Learning Outcomes
After reading this article, you will be able to evaluate how standalone company values are determined, explain the drivers and quantification of acquisition combined benefits, and calculate the distribution of merger gains between acquirer and target. You will gain confidence in applying value-based approaches to deals and in distinguishing the impact of different financing methods on acquisition success. This knowledge is directly relevant to the ACCA AFM exam.
ACCA Advanced Financial Management (AFM) Syllabus
For ACCA Advanced Financial Management (AFM), you are required to understand the key aspects of valuing and financing acquisitions and mergers. In particular, revision should focus on:
- The calculation and interpretation of standalone values for both acquirer and target companies
- The identification, classification, and quantification of revenue, cost, and financial combined benefits in mergers and acquisitions
- How potential gains from a deal are shared between bidder and target depending on offer structure and financing
- Approaches to valuing businesses in an acquisition context, including the use of free cash flows, DVM, and P/E multiples
- The financial and strategic impact of deal financing decisions
- The reasons why anticipated value creation from acquisitions may not always materialise for shareholders
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- What is meant by the "standalone value" of a company in a merger context?
- Which of the following is NOT a typical source of merger combined benefit?
a) Elimination of management duplication
b) Combining customer lists to boost sales
c) Regulatory penalties for market dominance
d) Improved debt capacity - If a bidder pays above the standalone value of a target but no combined benefits are realised, who benefits from the deal?
- Briefly explain how a share-for-share exchange affects the sharing of merger gains between bidder and target shareholders.
- List two possible risks if combined benefits from a proposed acquisition are overestimated.
Introduction
When a company is targeted for acquisition, its valuation is influenced not only by its current and forecasted performance but also by the value that could be created when it combines with the acquirer. Financial managers must be able to assess a target's value as an independent entity (standalone value), identify the additional value available from joining operations (combined benefits), and determine how these gains are split through the negotiation process. The finance and payment structure of the deal can further affect the theoretical and actual benefits to both parties. A thorough understanding of these concepts is essential for accurate deal appraisal and for meeting ACCA's exam requirements.
Key Term: standalone value
The estimated value of a business as if it were to continue operating independently, valued using conventional methods without adjustment for takeover or merger combined benefits.
DEAL VALUATION PRINCIPLES
Acquisitions are justified if the combined firm is worth more than the sum of the separate firms' values. The excess—the combined benefit—should ideally benefit shareholders. A structured approach is essential:
Standalone Company Values
First, each entity is valued independently. Apply the usual valuation techniques:
- Free cash flow models (discount future cash flows)
- Dividend valuation models (assume appropriate growth)
- Price to earnings (P/E) multiples from similar businesses
These methods ignore any uplift from being acquired or merged.
Key Term: free cash flow valuation
A method that values a business based on the present value of forecasted cash flows available for distribution to providers of finance.
Combined Benefits in Acquisitions
Combined benefits are the additional advantages expected from joining businesses. They explain why the merged firm may be worth more than the sum of its parts. Combined benefits are usually classified as:
- Revenue benefits: e.g., cross-selling, access to new markets
- Cost benefits: e.g., economies of scale, overhead reductions
- Financial benefits: e.g., lower cost of capital, increased debt capacity
Key Term: combined benefit
The increase in value that results from combining two companies, over and above the sum of their standalone values, usually due to enhanced revenue, reduced costs, or financial efficiencies.
The expected value of combined benefits should only be included in the deal valuation if the advantages are specific, quantifiable, and likely to be achieved.
Distribution of Bidder Gains
The total gain from a transaction equals the combined benefit value minus any premium paid above the target's standalone value. Who receives the gain depends on the form and level of the offer made.
Key Term: bidder gain
The portion of the total combined benefit value from an acquisition that accrues to the shareholders of the acquiring company, after accounting for the price or consideration paid to the target.
If the acquirer pays exactly the target's standalone value, the bidder receives all combined benefit advantages. If a large premium is paid (for example, to persuade shareholders to sell), most or all of the gain may accrue to the target's shareholders.
Worked Example 1.1
A plc has a standalone value of $600m. B plc, a potential target, is valued independently at $200m. The merger is expected to create cost savings and revenue enhancements worth $60m (present value). A offers $240m for B.
Required:
Calculate the maximum total gain from the acquisition, and show how it is divided between A and B's shareholders.
Answer:
Combined firm value = $600m + $200m + $60m = $860m
Total gain from deal = $860m – ($600m + $200m) = $60m
Amount paid to B shareholders = $240m.
Premium = $240m – $200m = $40m
Gain to B shareholders = $40m
Gain to A shareholders = $60m (combined benefit) – $40m (premium paid) = $20m
Financing the Deal
How the acquisition is paid for—cash, new debt, or shares—affects both the risk and the sharing of benefits:
- Cash offer: Immediate and certain value for target shareholders; acquirer's post-deal risk and control are unchanged.
- Share exchange: Target shareholders participate in future gains and risk; post-transaction ownership is diluted.
- Mixed offer: Balance of risks/gains; structuring may be used to reach a mutually attractive compromise.
Financing also impacts acquirer's gearing, cost of capital, tax exposure, and ability to absorb losses if anticipated combined benefits are not achieved.
Key Term: deal premium
The amount paid to acquire a target company above its standalone value, usually justified by anticipated combined benefits.
WHY COMBINED BENEFITS MAY NOT BE REALISED
- Overestimated or unachievable combined benefits are a common risk
- Poor post-merger coordination or culture mismatch may reduce benefits
- Paying a large premium can erase bidder gains or destroy acquirer wealth
- Share-for-share deals expose old shareholders to new risks
Worked Example 1.2
C Ltd acquires D Ltd, expecting the merger to create $25m in additional annual operating cash flows (perpetuity, pre-tax, 30% tax, discount rate 10%). If C pays a premium to D's shareholders of $170m above D's standalone value, will C's shareholders benefit?
Answer:
Present value of combined benefit = $25m × (1 – 0.3) / 0.1 = $175m
Maximum gain for C’s shareholders = $175m (if no premium). If premium paid is $170m, C's shareholders gain only $5m. If any part of the combined benefit is missed, the acquisition may destroy value for C shareholders.
Exam Warning
Overestimating combined benefits or paying a high premium can cause the acquirer’s shareholders to lose value—even when the combined group is theoretically worth more. In the exam, always identify the premium paid and perform a critical calculation to determine the true net benefit to the acquirer’s shareholders.
STRATEGIC IMPORTANCE OF DEAL STRUCTURE
- The way value is split depends on power balance in negotiations
- Competitive bidding can drive up the price, eroding acquirer gains
- Deal structure influences control, post-merger coordination complexity, and ability to access combined benefits
Revision Tip
Clearly distinguish between standalone value (before the deal), combined benefit value (potential from combination), and the premium actually paid. Always show your working in calculations.
Summary
Successful deal valuation requires estimating standalone values, quantifying realistic combined benefit gains, and assessing how financing and offer structure affect the sharing of value. The key is to ensure that the premium paid does not exceed the gain achievable—and that anticipated advantages are realistically achievable.
Key Point Checklist
This article has covered the following key knowledge points:
- Define and calculate standalone value for merger and acquisition analysis
- Identify and categorise sources and types of combined benefits
- Evaluate the calculation and sharing of total merger gains between acquirer and target shareholders
- Assess the impact of financing choice (cash, shares, or mix) on risk and sharing of benefits
- Explain dangers of overpaying or overestimating combined benefits in acquisitions
Key Terms and Concepts
- standalone value
- free cash flow valuation
- combined benefit
- bidder gain
- deal premium