IB2540 Principles of Finance 2 Spring Term 2017

Seminar Questions 8: Mergers & Acquisitions

Please attempt all questions in preparation for the seminars in Week 9.

1. Fly-by-Night Couriers is analysing the possible acquisition of Flash-in-the-Pan Restaurants.
Neither firm has debt. The forecasts of Fly-by-Night show that the purchase would increase its
annual after-tax cash flow by 600,000 indefinitely. The current market value of Flash-in-the-
Pan is 20 million. The current market value of Fly-by Night is 37 million. The appropriate
discount rate for the incremental cash flows is 8%.
a) What is the synergy from the merger?
b) What is the value of Flash-in-the-Pan to Fly-by Night?
Fly-by-Night is trying to decide whether to offer 40% of its stock or 25 million in cash to Flash-
in-the-Pan.
c) What is the cost to Fly-by-Night of each alternative?
d) What is the NPV to Fly-by-Night of each alternative?
e) Which alternative should Fly-by-Night choose?

2. Freeport Manufacturing is considering making an offer to purchase Portland Industries. The

treasurer of Freeport has collected the following information:
Freeport Portland
Price-earnings ratio 15 12
Number of shares 1,000,000 250,000
Earnings 1,000,000 750,000
The treasurer also knows that securities analysts expect the earnings and dividends (currently
1.80 per share) of Portland to grow at a constant rate of 5% each year. Her research indicates,
however, that the acquisition would provide Portland with some economies of scale that would
improve this growth rate to 7% per year.
a) What is the value of Portland to Freeport?
b) If Freeport offers 40 in cash for each outstanding share of Portland, what would the NPV of
the acquisition be?
c) If instead Freeport were to offer 600,000 of its shares in exchange for the outstanding stock
of Portland, what would the NPV of the acquisition be?
d) Should the acquisition be attempted, and if so, should it be a cash or stock offer?
e) Suppose Freeport wanted to make a stock offer with the same value to Freeport as the cash
offer in (b). How many shares in the combined firm will be offered for each share in
Portland? What is the value of each share in the combined firm?
f) Suppose the growth rate is actually 6% rather than 7%. How does this change the value for
the shareholders in Freeport and in Portland under the stock offer in (c) and under the cash
offer in (b) and your answers to (b) and (c) above?
3. Two firms, Warwick plc and Leamington Ltd, are planning to merge. Warwick plc currently
has equity with a total market value of 1.3m and debt with a market value of 2.7m,
consisting of a single tranche of zero coupon debt with four years to maturity and face value
4m. Leamington Ltd has assets worth 4m and is funded by equity and zero coupon debt
with face value 3.3m, also with four years to maturity. The merger is expected to generate
operating synergies of 0.25m and the volatility of returns of the merged firms assets is
expected to be 29% per annum. Warwick plc and Leamington Ltd have volatility of asset
returns of 40% and 25% respectively. Equity-holders in Warwick plc and equity-holders in
Leamington Ltd would each own 50% of the shares of the combined firm, WL plc. After the
merger both firms debts would be combined into a single tranche of zero coupon debt with
face value 7.3m and four years to maturity and the new firm is not expected to pay
dividends for the foreseeable future. The risk-free interest rate is 1% p.a.. Ignore taxes.
a) Calculate the value of the assets of the combined firm, WL plc, V.
Hence calculate the total value E of WL plcs equity and the total value D of WL plcs debt if
the takeover goes ahead. Show full workings.
Is the takeover in the interests of equity-holders in Warwick plc?
b) Briefly comment on your answer to (a), relating it to agency costs of debt.
Briefly explain why Warwick plcs managers may want to go ahead with the takeover
anyway. (Hint: consider Jensen (1986))

True/False questions

1. A merger produces an economic gain only if the two firms are worth more together than
apart.
2. The gain from a merger of firms A and B may be defined as
Value of combined firm [Value of A as standalone firm Value of B as standalone firm]
3. Firms that are badly managed are natural acquisition targets.
4. Since an acquisition financed with stock can be viewed as a cash acquisition combined with a
share issue, it is viewed less favourably than cash acquisitions.
5. Usually, the stockholders of the acquiring firm gain from a merger, whereas the stockholders
of the selling firm generally lose.
6. LBOs are rarely financed by junk debt.
Practice multiple choice questions:

1. Which of the following statements is supported empirically?

i) Shareholders of bidding firms experience large positive abnormal returns in
successful takeovers
ii) Shareholders in target firms experience larger abnormal returns if the
payment method is stock rather than cash
iii) Shareholders of bidding firms experience larger abnormal returns if the
payment method is stock rather than cash

a) (i) only.
b) (ii) only.
c) (iii) only.
d) (ii) and (iii) only.
e) None of (i) (iii).

Questions 2 3 refer to the following

Firm A Firm B Firm AB
Price per share 100 15
Total earnings 500 300
Shares outstanding 100 30
Total value 10,000 450 11,000

Firm A is proposing to acquire firm B at a price of 20 per share of firm Bs stock. The NPV of the
merger has been estimated at 400.
2. What is the synergy of the merger?
a) 150
b) 550
c) 600
d) 700
e) 10,000

3. What will the post-merger price per share for Firm As stock be if Firm A pays in cash?
a) 104
b) 108
c) 110
d) 114
e) None of the above

4. Two firms merge and no synergies occur. Which of the following is true?
a) The reduction in risk in the combined firm benefits the bondholders at the expense of
the stockholders
b) The value of the debt in the combined firm is likely to be greater than the sum of the
values of the debt in the two separate firms
c) The size of the gain to the bondholders depends on the specific reductions in
bankruptcy states after the merger
d) The reduction in risk in the combined firm increases the optimal debt capacity of the
combined firm
e) All of the above are true