Question

 

As treasurer of Firm A., you are investigating the possible acquisition of Firm B. You have the following data:

• You estimate that investors currently expect a steady growth of about 6% in Firm B’ earnings and dividends. Under new management this growth rate would be increased to 8% per year, without any additional capital investment required.

• Assume that the cost of equity remains unchanged and the Firm A's equity value also remains unchanged.

	Firm A	Firm B
Earnings per share	£8.00	£2.30
Dividend per share	£3.00	£1.20
Number of shares	1,500,000	900,000
Stock price	£90	£30

a) Discuss the advantages and disadvantages of mergers and acquisitions.

b) Using the above data, calculate the gain from the acquisition (explain your calculations).

c) What is the cost of the acquisition if Firm A pays £40 in cash for each share of Firm B?

d) What is the cost of the acquisition if Firm A offers one share of Firm A for every

three shares of Firm B? 

Answer 1

A)

Advantages of a Merger

1. Increases market share

When companies merge, the new company gains a bigger market share and gets competitive advantage.

2. Reduces the cost

Companies can buy raw materials in bulk, which can result in cost reductions. The cost of assets are now spread out over a total output, which result reducation of Total cost.

3. Avoids duplication

Some companies producing similar products may merge to avoid duplication and reduce competition. It also results focus on new product.

4. Expands business into new geographic areas

A company seeking to expand its business in a certain geographical area may merge with another similar company operating in the same area to get the business started.

5. Prevents closure of an unprofitable company

Mergers can save a company from going bankrupt and also save many jobs.

Disadvantages of a Merger

1. Raises prices of products

A merger results in reduced competition . Thus, the new company can gain a monopoly and increase the prices of its products.

2. Creates gaps in communication

The companies that have agreed to merge may have different cultures and area. It may result in a gap in communication and affect the performance of the employees.

3. Creates unemployment

In an aggressive merger, a company may opt to eliminate the underperforming employees of the other company. It may result in employees losing their jobs.

B) Use the perpetual growth model of stock valuation to find the appropriate discount rate (r) for the common stock of Company B:
P = Dividend1 / (r-g)
30 = 1.20/ (r-0.06)
r-0.06 = 1.20/30 =0.04
r= 0.10 = 10%
value of the combination (AB) would be the value of Company A before the merger (because Company A value is unchanged by the merger) plus the value of company B after the merger
PV(AB) = outstanding Shares A * price + outstanding shares B * D1/(r-g)
= 1,500,000*90 + 900,000*1.20/(0.10-0.08) (growth will be 8% after merger given)
= 189,000,000
Gain from Acquisition = PV(AB) - PV(A)-PV(B)
Now PV(A) = Outstanding Shares A * price
and PV(B) = outstanding Shares B * price
Gain from Acquisition =189,000,000 - 1,500,000*90-900,000*30
=189,000,000 - 135,000,000 - 27,000,000
=£9,000,000-------------------------------------ANSWER B

C) Cost = Cash Paid - PV(B)
= 40* 900,000 - 30*900,000 =£9,000,000-----------ANSWER C

D) After Merger, shares outsatnding of Company A will be
1,500,000 + 900,000/3 = 1,800,000
Hence Share Price will be PV(AB) / After merger share = 189,000,000/1,800,000 = £105
Cost = 900,000/3 * 105 - 900,000 * 30

= £ 4,500,000------------------------------ANSWER D