[MUSIC] What is the value of synergies? Okay, we just talked about the concept of synergies, but to value, to price, to understand and emanate in the real world, we also need to place a value on synergy, okay? We have to find the dollar value and what's you're going to learn now, is that doing this is just doing an NPV calculation, okay? So it's going to be very familiar for you because it's exactly what we covered in Module 3, right. We learn how to do an NPV calculation and that's the same thing were going to do here to place a value on synergies, okay. What we'll do is forecast cash flows from anticipated synergies. So you can think of those as the incremental cash flow from the merger. And then we're going to compute the NPV of the synergies by discounting right? We're going to discount the incremental cash flows using an appropriate discount rate. So it's exactly the way we've done NPV calculations in Module 3 right? What I want to do is to use a deal that happened in the past. It's a relatively old deal, but it's a great one for us because we have a very detailed data on management's forecast of synergies, which is the merger between Hewlett Packard and Compaq. So these two companies were in the computer business, okay? And what happened is that in that year, HP decided to acquire Compaq, right? So the merger was announced in September 2001. And it was completed in 2002, and at the time of the merger, the management gave a lot of details about where the synergies were going to come from. So we can use those numbers to try to figure out what is the NPV of the synergy in this case. Okay, so you have an article here that talks about this data, but what I've done is I pulled it out for you and I'm describing it here. Okay? So, this is the data that we have, so what management talked about doing that time was that there were gonna be major cost savings. Okay? As we just discussed. In some cases mergers can allow companies to reduce cost, okay. There are gonna be major cost savings and improved profitability as a result of that, okay. Specifically, management was projecting a recurring annual pretax cost saving of $2.5 billion. Starting in mid 2004. That's very common, right? It takes time for a merger to be completed. Companies have to be reorganized, right? So, typically when management talks about synergy, what you'll see is that they will give a company some time to realize those synergies. Okay? So, these cost reductions, in the case of HP Compaq, were going to come from reductions in the administrative costs, as we just discussed. Administrative management costs is typically a good source of synergism when there is a merger, but also through other sources like R&D efficiency, marketing efficiency. The companies are going to become more efficient, and hopefully reduce costs. Okay? But another very common effect of a merger is the erosion of sales. Think about this. Those are two companies in the same business. They used to be competitors, right? They are merging together. Some of the sales are going to go, right? They sell similar products. It's natural to expect that sales are going to go down a bit. In this case actually, the expectation was that there was going to be a significant reduction of on sales of $4.1 billion, again, starting in 2004, okay? So here you have the profit margin as well, which we're going to use to compute the value of synergy. You have some other data here as well that we're gonna use later, okay? Discount rates, tax rates. And the rate of growth of the synergy. Okay? So let's go back here, okay, and think about how we're going to use these numbers. Okay? So we have the lost synergy here in 2004. Right? And then we have to figure out what is the impact of this decreased revenue in the profits, okay? So revenues are going to go down by 4.1 billion. But think about this, this is coming from a decrease, from a reduction in the sale of computers, right? So the company's selling less. That mean that costs are going to go down as well. Right. So the impact on the bottom line is going to be equal to the profit margin of 12%, times the decreasing revenue. So this is the profit margin, okay? So what's going to happen in this case, is that profits are going to go down by $0.5 billion, okay. And then we have the annual synergy, which starts in 2004 coming from the reduction in costs, right. That's $2.5 billion directly from the management estimate. So, the total synergy cash flow is going to be 2.5 billion minus 0.5. So the company's going to realize an annual cash flow of 2 billion starting in 2004, okay? So the question now that I want you to work with is, what is the net present value of the synergy? Okay. You have the cash flow. You know when the synergy start. And remember this is just a regular NPV problem, okay. And you should know how to work this out. So spend some time and try to figure out this problem on your own. Okay, so let's solve this problem. Here you have the data that you need. The cost savings, the reduction in revenue. Right? So you have the annual synergy job, 2 billion starting in 2004. We are taxing it because it's a before tax value. Right? So the after tax synergy is 1.48 billion okay, but that only starts in 2004, right. So what you need to do to solve this problem is to apply the perpetuity formula, right. You have a cash flow of 1.48 billion, right. [BLANK AUDIO] We're going to use the growing perpetuity formula. Okay. Which we learned in Module 3 because this cash flow is going to continue growing into the future at a 3% rate, right. The discount rate is 12%. So you apply the growing perpetuity formula and as we learned in Module 3, this value is going to come here to 2003, right. If the cash flow starts in 2004 and you use the growing perpetuity formula then the value is going to go to 2003. With that you can compute the NPV, right. So here you have the solution for you, okay. You have the growing perpetuity here, okay, and then we are discounting it back for two years right, because we have to bring it from 2003 to 2001. Okay? So what we end up with, is a net present value of the synergies that is equal to $13 billion. Okay? So what is the idea? The idea is that this merger between HP and Compact, according to the management, was creating $13 billion of synergy. Okay? How are you going to use that? As you're going to learn now, we are going to use the valuation of the synergies to come up with the deal price, okay? What you learn is that there is a very close link between the value of the synergies and the offer price that HP can make to Compaq. Okay? So here is some more data for you. Okay? This is how much the companies were worth. Before the deal was announced. HP's market value was $45.8 billion, Compaq was $20.85 billion, you have stock prices and shares outstanding as well. Okay, so the question is, how much should HP pay for Compaq? Given the synergy, given the value of Compaq, how much should HP pay? Okay? Think about what we learned, the value of the synergies is the total NPV of the deal, right? In this case the deal was creating $13.1 billion in value, right? This NPV, this is the total value, right? And now we have two companies, okay? This is the difference between a new investment and an acquisition. This is the total NPV. The NPV has to be divided between the acquirer and the target, right? So let's think about that. What would be the NPV for the target right? The NPV for the target is just going to be the deal premium, right? If the offer price is how much they get, right so if you're a Compaq shareholder you're gonna get the price for your shares. Minus your current value okay, that's gonna be our NPV. The NPV for the acquirer is going to be what? Is going to be the synergy minus the deal premium, right. You're paying a premium for the target but then you're going to get the synergy, right cuz you're buying this target company, okay. So here is a key relationship. For a deal to be positive NPV for the acquirer, the synergy has to be bigger than the premium. So the acquirer's going to pay a premium. You're going to get the synergy. So if the synergy's lower than the premium, the deal is going to be negative NPV. Right? Even if the deal creates value, even if the deal reduces cost, generates synergies, the acquirer has to make sure that you're not overpaying. And notice that when we look at data, the average premium that is paid for public targets is very high, approximately 30%. Okay? So it has to be the case that M&A deals have to generate large synergies to make sense, right. Cuz you're paying on average 30% premium, so the value of the synergy has to be very significant, otherwise the acquirer would not make money. Right? So here's another question for you. How much should HP offer to Compaq? Okay, given what we just learned? Here's the answer. Right. We came up with the value of synergies, this is what our evaluation allow us to do, is to figure out that the synergies were worth 13.1 billion. Okay? So then it must be the case that this premium that HP is gonna pay for Compaq has to be lower than the value of the synergy. Right? Compaq was worth $21 billion before that. Okay? So the Compaq shareholders are not going to accept less than $21 billion. It has to be more than that. Right, but it has to be lower than 20.9 plus 13.1, right. So the maximum value that HP can pay for Compaq is that sum which in this cases $34 billion, right. If HP pays more than that then you cannot generate value for your shareholder. Right, of course, Compaq shareholders are going to be happy but the shareholders of Hewlett Packard will not. [BLANK AUDIO]