Solutions Manual

CHAPTER 21

MERGERS AND ACQUISITIONS;

DIVESTITURES

Answer to Questions

1. In a merger, two or more companies are combined, but only the identity of the
acquiring firm is maintained. In a consolidation, an entirely new entity is formed
from the combined companies.
2. If two firms benefit from opposite phases of the business cycle, their variability
in performance may be reduced. Risk-averse investors may then discount the
future performance of the merged firms at a lower rate and thus assign a higher
valuation than was assigned to the separate firms.
3. Horizontal integration is the acquisition of competitors, and vertical integration
is the acquisition of buyers or sellers of goods and services to the company.
Antitrust policy generally precludes the elimination of competition. For this
reason, mergers are often with companies in allied but not directly related fields.
4. Synergy is said to occur when the whole is greater than the sum of the parts.
This “2 + 2 = 5” effect may be the result of eliminating overlapping functions in
production and marketing as well as meshing together various engineering
capabilities. In terms of planning related to mergers, there is often a tendency to
overestimate the possible synergistic benefits that might accrue.
5. The firm can achieve this by acquiring a company at a lower P/E ratio than its
own. The firm with lower P/E ratio may also have a lower growth rate. It is
possible that the combined growth rate for the surviving firm may be reduced
and long-term earnings growth diminished.
6. If earnings per share show an immediate appreciation, the acquiring firm may be
buying a slower growth firm as reflected in relative P/E ratios. This immediate
appreciation in earnings per share could be associated with a lower P/E ratio.
The opposite effect could take place when there is an immediate dilution to
earning per share. Obviously, a number of other factors will also come into play.
7. Under the “pooling of interests”, the financial statements of the firms are
combined subject to some minor adjustments and no goodwill is created. Under
a “purchase of assets”, the difference between purchase price and adjusted book
value is established on the statement of financial position as goodwill and must
be written off over a maximum period of 40 years.

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8. An unfriendly takeover may be avoided by:
a. Turning to a second possible acquiring company – a “White Knight”.
b. Moving corporate offices to states with tough pre-notification and
protection provisions.
c. Buying back outstanding corporate equity share.
d. Encouraging employees to buy equity share.
e. Staggering the election of directors.
f. Increasing dividends to keep shareholders happy.
g. Buying up other companies to increase size and reduce vulnerability.
h. Reducing the cash position to avoid a leveraged takeover.
9. While management may wish to maintain their autonomy and perhaps keep their
jobs, shareholders may wish to get the highest price possible for their holdings.
10. The advantages of using convertible securities as a method of financing mergers
are as follows:
a. Potential earnings dilution may be partially minimized by issuing a
convertible security. If such a security is designed to sell at a premium
over its conversion value, fewer common shares will ultimately be
issued. For example, if the acquirer’s share currently has a market price
of P50 per share, and the price of the acquisition is P10 million, using
ordinary equity share would require issuing 200,000 shares. In
comparison, a convertible preferred issue could be designed to sell at
P100 with a 1.7 conversion ratio, which would mean a conversion
value of P85. The P10 million price would be realized by issuing
100,000 preferred shares convertible into 170,000 shares of ordinary
equity share. The purchaser would have decreased the eventual number
of shares to be issued, thereby reducing the dilution in earnings per
share that could ultimately result.
b. A convertible issue may allow the acquiring company to comply with
the seller’s income objectives without changing its own dividend
policy. If the two firms have different dividend payout policies and the
acquirer does not want to commit its ordinary equity share to a
dividend rate that suits the seller, convertible preferred share may be an
appropriate solution.
c. Convertible preferred share also represents a possible way of lowering
the voting power of the acquired company. This reduction of voice in
management can be important, especially if the seller is a closely held
corporation.

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 d. The convertible preferred debenture or equity share may appear more
attractive to the firm being acquired because it combines senior security
protection with a portion of the growth potential of ordinary equity
share.
11. The deferred payment plan, which has come to be called an earn-out, represents
a relatively recent approach to merger financing. The acquiring firm agrees to
make a specified initial payment of cash or equity share and, if it can maintain or
increase earnings, to pay additional compensation.
12. The amount of the future payments will be determined by three factors:
a. the amount of earnings in the forthcoming years in excess of the base-
period profits;
b. the capitalization rate (discount rate) agreed upon by the parties; and
c. the market value of the acquiring organization at the end of each year.
13. Refer to page 605.

Answer to Multiple Choice Questions

1. C 5. B 9. B 13. A
2. D 6. D 10. A 14. C
3. A 7. D 11. D 15. D
4. D 8. C 12. B

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