A workgroup on the choice between two possible acquisition targets.

1. Assignment 2
Tutor: Andrea Peric
Tutorial Number: 8
Group: 1
Edoardo Falchetti, Max Berben, Tim Schrader
Introduction
AirTech is a company active in the technological industry. After having reached a prominent level
of market capitalization, the firm is now aiming to expand, both to deploy positive NPV
opportunities in the market and to reduce the risks of entering financial distress. Following an
accurate scrutiny of the whole industry, AirTech has identified two possible alternatives among
several potential targets, narrowing down the search to SolarTech and BioTech.
Both the acquisition targets have the potential to revolutionize the location decision of data centers,
using different approaches: SolarTech aims to produce innovations able to enhance the efficiency of
solar panels, whereas BioTech focuses on building smaller biomass plants.
In this report, both investment opportunities will be thoroughly analysed. In the next section, the data
set will be examined, and an overview of the descriptive statistics will be provided. Next, the
forecasted cash flows for the two potential acquisition targets will be broken down, through a
comparison between the two companies’ NPVs. Afterwards, the diversification potential will be
assessed, by counterposing the statistics following an acquisition of either SolarTech or BioTech. An
interesting point of view will be analysed in the penultimate section, in which an investor is allowed
to choose the weights in his portfolio freely, with the goal of maximizing the portfolio Sharpe ratio.
Lastly, some empirical evidences on whether or not diversification is always good will be presented,
in relation to both conglomerates and individual investors. In the conclusion will be reported the most
remarkable results, with a final recommendation. The aim of this paper is to provide more information
about the two alternative projects, establishing a fair price and thoroughly assessing the effects of the
acquisitions on the risk and return of the resulting portfolio.
Data set
The data set analyzed is based on a sample period of 8 years and 1 month (97 months), running
from September 2006 to October 2014. The historical data series for the three companies –
AirTech, SolarTech, and BioTech – are provided together with another historical data series which
refers to the market index for the same period. The other data provided concern the market value of
the three companies, their capital structure, and the cost of debt. In addition, information about the
cash flows for the two potential acquisition targets and their relative cash flows growth rate are
provided, together with the risk-free rate (4.30%) and the corporate tax rate of AirTech (34%)
(Appendix, Table 1).
Data Analysis
At first, the average monthly returns for the three companies and the market index were calculated,
and further annualized through compound capitalization for analysis purposes. For the sample
period analysed, SolarTech was the one with the highest annual return (78.43%); on the other hand,
BioTech represents the one with the lowest return (12.32%). AirTech’s return is slightly higher than
the market index’s return (37.22 and 34.74%, respectively).
The same analysis has been carried out for what concerns the volatility, or standard deviation. The
formula used is STDEV.S, since it refers to a sample rather than a population. From the obtained

2. results, relevant insights can be ascertained: SolarTech’s annual volatility is equal to 36.49%, and is
higher than BioTech’s one which, in turn, is almost equal to the market index’s one (29.24 and
28.54%, respectively). From the analysis of the standard deviation, it is steadily observable that
AirTech’s standard deviation is higher than its targets’ ones: This is consistent with AirTech’s goal
of acquiring one of the two targets to decrease the standard deviation of the company, by taking
advantage of the possible diversification benefits.
Then the Sharpe ratio, the risk-adjusted measure of returns, was calculated for the three companies
and the index, using a risk-free rate of 4.30%. By observing the results, the two acquisition targets
have diametrically diverse Sharpe ratio values: SolarTech has a Sharpe ratio of 2.03, which is
considerably high. On the other hand, the Sharpe ratio of BioTech is only 0.27. The Sharpe ratios
for AirTech and the market index are respectively equal to 0.76 and 1.07.
From the analysis of the returns, volatility, and Sharpe ratio we can carve out a first general
overview of the two acquisition targets: SolarTech has a very high return compared to the other
companies, and is also less volatile than AirTech itself. BioTech, instead, has lower returns
compared to the others, but is the company which has the lowest volatility.
By examining the betas, a counterintuitive evidence against the average industry values of beta can
be found: Usually, companies in high-technologies industries tend to have very high betas, since
their activity is highly dependent upon their business cycles. Nevertheless, the three companies
analysed have beta values which are even lower than 1. The beta values are 0.53, 0.71, and 0.61, for
AirTech, SolarTech, and BioTech respectively (Appendix, Table 2).
AirTech has a financial structure consisting of 30% debt and 70% equity. By acquiring BioTech,
the ratio of debt in the firm would increase, being this value equal to 39% for BioTech. If the main
goal of the firm is to avoid incurring in a situation of financial distress, acquiring SolarTech would
be a more viable solution, and the financial distress would be hence diminished (D=25%)
(Appendix, Table 1).
Without considering any tax benefits, AirTech’s WACC is equal to 20.39%. Among the three
companies, SolarTech is the one with the highest WACC (26.04%), which means that it is costlier
for the company to finance its business operations. This could be explained by the fact that it has a
lower market value than both AirTech and BioTech (WACC=22.88%), and is hence smaller if
compared to the others. In general, smaller firms face higher costs to finance their operations
especially in their initial stages, because they are considered to be riskier (Appendix, Table 3).
Cash Flows estimation
After having analysed the descriptive statistics for the three companies and the market index, the
next step of our analysis is the cash flows estimation for the two potential acquisition targets,
SolarTech and BioTech.
The data also included the initial cash flows (year 0) for both companies, which are equal to
900,000 for SolarTech and 1,100,000 for BioTech. To forecast the future cash flows, an expected
future growth rate has been used – 6.054 and 4.351%, for SolarTech and BioTech respectively
(Appendix, Table 1). The cash flows have been forecasted until year 10; after year 10, a terminal
value has been calculated.
Even though SolarTech has a higher future cash flows growth rate, its final NPV (5,676,248.49) is
lower than BioTech’s one (7,294,089.07), since the latter has both a higher initial cash flow and a
lower WACC, which is the rate at which the future cash flows have been discounted to year 0 to
calculate the NPV (Discounted Cash Flow method).
The cash flows valuation therefore suggests that BioTech outperforms SolarTech in terms of future
cash flows, as disclosed by a higher NPV value (Appendix, Tables 4 & 5).

3. Diversification potential
To assess the diversification potential of both the acquisition targets, we add each of the two
companies separately to AirTech, as if they were another asset to add to the firm’s portfolio.
At first, the post-acquisition weights have been computed, as the ratio of a firm’s market value over
the sum of the two combined companies’ market values.
If AirTech would acquire SolarTech, the weights would respectively be 70.33 and 29.67%. On the
other hand, acquiring BioTech would result in a lower weight for AirTech, as expected for the
higher market value of BioTech respect to SolarTech’s one. The new weights would be 58.81 and
41.19%, for AirTech and BioTech respectively (Appendix, Table 6).
At first glance, in the new portfolio consisting of AirTech and SolarTech there is a considerable
improvement in the annual return (49.44, versus the 37.22% of AirTech only). By acquiring
SolarTech would lead to an enhancement also by a volatility standpoint (from the original volatility
of 43.18 to a post-acquisition value of 34.12%). Lastly, the Sharpe ratio increases from 0.76 to 1.32.
If AirTech acquired BioTech instead, the annual return would decrease to 26.96%, but the
diversification benefits would be enhanced, leading to a standard deviation of 30.20%.
The post-acquisition Sharpe ratio is almost the same as the pre-acquisition one (0.75 vs. 0.76)
(Appendix, Table 7).
Optimal Portfolio
In this section, by making use of the Excel solver tool, we were able to identify the optimal
allocation. A constraint that implies that no short sales are allowed has been used (each weight must
be ≥ 0). We suppose that an investor can choose his weights freely among the three companies. The
results for the weights are consistent with the analysis made in the previous sections: By
maximizing the Sharpe ratio (Optimal Portfolio), SolarTech is the “asset” with the highest share
(78.53%). AirTech and BioTech, instead, are assigned much lower weights: 11.72 and 9.75%,
respectively. The optimal portfolio has a return of 67.15%, a standard deviation of 30.13%, and a
Sharpe ratio of 2.03. By comparing these statistics with the post-acquisition statistics analysed in
the previous section, it is discernible to observe how the optimal portfolio is able to capture the
characteristics of both the acquisition targets: The expected return and the Sharpe ratio are higher,
as a result deriving from SolarTech’s high return – and the relatively high weight assigned to this
asset -, and the volatility is lower, due to the non-negligible weight assigned to BioTech, the
company among the three with the lowest standard deviation (Appendix, Table 8).
Among the three companies there is a low level of correlation (0.19 between AirTech and
SolarTech, 0.20 between AirTech and BioTech, and 0.04 between SolarTech and BioTech), hence
acquiring either of the two firms or both would provide diversification benefits (Appendix, Table
9).
Empirical evidences on diversification
Is diversification always good? In this last paragraph, we will discuss pros and cons of
diversification, both by an individual investor’s point of view and by a conglomerate’s one.
Conglomerates are corporations which own controlling stakes in other smaller companies, which in
turn can run both related or unrelated businesses.
By an individual investor’s standpoint, diversification represents a “free lunch” every rational
investor should benefit from. Nevertheless, empirical evidences show that most individual investors
hold less than ten stocks in their portfolios, which means that they don’t diversify enough to
eliminate the idiosyncratic risk (or firm-specific risk). A probable reason for this could be the
familiarity bias: Investors tend to invest in companies they are familiar with. In order to achieve a

4. high level of diversification within a portfolio, any investor should invest in at least 30 different
assets, as proved by empirical evidence.
From a conglomerate’s point of view, several considerations must be made upfront before opting
for a new acquisition. Indeed, there are both pros and cons that a company should heed when
deciding to acquire a new company. In general, the main advantages pursued by acquiring
companies are synergies with the potential targets – which are achieved when the value of the
combination of the two firms is greater than the sum of the two stand-alone values – and risk
reduction, realized as a result of a lower idiosyncratic risk of the combined firm. Additionally, a
more diversified firm is less likely to go bankrupt, therefore can afford a higher degree of leverage,
which in turn translates into greater tax savings. Despite this, several drawbacks may arise
following an inadequate acquisition: A company that decides to acquire another one may lose the
focus on its core business and, accordingly, the profits of the combined firm may be eroded. Plus,
handling a larger combined firm may reveal itself to be an extremely tough task for the central
management team, especially when the new companies acquired occur to be in industries in which
the acquiring firm lacks expertise.
For an individual investor who already owns a well-diversified portfolio, there is no further benefit
to be obtained from a diversification through acquisition made by a firm in his portfolio. In
addition, it is cheaper for an investor to diversify his portfolio by himself.
Among the most successful conglomerates is without any doubt Disney. Disney was able to build
its rise to the top by acquiring companies which were related to its core business, developing
synergies across its divisions. Furthermore, Disney has been able to instill the company’s culture
both to its employees and to its customers. Lastly, another remarkable point is given by the
company’s forward-looking attitude: Disney was patient enough to wait for its divisions to bear
fruit, as in the case of the theme parks.
But diversification through acquisition is not a guarantee to success: There are countless companies
which failed in diversification because they acquired companies which destroyed value instead of
creating it.
Conclusions
In this paper the two potential acquisition targets, SolarTech and BioTech, have been analysed in all
respects. From the investigation of the descriptive statistics, at first glance it is observable how
SolarTech and BioTech are completely different both in terms of returns and standard deviations:
SolarTech’s returns are more than six times higher than the ones of BioTech, which in turn can
boast a lower standard deviation. But even adjusting for the risk measure by making use of the
Sharpe ratio, there is a substantial difference between the companies: SolarTech’s Sharpe ratio is
more than 9 times the one of BioTech.
From the analysis of the cash flows, the structural differences between the two companies are
further emphasized: SolarTech has a higher growth rate, but given the higher cost of capital and the
lower initial cash flow, its final NPV is rather low if compared to BioTech’s one. For these reasons,
we can state that SolarTech’s acquisition could represent a longer-term investment respect to
BioTech.
By assessing the diversification potential of both acquisition targets, SolarTech represents the
optimal choice, with an improvement in both the return and the volatility, as well as the Sharpe
ratio. Acquiring BioTech, instead, would only lead to an enhancement in the risk component, since
the combined return would be lower.
Following the results obtained in our analysis, we consider SolarTech to be the best alternative
between the two targets, and we are convinced that the benefits generated from an acquisition of
SolarTech outperform the ones coming from the potential acquisition of BioTech.

5. Appendix
Table 1: Raw Data
Assumptions All AirTech SolarTech BioTech
Market Value 13230000 5580000 9268000
Risk free rate 4.30%
Tax rate 34.00%
Cost of debt 7% 11% 9%
% Debt 30% 25% 39%
% Equity 70% 75% 61%
This year’s cash
flows 900000 1100000
CF Growth 6.054% 4.351%
Table 2: Descriptive statistics
AirTech SolarTech BioTech
Market
Index
Returns
Monthly 2.67% 4.94% 0.97% 2.52%
Annual 37.22% 78.43% 12.32% 34.74%
St. dev.
Monthly 12.47% 10.53% 8.44% 8.24%
Annual 43.18% 36.49% 29.24% 28.54%
Sharpe
ratio 0.76 2.03 0.27 1.07
Beta 0.53 0.71 0.61 1.00
Table 3: Costs of capital
AirTech SolarTech BioTech
Ru 20.39% 26.04% 22.88%
Re 26.13% 31.05% 31.76%
Pretax
Wacc 20.39% 26.04% 22.88%

6. Table 4: Cash flows and NPV for SolarTech
Year Cash Flows
Terminal
Value NPV
0 900000 8597208.247 5676248
1 954486
2 1012270.58
3 1073553.44
4 1138546.37
5 1207473.97
6 1280574.44
7 1358100.42
8 1440319.82
9 1527516.78
10 1619992.64
Table 5: Cash flows and NPV for BioTech
Year Cash Flows
Terminal
Value NPV
0 1100000 9482953.024 7294089
1 1147861
2 1197804.432
3 1249920.903
4 1304304.961
5 1361055.27
6 1420274.785
7 1482070.941
8 1546555.848
9 1613846.493
10 1684064.953
Table 6: Post-acquisition weights
AirTech +
SolarTech
AirTech +
BioTech
Weights
AirTech 70.33% 58.81%
SolarTech 29.67%
BioTech 41.19%

7. Table 7: Post-acquisition statistics
AirTech +
SolarTech AirTech + BioTech
Returns 49.44% 26.96%
St. dev. 34.12% 30.20%
Sharpe
Ratio 1.32 0.75
Table 8: Optimal portfolio weights and statistics
Optimal Portfolio
Return 67.15%
Variance 0.76%
Standard
deviation 30.13%
Sharpe Ratio 2.09
WeightAirTech 11.72%
WeightSolarTech 78.53%
WeightBioTech 9.75%
Table 9: Correlation matrix
Correlation AirTech SolarTech BioTech
Market
Index
AirTech 1
SolarTech 0.191407 1
BioTech 0.20109 0.004671306 1
Market
Index 0.349465 0.558648156 0.5959145 1