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ILLUSTRATION: Valuation of target Company for VOC & SYNERGY

A Status Quo Valuation of Digital Equipment Corporation

In 1997, Digital Equipment, a leading manufacturer of mainframe computers, was the target of an acquisition bid by Compaq, which was at that time the leading personal computer manufacturer in the world. The acquisition was partly motivated by the belief that Digital was a poorly managed firm and that Compaq would be a much better manager of Digital’s assets. In addition, Compaq expected synergies in the form of both cost savings (from economies of scale) and higher growth (from Compaq selling to Digital’s customers).

To analyze the acquisition, we begin with a status quo valuation of Digital. At the time of the acquisition, Digital had the following characteristics:

➢ Digital had earnings before interest and taxes of $391.38 million in 1997, which translated into a pretax operating margin of 3% on revenues of $13,046 million and an after-tax return on capital of 8.51%; the firm had a tax rate of 36%.

➢ Based on its beta of 1.15, an after-tax cost of borrowing of 5% and a debt ratio of approximately 10%, the cost of capital for Digital in 1997 was 11.59%. (The Treasury bond rate at the time of the analysis was 6% and we used a risk premium of 5.5 %.)

Cost of equity = 6% + 1.15(5.5%) = 12.33%

Cost of capital = 12.33% (.9%) + 5% (.1) = 11.59%

➢ Digital had capital expenditures of $475million and depreciation of $461 million, and working capital is 15% of revenues.

➢ Operating income, net capital expenditures, and revenues were expected to grow 6% a year for the next 5 years.

➢ After year 5, operating income and revenues were expected to grow 5% a year forever. After year 5, capital expenditures were expected to be 110% of depreciation, with depreciation growing at 5% . The debt ratio remained at 10%, but the after-tax cost of debt dropped to 4% and the beta dropped to 1.