Mergers

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CHAPTER 33 Mergers Answers to Practice Questions 1. Answers here will vary, depending on student choice. 2. Answers here will vary, depending on student choice. 3. a. This is a version of the diversification argument. The high interest rates reflect the risk inherent in the volatile industry. However, if the merger allows increased borrowing and provides increased value from tax shields, there will be a net gain. b. The P/E ratio does not determine earnings. The efficient markets hypothesis suggests that investors will be able to see beyond the ratio to the economics of the merger. c. There will still be a wealth transfer from the acquiring shareholders to the target shareholders. 4. Start with the market value of the combined firm and subtract the market value of the acquiring firm pre-merger. This is the gain from the merger. The cost of the merger can be determined in the following way. First, determine what percentage of the combined firm the target shareholders now own as a result of receiving shares. Now multiply this percentage by the market value of the combined firm. This is the cost of the merger using post-merger pricing. 5. Suppose the market value of the acquiring firm is $150 million and the value of the firm with a merger is $200 million. If the probability of a merger is 70%, then the market value of the firm pre-merger could be: ($150 × 0.3) + ($200 × 0.7) = $185 million If the acquiring managers used this value, they would underestimate the value of the acquisition. 6. This is an interesting question that centers on the source of the information. If you obtain the information from someone at Backwoods Chemical whom you know has access to this valuable information, then you are guilty of insider trading if you act upon it. However, if you come across the information as a result of analysis you have done or research you have performed (which anyone could have done, but did not do), then you are free to act upon the information. 58
7. a. Use the perpetual growth model of stock valuation to find the appropriate discount rate (r) for the common stock of Plastitoys (Company B): 0.80 = 20 ⇒ r = 0.10 = 10.0% r − 0.06 Under new management, the value of the combination (AB) would be the value of Leisure Products (Company A) before the merger (because Company A’s value is unchanged by the merger) plus the value of Plastitoys after the merger, or:   0.80 PVAB = (1,000,000 × 90) + 600,000 ×   0.10 − 0 .08  = $114,000,0 00    We now calculate the gain from the acquisition: Gain = PVAB − (PVA + PVB ) Gain = $114,000,0 00 − ($90,000,0 00 + $12,000,00 0) = $12,000,00 0 b. Because this is a cash acquisition: Cost = Cash Paid – PVB = (25 × 600,000) – 12,000,000 = $3,000,000 c. Because this acquisition is financed with stock, we have to take into consideration the effect of the merger on the stock price of Leisure Products. After the merger, there will be 1,200,000 shares outstanding. Hence, the share price will be: $114,000,000/1,200,000 = $95.00 Therefore: Cost = (95 × 200,000) - (20 × 600,000) = $7,000,000 d. If the acquisition is for cash, the cost is the same as in Part (b), above: Cost = $3,000,000 If the acquisition is for stock, the cost is different from that calculated in Part (c). This is because the new growth rate affects the value of the merged company. This, in turn, affects the stock price of the merged company and, hence, the cost of the merger. It follows that: PVAB = (90 × 1,000,000) + (20 × 600,000) = $102,000,000 The new share price will be: $102,000,000/1,200,000 = $85.00 Therefore: Cost = (85 × 200,000) - (20 × 600,000) = $5,000,000 59
8. a. We complete the table, beginning with: Total market value = $4,000,000 + $5,000,000 = $9,000,000 Total earnings = $200,000 + $500,000 = $700,000 Earnings per share equal to $2.67 implies that the number of shares outstanding is: (700,000/2.67) = 262,172. The price per share is: ($9,000,000/262,172) = $34.33 The price-earnings ratio is: (34.33/2.67) = 12.9 b. World Enterprises issued (262,172 - 100,000) = 162,272 new shares in order to take over Wheelrim and Axle, which had 200,000 shares outstanding. Thus, (162,172/200,00) = 0.81 shares of World Enterprises were exchanged for each share of Wheelrim and Axle. World Enterprises paid a total of (162,172 × $34.33) = $5,567,365 for a c. firm worth $5,000,000. Thus, the cost is: $5,567,365 - $5,000,000 = $567,365 d. The change in market value will be a decrease of $567,365. 9. In a tax-free acquisition, the selling shareholders are viewed as exchanging their shares for shares in the new company. In a taxable acquisition, the selling shareholders are viewed as selling their shares. Whether the acquisition is tax-free or taxable also affects the resulting firm’s tax position. If the acquisition is tax-free, the firms are taxed as though they had always been together. If the acquisition is taxable, the assets of the selling firm are revalued, which may produce a taxable gain or loss and which affects future depreciation, and, hence, depreciation tax shields. It follows that buyers and sellers will only agree to a taxable merger when the tax benefits to one group outweigh the tax losses to the other and some middle ground is agreed upon. 10. Table 33.3 becomes: NWC 2.1 3.0 D FA 9.2 8.8 E Goodwill 0.5 11.8 11.8 If the acquisition is tax-free, then the value of AB Corporation does not change. If the acquisition is taxable, the revaluation of fixed assets increases the allowable depreciation, but the write-up in asset value is a taxable gain. This reduces the value of AB. 60
11. The common theme in Pickens’s attempts was to force management to operate the businesses in a way that maximized shareholders’ wealth. Through take- over attempts, Pickens forced management to re-examine operations and to find ways to cut operating costs, eliminate negative NPV projects and return cash to the shareholders. This usually involved share repurchases which increased the market value of the firm. On the whole, this is an example of the market disciplining a firm to become more efficient. 12. a. The available evidence indicates that shareholders are generally better off as sellers. The reason seems to be competition. Once a company is “in play,” the potential suitors are attracted and a bidding war ensues. By the time a winner is declared, whatever gains there are to the merger accrue mostly to the seller. b. An active acquisition strategy makes sense for any company and its shareholders whenever other companies can be purchased such that the benefits to the merger outweigh the cost. This is, of course, much easier said than done. 13. Adherents of the free-cash-flow hypothesis would argue that NatWest was expending resources in unproductive ways, in other words, that NatWest was unable to profitably operate its U.S. retail banking operations, for whatever reason. Thus, when these operations were sold, even though at less than full value, the action was viewed positively because it meant an end to further losses. Also, NatWest’s serious consideration of the possibility of putting this money into the hands of the stockholders would be viewed as another sign that management would not waste shareholder resources on unprofitable ventures. 61
Challenge Questions 1. Answers here will vary, depending on student choice. 2. Answers here will vary, depending on one’s views of the proper role of government, as well as one’s views of the role of financial markets. 3. There are many possible reasons for this rule, which gives the first firm a significant advantage in the bidding process. One reason is that the first firm did the initial work to identify the potential of the target firm and so deserves to have the best chance to reap the benefits. Whether it should be introduced into the United States is debatable and depends on one’s views on the proper role of government, as well as one’s views of the role of financial markets. 4. If you do, please contact the authors of the text; they, and most of the rest of the finance profession, would dearly love to better understand merger activity. 62