Chapter 20 – External Growth through Mergers
Chapter 20
External Growth through Mergers
Discussion Questions
20-1.
Name three industries in which mergers have been prominent.
Computers, telecommunications, public utilities, pharmaceuticals, and energy.
20-2.
What is the difference between a merger and a consolidation?
In a merger two or more companies are combined, but only the identity of the
acquiring firm is maintained. In a consolidation, an entirely new entity is
formed from the combined companies.
20-3.
Why might the portfolio effect of a merger provide a higher valuation for the
participating firms?
If two firms benefit from opposite phases of the business cycle, their variability
in performance may be reduced. Risk-averse investors may then discount the
future performance of the merged firms at a lower rate and thus assign a higher
valuation than was assigned to the separate firms.
20-4.
What is the difference between horizontal integration and vertical integration?
How does antitrust policy affect the nature of mergers?
Horizontal integration is the acquisition of competitors, and vertical integration
is the acquisition of companies that produce goods and services used by the
company.
Antitrust policy generally precludes the elimination of competition. For this
reason, mergers are often with companies in allied but not directly related
fields.
Chapter 20 – External Growth through Mergers
20-5.
What is synergy? What might cause this result? Is there a tendency for
management to over– or underestimate the potential synergistic benefits of a
merger?
Synergy is said to occur when the whole is greater than the sum of the parts.
This “2 + 2 = 5” effect may be the result of eliminating overlapping functions in
production and marketing as well as meshing together various engineering
capabilities. In terms of planning related to mergers, there is often a tendency to
overestimate the possible synergistic benefits that might accrue.
20-6.
If a firm wishes to achieve immediate appreciation in earnings per share as a
result of a merger, how can this be best accomplished in terms of exchange
variables? What is a possible drawback to this approach in terms of long-range
considerations?
The firm can achieve this by acquiring a company at a lower P/E ratio than its
own. The firm with a lower P/E ratio may also have a lower growth rate. It is
possible that the combined growth rate for the surviving firm may be reduced
and long-term earnings growth diminished.
20-7.
It is possible for the postmerger P/E ratio to move in a direction opposite to that
of the immediate postmerger earnings per share. Explain why this could
happen.
If earnings per share show an immediate appreciation, the acquiring firm may
be buying a slower growth firm as reflected in relative P/E ratios. This
immediate appreciation in earnings per share could be associated with a lower
P/E ratio. The opposite effect could take place when there is an immediate
dilution to earning per share. Obviously, a number of other factors will also
come into play.
20-8.
How is goodwill now treated in a merger?
It is placed on the books of the acquiring company, but it is not amortized. It is
only written down if it is impaired.
Chapter 20 – External Growth through Mergers
20-9.
Suggest some ways in which firms have tried to avoid being part of a target
takeover.
An unfriendly takeover may be avoided by:
a. turning to a second possible acquiring company—a “White Knight.”
b. moving corporate offices to states with tough pre-notification and protection
provisions.
c. buying back outstanding corporate stock.
d. encouraging employees to buy stock.
e. staggering the election of directors.
f. increasing dividends to keep stockholders happy.
g. buying up other companies to increase size and reduce vulnerability.
h. reducing the cash position to avoid a leveraged takeover.
20-10.
What is a typical merger premium paid in a merger or acquisition? What effect
does this premium have on the market value of the merger candidate and when
is most of this movement likely to take place?
Typically a merger premium of 40-60 percent is paid over the premerger price
of the acquired company. The effect of the premium is to increase the price of
the merger candidate and most of this movement is likely to take place before
public announcement.
20-11.
Why do management and stockholders often have divergent viewpoints about
the desirability of a takeover?
While management may wish to maintain their autonomy and perhaps keep
their jobs, stockholders may wish to get the highest price possible for their
holdings.
20-12.
What is the purpose(s) of the two-step buyout from the viewpoint of the
acquiring company?
The two-step buy-out provides a strong inducement to target stockholders to
quickly react to the acquiring company’s initial offer. Also, it often allows the
acquiring company to pay a lower total price than if a single offer is made.
Chapter 20 – External Growth through Mergers
20-4
Chapter 20
Problems
1. Tax loss carryforward (LO1) Boardwalk Corporation desires to expand. It is considering
income plus depreciation) for the next 20 years. If the Boardwalk Corporation has a cost of
20–1. Solution:
Boardwalk Corporation
Cash outflow:
Purchase price $ 2,400,000
Less tax shield benefit from tax
loss carry-forward ($600,000 × 35%) – 210,000
Net cash outflow $ 2,190,000
Cash inflows:
$300,000, n = 20, i = 11% (Appendix D)
$3000,000 × 7.963 = $ 2,388,900
Cash inflows $ 2,388,900
Cash outflow 2,190,000
Net present value $ 198,900
undertaken.
Chapter 20 – External Growth through Mergers
20-5
2. Tax loss carryforward (LO1) Assume that Western Exploration Corp. is considering the
acquisition of Ogden Drilling Company. The latter has a $400,000 tax loss carryforward.
Projected earnings for the Western Exploration Corp. are as follows:
Total
2011 2012 2013 Values
Before-tax income……………..
$160,000
$200,000
$320,000
Taxes (40%) …………………….
64,000
80,000
128,000
Income available
to stockholders……………….
$96,000
$120,000
$192,000
the tax loss carryforward?
b. How much will the total income available to stockholders be for the three years if the
acquisition occurs? Use the same format as that in the text.
20–2 Solution:
Western Exploration Corp.
loss × tax rate
$400,000 × 40% = $160,000
b. Western Exploration Corp.(with merger and associated tax
benefits)
2011
2012
2013
Total
Before tax income
$160,000
$200,000
$320,000
$680,000
Tax loss carry-
forward
160,000
200,000
40,000
400,000
Net taxable income
0
0
280,000
280,000
Taxes (40%)
0
0
112,000
112,000
Aftertax Income
available to
stockholders
$160,000
$200,000
$208,000*
$568,000**
* Before-tax income – taxes ($320,000 – $112,000 = $208,000)
** Before-tax income – taxes ($680,000 – $112,000 = $568,000)
Chapter 20 – External Growth through Mergers
20-6
3. Cash acquisition with deferred benefits (LO2) J & J Enterprises is considering a cash
acquisition of Patterson Steel Company for $4,000,000. Patterson will provide the
following pattern of cash inflows and synergistic benefits for the next 20 years. There is no
tax loss carryforward.
Years
1–5 6–15 16–20
Cash inflow (aftertax) ………………….. $440,000 $600,000 $800,000
Synergistic benefits (aftertax) ……….. 40,000 60,000 70,000
20–3 Solution:
J & J Enterprises
Cash outflow (Purchase price) $4,000,000
Cash inflows
PV factors for the analysis (12%) (Appendix D)
Years
(1–5)
(6-15)
(16-20)
3.605
1-15
6.811
1-20
7.469
–1-5
–3.605
–1-15
6.811
6 to 15
3.206
16 to 20
.658
Year (1-5)
Cash inflow $440,000
Synergistic benefits 40,000
Total cash inflow $480,000
P.V. $480,000 × 3.605 = $1,730,400
Years (6-15)
Cash inflow $600,000
Synergistic benefits 60,000
Total cash inflow $660,000
Chapter 20 – External Growth through Mergers
20-7
P.V. $660,000 × 3.206 = $2,115,960
20–3. (Continued)
Years (16-20)
Cash inflow $800,000
Synergistic benefits 70,000
Total cash inflow $870,000
P.V. $870,000 × .658 = $ 572,460
Total present value of inflows $4,418,820
Cash inflows $4,418,820
Cash outflow 4,000,000
Net present value $ 418,820
undertaken.
4. Cash acquisition with deferred benefits (LO2) Worldwide Scientific Equipment is
considering a cash acquisition of Medical Labs for $1.5 million. Medical Labs will provide
the following pattern of cash inflows and synergistic benefits for the next 25 years. There is
no tax loss carry forward.
Years
1–5 6–15 16–25
Cash inflow (aftertax) ………………….. $100,000 $120,000 $160,000
Synergistic benefits (aftertax) ……….. 15,000 25,000 45,000
20–4 Solution:
Worldwide Scientific Equipment
Cash outflow (Purchase price) $1,500,000
Cash inflows
Chapter 20 – External Growth through Mergers
20-8
PV factors for the analysis (9%) (Appendix D)
Years
(1–5)
(6-15)
(16-25)
3.890
1-15
8.061
1-25
9.823
1-5
–3.890
1-15
8.061
6 to 15
4.171
15 to 20
1.762
Year (1-5)
Cash inflow $100,000
Synergistic benefits 15,000
Total cash inflow $115,000
P.V. $115,000 × 3.890 = $ 447,350
Years (6-15)
Cash inflow $120,000
Synergistic benefits 25,000
Total cash inflow $145,000
P.V. $145,000 × 4.171 = $604,795
20–4. (Continued)
Years (16-20)
Cash inflow $160,000
Synergistic benefits 45,000
Total cash inflow $205,000
P.V. $205,000 × 1.762 = $ 361,210
Total present value of inflows $ 1,413,355
Cash inflows $ 1,413,355
Cash outflow 1,500,000
Net present value ($–86,645)
undertaken.
Chapter 20 – External Growth through Mergers
20-9
5. Impact of merger on earnings per share (LO3) Assume the following financial
data for Rembrandt Paint Co. and Picasso Art Supplies:
Rembrandt Picasso
Paint Co.
Art Supplies
Total earnings ……………………………………..…………..
$300,000
$900,000
Number of shares of stock outstanding …….…………..
100,000
500,000
Earnings per share ………………………………..…………..
$3.00
$1.80
Price-earnings ratio (P/E) …………………………..
12×
20×
Market price per share …………………………. $36 $36
Picasso Art Supplies?
b. Explain why the earnings per share of Picasso Art Supplies changed.
c. Can we necessarily assume that Picasso Art Supplies is better off after the merger?
20–5. Solution:
Rembrandt Paint Co. and Picasso Art Supplies
(approach similar to Table 20–3)
a. Total earnings Rembrandt $ 300,000
+ Picasso $ 900,000
Combined earnings $1,200,000
Shares outstanding Original Picasso shares 500,000
+ New Picasso shares 100,000
Postmerger Shares Outstanding 600,000
$1,200,000 $2.00
600,000
==
Chapter 20 – External Growth through Mergers
20-10
20–5. (Continued)
postmerger earnings per share.
c. Although earnings per share for Picasso Art Supplies went
up, we can not automatically assume the firm is better off.
We need to know whether the Rembrandt Paint Co. will
6. Impact of merger on earnings per share (LO3) Assume the following financial data for
the Noble Corporation and Barnes Enterprises:
Noble Barnes
Corporation
Enterprises
Total earnings …………………………………………..……..
$1,200,000
$3,600,000
Number of shares of stock outstanding………….……..
600,000
2,400,000
Earnings per share …………………………………….……..
$2.00
$1.50
Price-earnings ratio (P/E) …………………………………..
24×
32×
Market price per share ……………………………… $48 $48
c. Can we necessarily assume that Barnes Enterprises is better off after the merger?
20–6 Solution:
Noble Corporation and Barnes Enterprises
(approach similar to Table 20–3)