Question

Your company has earnings per share of $3. It has 1 million shares​ outstanding, each of which has a price of $42. You are thinking of buying​ TargetCo, which has earnings per share of $1​, 1 million shares​outstanding, and a price per share of $23. You will pay for TargetCo by issuing new shares. There are no expected synergies from the transaction. Suppose you offer an exchange ratio such​ that, at current​ pre-announcement share prices for both​ firms, the offer represents a 17% premium to buy TargetCo. Assume that on the announcement the target price will go up and your price will go down to reflect the fact that you are willing to pay a premium for TargetCo. Assume that the takeover will occur with certainty and all market participants know this on the announcement of the takeover.

a. What is the price per share of the combined corporation immediately after the merger is​ completed?

b. What is the price of your company immediately after the​ announcement?

c. What is the price of TargetCo immediately after the​ announcement?

d. What is the actual premium your company will​ pay?

Answer 1

a) For Your company:

EPS = $3, No. of shares = 1,000,000 CMP = $42

For Target co.

EPS = $1, No. of shares = 1,000,000 CMP = $23

What is being offered is 17% premium to CMP of Target co. which is (1.17*23) = $26.91

Hence, The Exchange ratio will be (42/26.91) = 1.56 shares 0f target company per each share of your company.

To exchange 1 million shares of target co. you have to issue = (1,000,000/1.56) shares of your co.

which is 641,025 shares.

Since there is no value addition so, the premium provided would be wiped out of your company.

Premium cost = (26.91-23)*1,000,000 = $3,910,000.

This will be wiped out of your company's valuation. Prior valuation was = $42,000,000

New Valuation of the merged company = $42,000,000 + $26,910,000 - $3,910,000 = $65,000,000

No. of shares = 1,641,025

Price of merged company = $65,000,000/ 1,641,025 = $39.61

b) Immediately after announcement the share price of your company will fall by same amount as increase of target co. (since both have same number of shares).

hence, price of your co. = $42-$3.91 = $38.09

c)

Immediately after announcement the share price of target will also increase by 17%.

hence, price of target co. = $26.91

d) Actual premium paid = Valuation of two entities before merger - Valuation of two entities after merger

= $42,000,000+$23,000,000 - 26,910,000+38,090,000 = $0

Hence, no premium is actually paid.

Whatever was the premium cost has been recovered by increase in valuation of target co.