Mergers and Acquisitions Solutions Manual

Mergers and Acquisitions Answers to Concept Questions 1. In the purchase method, assets are recorded at market value, and goodwill is created to account for the excess of the purchase price over this recorded value. In the pooling of interests method, the balance sheets of the two firms are simply combined; no goodwill is created. The choice of accounting method has no direct impact on the cash flows of the firms. EPS will probably be lower under the purchase method because reported income is usually lower due to the required amortization of the goodwill created in the purchase. 2. a. False. Although the reasoning seems correct, in general, the new firms do not have monopoly power. This is especially true since many countries have laws limiting mergers when it would create a monopoly. b. True. When managers act in their own interest, acquisitions are an important control device for shareholders. It appears that some acquisitions and takeovers are the consequence of underlying conflicts between managers and shareholders. c. False. Even if markets are efficient, the presence of synergy will make the value of the combined firm different from the sum of the values of the separate firms. Incremental cash flows provide the positive NPV of the transaction. d. False. In an efficient market, traders will value takeovers based on “fundamental factors” regardless of the time horizon. Recall that the evidence as a whole suggests efficiency in the markets. Mergers should be no different. e. False. The tax effect of an acquisition depends on whether the merger is taxable or nontaxable. In a taxable merger, there are two opposing factors to consider, the capital gains effect and the write-up effect. The net effect is the sum of these two effects. f. True. Because of the coinsurance effect, wealth might be transferred from the stockholders to the bondholders. Acquisition analysis usually disregards this effect and considers only the total value. 3. Diversification doesn’t create value in and of itself because diversification reduces unsystematic, not systematic, risk. As discussed in the chapter on options, there is a more subtle issue as well. Reducing unsystematic risk benefits bondholders by making default less likely. However, if a merger is done purely to diversify (i.e., no operating synergy), then the NPV of the merger is zero. If the NPV is zero, and the bondholders are better off, then stockholders must be worse off. 4. A firm might choose to split up because the newer, smaller firms may be better able to focus on their particular markets. Thus, reverse synergy is a possibility. An added advantage is that performance evaluation becomes much easier once the split is made because the new firm’s financial results (and stock prices) are no longer commingled. 5. It depends on how they are used. If they are used to protect management, then they are not good for stockholders. If they are used by management to negotiate the best possible terms of a merger, then they are good for stockholders. 6. One of the primary advantages of a taxable merger is the write-up in the basis of the target firm’s assets, while one of the primary disadvantages is the capital gains tax that is payable. The situation is the reverse for a tax-free merger. The basic determinant of tax status is whether or not the old stockholders will continue to participate in the new company, which is usually determined by whether they get any shares in the bidding firm. An LBO is usually taxable because the acquiring group pays off the current stockholders in full, usually in cash. 7. Economies of scale occur when average cost declines as output levels increase. A merger in this particular case might make sense because Eastern and Western may need less total capital investment to handle the peak power needs, thereby reducing average generation costs. 8. Among the defensive tactics often employed by management are seeking white knights, threatening to sell the crown jewels, appealing to regulatory agencies and the courts (if possible), and targeted share repurchases. Frequently, antitakeover charter amendments are available as well, such as poison pills, poison puts, golden parachutes, lockup agreements, and supermajority amendments, but these require shareholder approval, so they can’t be immediately used if time is short. While target firm shareholders may benefit from management actively fighting acquisition bids, in that it encourages higher bidding and may solicit bids from other parties as well, there is also the danger that such defensive tactics will discourage potential bidders from seeking the firm in the first place, which harms the shareholders. 9. In a cash offer, it almost surely does not make sense. In a stock offer, management may feel that one suitor is a better long-run investment than the other, but this is only valid if the market is not efficient. In general, the highest offer is the best one. 10. Various reasons include: (1) Anticipated gains may be smaller than thought; (2) Bidding firms are typically much larger, so any gains are spread thinly across shares; (3) Management may not be acting in the shareholders’ best interest with many acquisitions; (4) Competition in the market for takeovers may force prices for target firms up to the zero NPV level; and (5) Market participants may have already discounted the gains from the merger before it is announced. Solutions to Questions and Problems NOTE: All end-of-chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred. However, the final answer for each problem is found without rounding during any step in the problem. Basic 1. For the merger to make economic sense, the acquirer must feel the acquisition will increase value by at least the amount of the premium over the market value, so: Minimum economic value = $630,000,000 – 560,000,000 = $70,000,000 2. a) Since neither company has any debt, using the pooling method, the asset value of the combined firm must equal the book value of the equity, so: Assets = Equity = 20,000($20) + 10,000($8) = $480,000 b) With the purchase method, the assets of the combined firm will be the book value of Firm X, the acquiring company, plus the market value of Firm Y, the target company, so: Assets from X = 20,000($20) = $400,000 (book value) Assets from Y = 20,000($26) = $260,000 (market value) The purchase price of Firm Y is the number of shares outstanding times the sum of the current stock price per share plus the premium per share, so: Purchase price of Y = 20,000($26 + 5) = $310,000 The goodwill created will be: Goodwill = $310,000 – 260,000 = $50,000. And the total asset of the combined company will be: Total assets XY = Total equity XY = $400,000 + 260,000 + 50,000 = $710,000 3. In the pooling method, all accounts of both companies are added together to total the accounts in the new company, so the post-merger balance sheet will be: Jurion Co., post-merger Current assets Fixed assets $20,800 55,300 Total $76,100 Current liabilities Long-term debt Equity $11,300 22,800 42,000 $76,100 4. Since the acquisition is funded by long-term debt, the post-merger balance sheet will have long-term debt equal to the original long-term debt of Jurion’s balance sheet plus the new long-term debt issue, so: Post-merger long-term debt = $19,000 + 26,000 = $45,000 Goodwill will be created since the acquisition price is greater than the book value. The goodwill amount is equal to the purchase price minus the market value of assets. Generally, the market value of current assets is equal to the book value, so: Goodwill created = $26,000 – $19,500 (market value FA) – $3,800 (market value CA) = $2,700 Current liabilities and equity will remain the same as the pre-merger balance sheet of the acquiring firm. Current assets will be the sum of the two firm’s pre-merger balance sheet accounts, and the fixed assets will be the sum of the pre-merger fixed assets of the acquirer and the market value of fixed assets of the target firm. The post-merger balance sheet will be: Jurion Co., post-merger Current assets Fixed assets Goodwill Total 5. a. $20,800 62,500 2,700 $86,000 Current liabilities Long-term debt Equity $ 8,400 45,000 32,600 $86,000 The cash cost is the amount of cash offered, so the cash cost is $87 million. To calculate the cost of the stock offer, we first need to calculate the value of the target to the acquirer. The value of the target firm to the acquiring firm will be the market value of the target plus the PV of the incremental cash flows generated by the target firm. The cash flows are a perpetuity, so V* = $64,000,000 + $2,700,000/.12 = $86,500,000 The cost of the stock offer is the percentage of the acquiring firm given up times the sum of the market value of the acquiring firm and the value of the target firm to the acquiring firm. So, the equity cost will be: Equity cost = .40($128,000,000 + 86,500,000) = $85,800,000 b. The NPV of each offer is the value of the target firm to the acquiring firm minus the cost of acquisition, so: NPV cash = $86,500,000 – 87,000,000 = –$500,000 NPV stock = $86,500,000 – 85,800,000 = $700,000 c. Since the NPV is greater with the stock offer, the acquisition should be with stock. 6. a. The EPS of the combined company will be the sum of the earnings of both companies divided by the shares in the combined company. Since the stock offer is one share of the acquiring firm for three shares of the target firm, new shares in the acquiring firm will increase by one-third. So, the new EPS will be: EPS = ($105,000 + 320,000)/[80,000 + (1/3)(42,000)] = $4.521 The market price of Stultz will remain unchanged if it is a zero NPV acquisition. Using the PE ratio, we find the current market price of Stultz stock, which is: P = 21.80($320,000)/80,000 = $87.20 If the acquisition has a zero NPV, the stock price should remain unchanged. Therefore, the new PE will be: P/E = $87.20/$4.521 = 19.29 b. The value of Flannery to Stultz must be the market value of the company since the NPV of the acquisition is zero. Therefore, the value is: V* = $105,000(8.72) = $915,600 The cost of the acquisition is the number of shares offered times the share price, so the cost is: Cost = (1/3)(42,000)($87.20) = $1,220,800 So, the NPV of the acquisition is: NPV = 0 = V* + V – Cost = $915,600 + V – 1,220,800 V = –$305,200 Although there is a negative economic value to the takeover, it is possible that Stultz is motivated to purchase Flannery for other than financial reasons. 7. The decision hinges upon the risk of surviving. That is, consider the wealth transfer from bondholders to stockholders when risky projects are undertaken. High-risk projects will reduce the expected value of the bondholders’ claims on the firm. The telecommunications business is riskier than the utilities business. If the total value of the firm does not change, the increase in risk should favor the stockholder. Hence, management should approve this transaction. If the total value of the firm drops because of the transaction, and the wealth effect is lower than the reduction in total value, management should reject the project. 8. a. The NPV of the merger is the market value of the target firm, plus the value of the synergy, minus the acquisition costs, so: NPV = 1,100($26) + $4,600 – 1,100($29) = $1,300 b. Since the NPV goes directly to stockholders, the share price of the merged firm will be the market value of the acquiring firm plus the NPV of the acquisition, divided by the number of shares outstanding, so: Share price = [2,700($38) + $1,300]/2,700 = $38.48 c. The merger premium is the premium per share times the number of shares of the target firm outstanding, so the merger premium is: Merger premium = 1,100($29 – 26) = $3,300 d. The number of new shares will be the number of shares of the target times the exchange ratio, so: New shares created = 1,100(3/5) = 660 new shares The value of the merged firm will be the market value of the acquirer plus the market value of the target plus the synergy benefits, so: VBT = 2,700($38) + 1,100($26) + 4,600 = $135,800 The price per share of the merged firm will be the value of the merged firm divided by the total shares of the new firm, which is: P = $135,800/(2,700 + 660) = $40.42 e. The NPV of the acquisition using a share exchange is the market value of the target firm plus synergy benefits, minus the cost. The cost is the value per share of the merged firm times the number of shares offered to the target firm shareholders, so: NPV = 1,100($26) + $4,600 – 660($40.42) = $6,525 Intermediate 9. The cash offer is better for the target firm shareholders since they receive $29 per share. In the share offer, the target firm’s shareholders will receive: Equity offer value = (3/5)($29) = $17.40 per share From Problem 8, we know the value of the merged firm’s assets will be $135,800. The number of shares in the new firm will be: Shares in new firm = 2,700 + 1,100x that is, the number of shares outstanding in the bidding form, plus the number of shares outstanding in the target firm, times the exchange ratio. This means the post merger share price will be: P = $135,800/(2,700 + 1,100x) To make the target firm’s shareholders indifferent, they must receive the same wealth, so: 1,100(x)P = 1,100($29) This equation shows that the new offer is the shares outstanding in the target company times the exchange ratio times the new stock price. The value under the cash offer is the shares outstanding times the cash offer price. Solving this equation for P, we find: P = $29 / x Combining the two equations, we find: $135,800/(2,700 + 1,100x) = $29 / x x = 0.7536 There is a simpler solution that requires an economic understanding of the merger terms. If the target firm’s shareholders are indifferent, the bidding firm’s shareholders are indifferent as well. That is, the offer is a zero sum game. Using the new stock price produced by the cash deal, we find: Exchange ratio = $29/$38.48 = 0.7536 10. The cost of the acquisition is: Cost = 750($19) = $14,250 Since the stock price of the acquiring firm is $38, the firm will have to give up: Shares offered = $14,250/$38 = 375 shares a. The EPS of the merged firm will be the combined EPS of the existing firms divided by the new shares outstanding, so: EPS = ($2,400 + 1,100)/(1,300 + 375) = $2.09 b. The PE of the acquiring firm is: Original P/E = $38/($2,400/1,300) = 20.58 times Assuming the PE ratio does not change, the new stock price will be: New P = $2.09(20.58) = $43.01 c. If the market correctly analyzes the earnings, the stock price will remain unchanged since this is a zero NPV acquisition, so: New P/E = $38/$2.09 = 18.19 times d. The new share price will be the combined market value of the two existing companies divided by the number of shares outstanding in the merged company. So: P = [(1,300)($38) + 750($17)]/(1,300 + 375) = $37.10 And the PE ratio of the merged company will be: P/E = $37.10/$2.09 = 17.76 times At the proposed bid price, this is a negative NPV acquisition for A since the share price declines. They should revise their bid downward until the NPV is zero. 11. Beginning with the fact that the NPV of a merger is the value of the target minus the cost, we get: NPV NPV NPV NPV 12. a. = = = = V*B – Cost V + VB – Cost V – (Cost – VB) V – Merger premium The synergy will be the present value of the incremental cash flows of the proposed purchase. Since the cash flows are perpetual, the synergy value is: Synergy value = $400,000 / .09 Synergy value = $4,444,444 b. The value of Flash-in-the-Pan to Fly-by-Night is the synergy plus the current market value of Flash-in-the-Pan, which is: Value = $4,444,444 + 11,000,000 Value = $15,444,444 c. The value of the cash option is the amount of cash paid, or $13 million. The value of the stock acquisition is the percentage of ownership in the merged company, times the value of the merged company, so: Stock acquisition value = .40($15,444,444 + 18,000,000) Stock acquisition value = $13,377,778 d. The NPV is the value of the acquisition minus the cost, so the NPV of each alternative is: NPV of cash offer = $15,444,444 – 13,000,000 NPV of cash offer = $2,444,444 NPV of stock offer = $15,444,444 – 13,377,778 NPV of stock offer = $2,066,667 e. 13. a. The acquirer should make the cash offer since its NPV is greater. The number of shares after the acquisition will be the current number of shares outstanding for the acquiring firm, plus the number of new shares created for the acquisition, which is: Number of shares after acquisition = 18,000,000 + 4,000,000 Number of shares after acquisition = 22,000,000 And the share price will be the value of the combined company divided by the shares outstanding, which will be: New stock price = £625,000,000 / 22,000,000 New stock price = £28.41 b. Let equal the fraction of ownership for the target shareholders in the new firm. We can set the percentage of ownership in the new firm equal to the value of the cash offer, so: (£625,000,000) = £140,000,000 = .2240 or 22.40% So, the shareholders of the target firm would be equally as well off if they received 22.40 percent of the stock in the new company as if they received the cash offer. The ownership percentage of the target firm shareholders in the new firm can be expressed as: Ownership = New shares issued / (New shares issued + Current shares of acquiring firm) .2240 = New shares issued / (New shares issued + 18,000,000) New shares issued = 5,195,876 To find the exchange ratio, we divide the new shares issued to the shareholders of the target firm by the existing number of shares in the target firm, so: Exchange ratio = New shares / Existing shares in target firm Exchange ratio = 5,195,876 / 11,000,000 Exchange ratio = .4724 An exchange ratio of .4724 shares of the merged company for each share of the target company owned would make the value of the stock offer equivalent to the value of the cash offer. 14. a. The value of each company is the sum of the probability of each state of the economy times the value of the company in that state of the economy, so: ValueBentley = .60($310,000) + .40($180,000) ValueBentley = $258,000 ValueRolls = .60($280,000) + .40($110,000) ValueRolls = $212,000 b. The value of each company’s equity is sum of the probability of each state of the economy times the value of the equity in that state of the economy. The value of equity in each state of the economy is the maximum of total company value minus the value of debt, or zero. Since Rolls is an all equity company, the value of its equity is simply the total value of the firm, or $212,000. The value of Bentley’s equity in a boom is $115,000 ($310,000 company value minus $195,000 debt value), and the value of Bentley’s equity in a recession is zero since the value of its debt is greater than the value of the company in that state of the economy. So, the value of Bentley’s equity is: EquityBentley = .60($115,000) + .40($0) EquityBentley = $69,000 The value of Bentley’s debt in a boom is the full face value of $195,000. In a recession, the value of the company’s debt is $180,000 since the value of the debt cannot exceed the value of the company. So, the value of Bentley’s debt today is: DebtBentley = .60($195,000) + .40($180,000) DebtBentley = $189,000 Note, this is also the value of the company minus the value of the equity, or: DebtBentley = $258,000 – 69,000 DebtBentley = $189,000 c. The combined value of the company’s, the combined equity value, and combined debt value is: Combined value = $258,000 + 212,000 Combined value = $470,000 Combined equity value = $69,000 + 212,000 Combined equity value = $281,000 Combined debt value = $189,000 d. To find the value of the merged company, we need to find the value of the merged company in each state of the economy, which is: Boom merged value = $310,000 + 280,000 Boom merged value = $590,000 Recession merged value = $180,000 + 110,000 Recession merged value = $290,000 So, the value of the merged company today is: Merged company value = .60($590,000) + .40($290,000) Merged company value = $470,000 Since the merged company will still have $195,000 in debt, the value of the equity in a boom is $395,000, and the value of equity in a recession is $95,000. So, the value of the merged company’s equity is: Merged equity value = .60($395,000) + .40($95,000) Merged equity value = $275,000 The merged company will have a value greater than the face value of debt in both states of the economy, so the value of the company’s debt is $195,000. d. There is a wealth transfer in this case. The combined equity value before the merger was $281,000, but the value of the equity in the merged company is only $275,000, a loss of $6,000 for stockholders. The value of the debt in the combined companies was only $189,000, but the value of debt in the merged company is $195,000 since there is no chance of default. The bondholder’s gained $6,000, exactly the amount the stockholders lost. e. If the value of Bentley’s debt before the merger is less than the lowest firm value, there is no coinsurance effect. Since there is no possibility of default before the merger, bondholders do not gain after the merger. Challenge 15. a. To find the value of the target to the acquirer, we need to find the share price with the new growth rate. We begin by finding the required return for shareholders of the target firm. The earnings per share of the target are: EPSPalmer = $580,000/620,000 = $0.94 per share The price per share is: PPalmer = 1($0.94) = $10.29 And the dividends per share are: DPSPalmer = $290,000/620,000 = $0.47 The current required return for Palmer shareholders, which incorporates the risk of the company is: RE = [$0.47(1.05)/$10.29] + .05 = .0977 The price per share of Palmer with the new growth rate is: PP = $0.47(1.07)/(.0977 – .07) = $18.05 The value of the target firm to the acquiring firm is the number of shares outstanding times the price per share under the new growth rate assumptions, so: VT* = 620,000($18.05) = $11,191,147.54 b. The gain to the acquiring firm will be the value of the target firm to the acquiring firm minus the market value of the target, so: Gain = $11,191,147.54 – 620,000($10.29) = $4,811,147.54 c. The NPV of the acquisition is the value of the target firm to the acquiring firm minus the cost of the acquisition, so: NPV = $11,191,147.54 – 620,000($17) = $651,147.54 d. The most the acquiring firm should be willing to pay per share is the offer price per share plus the NPV per share, so: Maximum bid price = $17 + ($651,147.54/620,000) = $18.05 Notice that this is the same value we calculated earlier in part a as the value of the target to the acquirer. e. The price of the stock in the merged firm would be the market value of the acquiring firm plus the value of the target to the acquirer, divided by the number of shares in the merged firm, so: PFP = ($25,200,000 + 11,191,147.54)/(1,000,000 + 250,000) = $29.11 The NPV of the stock offer is the value of the target to the acquirer minus the value offered to the target shareholders. The value offered to the target shareholders is the stock price of the merged firm times the number of shares offered, so: NPV = $11,191,147.54 – 250,000($29.11) = $3,912,918.03 f. Yes, the acquisition should go forward, and Plant should offer the cash since the NPV is higher. g. Using the new growth rate in the dividend growth model, along with the dividend and required return we calculated earlier, the price of the target under these assumptions is: PP = $0.47(1.06)/(.0977 – .06) = $13.14 And the value of the target firm to the acquiring firm is: VP* = 620,000($13.14) = $8,147,951.81 The gain to the acquiring firm will be: Gain = $8,147,951.81 – 620,000($10.29) = $1,767,951.81 The NPV of the cash offer is now: NPV cash = $8,147,951.81 – 620,000($17) = –$2,392,048.19 And the new price per share of the merged firm will be: PFP = [$25,200,000 + 8,147,951.81]/(1,000,000 + 250,000) = $26.68 And the NPV of the stock offer under the new assumption will be: NPV stock = $11,191,147.54 – 250,000($26.68) = $1,478,361.45 Even with the lower projected growth rate, the stock offer still has a positive NPV. Plant should purchase Palmer with a stock offer of 250,000 shares. 16. a. To find the distribution of joint values, we first must find the joint probabilities. To do this, we need to find the joint probabilities for each possible combination of weather in the two towns. The weather conditions are independent; therefore, the joint probabilities are the products of the individual probabilities. Possible states Rain-Rain Rain-Warm Rain-Hot Warm-Rain Warm-Warm Warm-Hot Hot-Rain Hot-Warm Hot-Hot Joint probability .1(.1) = .01 .1(.4) = .04 .1(.5) = .05 .4(.1) = .04 .4(.4) = .16 .4(.5) = .20 .5(.1) = .05 .5(.4) = .20 .5(.5) = .25 Next, note that the revenue when rainy is the same regardless of which town. So, since the state "Rain-Warm" has the same outcome (revenue) as "Warm-Rain", their probabilities can be added. The same is true of "Rain-Hot" / "Hot-Rain" and "WarmHot" / "Hot-Warm". Thus the joint probabilities are: Possible states Rain-Rain Rain-Warm Rain-Hot Warm-Warm Warm-Hot Hot-Hot Joint probability .01 .08 .10 .16 .40 .25 Finally, the joint values are the sums of the values of the two companies for the particular state. Possible states Rain-Rain Rain-Warm Rain-Hot Warm-Warm Warm-Hot Hot-Hot $100,000 + 100,000 = $100,000 + 200,000 = $100,000 + 400,000 = $200,000 + 200,000 = $200,000 + 400,000 = $400,000 + 400,000 = Joint value $200,000 300,000 500,000 400,000 600,000 800,000 b. Recall that if a firm cannot service its debt, the bondholders receive the value of the assets. Thus, the value of the debt is the value of the company if the face value of the debt is greater than the value of the company. If the value of the company is greater than the value of the debt, the value of the debt is its face value. Here, the value of the common stock is always the residual value of the firm over the value of the debt. So, the value of the debt and the value of the stock in each state is: Possible states Rain-Rain Rain-Warm Rain-Hot Warm-Warm Warm-Hot Hot-Hot c. Joint Prob. .01 .08 .10 .16 .40 .25 Joint Value $200,000 $300,000 $500,000 $400,000 $600,000 $800,000 Debt Value $200,000 $300,000 $400,000 $400,000 $400,000 $400,000 Stock Value $0 $0 $100,000 $0 $200,000 $400,000 The bondholders are better off if the value of the debt after the merger is greater than the value of the debt before the merger. The value of the debt is the smaller of the debt value or the company value. So, the value of the debt of each individual company before the merger in each state is: Possible states Rain Warm Hot Probability .10 .40 .50 Debt Value $100,000 200,000 200,000 Individual debt value = .1($100,000) + .4($200,000) + .5($200,000) Individual debt value = $190,000 This means the total value of the debt for both companies pre-merger must be: Total debt value pre-merger = 2($190,000) Total debt value pre-merger = $380,000 To get the expected debt value, post-merger, we can use the joint probabilities for each possible state and the debt values corresponding to each state we found in part c. Using this information to find the value of the debt in the post-merger firm, we get: Total debt value post-merger = .01($200,000) + .08($300,000) + .10($400,000) + .16($400,000) + .40($400,000) + .25($400,000) Total debt value post-merger = $390,000 The bondholders are better off by $10,000. Since we have already shown that the total value of the combined company is the same as the sum of the value of the individual companies, the implication is that the stockholders are worse off by $10,000.