Question

The following information relates to Questions 1-6.

Modern Auto, an automobile parts supplier, has made an offer to acquire Sky Systems, creator of software for the airline industry. The offer is to pay Sky Systems’ shareholders the current market value of their stock in Modern Auto’s stock. The relevant information it used in those calculations is given below:

	Modern Auto	Sky Systems
Share price	$40	$25
Shares outstanding (millions)	40	15
Earnings (millions)	$100	$30

Although the total earnings of the combined company will not increase and are estimated to be $130 million, Charles Wilhelm (treasurer of Modern Auto) argues that there are two attractive reasons to merge. First, Wilhelm says, “The merger of Modern Auto and Sky Systems will result in lower risk for our shareholders because of the diversification effect.” Second, Wilhelm also says, “If our EPS increases, our stock price will increase in line with the EPS increase because our P/E will stay the same.”

              Sky Systems managers are not interested in the offer by Modern Auto. The managers, instead, approach HiFly, Inc., which is in the same industry as Sky Systems, to see if it would be interested in acquiring Sky Systems. HiFly is interested, and both companies believe there will be synergies from this acquisition. If HiFly were to acquire Sky Systems, it would do so by paying $400 million in cash.

              HiFly is somewhat concerned whether antitrust regulators would consider the acquisition of Sky Systems an antitrust violation. The market in which the two companies operate consists of eight competitors. The largest company has a 25 percent market share. HiFly has the second largest market share of 20 percent. Five companies, including Sky Systems, each have a market share of 10 percent. The smallest company has a 5 percent market share.

Note: For the multiple choice questions throughout the document, please bold and italicize the correct answer.

1. The acquisition of Sky Systems by Modern Auto and the acquisition of Sky Systems by HiFly, respectively, would be examples of a
   1. horizontal merger and a vertical merger.
   2. vertical merger and a horizontal merger.
   3. conglomerate merger and a vertical merger.
   4. conglomerate merger and a horizontal merger.
2. Are Wilhelm’s two statements about his share holders benefiting from the diversification effect of the merger and about the increase in the stock price, respectively, correct?

	The Merger Will Result in Lower Risk for Shareholders	Stock Price Will Increase in Line with the EPS Increase
A.	No	No
B.	No	Yes
C.	Yes	No
D.	Yes	Yes

3. Which of the following defenses best describes the role of HiFly in the acquisition scenario?
   1. Crown jewel.
   2. Pac-Man.
   3. White knight.
   4. White squire.
4. If Sky Systems were to be acquired by Modern Auto under the terms of the original offer, the post-merger EPS of the new company would be ______________

Show your work to get full credit

5. Suppose HiFly acquires Sky Systems for the stated terms. The gain to Sky Systems shareholders resulting from the merger transaction would be ______________

Show your work to get full credit

6. If HiFly and Sky Systems attempt to merge, what would be the increase in the Herfindahl-Hirschman Index (HHI) and the probable action by the Department of Justice and the FTC, respectively, in response to the merger announcement?

	Increase in the HHI	Probable Response of Department of Justice and FTC
A.	290	To challenge the merger
B.	290	To investigate the merger
C.	400	To challenge the merger
D.	400	To investigate the merger

Answer 1

Q) The acquisition of Sky Systems by Modern Auto and the acquisition of Sky Systems by HiFly, respectively, would be examples of a?

Answer :- The acquisition of Sky Systems by Modern Auto and the acquisition of Sky Systems by HiFly, respectively, would be examples of a conglomerate merger and a horizontal merger. The option D is correct.

Since Modern Auto is in entirely different business so it's a conglomerate merger, whereas the HiFly and Sky Systems are in similar industry so it's an horizontal merger.

Q) Are Wilhelm’s two statements about his share holders benefiting from the diversification effect of the merger and about the increase in the stock price, respectively, correct?

Answer:- Both statements are correct. Hence option D is correct. Diversification by acquiring other company with business entirely different from the present business leads to risk reduction for shareholders because the conglomerate will be less vulnerable to the market risk. As P/E is the stock price divided by the EPS,, and given that the P/E remains same hence when the EPS increases the stock price tends to increase in line with EPS.

Q) Which of the following defenses best describes the role of HiFly in the acquisition scenario?

Answer:- The defense mechanism by HiFly in the acquisition scenario is described as White Knight defense. Hence Option C is correct. When there is an hostile takeover about to happen the target company will approach a third party company which agrees to buy and is a good strategic fit, ie. having business in the same industry and with a higher price.

Q) If Sky Systems were to be acquired by Modern Auto under the terms of the original offer, the post-merger EPS of the new company would be ?

Answer:- The EPS of the merged entity can be calculated as:-

The share price of Sky Systems is $25 and has 15 million shares outstanding
Therefore the number of shares issued by Modern Auto to buy Sky Systems =  $ 25 x 15 / $ 40 (As the stock price of Modern Auto is 40.

= $ 25 x 15 / $ 40
= 9.375 million shares

Therefore the total number of shares of the combined entity is    40 million and the newly issued 9.375 million shares which = 49.375 million shares.

The total earnings of the combined entity is $100 million + $30 million= $130 millions.

Therefore EPS = $ 130 / 49.375 = 2.63

Q) Suppose HiFly acquires Sky Systems for the stated terms. The gain to Sky Systems shareholders resulting from the merger transaction would be ?

Answer:- The HiFly would be paying $ 400 million in cash.

The gain to the target ie. Sky Systems = TP = P(t) - V(t)
Where TP = Target Premium
P(t) = Price paid to target
V(T) = Pre merger value of target = Share price x Number of shares outstanding

P(t) = $ 400 million
V(T) = $25 x 15 million = $ 375 millions

Therefore gain to Sky Systems = $400 - $375 = $ 25 million

Q) If HiFly and Sky Systems attempt to merge, what would be the increase in the Herfindahl-Hirschman Index (HHI) and the probable action by the Department of Justice and the FTC, respectively, in response to the merger announcement?

Answer:-

Given Number of competitors=8
The largest company has a 25 percent market share.
HiFly has the second largest market share of 20 percent.
5 companies including Sky Systems, each have a market share of 10 percent.
The smallest company has a 5 percent market share.

The Herfindahl-Hirschman Index (HHI) before merger = (0.25 x 100)² + (0.20 x 100)² + (0.10 x 100)² x 5 + (0.05 x 100)²
= 625 + 400 + 500 + 25
= 1550
The Herfindahl-Hirschman Index (HHI) post merger = (0.25 x 100)² + (0.30 x 100)² + (0.10 x 100)² x 4 + (0.05 x 100)²
= 625 +900 + 400 + 25
= 1950    

Note:- In the post merger calculation of HHI HiFly and Sky Systems merge so (20 +10) percent and now there are only four companies with the market share of 10 percent, so the next term is multiplied with 4 instead of 5.

Since the post merger HHI is greater than 1800 ie. 1950 and the pre and post merger change in HHI (1950 - 1550) = 400 ( 50 or more) the antitrust challenge is virtually certain.

Therefore the response of Department of Justice and FTC is to challenge the merger. Hence Option C is correct.