Corporate Finance

Topics Covered

Time value of Money Annuity/Perpetuity Risk Portfolio Theory CAPM Capital Structure WACC Capital Budgeting NPV, IRR, Payback

Equity Valuation Enterprise Value Free Cash Flow IPO Mechanism Right Issues Stock Bonus and Stock Split M&A Synergy

What is time value of money?

The time value of money is a recognition that money received today is worth more than an equal amount of money received months or years in the future: In solving any time-value problems, it is important to know if the cash flows take place at the beginning or at the end of the period. Translating a current value into its equivalent future value is referred to as compounding. Translating a future cash flow or value into its equivalent value in a prior period is referred to as discounting.

Present Value

Discounting translates a value back in time. Discount factor=1/Compounding Factor Compounding Factor=FV/PV Discounting Factor=PV/FV

Annuity Factor

A series of cash flows of equal amount, occurring at even intervals is referred to as an annuity. Determining the value of an annuity, whether compounding or discounting, is simpler than valuing uneven cash flows.

Present Value of a Perpetuity

There are some circumstances where cash flows are expected to continue forever. For example, a corporation may promise to issue a perpetual bond carrying fixed rate of interest
PV=CF/i

To see why, consider the present value annuity factor for an interest rate of 10%, as the number of payments goes from 1 to 200

Example Application of PV - Bond Pricing

A bond is typically issued at par value of the principal amount. However, in the secondary market, the price of a bond can fluctuate greatly from its par value. The price of a bond is determined by:

Expected periodic cash flows The discount rate used for each cash flow.

Value of debt security = Present value of future interest payments + Present value of maturity value. A fundamental property of a bond is that its price changes in the opposite direction of the change in the interest rates.

Bond Pricing Formula

C = coupon payment (Interest Payments) n = number of payments i = interest rate, or required yield (Yield to Maturity) M = value at maturity, or par value (Principal)

The Concept of Risk

Whenever you make a financing or investment decision, there is some uncertainty about the outcome. Though the terms risk and uncertainty are often used to mean the same thing, there is a distinction between them. Uncertainty is not knowing what is going to happen. Risk is the degree of uncertainty. Thus, greater the uncertainty, the greater the risk.

Expected Return

Expected returns are a measure of the tendency of returns on an investment.

Stand alone risk of expected value= standard Deviation

Risk Tolerance

Most people do not like riskthey are risk averse. Does this mean a risk averse person will not take on risk? Nothey will take on risk if they feel they are compensated for it. A risk neutral person is indifferent toward risk. Risk neutral persons do not need compensation for bearing risk. A risk preference person likes risksomeone even willing to pay to take on risk.

Risk Tolerance

When we consider financing and investment decisions, we assume that most people are risk averse. Risk aversion is the link between return and risk. To evaluate a return you must consider its risk: Is there sufficient compensation (in the form of an expected return) for the investments risk?

Expected Return, Risk and Diversification

As managers, we are concerned about the overall risk of the businesss portfolio of assets. The return on a portfolio (rp) is the weighted average of the returns on the assets in the portfolio, where the weights are the proportion invested in each asset.

Portfolio Risk

Portfolio risk depends not only on stand alone risk of each individual asset in the portfolio but also on their co-movement. A statistical measure of how two variablesin this case, the returns on two different investments move together is the covariance. The portfolios variance depends on:

The weight of each asset in the portfolio. The standard deviation of each asset in the portfolio. The covariance of the assets returns.

Portfolio Variance

Let cov1,2 represent the covariance of two assets returns. We can write the portfolio variance as:

It can be shown that for a large portfolio of multiple of assets, the portfolio variance depends more on the covariances than on the respective variances of individual assets.

Diversifiable and Non-diversifiable Risks

We refer to the risk that goes away as we add assets to a portfolio as diversifiable risk (also known as unsystematic risk). We refer to the risk that cannot be reduced by adding more assets as nondiversifiable risk (also known as systematic risk). The idea that we can reduce the risk of a portfolio by introducing assets whose returns are not highly correlated with one another is the basis of modern portfolio theory (MPT).

Diversifiable and Nondiversifiable Risks

Some portfolios have a higher expected return than other portfolios with the same level of risk.

Some portfolios have a lower standard deviation than other portfolios with the same expected return.

Because investors like high returns and low risk, some portfolios are preferable to others.

Portfolio that deliver the highest return for the level of risk make up what is called the efficient frontier.

Modern Portfolio Theory

Harry Markowitz tuned us into the idea that investors hold portfolios of assets and therefore their concern is focused upon the portfolio return and the portfolio risk, not on the return and risk of individual assets (Journal of Finance, 1952). The risk of a well diversified portfolio depends on the market risk of the securities included in the portfolio. The contribution of an individual security to the risk of a well diversified portfolio depends on two factors: the importance (weight) of the security in the portfolio and the sensitivity of the security to market movements (beta). All the assets in each portfolio, even on the frontier, have some risk. However, regardless of the level of risk one chooses, one can get the highest expected return by a mixture of a portfolio in the efficient frontier and a risk free asset. (See figure in the following slide)

We see that the best portfolios are no longer those along the entire length of the efficient frontier; The straight line shown below provides better return than the efficient frontier for any given level of risk. This straight line is a combination of the risk free asset and one and only one market portfolio.

Capital Market Line

If investors are all risk aversethey only take on risk if there is adequate compensationand if they are free to invest in the risky assets as well as the risk-free asset, the best deals lie along the line that is tangent to the efficient frontier. This line is referred to as the capital market line (CML). The CML specifies the returns an investor can expect for a given level of risk. If the portfolios along the capital market line are the best deals and are available to all investors, it follows that the returns of these risky assets (Which are there in the portfolio) will be priced to compensate investors for the risk they bear relative to that of the market portfolio.

CAPM

So, there is a specific level of return which a investor should get from an asset for bearing a specific level of risk. The CAPM uses this relationship between expected return and risk to describe how assets are priced. The CAPM specifies that the return on any asset is a function of the return on a risk-free asset plus a risk premium. The return on the risk free asset is compensation for the time value of money. The risk premium is the compensation for bearing risk.

CAPM

The expected return on an individual asset is the sum of the expected return on the riskfree asset and the premium for bearing market risk.

If we represent the expected return on each asset and its beta as a point on a graph and connect all the points, the result is the security market line (SML).

CML and SML - Recap

CML: Graph Showing portfolio return and risk; shows highest return an investor can expect from a portfolio, for a given level of risk. SML Graph showing expected return from an individual asset and its Beta (risk of individual asset). It shows return an investor should expect from a risky asset which can compensate him for bearing the associated risk.

CAPM: Assumptions

All investors have rational expectations. There are no arbitrage opportunities. Returns are distributed normally. Perfectly efficient capital markets. Investors are solely concerned with level and uncertainty of future wealth Risk-free rates exist with limitless borrowing capacity and universal access. The Risk-free borrowing and lending rates are equal. No inflation and no change in the level of interest rate exists. Perfect information, hence all investors have the same expectations about security returns for any given time period.

CAPM: Limitations

A beta is an estimate. The CAPM includes some unrealistic assumptions. For example, it assumes that all investors can borrow and lend at the same rate. The CAPM is really not testable. The market portfolio is theoretical and not really observable. CAPM captures all market risk in one variable. CAPM does not explain the differences in returns for securities that differ over time, differ on the basis of dividend yield, and differ on the basis of the market value of equity (the so called size effect).

What is Capital Structure?

The combination of debt and equity used to finance a firms projects is referred to as its capital structure. The capital structure of a firm is some mix of debt, internally generated equity, and new equity. Equity owners can reap most of the rewards through financial leverage (raising level of Debt) when their firm does well. But they may suffer a downside when the firm does poorly

Cost of capital

The cost of capital is the return that must be provided for the use of an investors funds. Cost of Debt:

Direct Approach Rate of Borrowing Weighted Average Method Interest Expense / Total Borrowing What is the risk-free rate?

Cost of Equity: CAPM

Logic of using a long-term rate.

What is your equity beta? How much is the equity risk premium (ERP)?

WACC

Where: Re = cost of equity Rd = cost of debt E = market value of the firm's equity D = market value of the firm's debt V=E+D E/V = percentage of financing that is equity D/V = percentage of financing that is debt Tc = corporate tax rate

WACC

But WACC keeps on changing every year, so how can we discount future cash flow by current WACC? Use target capital structure to find WACC Use Industrys average capital structure to find WACC Discount each years cash flow by corresponding years WACC Variable WACC

What is capital budgeting?

Analysis of potential additions to fixed assets. Long-term decisions; involve large expenditures. Very important to firms future.

Stages in Capital Budgeting

Because a firm must continually evaluate possible investments, capital budgeting is an ongoing process. Five stages:

Stage 1: Investment screening and selection Stage 2: Capital budget proposal Stage 3: Budgeting approval and authorization Stage 4: Project tracking Stage 5: Post-completion audit

Project Classifications: Based on dependence

Independent Projects Mutually Exclusive Projects Contingent Projects Complementary Projects

What is the difference between independent and mutually exclusive projects?

Projects are: independent, if the cash flows of one are unaffected by the acceptance of the other. mutually exclusive, if the cash flows of one can be adversely impacted by the acceptance of the other.

An Example of Mutually Exclusive Projects

BRIDGE vs. BOAT to get products across a river.

Project Classification: According to Risks

Valuing a project requires considering risks associated with its cash flows:

Replacement projects: investments in the replacement of existing equipment or facilities. Expansion projects: investments in projects that broaden existing product lines and existing markets. New products and markets: projects that involve introducing a new product or entering into a new market. Mandated projects: projects required by government laws or agency rules.

Financial Appraisal Tools

Accounting rate of Return. Payback Method. Discounted Payback Method. NPV. IRR

Project IRR Equity IRR

Profitability Index.

What is the payback period?

The number of years required to recover a projects cost, or how long does it take to get the businesss money back?

Payback for Project L (Long: Most CFs in out years)

0 CFt -100 Cumulative -100 PaybackL = 2 + 1 10 -90 30/80 2

2.4

3 80 50

60 100 -30 0

= 2.375 years

Project S (Short: CFs come quickly)

0
CFt -100

1.6 2

3
20 40

70 100 50 -30 0 20

Cumulative -100

PaybackS

= 1 + 30/50 = 1.6 years

Strengths of Payback:
1. Provides an indication of a projects risk and liquidity. 2. Easy to calculate and understand.

Weaknesses of Payback: 1. Ignores the TVM. 2. Ignores CFs occurring after the payback period.

Discounted Payback: Uses discounted rather than raw CFs.

0

10%

3 80 60.11 18.79

CFt PVCFt

-100 -100

10 9.09 -90.91

60 49.59 -41.32

Cumulative -100

Discounted = 2 payback

+ 41.32/60.11 = 2.7 yrs

Recover invest. + cap. costs in 2.7 yrs.

NPV and IRR

Accounting rate of return method has limitations. The payback and discounted payback approaches also have limitations. The NPV (and IRR) method is free of such limitations.

Steps
1. Estimate CFs (inflows & outflows). 2. Assess riskiness of CFs. 3. Determine k = WACC for project. 4. Find NPV and/or IRR. 5. Accept if NPV > 0 and/or IRR > WACC.

Normal Cash Flow Project:

Cost (negative CF) followed by a series of positive cash inflows. One change of signs.

Nonnormal Cash Flow Project: Two or more changes of signs. Most common: Cost (negative CF), then string of positive CFs, then cost to close project. Nuclear power plant, strip mine.

NPV: Sum of the PVs of inflows and outflows. n

CFt NPV . t t 0 1 k

Cost often is CF0 and is negative.

NPV
t 1 n

1 k

CFt

CF0 .

Whats Project Ls NPV?

Project L:
0 -100.00 9.09 49.59 60.11 18.79 = NPVL 10% 1 10 2 60 3 80

NPVS = $19.98.

Rationale for the NPV Method

NPV = PV inflows - Cost = Net gain in wealth. Accept project if NPV > 0.
Choose between mutually exclusive projects on basis of higher NPV. Adds most value.

Using NPV method, which project(s) should be accepted?

If Projects S and L are mutually exclusive, accept S because NPVs > NPVL . If S & L are independent, accept both; NPV > 0.

Internal Rate of Return: IRR

0 CF0 Cost 1 CF1 2 CF2 Inflows 3 CF3

IRR is the discount rate that forces PV inflows = cost. This is the same as forcing NPV = 0.

NPV: Enter k, solve for NPV.

CFt NPV. t t 0 1 k
n

IRR: Enter NPV = 0, solve for IRR.

CFt 0. t t 0 1 IRR
n

Whats Project Ls IRR?

0
IRR = ?

1 10

2 60

3 80

-100.00 PV1 PV2 PV3

0 = NPV

IRRL = 18.13%. IRRS = 23.56%.

Rationale for the IRR Method

If IRR > WACC, then the projects rate of return is greater than its cost-- some return is left over to boost stockholders returns. Example: WACC = 10%, IRR = 15%. Profitable.

IRR Acceptance Criteria

If IRR > k, accept project. If IRR < k, reject project.

Decisions on Projects S and L per IRR

If S and L are independent, accept both. IRRs > k = 10%. If S and L are mutually exclusive, accept S because IRRS > IRRL .

Construct NPV Profiles

Enter CFs in CFLO and find NPVL and NPVS at different discount rates:
k 0 5 10 15 20 NPVL 50 33 19 7 NPVS 40 29 20 12 5

(4)

NPV ($)
60 50 40 30 20 10 0 0 -10 5 10 15 20 23.6

Crossover Point = 8.7%

k 0 5 10 15 20

NPVL 50 33 19 7 (4)

NPVS 40 29 20 12 5

S L

IRRS = 23.6%

Discount Rate (%)

IRRL = 18.1%

NPV and IRR always lead to the same accept/reject decision for independent projects:
NPV ($)

IRR > k and NPV > 0 Accept.

k > IRR and NPV < 0. Reject.

k (%) IRR

Mutually Exclusive Projects

NPV
L

k < 8.7: NPVL> NPVS , IRRS > IRRL CONFLICT k > 8.7: NPVS> NPVL , IRRS > IRRL NO CONFLICT

IRRS

8.7

%
IRRL

To Find the Crossover Rate

1. Find cash flow differences between the projects. 2. Calculate IRR on cash flow differential. Crossover rate = 8.68%, rounded to 8.7%. 3. Can subtract S from L or vice versa, but better to have first CF negative. 4. If profiles dont cross, one project dominates the other.

Two Reasons NPV Profiles Cross

1. Size (scale) differences. Smaller project frees up funds at t = 0 for investment. The higher the opportunity cost, the more valuable these funds, so high k favours small projects. 2. Timing differences. Project with faster payback provides more CF in early years for reinvestment. If k is high, early CF especially is good, NPVS > NPVL.

Reinvestment Rate Assumptions (Imp.)

NPV assumes reinvest at k (opportunity cost of capital). IRR assumes reinvest at IRR. Reinvest at opportunity cost, k, is more realistic, so NPV method is best. NPV should be used to choose between mutually exclusive projects.

Multiple IRR

There is another situation in which the IRR approach may not be usable-when projects with nonnormal cash flows are involved. Projects with nonnormal cash flows would provide multiple IRRs.

Inflow (+) or Outflow (-) in Year

0 1 + + 2 + + 3 + + + 4 + + + 5 + + N N N NN NN

+
-

+
+

+
+

N
NN

Equity Valuation

Because common stock never matures, todays value is the present value of an infinite stream of cash flows (i.e., dividend). But dividends are not fixed. Not knowing the amount of the dividendsor even if there will be future dividends makes it difficult to determine the value of common stock.

Valuation Models

Dividend Valuation Model (DVM):

Constant dividend: Let D be the constant DPS:

The required rate of return (re) is the return shareholders demand to compensate them for the time value of money tied up in their investment and the uncertainty of the future cash flows from these investments.

Valuation Models

Dividend growth at a constant rate (g): (also known as Gordon Model)

OR

OR

Sustainable Growth Model (What should be g?)

Return on Equity = Net Income/Total Equity Dividend Payout Ratio = Dividend per share/EPS Sustainable Growth (g) = (1-Dividend Payout)* ROE The sustainable growth model shows us that when firms pay dividends, earnings growth lowers. If the dividend payout is 20%, the growth expected will be only 80% of the ROE rate. A company cannot grow earnings faster than its current ROE without raising additional cash. That is, a firm that now has a 15% ROE cannot increase its earnings faster than 15% annually without borrowing funds. ROE is, in effect, a speed limit on a firm's growth rate, which is why money managers rely on it to gauge growth potential.

DCF Model

The price of a stock can also be found using discounted cash flows. Steps:

Find out free cash flows of the firm. Estimate the present value of the free cash flow using required rate of return (WACC) Find out the enterprise value. Deduct net debt Divide the resultant figure by the number of outstanding shares.

Enterprise Value

EV = Market value of equity + Preferred stock + Minority Interests + Market Value of debt cash and cash equivalents Takeover value of the company All the components are market, not book values Sum of claims of all the security-holders: debt holders, preferred shareholders, minority shareholders, common equity holders Better than market cap, since it also consider value of debt, which needs to be paid by the buyer of firm. EV can be negative in certain casesfor example, when there is too much cash in the company

Free Cash Flow

FCF is a cash flow available for distribution among all the security holders of a company. They include equity holders, debt holders, preferred stock holders and so on. FCF = EBIT + Depreciation Increase in working capital Capital Expenditure Tax Rate * EBIT Discount at WACC to get Enterprise Value

Capital Cash Flow

Capital Cash Flow = EBIT + Depreciation Increase in working capital Capital Expenditure Tax Rate * (EBIT Interest ) Tax Shield = tax rate * Interest Expense Capital Cash Flow = Free Cash Flow + Tax Shield Discount Capital Cash flow at following discount factor to get enterprise value RA = Rd * D/V + Re * E/V (Note how it differs from WACC, this discount factor is called expected return from Asset)

FCF vs CCF

Lets Define

Hypothetical taxes = tax rate * EBIT Actual Taxes = tax rate * (EBIT Interest) , This is what you have on your P&L statement

FCF doesnt include benefit of tax shield in the cash flow. But its discounted at WACC, so benefit of tax shield is included in the discount rate. Note: WACC includes (1-tax rate) in its calculation. Capital Cash Flow includes benefit of tax shield in the cash flow itself. So, you include the benefit of tax shield either in cash flow or discount rate.

Equity Cash Flow

One method to find Total Equity Value is to get Enterprise Value (Which is total firm value) using any of the two previously described methods and then use following equation to get Market Value of Equity Enterprise Value = Market value of equity + Preferred stock + Minority Interests + Market Value of debt cash and cash equivalents Another method is to find equity cash flow and discount it at cost of equity (Re). Equity Cash Flow = EBIT + Depreciation Increase in working capital Capital Expenditure Actual Taxes Interest Expense Debt Repayment + New Debts (This is the cash flow available only for equity holders, after paying debt holders)

Market Multiple

Another method of stock valuation is market multiple analysis. This method applies a market determined multiple to net income, EPS, net sales, book value etc. Examples:

Value of Equity = Market Average P/E * Firms EPS Value of Equity = Market Average P/S * Firm's Annual Sale Value of Equity = Market Average P/B * Firms Book Value One measure of market average can be the average of the industry group to which the firm belongs

This method is used to price an IPO and also to value unlisted firms.

Raising Money through Equity

Private Placement Public Offering Right Issues In a private placement, such as to angels or VCs, securities are sold to a few investors rather than to the public at large.

In a public offering, securities are offered to the public and must be registered with SEBI.

Why should a company consider going public?

Advantages of going public

Current stockholders can diversify. Liquidity is increased. Easier to raise capital in the future. Going public establishes firm value. Makes it more feasible to use stock as employee incentives. Increases customer recognition.

Disadvantages of Going Public

Must file numerous reports. Operating data must be disclosed. Officers must disclose holdings. Special deals to insiders will be more difficult to undertake. A small new issue may not be actively traded, so market-determined price may not reflect true value. Managing investor relations is timeconsuming.

What are the steps of an IPO?

Select investment banker (Underwriter) Firm Commitment underwriters buy the unsold shares Best Effort - underwriters only agree to do their best to sell shares to the public File Draft Offer Document with SEBI Offer document in draft stage Contains all financial data, information on the management team, description of company's target market, competitors, and growth strategy Everything an investor needs to know SEBI may specify changes to be made

Steps of IPO

File Offer Document with the Registrar of Companies /Stock Exchanges

After, Lead Banker carry out required changes in Draft Offer Document.

Find price range for preliminary (or red herring) Prospectus

Number of Shares and upper and lower prices are specified. File with Registrar of Companies/Stock Exchanges

Steps of IPO

Go on road show

Senior management team, investment banker, and lawyer visit potential institutional investors Usually travel to ten to twenty cities in a two-week period, making three to five presentations each day.

Set final offer price in final prospectus Through book building process

Describe how an IPO would be priced.

Since the firm is going public, there is no established price. Banker and company project the companys future earnings and free cash flows The banker would examine market data on similar companies. Price set to place the firms P/E and M/B ratios in line with publicly traded firms in the same industry having similar risk and growth prospects On the basis of all relevant factors, the investment banker would determine a ballpark price, and specify a range (such as Rs.55 to Rs62) in the preliminary prospectus.

Class of Investors

Three classes of investors can bid for the shares:

Qualified Institutional Buyers: QIBs include mutual funds and Foreign Institutional Investors. At least 50% of the shares are reserved for this category. Retail investors: Anyone who bids for shares under Rs 50,000 is a retail investor. At least 25% is reserved for this category. The balance bids are offered to high net worth individuals and employees of the company.

What is book building?

Investment banker asks investors to indicate how many shares they plan to buy, and records this in a book Price Discovery Process The number of shares are fixed. After evaluating the bid prices, the company will accept the lowest price that will allow it to dispose the entire block of shares. That is called the cut-off price. All bidders get allotment at cutoff price. The bids are first allotted to the different categories and the over-subscription in each category is determined. Retail investors and high net worth individuals get allotments on a proportional basis

What are the direct and indirect costs of an IPO?

Underwriter usually charges a 5-7% spread between offer price and proceeds to issuer. Direct costs to lawyers, printers, accountants, etc. can be over a crore of rupees. Preparing for IPO consumes most of managements attention during the preIPO months.

What is a rights offering?

A rights offering occurs when current shareholders get the first right to buy new shares. Shareholders can either exercise the right and buy new shares, or sell the right to someone else. Wealth of shareholders doesnt change whether they exercise right or sell it.

Right Issues: Example

Current Share Price = Rs 50 You have 50 shares, Current Value = Rs 2500 Company announces right offer, 1 share for every 5 shares at Rs 40 (20% discount) You choose to exercise (get 10 new shares @ 40) 10*40 = Rs 400 passes from shareholder to firm. Total Value of Investment = 2500 + 400 = Rs 2900 Share Price After Right Issues: 2900/60 = 48.333 This is theoretical price, price generally rises because of positive signal. You choose to sell the right Right price = 48.333 40 = 8.333 Your wealth = 48.333 * 50 + 10*8.333 = Rs 2500

Different Types of Dividends

Many companies pay a regular cash dividend.

Public companies often pay quarterly. Sometimes firms will throw in an extra cash dividend. The extreme case would be a liquidating dividend. No cash leaves the firm. The firm increases the number of shares outstanding. Wrigleys Gum sends around a box of chewing gum. Dundee Crematoria offers shareholders discounted cremations.

Often companies will declare stock dividends.

Some companies declare a dividend in kind.

Share Repurchase: Instead of declaring cash dividends, firms can rid itself of excess cash through buying shares of their own stock.

Stock Bonus and Stock Split

Bonus Shares

Additional Shares issued and given free. A company builds up its reserves by retaining part of its profit over the years, these reserves increase gradually, and the company wanting to issue bonus shares converts part of the reserves into capital. Accounting Treatment: Transfer the total value of new shares issued from reserves to share capital Positive Signal Face value decreases. If a share of face value 10 split into two, the face value of each share become 5. Just a technical change increases liquidity of trading

Stock Split

A bonus is a free additional share. A stock split is the same share split into two.

M&A

Decisions

What price to pay? Value Target, Value Synergies How to pay? All Equity, All Cash, Combination of equity and cash How to finance the deal? Raise new equity, new debt, internal funds Targets Performance Improvement requirement to achieve the desired synergies and how to achieve it?

M&A: Synergy

Additional value that is generated by combining two firms, which would not be generated if companies operated independently. Synergies create value by harvesting benefits that each company would not be able to gain on its own. To be successful in M&A it is important to

Understand the credible sources of synergy and dubious ones Value Synergies

Value from Synergies = Value of combined firm with synergies Value of Acquirer Value of Target if optimally managed (According to market expectations)

The Synergy Trap

When an acquirer pays acquisition premium, he/she has two business problems to solve: to meet the performance targets the market already expects; to meet the even higher targets implied by the acquisition premium. Hence, Synergy can be defined as increases in competitiveness and resulting cash flows beyond what the two companies are expected to accomplish independently.

The Acquisition Game

Acquisition is a business gamble where the acquirer pays up front for the right to control the assets of the target firm and earn, hopefully, a future stream of cash flows. But while the acquisition premium is known with certainty, the payoffs are not. NPV (of playing the acquisition game)= Synergy- Premium.