Question

The Wycombe Company is doing well and is interested in diversifying, so it has been looking around for an acquisition target. The Albe Company has been found with the help of an investment banker. Albe is quite profitable and is about half the size of Wycombe. This size relationship is reflected in their market values. Both firms are financed entirely by equity. The investment banker has advised that it will be necessary to pay a premium of about 30% over market price to acquire Albe. Wycombe’s president is having a hard time with this news and has asked you for advice. Construct and explain an approach to the acquisition that might make the premium easier to rationalize. Would it affect your argument if neither Albe nor Wycombe were particularly profitable? If so, how?

Answer 1

The acquisition premium of 30% is on account of following three things:

1. Control of Albe: The acquisition will give a controlling position in Albe. The control will come at a price. The controlling position can enable Wycombe to bring whatever changes they want in Albe.

2. Synergies: There will be some synergies in terms of financial muscle, revenues and costs. Financial muscle can help Wycombe negotiate better leverage deals. Debt can be raised at lower cost. This can create additional value as both the firms are currently 100% financed by equity.

3. The combined entity can get a better valuation. The incremental valuation will compensate for the premium being paid to acquire.

If none of the two are profitable, then our argument will change. Premium of 30% appears too high to acquire another company that is yet to turn profitable. Further, since Wycombe itself is not profitable, the entire financing required to acquire Albe will be external and may carry high cost. Acquistion premium coupled with higher cost of financing to acquire, will further deteriorate the financial health of Wycombe.