Question

According to the Wall Street Journal, merger and acquisition activity in the first quarter rose to $5.3 billion. Approximately three-fourths of the 78 first-quarter deals occurred between information technology (IT) companies. The largest IT transaction of the quarter was EMC’s $625 million acquisition of VMWare. The VMWare acquisition broadened EMC’s core data storage device business to include software technology enabling multiple operating systems – such as Microsoft’s Windows, Linux, and OS X – to simultaneously and independently run on the same Intel-based server or workstation. Suppose that at the time of the acquisition a weak economy led many analysts to project that VMWare’s profits would grow at a constant rate of 2 percent for the foreseeable future, and that the company’s annual net income was $39.60 million.

If EMC’s estimated opportunity cost of funds is 9 percent, as an analyst, how would you view the acquisition?

a. Favorably - the price is less than the company is worth.

b. Indifferent - the price is equal to the company's worth.

c. Unfavorably - the price is more than the company is worth.

Would your conclusion change if you knew that EMC had credible information that the economy was on the verge of an expansion period that would boost VMWare’s projected annual growth rate to 4 percent for the foreseeable future?

a. No - the company is still worth more than the price.

b. Yes - the company is now worth less than the price.

c. Yes - the company is now worth more than the price.

d. No - the company is still worth less than the price.

Answer 1

Answer:

Given,

Wall Street Journal, merger and acquisition activity in the first quarter of 2004 rose to 5.3 billion- an investment level not seen since the second quarter of 2001,

three fourths of the 78 first quarter deals occurred between information technology companies,

largest IT transaction of the quarter was EMC's $625 million acquisition of VMWare,

the time of the acquisition the weak economy led many analysts to project that VMWare's profits would grow at a constant rate of 1% for the forseeable future,

and that the company's annual net income was $50.72 million

If EMC’s estimated opportunity cost of funds is 9 percent, as an analyst, then acquisition is:

c. Unfavorably - the price is more than the company is worth.

CALCULATION:

using the following equation the value of the firm is calculated as below:

Where

in the case of this firm:

Substituting the values in the equation :

Thus at the projected profit growth rate of percent per annum the value of the firm is $ 621.72 million which is lower than the price of $625 millioin at which it has been acquired.

If EMC had credible information that the economy was on the verge of an expansion period that would boost VMWare’s projected annual growth rate to 4 percent for the foreseeable future then the conclusion is:

c. Yes - the company is now worth more than the price.

CALCULATION:

In this case:

Substituting the values in the equation :

Thus at the projected profit growth rate of 4 percent per annum the value of the firm is $863.28 million which is higher than the price of $625 million at which it has been acquired.

Thus if EMC had credible information that the ecomony was on the average of expansion which would boost VMware's projected growth rate to 4 percent,the acquisition price of $625 million would be justified.