Questions

Q.1 Acquiring Corp. is considering a takeover of Takeover Target Inc. Acquiring has 10 million shares
outstanding, which sell for $40 each. Takeover Target has 5 million shares outstanding, which sell for
$20 each. If the merger gains are estimated at $25 million, what is the highest price per share that
Acquiring should be willing to pay to Takeover Target shareholders?

Q.2 If Acquiring Corp. from previous problem has a price-earnings ratio of 12 and Takeover Target has a
P/E ratio of 8, what should be the P/E ratio of the merged firm? Assume in this case that the merger is
financed by an issue of new Acquiring Corp. shares. Takeover Target will get one Acquiring share for
every two Takeover Target shares held.

Q.3 Velcro Saddles is contemplating the acquisition of Pogo Ski Sticks, Inc. The values of the two
companies as separate entities are $20 million and $10 million, respectively. Velcro Saddles estimates
that by combining the two companies, it will reduce marketing and administrative costs by $500,000 per
year in perpetuity. Velcro Saddles is willing to pay $14 million cash for Pogo. The opportunity cost of
capital is 8%.

(a) What is the gain from merger?

(b) What is the cost of the cash offer?

(c) What is the NPV under the stock offer?

Q.4 Castles in the Sand currently sells at a price-earnings multiple of 10. The firm has 2 million shares
outstanding, and sells at a price per share of $40. Firm Foundation has a P/E multiple of 8, has 1 million
shares outstanding, and sells at a price per share of $20.

(a) If Castles acquires the other firm by exchanging one of its shares for every two of Firm Foundation,
what will be the earnings per share of the merged firm?

(b) What should be the P/E of the new firm if the merger has no economic gains? What will happen to
Castle’s price per share? Show that shareholders of neither Castles nor Firm Foundation realize any
change in wealth.

(c) What will happen to Castle’s price per share if the market does not realize that the P/E ratio of the
merged firm ought to differ from Castle’s pre-merger ratio?