H-P executives indicate that they use traditional discounted cash flow (DCF) analysis to evaluate investment projects and that the firm's cost of capital is about 12 Percent. Consider Exhibit 10.2 which shows how McKinsey consultants proposed that H_p value the cost savings stream stemming from its merger with Compaq.
On October 15,2003, H-P's forward P/E ratio was 16.1, less than its historical value that stoof around 20. H-P executives suggest that the lower P/E ratio reflected continued investor uncertainty about whether or not the merger would be successful. Discuss the manner in which H-P executives valued the expected cost savings stream when evaluating the merger.
In particular address the following questions: was the technique H-P executives used the same, or comparable, to traditional DCF analysis? Do you believe that H-P paid a reasonable premium for Compaq? Are there any valuation implications attached to H-P's P/E ratio being at 16 rather than 20?