# Net Present Value (NPV) and Firms’ Mergers

## Net Present Value (NPV)

Net present value method discounts inflows and outflows thereby ascertaining the net present value through deducting discounted cash flows to obtain net present value. Present values of cash flow involve a selection of acceptable rates which will be used to discount cash inflows and outflows.

### Advantages of net present value

1. It recognizes the time value of money as a dollar today is not equal to a dollar tomorrow.
2. It accounts for entire cash inflows or investment returns and therefore it is considered a very realistic value.
3. NPV is consistent with the owner’s objective of maximizing welfare as a positive NPV increases the worthiness of owners.

### Disadvantages of net present value

1. Calculation of net present value is complex as it involves the use of tables and tedious calculations.
2. It uses the cost of finance (r) which is considered a complex idea for management and therefore the tendency of avoiding its usage.
3. Calculation of net present value ignores payback period and thus not a correct measure of returns.

## Acceptance and Rejection Rules of Net Present Value

Under this method, management should accept a given investment if net present value is positive and it is greater than zero. However, if all projects have positive values, the highest value is recommended for selection as the highest inflow is a clear indication of capital gain to the investment. If the net present value is negative, the project should be rejected as cash outflow is greater than inflow thereby resulting in loss to the management of such projects. However, if the present values of all projects are equal, then the decision-maker is indifferent to the best project to undertake.

## Present Value of Uneven Periodic Sum

Calculation of present value of cash flows=

Generally, present Value =

where

At= Uneven stream of cash flow; r= cost of finance: (Year 0=3219000; year 1=350,000; Year 2=939,000; Year 3=1,122,000; Year 4=500,000; Year 5=900,000 and discount rate of 5%).

Present value of cash flows: Using tables (Brealey, Myers and Allen, 2005)

• Year 1= 0.952*350,000 =333,200
• Year 2= 0.907*939,000 =851,000
• Year 3= 0.864*1,122,000 =969,408
• Year 4= 0.823*500,000 =411,500
• Year 5=0.784*900,000 =705,600

Total =3,270,708

## Net present value

Net present value (NPV) = total present value of cash flows-initial cash outlay discounted at zero.

NPV= 3,270,708-3,219,000=51,708

Conclusion: the project should be accepted as it has a positive NPV. The management should undertake the project as it is profitable.

### Mergers

A merger occurs when two firms, of same size, accept to operate as a single new company instead of remaining in separate ownership and individualistic operations. It is also called the merger of equals and the stocks of these companies are given up and a new company stock issued in place of the first shares. Merger waves occur mostly during economic expansions and ends when markets and economy slows down. In normal circumstances, mergers of equals are uncommon as one company will have to buy another as part of the deal.

However, there is a tendency of bought acquired firms to accept the actions as merger of equals. This is to prevent the negative connotation to the top management and deal makers. A purchase deal can be classified as a merger if managing directors agrees to work for the betterment of their organizations. However, when the target organization does not want to be bought but taken in a hostile way, then it is acquisition (Expectations investing report, 2001).

Mergers can be horizontal, vertical; market extension, product extension, conglomeration, purchase and consolidation mergers.

### Argument for mergers

To start with, mergers enhance cost saving in companies through staff reductions. However, this causes job losses and cuts monthly salary expenditures related to former executives and junior employees. Secondly, it results in economies of scale in purchasing stationary or information technology platform and placement of orders.

In addition, mergers can help improve the purchasing power through low price negotiation. Thirdly, mergers increases products range and distribution channel rationalization. This can be through acquisition of smaller firms with unique production technologies. This can also help in acquiring more customers.

Fourth, mergers increases market reach and industry visibility. Firm enter into mergers to reach new markets, grow revenue base and earning potential. It can also increase a firm’s investment standing, marketing, distribution and new sales potential. Finally, mergers help in acquiring excess investment capital thereby increasing the earning potential even though they are not appropriate strategies available (McDonald, Coulthard and De Lange, 2006).

### Argument against mergers

First, there is general lack of communication amongst and with key stakeholders during mergers and acquisitions. This may result in disappointments with managerial terms which may cause higher losses in stock value. Secondly, mergers can easily be flawed thus causing inefficiencies from economies of scale which may prove indescribable. In most cases, the difficulties related to the workings of mergers are all too hard to conceptualize (McDonald et al., 2006).

Third, mergers are considered imitation attempts. For instance, big merger usually prompts top executives of similar firms to follow suit. This will therefore result in flawed Intentions for starters. Fourth, mergers usually concentrate in glory seeking than as a business strategy. The main intention of any given merger is to buy out competitors based on guidance from support service providers like lawyers or bankers who are major gainers.

Fifth, mergers are majorly influenced by globalization levels, arrival of modern technologies and a fast but challenging economic landscape. Sixth, survival of mergers occasionally result in the neglect the essential business agendas by top management which may result in failures for major firms. Therefore, potential constraints are the result of management involved in the excitement of big deal.

Seventh, during mergers, cultural decisions based on product or market synergies are usually ignored. This hampers chances of success, resentment and shrinking productivity and it is a mistake to assume that personnel issues are easily overtaken. Finally, mergers are adversely affected by overpayments. However, higher prices paid by bidders should be accompanied by higher earnings growth for support. In some instances, bidding contests result in higher acquisition prices which are not justified by reasonable growth expectation.

### Success factors in mergers

First is the need to grow its assets and product range. This can be through internal method and mergers. Internal method is ineffective and slow for firms intending to take the benefit of opportunity window where it has a short-term advantage over competitors.

However, mergers are cheaper and faster as the firm does not need to incur all costs alone.

Second, motivating factor is the pursuit of synergistic benefits. Synergy may be derived from cost economies or from revenue enhancement. For instance, a combination of two firms yields a more valuable entity than two firms operating independently. However, these gains are difficult to achieve in normal circumstances, but when they are achieved, the merged firms usually have a lower per unit costs.

Third motive is the need for diversification aimed at lowering of risk levels and exposure in volatile industry segments. However, for diversification to be successful more skills and infrastructure are needed and thus only few organizations are able to grow and enhance shareholders wealth through diversification.

### Implication on Shareholders

Different groups of people are affected by mergers in different ways depending on whether these deals are hostile or friendly (Gaughan, 2001).

First, from merger agreements, the target shareholders earn positive returns. This is mainly possible if mergers are friendly, well negotiated bids. A principal or target common shareholder earns a significant positive and abnormal return which is a function of premiums received by target shareholders.

Secondly, target shareholders earnings potentials improve significantly from tender offers. In addition, hostile bids shareholders also experience positive earning incremental. However, hostile biddings result in competitive environment therefore has an influence on prices of acquisitions and thus its shareholders’ return (Investopedia, 2008).

Thirdly, takeovers may result in gainful insights for preference stockholders as bidders are considered a major source of protection therefore lowering the risk of preferred bonds and stocks.

Fourth, the shareholders of acquired company may realize negative earnings from mergers. In fact, acquiring organization stakeholders tend to perform poorly from mergers and acquisitions. This is an indication of a skeptical market and bidders should therefore enjoy synergistic gains which greatly offset the premium prices paid for the target. However, bidder’s stock responses are usually small relative to the target as bidders tend to exceed targets.

Finally, shareholders of acquiring organization usually gain a negligible amount if any from tender offers and are poor performers if their organization uses a hostile bid on its targeted firm. However, evidence statistics support a mildly positive to zero response from such activities accruing to acquiring shareholders.

## References

Brealey, R.A., Myers, S.C., and Allen, F. (2005). Principles of corporate finance: Present value tables. Web.

Expectations investing report, (2001). How do you analyze an M&A deal? Web.

Gaughan, P. A. (2001). Mergers and acquisitions: An overview. Web.

Investopedia, (2008). Mergers and acquisitions. Web.

McDonald, J., Coulthard, M., and De Lange, P. (2006). Planning for a successful merger or acquisition: Lessons from an Australian study. A Journal of Global Business and Technology, 1(2), 1-11. Web.

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