Question

The following information is for two all equity companies, Cathay Pacific and Hong Kong Airline:

	Cathay Pacific	Hong Kong Airline
Price per share	50	10
Total earnings	2,100,000	880,000
Share outstanding	1,400,000	800,000

Cathay Pacific is planning to acquire Hong Kong Airline by exchanging 200,000 of its new shares for all the shares in Hong Kong Airline. The synergy from the merger, as estimated by Morgan Stanley, is worth $18,000,000.

a What is the actual cost of the acquisition?
b Calculate the EPS and P/E of Cathay Pacific before and after the acquisition. Based on the changes in these two figures, comment on the decision to carry out the acquisition.
c Regardless of your findings in (b), people have always said that mergers and acquisitions are advantageous. Please provide valid explanations to support this argument from the perspective of revenue enhancement and cost reduction.

Answer 1

a) cost acquisition is V(C,H) = V(C)+V(H)+synergy

cost of acquisition = 2,100,000 + 880,000 + 18,000,000

cost = $ 20,188,000

cathay pacific planned to acquire Hong Kong Airline by exchanging 200,000 shares so, the total outstanding shares after merger will be 1,400,000 + 200,000 = 1,600,000 and the per share value will be $ 20,188,000/ 1,600,000 = $12.6175

b) EPS before acquisition = 2,100,000/1,400,000 = $1.5

EPS after acquisition = 2,100,000+880,000/ 1,600,000 = $1.8625

c) mergers and acquisitions are advantageous because of several reasons some of which are :

• Revenue Enhancement : an important reason for acquisition is that the combine dfirm may generate greater revenues than two separate firms. Marketing Gains, Strategic Benefits, and Increase in market power may lead to increases in revenue.
• Marketing Gains : it is greatly believed that mergers and acquisition can result into large amount of operating revenues from improved marketing. for instance, following areas can be improved :

1. Previously ineffective advertising efforts and programmes.
2. A weak distribution network
3. An unbalanced product mix.

• Strategic Benefits : some acquisition provides an opportunity to take advantage of the competitive environment in order to enhance management efficiency to the future operations.
• Synergy : when the acquisition results in incremental capital gain then it is known as synergy. for example, when Walt Disney bought Capital Cities, Disney chairman Michael Eisner said that the companies would find synergy and that the case will be " 1 and 1 will add up to 4".
• Market Power : acquisition leads to increase in market share and market power of the buying company. in such cases profits can be increased through higher prices and reduced competition for customers.
• Cost Reductions : the most basic reason to merge is that a combined firm may achieve greater operating efficiency.
• Economies of Scale : this expression refers to the sharing of facilities such as top management, computer services and corporate headquarters. Economies of scale relate to the average cost per unit of goods and services reduced.
• Economics of Vertical Integration : the vertical acquisitions make it easier to coordinate closely related operating activities. however, operating economies can be gained from  horizontal combinations as well.
• Lower Taxes : possible tax gains from an acquisition are following :

1. the use of surplus funds
2. the use of tax losses
3. the ability to write up the value of depreciable assets
4. the use of unused debt capacity.