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1FIN B386F Financial Decision Making Learning Objectives Outline – 2 Merger & Acquisition 3 Legal procedures of Acquisition 3 Types of Acquisition Valuation of Synergy benefits from Acquisition Synergy benefits: 4 main sources Financing for Acquisition By Cash offer By Share offer Dubious reasons: EPS growth & Diversification Divestitures & Corporate Restructuring 4 Types of Divestitures Reasons for Divestitures Reasons for failure Acquisition Defensive Tactics Takeovers – The Market for Corporate Control There are 3 ways to change the management control of a firm. These are: a)Acquisition: The purchase of one firm by another in a merger or acquisition b)Proxy Contest: This is an attempt to gain control of a firm by soliciting enough stockholder votes to replace existing management c)Going Private (Leverage buyout): A leverage buyout of a firm by a private group of investors (When this group is led by the company’s management, the acquisition is called a management buyout MBO) 3 Mergers and Acquisitions Three basic legal procedures one firm can use to acquire another firm: 1. Merger or consolidation 2. Acquisition of stock 3. Acquisition of assets These forms are different from a legal standpoint, but the financial press frequently does not distinguish between them Merger is often used regardless of actual form of the acquisition Acquiring firm is referred to as the bidder, the company that offers to distribute cash or securities to obtain the stock or assets of another company Firm that is sought (and perhaps acquired) is called the target firm Cash or securities offered to the target firm are the consideration in the acquisition 4 Mergers and Acquisitions Merger is the complete absorption of one company by another, wherein the acquiring firm retains its identity and the acquired firm ceases to exist as a separate entity. The bidder remains and the target ceases to exist. Consolidation is a merger in which an entirely new firm is created and both the acquired firm and the acquiring firm cease to exist. A new firm is created. Joined firms cease their previous existence. The rules for mergers and consolidation ae basically the same. Acquisition by merger or consolidation results in a combination of the assets and liabilities of acquired and acquiring firms; the only difference lies in whether or not a new firm is created. 5 Company A Company B Company A Company B ceases to exist Company A Company B Company C Company A & B no longer exist Mergers and Acquisitions Some advantages and some disadvantages of using a merger: Primary advantage is that a merger is legally simple and does not cost as much as other forms of acquisition Firms agree to combine their entire operations, so there is no need to transfer title to individual assets of the acquired firm to the acquiring firm Primary disadvantage is that a merger must be approved by a vote of the stockholders of each firm Typically, two-thirds (or more) of the share votes are required for approval and obtaining the necessary votes can be time-consuming and difficult. 6 Acquisition of stock Another way to acquire another firm is to purchase the firm’s voting stock with an exchange of cash, shares of stock, or other securities Process will often start as private offer from management of one firm to that of another. Tender offer is a public offer by one firm to directly buy the shares of another firm Communicated to the target firm’s shareholders by public announcements such as those made in newspaper advertisements Tender offer is frequently contingent on the bidder’s obtaining some percentage of the total voting shares Shareholders who choose to accept the offer tender their shares by exchanging them for cash or securities (or both), depending on the offer 7 Acquisition of stock Some factors involved in choosing between an acquisition by stock and a merger: In an acquisition by stock, no shareholder meetings must be held and no vote is required If the shareholders of the target firm don’t like the offer, they are not required to accept it and need not tender their shares In an acquisition by stock, the bidding firm can deal directly with the shareholders of the target firm by using a tender offer Acquisition is occasionally unfriendly. In such cases, a stock acquisition is used to circumvent the target firm’s management, which is usually actively resisting acquisition Frequently, a significant minority of shareholders will hold out in a tender offer; target firm cannot be completely absorbed when this happens, and this may delay realization of merger benefits or be costly in some other way Complete absorption of one firm by another requires a merger 8 Acquisition of assets A firm can effectively acquire another firm by buying most or all of its assets Target firm will not necessarily cease to exist; it will have just sold off its assets “Shell” will still exist unless its stockholders choose to dissolve it This type of acquisition requires a formal vote of the shareholders of the selling firm Advantage to this approach is that there is no problem with minority shareholders holding out Disadvantage is that the acquisition of assets may involve transferring titles to individual assets, and the legal process of transferring assets can be costly 9 Types of Acquisition Financial analysts typically classify acquisitions into three types: 1. Horizontal acquisition is an acquisition of a firm in the same industry as the bidder One risk in a horizontal merger is antitrust regulations 2. Vertical acquisition involves firms at different steps of the production process 3. Conglomerate acquisition occurs when the bidder and the target firm are in unrelated lines of business Popular in the technology area Firms don’t have to merge to combine their efforts Strategic alliance is an agreement between firms to cooperate in pursuit of a joint goal Joint venture is typically an agreement between firms to create a separate, co-owned entity established to pursue a joint goal 10 A diagram illustrating horizontal integration and contrasting it with vertical integration. 11 Forward vertical integration when it controls distribution centers and retailers where its products are sold. Backward vertical integration when it controls subsidiaries that produce some of the inputs used in the production of its products. A diagram illustrating horizontal integration and contrasting it with vertical integration. Types of Acquisition Questions: Are the following hypothetical mergers horizontal, vertical or conglomerate a) IBM acquires the computer manufacturer Lenovo Horizontal merger. IBM is in the same industry as Lenovo b) Lenovo acquires Safeway ( a supermarket chain) Conglomerate merger. Lenovo and Safeway are in different industries. c) Safeway acquires Campbell Soup Vertical merger. Safeway is expanding backward to acquire one of its suppliers, Campbell Soup. d) Campbell Soup acquires IBM. Conglomerate merger. Campbell and IBM are in different industries. 12 13 Why might mergers and acquisitions be beneficial Synergy Effect The whole is worth more than the sum of the parts Some mergers create synergies because the firm can either cut costs or use the combined assets more effectively This is generally a good reason for a merger Examine whether the synergies can create enough benefit to justify the cost for the following 4 basic categories. a) Revenue enhancement b) Cost reduction c) Lower taxes d) Reduction in capital needed Synergy Suppose Firm A is contemplating acquiring Firm B Successful merger requires value of the whole (i.e., combined firm) exceed the sum of the parts (i.e., values of separate firms) If VAB is the value of the merged firm, and VA and VB are the values of the separate firms, the merger makes sense only if: VAB > VA + VB (The whole is more than the sum of the parts) Difference between the value of the combined firm and the sum of the values of the firms as separate entities is the incremental net gain from the acquisition, ΔV: ΔV = VAB (VA + VB) Synergy is the positive incremental net gain associated with the combination of two firms through a merger or acquisition When ΔV is positive, the acquisition is said to generate synergy 14 Synergy If Firm A buys Firm B, it gets a company worth VB plus the incremental gain, ΔV, so the value of Firm B to Firm A (VB *) is: Value of Firm B to Firm A (Acquiring firm) = VB * = ΔV + VB VB * can be determined in two steps: 1. Estimating VB 2. Estimating ΔV If B is a public company, its market value as an independent firm under existing management (VB) can be observed directly, but if Firm B is not publicly owned, its value will have to be estimated based on similar companies that are publicly owned 15 Synergy To determine the incremental value of an acquisition, we need to know the incremental cash flows, ΔCF, the cash flows for the combined firm less what A and B could generate separately: ΔCF = ΔRevenue ΔCost ΔTax ΔCapital requirements Merger will make sense only if one or more of these cash flow components are beneficially affected by the merger. Possible cash flow benefits of mergers and acquisitions fall into four basic categories: a) Revenue enhancement b) Cost reductions c) Lower taxes d) Reductions in capital needs 16 P/L B/S Revenue Enhancement Marketing gains might occur as a result of improvements in the following areas as a result of changes in advertising efforts, changes in the distribution network, changes in the product mix. a) Previously ineffective media programming and advertising efforts b) A weak existing distribution network c) An unbalanced product mix Strategic benefits are opportunities to take advantage of the competitive environment if certain things occur or, more generally, to enhance management flexibility with regard to the company’s future operations Beachheads – acquisitions that allow a firm to enter a new industry that may become a platform for further expansion Increases in market power (reduction in competition or increase in market share) may result in profit enhancements through higher prices. Mergers that substantially reduce competition may be challenged by U.S. Department of Justice or Federal Trade Commission on antitrust grounds 17 Cost Reductions Economies of scale relate to the average cost per unit of producing goods and services Ability to produce larger quantities while reducing the average per unit cost Most common in industries that have high fixed costs Spreading overhead refers to sharing central facilities such as corporate headquarters, top management, and computer services Economies of vertical integration have a main purpose of making it easier to coordinate closely related operating activities Coordinate operations more effectively Reduced search cost for suppliers or customers For example, most forest product firms that cut timber also own sawmills and hauling equipment Complementary resources are characterized by some firms acquiring others to make better use of existing resources or to provide the missing ingredient for success For example, a ski equipment store may merge with a tennis equipment store to produce more even sales over both the winter and summer seasons, thereby better using store capacity Anther example: banks that allow insurance or stock brokerage services to be sold on premises 18 Lower Taxes Possible tax gains from an acquisition include the following: a) Take advantage of net operating losses Carry-backs and carry-forwards Merger may be prevented if the tax authorities believe the sole purpose is to avoid taxes b) Unused debt capacity Allows merged firms to borrow more giving rise to tax shields c) Surplus funds Under free cash flow, firms are encouraged to pay dividends to remove the free cash from the firm. This method may result in shareholders having to pay more taxes. Using the excess cash for acquisitions avoids having to pay additional taxes. Net operating losses (NOL) are tax losses a firm cannot use because they lost money on a pretax basis (and will not pay taxes) 19 Reductions in Capital needs All firms must invest in working capital and fixed assets to sustain an efficient level of operating activity A merger may reduce the required investment in working capital and fixed assets relative to the two firms operating separately Acquiring firms may be able to manage existing assets more effectively under one umbrella Can occur with a reduction in working capital resulting from more efficient handling of cash, accounts receivable, and inventory Acquiring firm may also sell off certain assets that are not needed in the combined firm Some assets may be sold if they are redundant in the combined firm (this includes reducing human capital as well) 20 Analytical income statement Sales – Total variable costs – Fixed costs EBIT (Operating income) – Interest EBT – Taxes Net income 21 Revenue Enhancement Cost Reductions Lower Taxes Dubious reason for EPS Growth Mergers and acquisition may give the appearance of growth in EPS without actually changing cash flows. Buying a firm with a lower P/E ratio can increase earnings per share. But the increase should not result in a higher share price. If there are no synergies or other benefits to the merger, then the growth in EPS is not true growth. Example: Suppose Global Resources, Ltd., acquires Regional Enterprises, but the merger creates no additional value; after the merger we should have the following information if the market is smart. Global will have 140 shares outstanding Market value of the combined firm is $3,500 Earnings per share of the merged firm are $1.43 Because the stock price of Global after the merger is the same as before the merger, the price-earnings ratio must fall. 22 Dubious reason for EPS Growth Acquisition can create appearance of EPS growth Suppose Global Resources, Ltd., acquires Regional Enterprises. The financial positions of both firms before the acquisition is shown below. Assume the merger creates no additional value, so the combined firm (Global Resources after acquiring Regional) has a value that is equal to the sum of the values of two firms before the merger. Before the merger, both firms have 100 shares outstanding. However, Global sells for $25 per share versus a price of $10 per share for Regional. Global acquires Regional by exchanging 1 of its share for every 2.5 shares in Regional. Because there are 100 shares in Regional, this will take 100/2.5 = 40 shares in all. After the merger, Global will have 140 shares outstanding and several things will happen. 23 Dubious reason for EPS Growth The market value of the combined firm is $3,500, that is $2,500 plus $1,000. This is equal to the sum of the values of these 2 firm before the merger and the price per share $3,500/140 = $25 If the market is “smart”, it will realize that the combined firm is worth the sum of the values of these 2 separate firms. The earnings per share of the merged firm is $1.43 ($200/140) and the acquisition enables Global to increase its earnings per share from $1 to $1.43, an increase of 43 %. Because the stock price of Global after the merger is the same as before the merger (the merger creates no additional value), the price-to-earnings ratio must fall to 17.50, that is, $25/$1.43 and recognizes that the total market value has not been altered by the merger. 24 P/E must fall $200/140 $3,500/140 $2,500+ $1,000 Dubious reason for EPS Growth If the market is “fooled”, it might mistake the 43% increase in earnings per share for true growth. In this case, the PE ratio of Global may not fall after the merger and remains equal to 25. Because the combined firm has earnings of $200, the total value of the combined firm will increase to $5,000 (25 x $200). The per share value for Global will increase to $35.71 ($5,000/140). This is earnings growth is illusion only as can be seen, the merger does not create value. 25 Bootstrapping In the previous example, Global takes over Regional and it is assumed that the post acquisition value of the combined company can be estimated by applying Global’s P/E ratio to be combined company’s earnings. This is known as bootstrapping and it is based on th

at the market will assume that the management of the acquiring company will be able to apply common approach to both companies after the takeover, thus improving the performance of the acquired company by using the methods that they have been using on their own company before the takeover. 26 Dubious reason for Diversification Diversification is commonly mentioned as a benefit of a merger, but diversification is not a good reason for a merger because: Diversification doesn’t create value itself because diversification reduces unsystematic, not systematic risk. Value of an asset depends on its systematic risk, and systematic risk is not directly affected by diversification Because the unsystematic risk is not especially important, there is no particular benefit from reducing it Stockholders can get all the diversification they want by buying stock in different companies. They can diversify their own portfolio more cheaply than a firm can diversify by acquisition. As a result, they won’t pay a premium for a merged company for the benefit of diversification Reducing unsystematic risk benefits bondholders by making default less likely. 27 The Cost of an Acquisition by Cash and Stock We learned earlier the net incremental gain from a merger is: ΔV = VAB (VA + VB) Total value of Firm B to Firm A, VB *, is: VB *= VB + ΔV Net present value (NPV) of the merger is: NPV = VB * Cost to Firm A of the acquisition Suppose the premerger information below applies for Firms A and B: Both of these firms are 100% equity You estimate the incremental value of the acquisition, ΔV, is $100 Board of Firm B has indicated that it will agree to a sale if the price is $150, payable in cash or stock 28 The cost of an acquisition: Cash acquisition Should Firm A acquire Firm B Should it pay in cash or stock Value of Firm B to Firm A is: VB * = ΔV + VB = $100 + $100 = $200 If Firm A pays $150 in cash to purchase all the shares of Firm B, the cost of acquiring Firm B is $150 and the NPV of a cash acquisition is: NPV = VB * Cost = $200 $150 = $50 After the merger, Firm AB will still have 25 shares outstanding Value of Firm A after the merger is: VAB = VA + (VB * Cost) = $500 + $200 $150 = $550 Price per share after merger is $550/25 = $22, representing a gain of $2 per share 29 The cost of an acquisition: Stock acquisition Value of merged firm in this case will equal the premerger values of Firms A and B plus the incremental gain from the merger, ΔV: VAB = VA + VB + ΔV = $500 + $100 + $100 = $700 To give $150 worth of stock for Firm B, Firm A will have to give up $150/$20 = 7.5 shares After the merger, there will be 25 + 7.5 = 32.5 shares outstanding, and the per share value will be $700/32.5 = $21.54 Total value of consideration received by B’s stockholders is 7.5 × $21.54 = $161.54 NPV of the merger to Firm A is: NPV = VB * Cost = $200 $161.54 = $38.46 Cash acquisition (from previous slide) is better in this case for Company A (the acquirer). 30 31 Stock Acquisition Evaluating the terms of a merger can be tricky when there is an exchange of shares as the cost of acquisition: Depends on the number of shares given to the target stockholders Depends on the price of the combined firm’s stock after the merger Acquisition by Cash and Stock (Example) Acquiring Food Company is considering acquisition of a smaller company, Target Food Company. Acquiring Food Company is proposing to finance the deal by purchasing all of Target’s outstanding stock for $19 per share. Some financial information for these 2 companies is given below. Cost of capital is 20%. 32 Acquisition by Cash and Stock (Example) a) Why would Acquiring Food and Target Food be worth more together than apart As can be see, the operating costs can be reduced by combining the companies’ marketing, distribution and administration by $2 million per year. Revenue can also be increased in Target Food’s region by another $2 million per year. The earnings for the two firms operating together will increase projected earnings by $4 million. Assuming this increased earnings are the only synergy to be generated by the merger. The economic gain to the merger is the present value of the extra earnings. If the earnings increase in permanent ( a perpetuity) and the cost of capital is 20%. The present value of synergy (economic gain) is $4 million / 0.2 = $20 million 33 Acquisition by Cash and Stock (Example) b) What is the cost of acquisition to Acquiring Food Company by cash In this case, it is a cash offer of $19 per share and $3 per share over the current market price ($16). Target Food has 2.5 million outstanding shares and Acquiring Food has to pay a premium of $3 x 2.5 million = $7.5 million over Target’s market value. Target shareholders will capture $7.5 million out of $20 million gain form the merger, leaving $12.5 million gain to Acquiring shareholders. NPV cash to Acquiring Food = Value of Target Food + PV of Synergy – Cost paid to Target Food = $16 x 2.5 million + $20 million – $19 x 2.5 million = $40 million + $20 million – $47.5 million = $12.5 million 34 Acquisition by Cash and Stock (Example) c) What is the cost of acquisition to Acquiring Food Company by stock Suppose Acquiring Food would like to conserve cash and elect to pay Target Food shareholder by stock. The deal call for Target Food shareholders to receive 1 Acquiring Food for every 3 shares of Target Food. In this case, 2.5 million Target shares will result in issue of 2.5 million / 3 = 0.833 million shares of Acquiring Food. That means after the acquisition, there will be 10 million + 0.833 million = 10.833 million of shares in the merged firm. Total value of merged firm = Value of Acquiring Food + Value of Target Food + PV of Synergy = $48 x 10M + $16 x 2.5M + $20M =$480M + $40M + $20M = $540M Share price after merger = $540M / 10.833M = $49.85 35 Acquisition by Cash and Stock (Example) The value of shares given to Target’s original shareholders is 0.833 million x $49.85 = $41.5 million NPV stock to Acquiring Food = Value of Target Food + PV of Synergy – Value of shares paid to Target = $16 x 2.5 million + $20 million – $49.85 x 0.833 million = $40M + $20M + 41.5M = $18.5M This is higher than cash offer $12.5M and therefore, share offer is better than cash offer for Acquiring Food Company. There is a key distinction between cash and stock offer for financing mergers. If cash is offered, the cost of merger is not affected by the size of the merger gains. If stock is offered, the cost depends on the gains because the gains show up in the post merger share price, and these shares are used to pay for the acquired firm. 36 Acquisition by Cash and Stock (Example) Suppose Target Food shareholders demand 1 Acquiring share for every 2.5 Target Food shares. Otherwise, they will not accept the offer. Under these revised terms, is the merger still a good deal for Acquiring Food In this case, 2.5 million Target shares will result in issue of 2.5 million / 2.5 = 1 million shares of Acquiring Food. That means after the acquisition, there will be 10 million + 1 million = 11 million of shares in the merged firm. Total value of merged firm remains the same as: = Value of Acquiring Food + Value of Target Food + PV of Synergy = $48 x 10M + $16 x 2.5M + $20M =$480M + $40M + $20M = $540M Share price after merger = $540M / 11 = $49.09 37 Acquisition by Cash and Stock (Example) The value of shares given to Target’s original shareholders is 1 million x $49.09 = $49.09 million NPV stock to Acquiring Food = Value of Target Food + PV of Synergy – Value of shares paid to Target = $16 x 2.5 million + $20 million – $49.09 x 1 million = $40M + $20M – 49.09M = $10.91M This is positive and therefore, Acquiring Food Inc. should accept it. In this case, cash offer $12.5M is better then share offer $10.91M from Acquiring Food Inc.’s position. 38 39 Cash versus Common Stock Distinction between cash and common stock financing in a merger is an important one If using cash, cost of acquisition is not dependent on acquisition gains All else equal, if common stock is used, cost is higher because Firm A’s shareholders (acquiring firm) must share acquisition gains with shareholders of Firm B (target company) Whether a firm should finance an acquisition with cash or with shares of stock depends on several factors, including the following: Considerations when choosing between cash and stock a) Sharing gains: If cash is used to finance an acquisition, selling firm’s shareholders will not participate in potential gains from the merger b) Taxes: Acquisition by paying cash often results in taxable transaction, while acquisition by exchanging stock is usually tax-free c) Control: Acquisition by paying cash does not affect control of acquiring firm, while acquisition with voting shares may have implications for control of merged firm Typically, cash financing is more common than stock financing Cash versus Common Stock Because of asymmetric information, the acquiring firm knows best the true value of its own stock If the acquiring firm thinks that its own stock is overvalued, it has an incentive to pay with stock, since the target firm’s shareholders would be getting less than the stock price suggests (this assumes that in the long run, the market will correct itself and the price will fall) 40 Cash and Share offer: Advantages and Disadvantages In a cash offer, the target company shareholders are offered a fixed cash sum per share. Advantages When the bidder has sufficient cash the takeover can be achieved quickly at low cost. Target company shareholders have certainty about the bid’s value i.e. there is less risk compared to accepting shares in the bidding company. There is increased liquidity to target company shareholders, i.e. accepting cash in a takeover, is a good way of realizing an investment. The acceptable consideration is likely to be less than with a share exchange as there is less risk to target company shareholders. This reduces the overall cost of the bid to the bidding company. Disadvantages With larger acquisition the bidder must often borrow in the capital markets or issue shares in order to raise the cash. This may have an adverse effect on gearing and also cost of capital due to the increased financial risk. For target company shareholders, this is a taxable gain for cash received. Target company shareholders may be unhappy with a cash offer because they cannot participate in the new company. 41 Cash and Share offer: Advantages and Disadvantages In a share exchange, the bidding company issues some new shares and then exchanges them with the target company shareholders. Advantages The bidding company does not have to raise cash to make the payment Shareholder capital is increased and gearing similarly improved as the shareholders of the acquired company become shareholders in the post acquisition (merged) company. A share exchange can be used to finance very large acquisitions. The gain due to share exchange is not taxable transaction. Disadvantages The bidding company’s shareholders have to share future gains with the acquired entity and the current shareholders will have a lower proportionate control and share in profits of the combined entity than before. Price risk – there is price risk that the market price of the bidding company’s shares will fall during the bidding process which may result in the bid failing For example, if a 1 or 2 share exchange is offered based on the fact that the bidding company’s shares are worth approximately double the value of the target company’s shares, the bid might fail if the value of the bidding company’s shares falls before the acceptance date. 42 Why mergers and acquisitions fail Unrealistic Price Paid for target (Paying too much) The process of M&A involves valuation of the target company and paying a price for taking over the assets of the company. Quite often, one finds that the price paid to the target company is much more than what should have been paid While the shareholders of the target company stand benefited the shareholders of the acquired end up on the losing side. Overstated Synergies Mergers and acquisitions are looked upon as an important instrument of creating synergies through increased revenue, reduced costs, reduction in working capital and improvements in the investment intensity. Overestimated of these can lead to failures of mergers and acquisitions. 43 Why mergers and acquisitions fail Difficulties in Cultural Integration Every merger involves combining of two or more different entities. These entities reflect corporate cultures, styles of leadership, differing employee expectations and functional differences. If the merger is implemented in a way that does not deal sensitivity with the companies’ people and their different corporate cultures, the process may turn out to be a disaster. Integration Difficulties Companies very often face integration difficulties, i.e. the combined entity has to adapt to a new set of challengers given the changed circumstances. To do this, the companies prepare plans to integrate the operations of the combining entities. If the information available on related issues is inadequate or inaccurate, integration becomes difficult. An acquirer needs to have a workable and clear plan to address problems due to differences in management styles, incompatibilities in data information systems and continued opposition to the acquisition by some of the acquired entity’s staff. 44 Why mergers and acquisitions fail Lack of industrial or commercial fit Failure can result from a horizontal or vertical takeover where the acquired entity turns out not to have the product range or industrial position that the acquirer anticipated. Inadequate Due Diligence Due diligence is a crucial component of M&A process as it helps detecting financial and business risks that the acquirer inherits from the target company. Inaccurate estimated of the related risk can result in failure of the merger. High Leverage One of the most crucial elements of an effective acquisition strategy is planning how one intents to finance the deal through an ideal capital structure. The acquirer may decide to acquire the target through cash. To pay the price of the acquisition, the acquirer my borrow heavily from the market. 45 Exercise: Merger Value and Cost Question: Consider the following information for two all-equity firms, Firm A and Firm B: Firm A Firm B Shares outstanding 2,000 6,000 Price per share $40 $30 Firm A estimates that the value of the synergistic benefit from acquiring Firm B is $6,000. Firm B has indicated that it would accept a cash purchase offer of $35 per share. Should Firm A proceed Answer: The total value of Firm B to Firm A is the premerger value of Firm B plus the $6,000 gain from the merger. The premerger value of Firm B is $30 x 6,000 = $180,000, so the total value is $186,000. At $35 per share, Firm A is paying $35 x 6,000 = $210,000; the merger therefore has a negative NPV of $186,000 – $210,000 = -$24,000 At $35 per share, Firm B is not an attractive merger partner. 46 Exercise: Stock Mergers and EPS Question: Consider the following information for two all-equity firms, Firm A and Firm B: Firm A Firm B Total earnings $3,000 $1,100 Shares outstanding 600 400 Price per share $70 $15 P/E 14 5.45 Firm A is acquiring Firm B by exchanging 100 of its shares for all shares in Firm B. a)What is the cost of merger if the merged firm is worth $63,000 b)What will happen to Firm A’s EPS c)Its PE ratio 47 Exercise: Stock Mergers and EPS Answer: a) Cost of merger After the merger, the firm will have 700 shares outstanding. Because the total value if $63,000, the price per share is $63,000/700 = $90, up from $70. Because Firm B’s stockholders end up with 100 shares in the merged firm, the cost of merger is 100 x $90 = $9,000, not 100 x $70 = $7,000. b) EPS Also, the combined firm will have $3,000 + $1,100 = $4,100 in earnings, so EPS will be $4,100/700 = $5.86, up from $3,000/600 = $5.00 c) PE ratio The old PE ratio was $70/$5 = 14.00 The new one is $90/$5.86 = 15.37 48 49 Exercise: Cash versus Stock Payment Question: Company A is analyzing the possible acquisition of Compa