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Chapter 31 - Mergers

CHAPTER 31
Mergers

Answers to Problem Sets

1. a. Horizontal. Both firms operate in the same line of business.


b. Conglomerate. The companies operate in totally separate industries.
c. Vertical. The companies operate at different stages of production (Walmart
sells the products that H.J. Heinz produces).
d. Conglomerate. The companies operate in totally separate industries. 

Est. Time: 01 – 05

2. a and d; c can also make sense, although merging is not the only way to
redeploy excess cash. b does not make economic sense as investors can
diversify on their own. e may lead to a bootstrap effect wherein the two firms’
EPS is higher, but due to no real value behind the merger, the combined value is
not increased.

Est. Time: 01 – 05

3. a. The gain from the merger is equal to the present value of the savings. It is
estimated that $500,000 per year will be saved in perpetuity. Therefore, the PV of
the savings is $500,000/10% = $5 million (we assume that the $500,000 saving is an
after-tax figure).
b. Cost = cash paid – PV(Pogo). Therefore, the cost = $14 million - $10
million = $4 million.
c. Cost = xPV(AB) – PV(B). The PV of (AB) is $35 million. Therefore, cost =
(.5 x $35 million) - $10 million = $7.5 million.
d. NPV = gain – cost. NPV = $5 million - $4 million = +$1 million.
e. NPV = gain – cost. NPV = $5 million - $7.5 million = -$2.5 million.

Est. Time: 06 – 10

4. a; a merger in which payment is entirely in the form of voting stock is generally


tax free.

Est. Time: 01 – 05

5. a. True
b. False. Sellers typically earn higher returns than buyers for two reasons.
One is that buying firms are typically larger than selling firms, so smaller benefits
normally don’t affect the buyer’s share price by much. The second reason is the
effect of competition among potential buyers.

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© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any
manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
Chapter 31 - Mergers

c. False. These firms would require a very large premium for the acquiring
firm, thereby making for a too costly acquisition target.
d. True
e. False (they may produce gains, but “large” is stretching it)
f. False
g. True

Est. Time: 01 – 05

6. a. Any premium paid by the bidder over the book value of the target’s equity
is reflected in the bidder’s balance sheet, e.g., it is shown as “goodwill.”

b. The bidder offers to buy the target’s stock directly from its shareholders.

c. The target’s stockholders can purchase additional shares at a bargain


price; poison pills are used by targeted firms as defenses against
unwanted acquirers.

d. A large block of stock is held by an unfriendly company. To keep its


independence, the target firm is induced to repurchase the stock at a
premium.

e. The gain from combining two firms

Est. Time: 01 – 05

7. Answers here will vary, depending on student choice.

Est. Time: 06 – 10

8. Answers here will vary, depending on student choice.

Est. Time: 06 – 10

9. 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 may be a net gain. It is necessary to ensure that these
gains exist and that investors would not be better off diversifying on
their own in the stock market.

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.

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© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any
manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
Chapter 31 - Mergers

c. There will still be a wealth transfer from the acquiring shareholders to


the target shareholders.

Est. Time: 06 – 10

10. Suppose the stand-alone market value of a target firm is $150 million and the
value of the firm to a strategic buyer is $200 million (that is, there are $50 million
in synergies). If the probability of a merger is 70%, then the market value of the
firm premerger could be:
($150  0.3) + ($200  0.7) = $185 million
If the acquiring managers add the $50 million in synergies to the $185 million
market value, they will overestimate the value of the acquisition and set the
reserve price too high.

Est. Time: 01 – 05

11. 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 and is breaching a fiduciary
obligation by telling you, then you are guilty of insider trading if you act upon the
information. However, if you come across the information as a result of analysis
that 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.

Est. Time: 01 – 05

12. 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     $114,000,0 00
 0.10  0 .08 

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:

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© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any
manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
Chapter 31 - Mergers

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.
This is determined by adding the outstanding shares of Leisure Products
(1,000,000) to the number of shares offered for Plastitoys’ existing stock
(1/3 x 600,000 = 200,000). 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

Est. Time: 11 – 15

13. 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 (162,172/200,000) = 0.81 shares of World
Enterprises were exchanged for each share of Wheelrim and Axle.

c. World Enterprises paid a total of (162,172  $34.33) = $5,567,365 for a


firm worth $5,000,000. Thus, the cost is:

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© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any
manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
Chapter 31 - Mergers

$5,567,365 – $5,000,000 = $567,365

d. The change in market value will be a decrease of $567,365.

Est. Time: 11 – 15

14. 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.

Est. Time: 06 – 10

15. If B’s fixed assets are actually worth $12 million, then this changes the fixed
asset entry of the combined company to $92 million. It also reduces the goodwill
from $8 million to $5 million. Therefore, Table 31.3 becomes:
NWC 21 30 D
FA 92 88 E
Goodwill 5
118 118
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.

Est. Time: 06 – 10

16. Answers here will vary, depending on student choice.

Est. Time: 06 – 10

17. 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.

Est. Time: 06 – 10

18. The reduction in operating costs is worth .45/.11 = ¥4.1 billion.

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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
Chapter 31 - Mergers

a. The NPV to Wasabi of a cash offer to Haiku is −14 + 11 + 4.1 = + ¥1.1 billion.
So Wasabi’s market value should increase to ¥21.1 billion. With a stock offer,
Wasabi would retain 67% of a merged firm worth 20 + 11 + 4.1 = ¥35.1 billion.
Wasabi’s market value should increase to .67×35.1 = ¥23.5 billion. On this
calculation, the stock offer is better for Wasabi’s shareholders.

b. On the other hand, a stock offer could send a negative signal that would drive
down Wasabi stock price and force it to issue more shares to finance the
acquisition. A decision to issue stock instead of paying cash could suggest a lack
of confidence by Wasabi management. See the discussion of “Market Reaction
to Stock Issues” in Ch. 15, pp. 387-389. See also Section 18-4.

Est. Time: 06 – 10

19. It’s tempting to think that acquisitions of European companies is especially


attractive when the U.S. dollar is trading high vs. the euro. But a fall in the euro
relative to the dollar is not sufficient cause for a takeover by the U.S. company.
The cost of the takeover falls, but the present value of a European company’s
(euro) earnings should fall proportionally. The present value of merger gains
(synergies) may or may not increase when the euro falls. If the U.S. company is
convinced that the euro is undervalued relative to the dollar, then it can simply
buy euros in the market for foreign exchange. No need to buy a European
company.

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20. The answer to this solution requires student self-study and there is no one
correct answer.

Est. Time: 06 – 10

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© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any
manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.