Question

Consider the following premerger information about Firm A and Firm B:

                                       Firm A       Firm B

Total Earnings               $3,150         $1,000

Shares Outstanding       1,500            300

Price per share               $43               $47

Assume that Firm A acquires Firm B via exchange of stock price of $49 for each share of b's stock. Both A and B have no debt outstanding.

a) What will the earnings per share (EPS) of Firm A be after the merger?

b) What will Firm A's price per share be after the merger if the market incorrectly analyzes this reported earnings growth (that is, the price-earnings ratio does not change)?

c) What will the price earnings ratio of the post merger firm be if the market correctly analyzes the transaction?

d) If there are no synergy gains, what will the price of A be after the merger? What will the price-earnings ratio be? What does your answer for the share price tell you about the amount A bid for B? Was it too high? Too low? Explain?

Answer 1

Since there is no debt involved, Firm A acquired Firm B out of its earnings.

Cost of acquisition= 49*300= $14,700

a) Total earnings of firm A after merger= 3150+ 1000= $4150

No. of shares added post merger= 14700/43= 341.86

Total shares post merger= 1500+341.86= 1841.86

EPS of firm A post merger= 4150/1841.86= ~2.25

b) P/E ratio donot change

P/E before merger= 43/ (3150/1500)= ~20.476

If price of firm A post merger= x, then 20.476= x/2.25

x= ~$46.07

c)If market correctly analyses transaction, no change in the price of the firm A

That means, P/E = 43/2.25= ~19.11

d) If there are no synergy gains, then price of firm A post merger will be weighted average of market prices of firm A and firm B

= (43*1500+47*300)/(1500 +341.86)= ~$42.67

P/E= 42.67/ 2.25= ~18.96

Since the share price of firm A has reduced, it implies that firm A has bought firm B at premium. Generally, if shares are bought at premium to market value, it is assumed that the merger shall add synergies intrensically in either operations, branding, good will etc. If no such synergies are considered, then the shares should be bought at market valuation itself.