Question

The Birdie Golf-Hybrid Golf Merger -Birdie Golf, Inc., has been in merger talks with Hybird Golf Company for the past six months After several rounds of negotiations, the offer under discussion is a cash offer of $550 million for Hybrid Golf. Both companies have niche markets in the golf club industry, and both believe that a merger will result in synergies due to economies of scale in manufacturing and marketing, as well as significant savings in general and administrative expenses Bryce Bichon, the financial officer for Birdie, has been instrumental in the merger negotiations. Bryce has prepared the following pro forma financial statements for Hybrid Golf assuming the merger takes place. The financial statements include all synergistic benefits from the merger Year 1 $ 800,000,000 $900,000,000 $1,000,000,000 $1,125,000,000 $1,250,000,000 2 3 Production costs 82,000,000 83,000,000 113,000,000 Other expenses 125,000,000 $83,000,000 $100,000,000 118,000,000 $ 139,000,000 $ 167.000,000 19.000,000 22,000,000 24,000,000 25,000,000 27.000,000 $ 64,000,000 $ 78,000,000 $ 94,000,000 $ 114,000,000 $ 140,000,000 Taxable income Taxes (40%) Net income Additions to retained earnings 38,400,000 $46,800,000 56,400,000 68,400,000 $ 84,000,000 0 34,000,000 27,000,000 27,000,000 25,000,000 · If Birdie Golf buys Hybrid Golf, an immediate dividend of $150 million would be paid from Hybrid Golf to Birdie. Stock in Birdie Golf currently sells for $94 per share, and the company has 18 million shares of stock outstanding. Hybrid Golf has 8 million shares of stock outstanding. Both companies can borrow at an 8 percent interest rate. Bryce believes the current cost of capital for Birdie Golf is 11 percent. The cost of capital for Hybrid Golf is 12.4 percent, and the cost of equity is 16.9 percent. In five years, the value of Hybrid Golf is expected to be $600 million.

Answer 1

While evaluating the target’s expected present value, the most relevant discount rate is the target’s cost of equity since the price shall be paid to the equity holders of the target company. We tend to avoid using the acquirer’s WACC or cost of equity so that the valuation of the target company do not change as per the changes in the acquirer. Hence, in the given case, the most relevant discount rate is 16.9%. It’s expected value discounted by that rate shall be the minimum price that the common shareholders of the firm shall be willing to accept. Now, in this case, cost of capital for the acquirer is lower and hence, the valuation would anyways have been higher if discounted by that rate. Now, it doesn’t make sense to pay a higher price when the target common shareholders are willing to accept a lower one.