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CHAPTER 21
MERGERS AND ACQUISITIONS
Answers to Concepts Review and Critical Thinking Questions
1. In merger accounting, if an acquiring company pays more than the market value for a target company,
the amount paid above market value is considered goodwill. If the acquisition does not work as
planned, the goodwill is impaired, that is, a reduction is made in the goodwill account in the amount
2. a. False. Although the reasoning seems correct, in general, the new firms do not have monopoly
b. True. When managers act in their own interest, acquisitions are an important control device for
c. False. Even if markets are efficient, the presence of synergy will make the value of the combined
firm different from the sum of the values of the separate firms. Incremental cash flows provide
d. False. In an efficient market, traders will value takeovers based on “fundamental factors”
regardless of the time horizon. Recall that the evidence as a whole suggests efficiency in the
e. False. The tax effect of an acquisition depends on whether the merger is taxable or non-taxable.
In a taxable merger, there are two opposing factors to consider, the capital gains effect and the
f. True. Because of the coinsurance effect, wealth might be transferred from the stockholders to the
bondholders. Acquisition analysis usually disregards this effect and considers only the total
3. Diversification doesn’t create value in and of itself because diversification reduces unsystematic, not
systematic, risk. As discussed in the chapter on options, there is a subtler issue as well. Reducing
unsystematic risk benefits bondholders by making default less likely. However, if a merger is done
4. A firm might choose to split up because the newer, smaller firms may be better able to focus on their
particular markets. Thus, reverse synergy is a possibility. An added advantage is that performance
5. It depends on how they are used. If they are used to protect management, then they are not good for
stockholders. If they are used by management to negotiate the best possible terms of a merger, then
6. One of the primary advantages of a taxable merger is the write-up in the basis of the target firm’s
assets, while one of the primary disadvantages is the capital gains tax that is payable. The situation is
the reverse for a tax-free merger.
7. Economies of scale occur when average cost declines as output levels increase. A merger in this
particular case might make sense because Eastern and Western may need less total capital investment
8. Among the defensive tactics often employed by management are seeking white knights, threatening
to sell the crown jewels, appealing to regulatory agencies and the courts (if possible), and targeted
share repurchases. Frequently, anti-takeover charter amendments are available as well, such as poison
pills, poison puts, golden parachutes, lockup agreements, and supermajority amendments, but these
9. In a cash offer, it almost surely does not make sense. In a stock offer, management may feel that one
suitor is a better long-run investment than the other, but this is only valid if the market is not efficient.
10. Various reasons include: (1) Anticipated gains may be smaller than thought; (2) Bidding firms are
typically much larger, so any gains are spread thinly across shares; (3) Management may not be acting
Solutions to Questions and Problems
NOTE: All end-of-chapter problems were solved using a spreadsheet. Many problems require multiple
steps. Due to space and readability constraints, when these intermediate steps are included in this solutions
manual, rounding may appear to have occurred. However, the final answer for each problem is found
without rounding during any step in the problem.
Basic
1. For the merger to make economic sense, the acquirer must feel the acquisition will increase value by
at least the amount of the premium over the market value, so:
2. With the purchase method, the assets of the combined firm will be the book value of Firm X, the
acquiring company, plus the market value of Firm Y, the target company, so:
The purchase price of Firm Y is the number of shares outstanding times the sum of the current stock
price per share plus the premium per share, so:
The goodwill created will be:
And the total assets of the combined company will be:
3. Since the acquisition is funded by long-term debt, the post-merger balance sheet will have long-term
debt equal to the original long-term debt of Jurion’s balance sheet plus James’ long-term debt plus the
new long-term debt issue, so:
Goodwill will be created since the acquisition price is greater than the market value. The goodwill
amount is equal to the purchase price minus the market value of assets plus the market value of debt.
Generally, the market value of current assets is equal to the book value, so:
Current liabilities and equity will remain the same as the pre-merger balance sheet of the acquiring
firm. Current assets will be the sum of the two firms’ pre-merger balance sheet accounts, and the fixed
assets will be the sum of the pre-merger fixed assets of the acquirer and the market value of fixed
assets of the target firm. The post-merger balance sheet will be:
4. a. The cash cost is the amount of cash offered, so the cash cost is $50 million.
To calculate the cost of the stock offer, we first need to calculate the value of the target to the
acquirer. The value of the target firm to the acquiring firm will be the market value of the target
plus the PV of the incremental cash flows generated by the target firm. The cash flows are a
perpetuity, so
b. The NPV of each offer is the value of the target firm to the acquiring firm minus the cost of
acquisition, so:
c. Since the NPV is greater with the stock offer, the acquisition should be in stock.
5. a. The EPS of the combined company will be the sum of the earnings of both companies divided
by the shares in the combined company. Since the stock offer is one share of the acquiring firm
for three shares of the target firm, new shares in the acquiring firm will be one-third of Flannery’s
shares outstanding. So, the new EPS will be:
b. The value of Flannery to Stultz must be the market value of the company since the NPV of the
acquisition is zero. Therefore, the value is:
V* = $160,000(13.5)
V* = $2,160,000
The cost of the acquisition is the number of shares offered times the share price, so the cost is:
6. The decision hinges upon the risk of surviving. That is, consider the wealth transfer from bondholders
to stockholders when risky projects are undertaken. High-risk projects will reduce the expected value
of the bondholders’ claims on the firm. The telecommunications business is riskier than the utilities
business.
reduction in total value, management should reject the project.
7. a. The NPV of the merger is the market value of the target firm, plus the value of the synergy, minus
the acquisition costs, so:
b. Since the NPV goes directly to stockholders, the share price of the merged firm will be the market
value of the acquiring firm plus the NPV of the acquisition, divided by the number of shares
outstanding, so:
c. The merger premium is the premium per share times the number of shares of the target firm
outstanding, so the merger premium is:
d. The number of new shares will be the number of shares of the target times the exchange ratio,
so:
The value of the merged firm will be the market value of the acquirer plus the market value of
the target plus the synergy benefits, so:
The price per share of the merged firm will be the value of the merged firm divided by the total
shares of the new firm, which is:
e. The NPV of the acquisition using a share exchange is the market value of the target firm plus
synergy benefits, minus the cost. The cost is the value per share of the merged firm times the
number of shares offered to the target firm shareholders, so:
Intermediate
8. The share offer is better for the target firm shareholders since they receive only $27 per share in the
cash offer. In the share offer, the target firm’s shareholders will receive:
From Problem 7, we know the value of the merged firm’s assets will be $508,200. The number of
shares in the new firm will be:
That is, the number of shares outstanding in the bidding firm, plus the number of shares outstanding
in the target firm, times the exchange ratio. This means the post-merger share price will be:
To make the target firm’s shareholders indifferent, they must receive the same wealth, so:
This equation shows that the new offer is the shares outstanding in the target company times the
exchange ratio times the new stock price. The value under the cash offer is the shares outstanding
times the cash offer price. Solving this equation for P, we find:
Combining the two equations, we find:
There is a simpler solution that requires an economic understanding of the merger terms. If the target
firm’s shareholders are indifferent, the bidding firm’s shareholders are indifferent as well. That is, the
offer is a zero sum game. Using the new stock price produced by the cash deal, we find:
9. The cost of the acquisition is:
Cost = 500($43)
Cost = $21,500
Since the stock price of the acquiring firm is $38, the firm will have to give up:
a. The EPS of the merged firm will be the combined EPS of the existing firms divided by the new
shares outstanding, so:
b. The PE of the acquiring firm is:
c. If the market correctly analyzes the earnings, the stock price will remain unchanged since this is
a zero NPV acquisition, so:
d. The new share price will be the combined market value of the two existing companies divided
by the number of shares outstanding in the merged company. So:
At the proposed bid price, this is a negative NPV acquisition for A since the share price declines.
They should revise their bid downward until the NPV is zero.
