Chapter 20
External Growth through Mergers
Discussion Questions
20-1. Name three industries in which mergers have been prominent.
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
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
20-4. What is the difference between horizontal integration and vertical integration?
How does antitrust policy affect the nature of mergers?
Antitrust policy generally precludes the elimination of competition. For this
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
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
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
20-8. How is goodwill now treated in a merger?
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
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
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
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
Chapter 20
Problems
1. Tax loss carryforward (LO20-1) The Clark Corporation desires to expand. It is
considering a cash purchase of Kent Enterprises for $3 million. Kent has a $700,000 tax
loss carryforward that could be used immediately by the Clark Corporation, which is
paying taxes at the rate of 30 percent. Kent will provide $420,000 per year in cash flow
(aftertax income plus depreciation) for the next 20 years. If the Clark Corporation has a
cost of capital of 13 percent, should the merger be undertaken?
20-1. Solution:
The Clark Corporation
Cash outflow:
Cash inflows:
Cash inflows $ 2,950,500
2. Tax loss carryforward (LO20-1) Assume that Western Exploration Corp. is considering
the acquisition of Ogden Drilling Company. The latter has a $470,000 tax loss
carryforward. Projected earnings for the Western Exploration Corp. are as follows:
Total
20X1 20X2 20X3 Values
Before-tax income……………… $185,000 $250,00
0
$370,000 $805,000
Taxes (35%)……………………… 64,750 87,500 129,500 281,750
Income available
to stockholders
……………………………………. $120,250
$162,50
0 $240,500 $523,250
a. How much will the total taxes of Western Exploration Corp. be reduced as a result of
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.
a. Reduction in taxes due to tax loss carryforward =
Loss × Tax rate
b. Western Exploration Corp.(with merger and associated tax
benefits)
20X1 20X2 20X3 Total
Aftertax income
available to
3. Cash acquisition with deferred benefits (LO20-2) J & J Enterprises is considering a cash
acquisition of Patterson Steel Company for $4,500,000. 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)…………………… $490,000 $650,000 $850,000
Synergistic benefits (aftertax)………… 45,000 65,000 75,000
The cost of capital for the acquiring firm is 12 percent. Compute the net present value.
Should the merger be undertaken?
(If you have difficulty with deferred time value of money problems, consult Chapter 9.)
20-3 Solution:
J & J Enterprises
Cash inflows
PV factors for the analysis (12%) (Appendix D)
Year (1–5)
Years (6–15)
20-3. (Continued)
Years (16–20)
4. Cash acquisition with deferred benefits (LO20-2) Worldwide Scientific Equipment is
considering a cash acquisition of Medical Labs for $1.6 million. Medical Labs will provide
the following pattern of cash inflows and synergistic benefits for the next 25 years. There is
no tax loss carryforward.
Years
1–5 6–15 16–25
Cash inflow (aftertax)…………………… $150,000 $170,000 $210,000
Synergistic benefits (aftertax)………… 20,000 30,000 50,000
The cost of capital for the acquiring firm is 11 percent. Compute the net present value.
Should the merger be undertaken?
20-4 Solution:
Worldwide Scientific Equipment
Year (1–5)
Years (6–15)
Cash inflow $170,000
20-4. (Continued)
Years (16–20)
Total present value of inflows $ 1,647,380
The positive net present value indicates the merger should be
undertaken.
5. Impact of merger on earnings per share (LO20-3) Assume the following financial data
for Rembrandt Paint Co. and Picasso Art Supplies:
Rembrandt
Paint Co.
Picasso Art
Supplies
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
a. If all the shares of Rembrandt Paint Co. are exchanged for those of Picasso Art Supplies
on a share-for-share basis, what will postmerger earnings per share be for Picasso Art
Supplies? Use an approach similar to that in Table 20-3.
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)
New earnings per share for Picasso Enterprises
20-5. (Continued)
b. Earnings per share of Picasso increased because it has a
higher P/E ratio than Rembrandt (32x versus 24x). Any time
c. Although earnings per share for Picasso went up, we cannot
automatically assume the firm is better off. We need to know
whether Rembrandt will increase or decrease the future
6. Impact of merger on earnings per share (LO20-3) Assume the following financial data
for the Noble Corporation and Barnes Enterprises:
Noble Barnes
Corporation Enterprises
Total earnings…………………………………………………….$1,820,000 $5,620,000
Number of shares of stock outstanding………………….650,000 2,810,000
Earnings per share……………………………………………… $2.80 $2.00
Price-earnings ratio (P/E)……………………………………. 20× 28×
Market price per share……………………………….. $56 $56
a. If all the shares of the Noble Corporation are exchanged for those of Barnes Enterprises
on a share-for-share basis, what will postmerger earnings per share be for Barnes
Enterprises? Use an approach similar to that in Table 20–3.
b. Explain why the earnings per share of Barnes Enterprises changed.
c. Can we necessarily assume that Barnes Enterprises is better off after the merger?