Damodaran on Valuation

15.5. COMMON ERRORS IN VALUING SYNERGY

While firms are often willing to pay billions of dollars for synergy in mergers, there are several common errors that are made by analysts who are called upon to value synergies. Acquiring firms often subsidize target firm stockholders by misidentify-ing sources of synergy or using the wrong discount rate on savings from synergy. It is also common to see a mixing up and double counting of synergy and control values. Finally, overoptimism about when synergy gains will show up often leads to too high a value being attached to synergy.

15.5.1. Subsidizing Target Firm Stockholders

Acquiring firms should follow a simple rule when it comes to value. They should not render unto target firm stockholders premiums for items or strengths that these stockholders had no role in creating. Consider two very simple examples where we can see this subsidization of target firm stockholders by acquiring firms:

1. An acquiring firm with a high debt rating acquires a target firm with a much lower debt rating. Assume, for purposes of this illustration, that the after-tax cost of debt for the acquiring firm is 3 percent and that of the target firm is 5 percent and that the debt ratio of the latter is 30 percent. In computing the cost of capital for the target firm, the analyst decides to use the acquiring firm's cost of debt, arguing that the acquisition will be funded with new debt at the lower cost. The lower cost of capital (arising from replacing the target firm's ...