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Dewangga Alamsyah – 1406611732

Alwan Rais – 1506749975

Naufal Maulana – 1506738611

Suryo Pujo Nagoro - 1506720034

1. Why did jessica Gallinelli buy shares in Honeywell and short sharws in GE

After the merger with AlliedSignal, Honeywell’s CEO predict that the company would increase the
earnings per share by at least 20% per year. That means the company would give the holders much
more return in dividend much more than before the merger. That announcement would make the
Honeywell price of shares increasing than before because the expected return would be bigger than
before. But after six months after completion of the deal, the CEO said the expected return would not
meet the prediction which is 14% but would be 12%. This announcement would make the price per
shares declining. The investors would expecting the company to make another merger to make the
company' shares increase again and meet the prediction

Afyer the declining of Honeywell' price per shares, it had an offer with UTC Company to have a merger.
The discussion od the merger with UTC make the price up to 10 bucks in the short term. It wasn't stop
there, the Honeywell also have a bid with General Electronic with 1:1 shares-per-shares exchange ratio.
This offer would bring the price of shares of Honeywell rise. The GE company was one of the largest and
most diversified company in the world that would make the honeywell get bigger earnings per shares.
after the announcement of the bid the price of Honeywell would be rise.

Jessica Gallinelli should buy shares with Honeywell because after the merger with the GE company, the
dividends of Honeywell would ne increasing because the revenue of both company. It would make
Jessica gain the return from the dividend higher. But the price of Honeywell would be increasing after
the announcement, the merger, and declaration of dividends. Jessica would bought the shares in higher
price after two announcement of the merger. Instead of buying the Honeywell shares in the short
period, she should rather buy the GE shares. Because in the short term the price of GE would be
increasing with the announcement of the merger and also it would ne 1:1 exchange ratio to get the
Honeywell' shares. So Jessica would have the Honeywell company's shares with lower price from the GE
and also gain from the dividends bigger after the merger.

2. What is the share value range of Honeywell?

WACC = 10.69%

2001E 2002E 2003E 2004E 2005E

EBIT 3448 3655 3874 4107 4232
(Taxes) 1069 1133 1201 1273 1340
Net operating profit after tax 2379 2522 2673 2834 2983
Depreciation 197 446 472 501 466
Subtotal 2576 2968 3146 3334 3449
(Change in NWC) -2 308 326 346 322
(Capital Investment) 537 780 827 876 815
FCF from Operations 2041 1880 1993 2113 2312
Terminal Value 44917

Value of Company = 2041/1.107 + 1880/1.107^2 + 1993/1.107^3 + 2113/1.107^4 + (2312 +

44917)/1.107^5 = 34684

Value of Debt = 5251

Value of Equity = 29432

Value per share = 36.72

Number of shares outstanding = 29432/36.72 = 801.5

The common shares’ forecast is constant, which implies that the value per share might also be constant.
In the following years (unless there is a possible change in the future value of the entity’s equity, there
won’t be any range of share values)

3. What is the return of Gallinelli’s arbitrage position to date?

Position and Payoff in Target Shares

Buy Target shares at

Value of Target Shares at End of Holding Period

Gross Spread Per Share on Target shares

Total value of Gross spread on Target Shares (× No. of shares (million)) 10

Position and Payoff in Buyer Shares

Short Buyer shares at

Value of Buyer Shares at End of Holding Period

Gross Spread Per Share on Buyer shares

Total Value of Gross Spread on Buyer Shares (× No. of shares (million)) 10

Total Assets of the Arbitrage Position

Short Position in Buyer Shares

Borrowed shares of Buyer


Debt @ % Assets

Capital Employed
Total Liabilities and Capital of the Arbitrage Position

Net Spread Calculation

Gross Spread

(-) Interest @ 15%


(-) Short Dividends Foregone

(+) Long Dividends Received

Net spread

Days in holding period



Return on capital for holding period only: 37%

Return on capital annualized: 105%

4. What is the EC’s recent announcement change the investor’s outlook about the consummation of
the deal?

The market will react negatively to the review initiated by European Commission with share prices of
both GE and Honeywell going down instantaneously. Reasonably, before the news was released by
regulators, both stocks had been underperforming for several days. This preceding decrease is typically
because the market had anticipated the bad news. As post-event drift is mainly after news and is usually
very robust (Wesley. Chan, 2000), then after the official announcement, the stocks will continue drifting
downwards unless other good news are presented to the public or the market revises its expectation.

Concerning arbitrage spread, it is defined as the difference between post-announcement share price for
the target firm and the offer price by the bidder (Betton, Eckbo and Thornburn, 2008). Based on our
formulas below,

Pcurrent = prob. x Pbid + (1 – prob.) x Pstand-alone (1)

Arbitrage spread = Pbid - Pcurrent (2)

we can arrive at formula (3), which interprets that the spread is related inversely to the possibility that
the deal goes through, i.e. with other factors remaining constant, the higher the probability of
consummation is, the narrower the discrepancy (between today’s share price for the acquiree and the
bid price) is, or vice versa.

Arbitrage spread = (Pbid - Pstand-alone) x (1 – prob.) (3)

Therefore, arbitrage spread is an indicator of the possibility of merger. Specifically, when the arbitrage is
small, good opportunities are that the merger will be conducted eventually. While when arbitrage
spread is big, it may, to a large extent, suggest that the deal will not be consummated at all (Bruner,
2004). Since the arbitrage spread diminishes at the end of an M&A when target firm’s share price equals
to the share price of the takeover firm, the conclusion suits best when M&A is done entirely through
stock exchange (Value Research, 2012).

Additionally, as probability always fall into the range of 0 and 1, we delete all cells with probability
outside the range, which occurs Honeywell’s stand-alone values exceed its share prices. Nevertheless, it
is necessary to clarify that even though we delete these values, it is still possible for this M&A to be
conducted. Because the market always leads bidders to purchase assets of undervalued targets (Betton,
Eckbo, Thorburn, 2008) and when the share price is less than the stand-alone value, it implies that the
firm is undervalued by the market.

To be more specific, Figure 1 in Question 1 demonstrates this inverse relationship between arbitrage
spread and possibility as well. From the declaration of GE-Honeywell merger to the beginning of
December 2000, the arbitrage spread decreased continuously from $4.27 to $2.62. However, the spread
leaped back to $4.15 on December 15th as Honeywell pre-announced its would-be lower-than-
expectation quarter earnings (ICIS Chemical Business, 2001). Its bad performance and customer
uncertainty due to divesting business units may well influence GE’s interest in taking it over.
Simultaneously, the market updated the prediction that probability of consummation would be
impaired by the news, which explains the abrupt jump in the spread. Afterwards, the spread did not go
against the decreasing trend until EC announced the antitrust scrutiny. Since the investigation raised
stakeholders’ concern that this combination would fail in the end, a significant increase in spread was
brought about.

5. What should Gallinelli do?

First of all, as already mentioned in question 1, the whole transaction will not be completed in the first
quarter of 2001 and thus lead to higher merger-related expenses (Elliott, 2001). Further to this, it also
diminishes the potential synergies, which are already projected and reflected the current value of GE
and Honeywell. As a result, those news will clearly affect GE and Honeywell negatively and will lead to
falling stock prices, but even more important for Gallinelli, it will widen the spread between both
companies. This is highly unfavourable for her positions as the share of Honeywell will no longer have
the same correlation to GE’s stock price and thus her merger arbitrage strategy will not work anymore.

In our view, the best strategy from this situation is to reduce/close her long position in Honeywell and
increase instead the short holding in GE to profit from falling stock prices. However, this strategy is hard
to follow due to the limited trading volume, nevertheless as an interesting alternative, she can buy
either put options and write call options on both stocks.

Further to this, buying put options is the better alternative than writing call options as on one hand the
implied volatility will increase after the EU-announcement, which will lead to higher intrinsic value of the
option. On the other hand, Gallinelli would only get the option premium, which would only partly offset
her losses, depending on strike price and time to maturity (Mullaney, 2009). Unfortunately, she will not
running a merger arbitrage strategy anymore, however she will be able to perform clearly better from
the dropping stocks. If she is going to follow a market neutral strategy as it is probably written in the
fund prospectus, another possibility is to bet on widen spread as the deal will not be completed in the
first quarter of 2001 and thus the uncertainty of the transaction will increase, which will result in a
widen arbitrage spread. That means, she has to reverse both positions by selling Honeywell and buying
GE stocks simultaneously. To further enhance this strategy, she has to buy as well put options on
Honeywell and buy call options on GE. As a result, she will be able to generate profit from a widen
arbitrage spread in the short-term.