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Chapter 20 - Mergers and Acquisitions and Financial Distress
LG1 1. Describe the difference between a merger and an acquisition.
LG1 2. Describe the difference between a horizontal merger and a vertical merger.
A horizontal merger combines two companies in the same industry, such as the merger between
LG1 3. Classify each of the following as a horizontal merger, a vertical merger, a market extension merger,
a conglomerate merger, or a product extension merger.
LG1 4. What is synergy and how does it apply to mergers?
The main motivation for a merger or acquisition is synergy. That is, the value of the combined firms
LG1 5. Describe the three dimensions of revenue synergies that may be achieved in a merger.
First, acquiring a firm in a growing market may enhance revenues. Second, the acquiring firm’s
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LG1 6. What is the difference between economies of scope and economies of scale? Can two firms
involved in a merger benefit from both economies of scale and economies of scope?
As firms become larger through a merger, the increase in size allows for the reduction or
LG2 7. What is the Herfindahl-Hirschman Index? How is it calculated and interpreted?
The Herfindahl-Hirschman Index (HHI) is a measure of market concentration whose value can
LG1 8. How can managers’ personal incentives result in value-destroying mergers and acquisitions?
Managers expand through mergers to get personal benefits from building and managing large
corporations. Academic research has documented this motive, finding that mergers are often
positively related to sales and asset growth, and do not always result in increased stock prices.
LG2 9. Why is NPV valuation an appropriate tool to use in the evaluation of a merger target?
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LG3 10. What is the difference between business failure, economic failure, and technical insolvency?
At the extreme, business failure is a type of financial distress in which a firm no longer stays in
business. However, financial distress does not automatically mean the end of the firm. Other levels of
LG3 11. A firm is experiencing a temporary period of financial distress as the result of a hurricane that has
hit its local area. Because many of the firm’s customers have been severely hurt by the hurricane,
they are unable to pay their debts to the firm. This stoppage of cash inflows has left the firm
temporarily unable to pay its own bills. What options do the firm’s creditors have with respect to
getting paid?
LG3 12.What is the job of the trustee in an informal liquidation of a firm’s assets?
The trustee or assignee liquidates the firm’s assets through a private sale or a public auction. The
LG4 13. What is the difference between a Chapter 11 and a Chapter 7 bankruptcy?
The goal of a Chapter 11 proceeding is to plan a reorganization of the corporation with some
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LG4 14. Does a Chapter 7 bankruptcy increase the probability that creditors will be paid in full more so
than a Chapter 11 bankruptcy?
LG4 15. What is the order of payment to a firm’s creditors in a Chapter 7 bankruptcy?
The distribution of the funds from asset liquidation occurs according to the following priority of
claims: (1) property taxes past due; (2) claims of secured creditors, who receive the proceeds
from the sale of specific collateral as stated in a lien or mortgage; (3) administrative expenses
LG4 16. To what extent are employees of a bankrupt firm paid their wages and benefits due?
LG5 17. What is a credit-scoring model?
Credit-scoring models are quantitative models that use data on observed firm characteristics either to
LG5 18. What is the difference between a linear discriminant and a linear probability credit-scoring
LG5 19. A firm has an Altman’s Z-score of 1.76. What does this mean?
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LG5 20. The Altman’s Z-score model has several weaknesses. What are they?
The first problem is that this model usually discriminates only between two extreme cases of
firm behavior: bankruptcy and no bankruptcy. In the real world various gradations of bankruptcy
risk exist, from nonpayment or delay of interest payments (nonperforming assets) to outright
centralized, publicly available database on defaulted loans or bankruptcies for proprietary or
other reasons exists. Some task forces by consortiums of commercial banks and consulting firms
are currently seeking to construct such databases, but it may well be many years before they are
fully developed. This constrains the ability of many creditors to use credit-scoring models for
LG5 21. A linear probability model you have developed finds that a firm has a PD of 0.16. What does this
mean?
The firm’s expected probability of default, or bankruptcy, is estimated as 16 percent.
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LG2 20-1 Calculation of Average Costs with Economies of Scope Peter’s TV Supplies is considering a
merger with Jan’s Radio Supply Stores. Peter’s total operating costs of producing services are
$250,000 for a sales volume (SP) of $4.5 million. Jan’s total operating costs of producing services are
$50,000 for a sales volume (SJ) of $550,000.
a. Calculate the average cost of production for the two firms.
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Chapter 20 - Mergers and Acquisitions and Financial Distress
b. If the two firms merge, calculate the total average cost (TAC) for the merged firm assuming no
synergies.
c. Suppose, instead, that synergies in the production process result in a cost of production for the
merged firms totaling $270,000 for a sales volume of $5,050,000. Calculate the total average
cost (ACPeterJan) for the merged firm.
LG2 20-2 Calculation of Average Costs with Economies of Scope Cindy’s Computer Corp. is
considering a merger with Bobby’s Hard Drive, Inc. Cindy’s total operating costs of producing
services are $3.4 million for a sales volume (SC) of $16 million. Bobby’s total operating costs of
producing services are $2.5 million for a sales volume (SB) of $8 million.
a. Calculate the average cost of production for the two firms.
b. If the two firms merge, calculate the total average cost (TACCindyBobby) for the merged firm
assuming no synergies.
c. Suppose, instead, that synergies in the production process result in a cost of production for the
merged firms totaling $5.3 million for a sales volume of $24 million. Calculate the total average
cost (ACCindyBobby) for the merged firm
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LG2 20-3 Calculation of Change in the HHI Associated with a Merger Consider a market that has
three firms with the following market shares:
Suppose firm B wants to acquire firm C so that the post-acquisition market would exhibit the
following shares:
Calculate the pre and postmerger HHI, and the change in the HHI resulting from the merger.
According to Department of Justice guidelines, is this merger likely to be challenged?
The premerger HHI for the market is:
Thus, the market is highly concentrated according to the Department of Justice guidelines. The
postmerger HHI would be:
Thus, the increase or change in the HHI (ΔHHI) postmerger is:
LG2 20-4 Calculation of Change in the HHI Associated with a Merger Consider a market that
has three firms with the following market shares:
Firm A = 35 percent
Firm B = 41 percent
Firm C = 24 percent
Suppose firm A wants to acquire firm C so that the post-acquisition market would exhibit the
following shares:
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Chapter 20 - Mergers and Acquisitions and Financial Distress
The premerger HHI for the market is:
Thus, the increase or change in the HHI (ΔHHI) postmerger is:
LG5 20-5 Calculation of Altman’s Z-Score: Suppose that the financial ratios of a potential
borrowing firm take the following values: X1 = Net working capital/Total assets = 0.10, X2 =
Retained earnings/Total assets = 0.20, X3 = Earnings before interest and taxes/Total assets = 0.22,
X4 = Market value of equity/Book value of long-term debt = 0.60, X5 = Sales/Total assets ratio =
0.90. Calculate and interpret the Altman’s Z-score for this firm
According to the Altman’s Z-score, this firm should be placed in the indeterminate bankruptcy
risk class.
LG5 20-6 Calculation of Altman’s Z-Score: Suppose that the financial ratios of a potential
borrowing firm took the following values: X1 = Net working capital/Total assets = 0.27, X2 =
Retained earnings/Total assets = 0.37, X3 = Earnings before interest and taxes/Total assets = 0.44,
X4 = Market value of equity/Book value of long-term debt = 1.25, X5 = Sales/Total assets ratio =
2.75. Calculate and interpret the Altman’s Z-score for this firm
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Chapter 20 - Mergers and Acquisitions and Financial Distress
LG5 20-7 Calculation of Bankruptcy Probability Suppose a linear probability model you have
developed finds there are two factors influencing the past bankruptcy behavior of firms: the debt
ratio and the profit margin. Based on past bankruptcy experience, the linear probability model is
estimated as:
LG5 20-8 Calculation of Bankruptcy Probability A linear probability model you have developed
finds there are two factors influencing the past bankruptcy behavior of firms: the equity
multiplier and the total asset turnover ratio. Based on past bankruptcy experience, the linear
probability model is estimated as:
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