CHAPTER 28 –
1
CHAPTER 29
MERGERS, ACQUISITIONS,
AND DIVESTITURES
Answers to Concepts Review and Critical Thinking Questions
1. In the purchase method, assets are recorded at market value, and goodwill is created to account for the
excess of the purchase price over this recorded value. In the pooling of interests method, the balance
2. a. False. Although the reasoning seems correct, in general, the new firms do not have monopoly
power. This is especially true since many countries have laws limiting mergers when it would
create a monopoly.
b. True. When managers act in their own interest, acquisitions are an important control device for
shareholders. It appears that some acquisitions and takeovers are the consequence of underlying
conflicts between managers and shareholders.
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 more subtle issue as well. Reducing
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
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
7. Economies of scale occur when average cost declines as output levels increase. A merger in this
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
9. In a cash offer, it almost surely does not make sense. In a stock offer, management may feel that one
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:
Assets from X = 41,800($21) = $877,800 (book value)
Assets from Y = 26,500($19) = $503,500 (market value)
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 the original long-term debt on
James’ balance sheet, plus the new long-term debt issue, so:
Post-merger long-term debt = $14,100 + 2,200 + 32,800
Post-merger long-term debt = $49,100
4. 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 Silver’s balance sheet plus the new long-term debt issue,
so:
Post-merger long-term debt = $4,300 + 12,500
Post-merger long-term debt = $16,800
5. a. The cash cost is the amount of cash offered, so the cash cost is $33 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
6. 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
P = 12.70($690,000)/146,000
P = $60.02
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* = $230,000(6.35)
V* = $1,460,500
The cost of the acquisition is the number of shares offered times the share price, so the cost is:
7. 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
8. 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:
NPV = 3,600($19) + $16,700 – 3,600($21)
NPV = $9,500
b. Since the NPV goes directly to stockholders, the share price of the merged firm will be the market
New shares created = 1,800 new shares
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:
VBT = 8,700($47) + 3,600($19) + $16,700
VBT = $494,000
9. The share offer is better for the target firm shareholders since they receive $23.52 per share. In the
share offer, the target firm’s shareholders will receive:
Equity offer value = (1/2)($47.05)
Equity offer value = $23.52 per share
From Problem 8, we know the value of the merged firm’s assets will be $494,000. The number of
10. The cost of the acquisition is:
Cost = 300($13) = $3,900
Since the stock price of the acquiring firm is $60, the firm will have to give up:
Shares offered = $3,900/$60
Shares offered = 65 shares
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:
Price = [(900)($60) + 300($12)]/(900 + 65)
Price = $59.69
And the PE ratio of the merged company will be:
11. Beginning with the fact that the NPV of a merger is the value of the target minus the cost, we get:
NPV =
*
B
V
– Cost
12. a. The synergy will be the present value of the incremental cash flows of the proposed purchase.
Since the cash flows are perpetual, the synergy value is:
Synergy value = $445,000/.08
Synergy value = $5,562,500
13. a. The number of shares after the acquisition will be the current number of shares outstanding for
the acquiring firm, plus the number of new shares created for the acquisition, which is:
Number of shares after acquisition = 11,000,000 + 8,500,000
Number of shares after acquisition = 19,500,000
And the share price will be the value of the combined company divided by the shares outstanding,
CHAPTER 28 –
10
b. Let
equal the fraction of ownership for the target shareholders in the new firm. We can set the
percentage of ownership in the new firm equal to the value of the cash offer, so:
(£475,000,000) = £134,000,000
= .2821, or 28.21%
So, the shareholders of the target firm would be equally as well off if they received 28.21 percent
of the stock in the new company as if they received the cash offer. The ownership percentage of
the target firm shareholders in the new firm can be expressed as:
14. a. The value of each company is the sum of the probability of each state of the economy times the
value of the company in that state of the economy, so:
b. The value of each company’s equity is sum of the probability of each state of the economy times
the value of the equity in that state of the economy. The value of equity in each state of the
economy is the maximum of total company value minus the value of debt, or zero. Since Rolls
is an all equity company, the value of its equity is the total value of the firm, or $236,050. The
value of Bentley’s equity in a boom is $198,000 ($348,000 company value minus $150,000 debt
value), and the value of Bentley’s equity in a recession is zero since the value of its debt is greater
than the value of the company in that state of the economy. So, the value of Bentley’s equity is:
CHAPTER 28 –
11
c. The combined value of the companies, the combined equity value, and combined debt value is:
d. To find the value of the merged company, we need to find the value of the merged company in
each state of the economy, which is:
Boom merged value = $348,000 + 312,000
Boom merged value = $660,000
Recession merged value = $132,000 + 95,000
Recession merged value = $227,000
e. There is a wealth transfer in this case. The combined equity value before the merger was
$364,750, but the value of the equity in the merged company is only $358,450, a loss of $6,300
f. If the value of Bentley’s debt before the merger is less than the lowest firm value, there is no
coinsurance effect. Since there is no possibility of default before the merger, bondholders do not
gain after the merger.
15. a. To find the value of the target to the acquirer, we need to find the share price with the new growth
rate. We begin by finding the required return for shareholders of the target firm. The earnings per
share of the target are:
EPSP = $960,000/750,000
EPSP = $1.28 per share
PP = $.63(1.06)/(.0909 – .06)
PP = $21.49
b. The gain to the acquiring firm will be the value of the target firm to the acquiring firm minus the
market value of the target, so:
c. The NPV of the acquisition is the value of the target firm to the acquiring firm minus the cost of
the acquisition, so:
CHAPTER 28 –
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d. The most the acquiring firm should be willing to pay per share is the offer price per share plus
the NPV per share, so:
e. The price of the stock in the merged firm would be the market value of the acquiring firm plus
the value of the target to the acquirer, divided by the number of shares in the merged firm, so:
PFP = ($60,900,000 + 16,114,285.71)/(1,500,000 + 225,000)
PFP = $44.65
f. Yes, the acquisition should go forward, and Plant should offer shares since the NPV is higher.
g. Using the new growth rate in the dividend growth model, along with the dividend and required
return we calculated earlier, the price of the target under these assumptions is:
PP = $.63(1.05)/(.0909 – .05)
PP = $16.08
And the value of the target firm to the acquiring firm is:
*
P
V
*
P
V
= 750,000($16.08)
CHAPTER 28 –
14
16. a. To find the distribution of joint values, we first must find the joint probabilities. To do this, we
need to find the joint probabilities for each possible combination of weather in the two towns.
The weather conditions are independent; therefore, the joint probabilities are the products of the
individual probabilities.
Possible states
Joint probability
Rain-Rain
.1(.1) = .01
Rain-Warm
.1(.4) = .04
Rain-Hot
.1(.5) = .05
Warm-Rain
.4(.1) = .04
Warm-Warm
.4(.4) = .16
Warm-Hot
.4(.5) = .20
Hot-Rain
.5(.1) = .05
Hot-Warm
.5(.4) = .20
Hot-Hot
.5(.5) = .25
Next, note that the revenue when rainy is the same regardless of which town. So, since the state
“Rain-Warm” has the same outcome (revenue) as “Warm-Rain”, their probabilities can be added.
The same is true of “Rain-Hot”/”Hot-Rain” and “Warm-Hot”/“Hot-Warm”. Thus the joint
probabilities are:
Possible states
Joint probability
Rain-Rain
.01
Rain-Warm
.08
Rain-Hot
.10
Warm-Warm
.16
Warm-Hot
.40
Hot-Hot
.25
Finally, the joint values are the sums of the values of the two companies for the particular state.
Possible states
Joint value
Rain-Rain
$230,000 + 230,000 =
$460,000
Rain-Warm
$230,000 + 450,000 =
680,000
Rain-Hot
$230,000 + 905,000 =
Warm-Warm
$450,000 + 450,000 =
900,000
Warm-Hot
$450,000 + 905,000 =
Hot-Hot
$905,000 + 905,000 =
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b. Recall that if a firm cannot service its debt, the bondholders receive the value of the assets. Thus,
the value of the debt is reduced to the value of the company if the face value of the debt is greater
than the value of the company. If the value of the company is greater than the value of the debt,
the value of the debt is its face value. Here, the value of the common stock is always the residual
value of the firm over the value of the debt. So, the value of the debt and the value of the stock
in each state are:
Possible states
Joint Prob.
Joint Value
Debt Value
Stock Value
Rain-Rain
.01
$460,000
$460,000
$0
c. The bondholders are better off if the value of the debt after the merger is greater than the value
of the debt before the merger. The value of the debt is the smaller of the debt value or the company
value. So, the value of the debt of each individual company before the merger in each state is:
Possible states
Probability
Debt Value
Rain
Warm
Hot
To get the expected debt value, post-merger, we can use the joint probabilities for each possible
state and the debt values corresponding to each state we found in part c. Using this information
to find the value of the debt in the post-merger firm, we get:
Total debt value post-merger = .01($460,000) + .08($680,000) + .10($900,000)
+ .16($900,000) + .40($900,000) + .25($900,000)
Total debt value post-merger = $878,000
Rain-Warm
Rain-Hot
Warm-Warm
.16
Warm-Hot
Hot-Hot
.25