) allows more in-depth analysis in valuing a
firm. However, given the nature of Murdoch as a private business, it will be quite
difficult to find information conforming to the market’s standards, e.g. LSE-
conforming financial statement, future investment plan, a change in the
management, etc, to perform such analysis.
The maximum price of the acquisition bid
The maximum price London Globe should pay for each share of Murdoch is simply
the equity value per shares outstanding, which is £27.11/share (as seen on the table).
III. Finalising the deal
As London Globe figured out the value of Murdoch, then the next is to know for
what price the deal is going to be sealed (assuming there is no other bidder takes
The premiums paid to a privately owned business is higher than the average public-
owned ones (Ang and Kohers, 2001). Especially for cash as the method of payment,
shareholders of private firms have received premium in the amount of 2.2 times their
book value of holdings, or in other words the offer-to-book ratio is 2.2 (Ang and
Kohers, 2001). For the publicly traded target companies, Ang and Kohers find the
ratio figure as 1.9 on average.
Given that the equity value is £27.11/share, and the deal will be in cash, thus
according to the offer-to-book ratio of 2.2, the deal might be settled at £27.11 times
2.2, amounting £59.63/share. However, since the calculation has estimated the equity
value of Murdoch at the market rate, not the book value, the usage of such ratio can
be misleading. Another fact, given that the average premium paid in an acquisition
deal for a public company is about 30 to 40 percent from the market value of equity
of the target (Weston et al, 2004), this ratio may well be the most relevant in Murdoch
case. The problem is, Murdoch is a private firm. It is necessary to estimate the proper
premium ratio that reflects offer-to-market-value ratio for private firms.
As aforementioned, there are two ratios to be observed: the offer-to-book for private
firms at 2.2; and the offer-to-market for public companies at 1.35 (average between 30
and 40 percent of premium rate). Following the argument that private firms receive
more premium than the average public companies (Ang and Kohers, 2001), then the
offer-to-market for private firms, in consistency will also be higher than that of public
companies. Taking the average of both 2.2 and 1.35, the number will be at 1.8.
Consider this as the estimation of offer-to-market ratio for private firms gives the
figure of £27.11 x 1.8 = £48.79/share (£1.22 billion) as the final deal value in this
acquisition. In theoretical sense, this means that London Globe will have to pay more
than it should. Since the synergy value has been included the valuation of Murdoch,
this excess premium will to some extent degrade the value of London Globe itself. In
reality, the case for the acquisition of private firms involves very high premiums. The
reason being is that the shareholders of private firms have stronger bargaining power
due to the very low likelihood of the agency cost problem to occur (Ang and Kohers,
2001). Or in other words, since the shareholders are actually in the management
board, which means they know exactly what the business is all about and its
prospects in the future, it requires very high premium to acquire a private firm.
IV. Eliminating competitive bidder
The first bidder (FB), which is London Globe, will have to make a bidding strategy
against the second bidder (SB) who is assumed to have valuated Murdoch and their
results on synergy ranging uniformly between -50 and 200 from FB’s valuation of the
maximum price.
The maximum price that FB has calculated is £677.77 million. The next step is to
determine at what price that FB can deter the competition from SB, i.e. determining
the pre-emptive bid. According to Fishman model (1988), we can formulate the pre-
emptive bid by using SB’s valuation range [l, h] ~ [-50, 200], the cost of acquisition by
SB, and the market value of the target.
For such purpose, the following assumptions are used:
- The market equity value of Murdoch is £677.77 million, since SB has assumed
the synergy valuation by FB as the fair equity market value of Murdoch.
• The cost of acquiring Murdoch by SB is assumed 5% from the market value of
The calculation uses the following formula (Fishman, 1988):

( )
2 2
( ) 3
o o
v v l h
p r c
h l

Detailed process of the calculation is presented in the following table.
Variable input Calculation steps
Vo= £677.77m
C2= 5%*£677.77m
= £33.88m
( )
2 2
( ) 3
o o
v v l h
p r c
h l

( )
2 2
£677.67 2 £677.67 ( 50) 200
( ) 3 £33.88 £1, 032.35
2 200 50
m m
p r m m
× × +
· × ·
Table 6. Pre-emptive bid by Fishman model
Pre-emptive bid value: £1,032.35m, or £41.29/share.
Bidding strategy
Fishman model (1988) provides a straightforward look at calculating the pre-emptive
bid. However, this model depends very heavily on the assumption of the cost of
acquisition by the SB. The 5% cost stated in the calculation is just an illustration, and
might be the case that it is not accurately estimated. This cost may comprise of the
investment bank fee for investigation, legal consulting fee, insider information
attainment, etc, which plays a very crucial role in determining the gain from the
acquisition deal (Fishman, 1988).
One point to look at as well is that when there is a competing bidder for an
acquisition, the bidding can turn out to be costly. Even though London Globe has
realised the amount of cash they have to generate to prevent competition, it might be
the case that Murdoch is not worth the efforts. Thus, London Globe has to formulate
a bidding strategy in order to win the bid as efficiently as possible. One way to do is
to put the first bid at a low value. The first bid by FB is the source of valuation
signalling for the SB (Hirshleifer, 1995). SB usually determines the minimum
threshold of FB’s valuation by looking at their first bid value. From that value, SB will
begin to investigate and assume the initial bid value to compete with FB. In general,
when there is no significant gap between two bids (no far higher offer compared to
the other), the deal will be closed at relatively low price (Hirshleifer, 1995). At least,
London Globe has figured out (at 5% cost) that the pre-emptive bid will be, at the
most, £41.29/share (£1,032.35m). The bidding then can start from the initial point of
£27.11/share through £41.29/share.
V. External vs. internal equity financing
Capital Structure External financing Internal financing
London Globe
£4,000.00m £4,000.00m
Murdoch £677.67m £677.67m
£4,677.67m £4,677.67m
Generate £50m cash £50.00m -
Total equity £4,727.67m £4,677.67m
London Globe £150.00m £150.00m
Murdoch £500.00m £500.00m
Total debt £650.00m £650.00m
Debt-equity ratio 0.137 0.138
Beta un-levered 1.21 1.21
Beta levered 1.32 1.32
Cost of equity 18.54% 18.55%
Cost of debt after tax 5.20% 5.20%
WACC 16.93% 16.92%
Table 7. Capital structure between external and internal equity financing
To finance Murdoch’s plant restructuring, or in other words pledging in a new
investment, London Globe should always consider the financing method suitable for
the feasible capital structure of the company. Table 7 presents how capital structure
will look like using two different financing strategies. The first one is the external
London Globe has 50 million shares outstanding at current market price of £80/share.
equity financing and the other internal one. External equity financing involves
issuing either common stocks or warrants (Damodaran, 1997); whilst the internal one
reserves cash from the retained earnings the company has produced.
Suppose that the un-levered beta of the combined firms (between London Globe and
Murdoch) is known
, the cost of capital from both scenarios can be observed. The
figures showed do not really reflect any substantial difference between the two costs
of capital. This is because the amount of cash London Globe has to generate is
immaterial compared to the combined equity value, i.e. £50 million compared to
more than £4.5 billion.
Nonetheless, the observable point on table 7 is that the cost of capital for internal
equity financing is lower than that of external equity financing. The probable reason
for this is that the debt-to-equity ratio for the combined firm has not been the optimal
debt-to-equity ratio (Damodaran, 1997). Or in other words, the combined firm is
under-levered, because if it was over-levered, higher debt-equity would result in
higher cost of capital (Damodaran, 1997). In such condition then, it is better for
London Globe to finance the investment project with internal equity financing rather
than external one. In addition, given the fact that London Globe has been blessed by
the current booming in the housing market, there is no immediate necessity to
capitalise more in equity.
The role of asymmetric information on merger and external equity financing
To estimate the un-levered beta of the combined firm, the industry average un-levered beta of
building industry in Europe, specifically the residential and commercial building industry, is used. This
beta is 1.30. Taking the average between Murdoch’s un-levered beta of 1.12 and London Globe’s 1.30
gets the combined un-levered and levered beta of 1.21 and 1.32 respectively (see appendix for more
The external equity financing is a corporate capital structure policy upon an
investment opportunity. A company, from its own rational consideration may go for
this opportunity or leave it. In the case for a public company, such decision on
whether to take on the opportunity is observed by the market. The market is digging
the information about a public company’s investment policies in order to price its
stocks efficiently based on the information obtained (Myers and Majluf, 1984).
Thus, asymmetric information is a condition when the managers of the company
know something that the market does not. For example, in the case of external equity
financing let’s say a company sees an investment opportunity and need to finance it
with external equity financing. The project valuation figures show this as a
promising project to take on. The stockholders, however, are not sure about the cash
that can be generated from a further issue of stocks, since such issue might be sold at
lower price and thus lower the value of their holdings. The management board might
pull off and abandon this investment opportunity to retain the stockholder’s wealth.
The market, on the other hand, does not know about this and perceive that no new
issues of stocks as good news (asymmetric information). In fact, missing out a
profitable investment opportunity decreases the value of the company and if the
market knows this, it will bring the stock price down (Myers and Majluf, 1984). On
the contrary, if the company undertakes the external financing for this investment the
market does not know how feasible this project will be, and might reassess the level
of corporate risk, especially when the market knows that the company is undertaking
a negative NPV investment project for instance.
From the argument of asymmetric information, it might be the case that the company
will prefer internal equity financing by rearranging its dividend payout ratio as an
alternative to external equity financing (Myers, 1984).
Furthermore, as aforementioned, in the case of London Globe and Murdoch as a
combined entity, it has under-levered circumstances, which makes its financing slack
huge enough to carry more debt (Damodaran, 1997). Thus, even if the company does
not posses enough internal resource to finance any investment, it still has the option
of optimising its leverage ratio by undertaking debt financing, as illustrated below.
Capital Structure External financing Debt financing
London Globe £4,000.00m £4,000.00m
Murdoch £677.67m £677.67m
£4,677.67m £4,677.67m
Generate £50m cash £50.00m -
Total equity £4,727.67m £4,677.67m
London Globe £150.00m £150.00m
Murdoch £500.00m £500.00m
Generate £50m cash - £20.00m
Total debt £650.00m £700.00m
Debt-equity ratio 0.137 0.149
Beta un-levered 1.21 1.21
Beta levered 1.32 1.33
Cost of equity 18.54% 18.62%
Cost of debt after tax 5.20% 5.20%
WACC 16.93% 16.87%
Table 7. Capital structure between external equity and debt financing
The weighted average cost of capital (WACC) for debt financing is lower than that of
external equity financing scenario. This proves the point that external financing,
given the asymmetric information effect, is something that any company wants to
Let’s make the circumstances even more intriguing. If a company has little financing
slack and retained earning, which means internal equity and debt financing are out
of the question, merger will be the answer to increase value rather than issuing new
stocks (Myers and Majluf, 1984). A merger can combine both companies’ financing
slack and internal equity, avoiding them to undertake external equity financing.
VI. Concluding remarks
The total value of Murdoch is £1,177.67 million with £677.67 (£27.11/share) of which
being the market value estimate of equity as well as the maximum price for London
Globe to pay for the acquisition. It seems though that London Globe has to spend
£1.22 billion (£48.79/share) to close the deal assuming there is no other bidder, given
the excess premium needed to acquire a private company. To prevent a competing
bidder from acquiring Murdoch, London Globe assumes the pre-emptive bid to
exceed £1.03 billion (£41.29/share).
Lastly, in choosing the method of financing the plan-restructuring, London Globe
should pursue either internal equity or debt financing given the asymmetric
information problem.
For smaller and riskier firms
If interest coverage ratio is
greater than ≤ to Rating is Spread is
-100000 0.499999 D 20.00%
0.5 0.799999 C 12.00%
0.8 1.249999 CC 10.00%
1.25 1.499999 CCC 8.00%
1.5 1.999999 B- 6.00%
2 2.499999 B 4.00%
2.5 2.999999 B+ 3.25%
3 3.499999 BB 2.50%
3.5 3.9999999 BB+ 2.00%
4 4.499999 BBB 1.50%
4.5 5.999999 A- 1.00%
6 7.499999 A 0.85%
7.5 9.499999 A+ 0.70%
9.5 12.499999 AA 0.50%
12.5 100000 AAA 0.35%
Synthetic bond rates table using the interest coverage ratio
Based on S&P 500 bond rating classes
©2007 Aswath Damodaran, Stern Business School, New York University
Industry sector Firms Beta D/E Tax U-Beta Cash/ U-Beta
Value Cash
Bldg Prod-Air&Heating 8 0.70 14.27% 25.23% 0.64 3.45% 0.66
Bldg Prod-Cement/Aggreg 32 1.08 38.41% 24.43% 0.84 4.41% 0.88
Bldg Prod-Doors&Windows 3 0.53 21.40% 24.83% 0.45 3.04% 0.47
Bldg Prod-Wood 7 1.03 35.53% 34.58% 0.84 3.79% 0.87
Bldg&Construct Prod-Misc 31 0.91 17.23% 28.40% 0.81 7.18% 0.87
Bldg-Mobil Home/Mfd Hous 6 0.67 12.27% 27.01% 0.62 11.92% 0.70
Bldg-Residential/Commer 20 1.34 11.45% 25.45% 1.24 4.79% 1.30
Average industry financial data (abridged version)
Based on European industry average
©2007 Aswath Damodaran, Stern Business School, New York University
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