Answers and Solutions: 22 – 1
Chapter 22
Mergers and Corporate Control
ANSWERS TO END-OF-CHAPTER QUESTIONS
22-1 a. Synergy occurs when the whole is greater than the sum of its parts. When applied to
mergers, a synergistic merger occurs when the postmerger free cash flows exceed the
sum of the separate companies‘ premerger free cash flows. A merger is the joining of
two firms to form a single firm.
c. A friendly merger occurs when the target company’s management agrees to the
merger and recommends that shareholders approve the deal. In a hostile merger, the
stockholders, frequently over the opposition of the target company’s management. A
target company is a firm that another company seeks to acquire. Breakup value is a
financial merger, the companies will not be operated as a single unit, and no operating
economies are expected.
website, in whole or in part.
e. The free cash flow to equity model, or also called the residual dividend model, first
cash flow less interest expense plus the interest tax shield. It then discounts the
FCFEs at the levered cost of equity to arrive at the value of equity in operations. You
add in the value of non-operating assets and you get the value of the equity. To get
the value of operations you then add in the value of the debt.
g. A white knight is a friendly competing bidder that a target management likes better
than the company making a hostile offer, and the target solicits a merger with the
white knight as a preferable alternative. A proxy fight is an attempt to gain control of
a firm by soliciting stockholders to vote for a new management team.
assets, often a whole division, to another firm or individual. In a spin-off, a holding
company distributes the stock of one of the operating companies to its shareholders.
Thus, control passes from the holding company to the shareholders directly.
j. A holding company is a corporation formed for the sole purpose of owning stocks in
in two different markets at different prices, and pocketing a risk-free return. In the
context of mergers, risk arbitrage refers to the practice of purchasing stock in
companies that may become takeover targets.
website, in whole or in part.
22-2 Horizontal and vertical mergers are most likely to result in governmental intervention,
22-3 A tender offer might be used. Although many tender offers are made by surprise and over
22-4 An operating merger involves integrating the company’s operations in hopes of obtaining
22-5 The compressed APV model discounts the free cash flows and the interest tax shields at
the unlevered cost of equity. Because the unlevered cost of equity doesn’t change when
the capital structure changes, the compressed APV model can be used even when the
Answers and Solutions: 22 – 4
SOLUTIONS TO END-OF-CHAPTER PROBLEMS
22-1 FCF1 = 2.00(1.05) = $2.1 million; gL = 5%; b = 1.4; rRF = 5%; RPM = 6%; wd = 30%; T =
40%; rd = 8%
a. Determine the cost of equity and the weighted average cost of capital:
b. Determine the intrinsic value of operations:
Vops =
gWACC
)g1(FCF
0
=
05.01082.0
1.2$
Price = 25.26 million / 1 million shares
= $25.26 / share.
22-2 Current b = 1.4; rRF = 5%; RPM = 6%; current wd = 30%; T = 40%; rd = 8%,
FCF1 = $2.5 million, FCF2 = $2.9 million, FCF3 = $3.4 million, and FCF4 = 3.57 million;
a. Determine Vandell‘s pre-acquisition cost of equity and the unlevered cost of equity:
rsL = rRF + RPM(b)
Note: This is the same rsL as calculated in problem 22-1.
rsU = wdrd + wsrsL
b. Determine the unlevered value of operations:
Unlevered horizon value = FCF4(1+g)/(rsU-gL)
website, in whole or in part.
Equity value to acquirer = Vops – Assumed debt
= $41.54 million
Note: Because we are finding the value of the target’s equity to the acquiror, we need not
subtract the value of the new debt. In other words, the acquirer could pay $41.54 million
million of existing debt that will be assumed; the other part is the new debt: $18.75 –
$10.82 = $7.93 million. Therefore, if the acquirer pays $41.54 million for the target’s
equity, $7.93 would come from new debt issued by the acquirer and the remainder
($41.54 – $7.93 = $33.61) would come from the acquirer’s cash (which is in effect
Note: Since the capital structure isn’t changing after the horizon, we could use the FCF
corporate valuation model to calculate the value of operations at the horizon. This should
be equal to the sum of the horizon value for the unlevered operations ($55.29) and the
= 13.4%.
WACC = wdrd(1-T) + wsrs
FCF Corporate Valuation Model Horizon Value = FCF4(1+g)/(WACC-gL)
= 3.57(1.05)/(0.1082 – 0.05)
= 3.7485/(0.0582)
22-3 On the basis of the answers in Problems 1 and 2, the bid for each share should range
22-4 Current b = 1.4; rRF = 5%; RPM = 6%; current wd = 30%; T = 40%; rd = 8%,
The difference between this problem and Problem 22-2 is the tax shield in year 4, which
reflects the capital structure with 45% debt instead of the previous 30% debt. The first
step is to determine the Year 4 tax payment:
a. Determine the Year 4 interest payment and tax shield:
b. Determine the unlevered value of operations and the value of the tax shield tax shield:
Unlevered horizon value = FCF4(1+g)/(rsU-g)
= 3.57(1.05)/(0.1178-0.05)
Answers and Solutions: 22 – 9
= 11.14%
Interest5 = Debt4 (9.5%) = $22.27 (9.5%) = 2.116
TS5 = Interest5(Tax rate) = 2.116(0.35%) = 0.7405 (You must use the post merger
tax rate)
= 0.7405(1.06)/(0.1114 – 0.06) = $15.28 million
The value of the tax shields =
28.15741.0
735.0
980.0
595.0
42.0
Answers and Solutions: 22 – 10
The unlevered value of operations is
5432 )1114.1(
74.4312.2
)1114.1(
0.2
)1114.1(
75.1
)1114.1(
5.1
1114.1
3.1
= $32.02 million
b. The value of operations is the sum of the interest tax shields and the unlevered value
= 11.50 + 32.02 = $43.52 million.
The value of the equity is the value of operations (plus any non-operating assets,
of 9.5 percent, the new levered cost of equity and WACC will be:
rsL = rsU + (rsU –rd)(D/S)
= 11.14% + (11.14% – 9.5%)(0.40/0.60)
= 12.23%