Question

Two companies called X plc and Y plc are considering a merger. Financial data for

the two companies are given below:

                                                                                            X                           Y

Number of shares issued 3m 6m

Profit after tax                                                             GHS1.8m                  GHS0.5m

Price/earnings ratio                                                          12.0                        10.3

The two companies have estimated that, due to economies of scale, the newly merged company would generate cost savings of GHS200,000 per year.

(i) It is suggested initially that 100% of Y PLC’s shares should be exchanged for shares in X at a rate of one share in X for every three shares in Y. What would be the expected reduction of EPS from the point of view of X’s shareholders?

(ii) An alternative to this is for X’s shares to be valued at GHS7.20 and for the total share capital of Y to be valued at GHS10.5m for merger purposes. A certain percentage of Y’s shares would be exchanged for shares in X, while the remaining shares of Y would be exchanged for 6.5% bonds (issued at GHS100 nominal value) in the new company. Given that the corporate tax rate is 30%, how much would have to be raised from the bond issue as part of the purchase consideration in order for there to be no dilution of EPS from X’s existing shareholders’ point of view?

Answer 1

i) Current EPS of X = PAT/no. of shares = GH$1.8m / 3m = GH$0.6 per share

No. of shares of X to be exchanged for 6m shares of Y = 6m/3 = 2m

New no of shares of X = 3m +2m =5m

New PAT of the combined entity = GH$1.8m+GH$0.5m + GH$200000 =GH$2.5 m

So, new EPS = GH$2.5m/5m = GH$0.5 per share

Expected Reduction of EPS = Current EPS - new EPS = GH$0.6 per share- GH$0.5 per share

= GH$ 0.1 per share

ii) For do dilution in EPS , new EPS = GH$0.6 per share (as above)

Suppose, GH$x m of bonds were issued and remaining ( GH$10.5 m -GH$x m ) worth of shares were exchanged and new (10.5-x)/7.2 m shares of X were issued

pre- tax Interest expense on GH$x million of bonds = GH$ 0.065*x million

After tax Interest expense on GH$x million of bonds = GH$ 0.065*x million * 0.7

So, new PAT of the combined entity = GH$2.5 million -GH$0.0455*x million

So, new EPS = (2.5-0.0455*x)/ (3+ (10.5-x)/7.2) = 0.6

=> 2.5- 0.0455*x = 1.8 + 0.875 -0.083333*x

=> x = 4.6255

So, GH$ 4.6255 m of bonds have to be issued for the shareholders of X to have the same EPS