Question

As financial manager of Corton Inc., you are investigating a possible acquisition of Denham. You have the basic data given in the following table.

	Corton				Denham
Forecast earnings per share		$	7.80			$	1.30
Forecast dividend per share		$	4.68			$	.69
Number of shares			2,400,000				2,000,000
Stock price		$	90			$	20

You estimate that investors expect a steady growth of about 6% in Denham’s earnings and dividends. Under new management, this growth rate would be increased to 7.47% per year without the need for additional capital.

Required:

1. What is the gain from the acquisition?
2. What is the cost of the acquisition if Corton pays $25 in cash for each share of Denham?
3. What is the cost of the acquisition if Corton offers one share of Corton for every one shares of Denham?
4. How would the cost of the cash offer change if the expected growth rate of Corton was not changed by the merger?
5. How would the cost of the share offer change if the expected growth rate was not changed by the merger?

(For all requirements, do not round intermediate calculations. Enter your answers in millions rounded to 2 decimal places.)

A	Gain		million
B	Cost		million
C	Cost		million
D	Cash offer		million
E	Share offer		million

Answer 1

Ans. a)

As per Dividend Discount Model

P₀ = D₁ / r-g

Where for Denham at existing growth rate of 6%

P₀ = Price of the Share = $20

D₁ = Expected Dividend in next year = 0.69

g = Growth rate in Dividends 6% or 0.06

r = Discount Rate =?

Step 1 = >

Calculation of Discount Rate for Denham at existing growth rate of 6%

20 = 0.69/ (r-.06)

20r – 1.2 = 0.69

20r = 1.89

r = 1.89/ 20

r = 0.0945 = 9.45%

Step 2 = >

Now, the price per share of Denham at increase growth rate of 7.47% would be:

P₀ = D₁ / r-g

P₀ = 0.69/ (.0945 - .0747)

P₀ = $ 34.84848485

Step 3 = > (Final)

So, Gain from Acquisition = Increase in share price due to increased growth * Number of Shares

= ($34.84848485- $20)*2000000

= $29,696,970

= Gain 29.70 million

Ans. b)

Cost of the acquisition if Corton pays $25 in cash for each share of Denham

= Price paid per share * Number of Shares

= $25 * 2,000,000

= $ 50,000,000

= Cost $50 Million

Ans. c)

Cost of the acquisition if Corton offers one share of Corton for every one shares of Denham

Step 1 = >

Market Capitalization of Denham after merger and increased growth rate of 7.47%

= (Price per share due to increased growth * number of shares)

= $34.84848485 * 2,000,000

= $ 69,696,970

Step 2 = >

Market Capitalization of Corton before merger

= (Price per share * number of shares)

= $90 * 2,400,000

= $ 216,000,000

Step 3 = >

Total value of the merged firm

= $ 69,696,970 + $ 216,000,000

= $ 285,696,970

Step 4 = >

Total number of shares in the merged firm

= Number of existing shares of Corton + Number of shares of Corton given for every one shares of Denham

= 2,400,000 + 2,000,000

= 4,400,000 shares

Step 5 = >

Price per share of the merged firm

= Total value of the merged firm/ Total number of shares in the merged firm

= $ 285,696,970/4,400,000

= $64.93112948

Value of shares hold by the old shareholders of the Corton

= Price per share of the merged firm * Number of existing shares of Corton

= $64.93112948 * 2,400,000

= $155,834,711

Step 6 = > (Final)

Cost of the acquisition if Corton offers one share of Corton for every one shares of Denham

= Market Capitalization of Corton before merger - Value of shares hold by the old shareholders of the Corton

= $ 216,000,000 - $155,834,711

= $60,165,289

= Cost $ 60.17 Million

Ans. d)

Cost of the cash offer if the expected growth rate of Corton was not changed by the merger will not change, if the price per share of Denham is retained at $25 per share as this would be the actual price paid to Corton to the shareholders of Denham.

Cost of the acquisition if Corton pays $25 in cash for each share of Denham

= Price paid per share * Number of Shares

= $25 * 2,000,000

= $ 50,000,000

= Cash Offer $50.00 Million

Ans. e)

Cost of the share offer change if the expected growth rate was not changed by the merger:

Step 1 = >

Market Capitalization of Denham at the growth rate of 6%

= (Price per share * number of shares)

= $20 * 2,000,000

= $ 40,000,000

Step 2 = >

Market Capitalization of Corton before merger

= (Price per share * number of shares)

= $90 * 2,400,000

= $ 216,000,000

Step 3 = >

Total value of the merged firm

= $ 40,000,000 + $ 216,000,000

= $ 256,000,000

Step 4 = >

Total number of shares in the merged firm

= Number of existing shares of Corton + Number of shares of Corton given for every one shares of Denham

= 2,400,000 + 2,000,000

= 4,400,000 shares

Step 5 = >

Price per share of the merged firm

= Total value of the merged firm/ Total number of shares in the merged firm

= $ 256,000,000/4,400,000

= $58.18181818

Value of shares hold by the old shareholders of the Corton

= Price per share of the merged firm * Number of existing shares of Corton

= $58.18181818 * 2,400,000

= $139,636,364

Step 6 = > (Final)

Cost of the acquisition if Corton offers one share of Corton for every one shares of Denham

= Market Capitalization of Corton before merger - Value of shares hold by the old shareholders of the Corton

= $ 216,000,000 - $139,636,364

= $76,363,636

= Share offer $ 76.36 Million