Investment and Finance (ABWL1)

Tutorial 6: Sample Solutions:

SS 2010

O.Kolokolova / Z.Guo / A.Mattes

Mergers and Acquisitions

Preliminaries
Gain of a merger = PV(AB) (PV(A)+PV(B))
Cost of a merger = Stock/Cash paid PV(B)
NPVof a merger = Gain Cost

Ex.1
True or false?
(a) One of the first tasks of an LBOs financial manager is to pay down debt.
(b) Once an LBO or MBO goes private, it almost always stays private.
(c) The following motives for mergers make economic sense:
i. Merging to achieve economies of scale.
ii. Merging to reduce risk by diversification.
iii. Merging to make better use of tax-loss carry-forward.
iv. Merging just to increase earnings per share.
(d) Sellers most of the time gain in mergers.
(e) Buyers usually gain more than sellers.
(f) Firms that do well tend to be acquisition targets.
(g) The cost of a merger to a buyer equals the gain realized by the seller.
Answer
(a) True. Leveraged buyout (LBO) Acquisition in which
(1) a large part of the purchase is debt-financed and
(2) the remaining equity is privately held by a small group of investors.
(b) False. Management buyout (MBO) - Leveraged buyout in which the acquisition group is led
by the firms management.
(c) 1. True.
2. False.
3. True.
4. False.
(d) True.
(e) False.
(f) False.
(g) True. Cost to a buyer = Gain to a seller = cash or equity paid PV(sold firm).
Ex.2
As the treasurer of Leisure Products, Inc., you are investigating the possible acquisition of
Plastitoys. You have the following data:

Earnings per share

Dividend per share
Number of shares
Stock price

Leisure products (A)

$ 5.00
$ 3.00
1000000
$ 90

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Plastitoys (B)
$ 1.50
$ 0.80
600000
$ 20

Investment and Finance (ABWL1)

SS 2010

O.Kolokolova / Z.Guo / A.Mattes

You estimate that investors currently expect a steady growth of about 6% in Plastitoys earnings
and dividends. Under new management this growth rate could be increased to 8% per year,
without any additional investment required.
(a) What is the gain from the acquisition?
(b) What is the cost of the acquisition if Leisure Products pays $25 in cash for each share of
Plastitoys?
(c) What is the cost of the acquisition if Leisure Products offers one share of Leisure Products
for every three shares of Plastitoys?
(d) How would the cost of the cash offer and the share offer alter if the expected growth rate of
Plastitoys were not changed by the merger?
Answer
(a) gain = PV(AB) PV(A) PV(B) = PV(A) + PVnew(B) PV(A) PVold(B)
= PVnew(B) PVold(B)
stock price = PV(future dividends)
Pold(B) = 20 = 0.80/(r-0.06) r = 10%
Pnew(B) = 0.80/(0.10-0.08) = $40
gain = (40-20)*0.6 = 12 (million $)
(b) cost(cash offer) = (25 -20)*0.6 = 3 (million $)
(c) PV(AB) = 1*90 + 0.6*40 = 114 (million $)
#(AB shares) = 1+ 0.6/3 = 1.2 (million)
Pnew(AB) = 114/1.2 = $95
cost(stock offer) = 95*0.6/3 20*0.6 = 7 (million $)
(d) cost(cash offer) wouldnt change
PV(AB) = 1*90 + 0.6*20 = 102 (million $)
P(AB) = 102/1.2 = $85
Cost(stock offer) = 85*0.2 - 20*0.6 = 5 (million $)
Note, that in this case the gain is zero since there is no synergy.
Ex.3
Company A is presently traded at $24 per share. The management controls 40% of a total of 1
million shares outstanding. Company B wishes to acquire A because of likely synergies. The
estimated PV of the synergies is $8 million. Moreover, B thinks that that management of A is
overpaid and overperked. It estimates that with better motivation, lower salaries, and fewer
perks for the management, including the disposition of two yachts, approximately $400'000 per
year in expenses could be saved. This would add another $3 million in value to the acquisition.
(a) What is the maximum price per share that B would be willing to pay for A?
(b) At what price per share would the managers of A be indifferent to giving up the PV of their
private control benefits?
Answer
(a) max price per share: gain per share = cost per share
$8 + $3 = P - $24 P = $35
(b) PV(management benefits per share owned) = $3mio/0.4mio = $7.5
Pindif. = $24 + $7.5 = $31.5

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Investment and Finance (ABWL1)

SS 2010

O.Kolokolova / Z.Guo / A.Mattes

Ex.4
Velcro Saddles is contemplating the acquisition of Pogo Ski Sticks, Inc. The values of the two
companies as separate entities are $20 million and $10 million, respectively. Velcro Saddles
estimates that by combining the two companies, it will reduce marketing and administrative
costs by $500000 per year in perpetuity. Velcro Saddles can either pay $14 million in cash for
Pogo or offer Pogo a 50% holding in Velcro Saddles. The opportunity cost of capital is 10%.
(a) What is the gain from this merger?
(b) What is the cost of the cash offer?
(c) What is the cost of the alternative stock offer?
(d) What is the NPV of the acquisition under the cash offer?
(e) What is the NPV under the stock offer?
Answer
(a) gain = 500000/0.1 = 5 (million $)
(b) cost(cash offer) = cash paid PV(Pogo) = 14 - 10 = 4 (million $)
(c) PV(merged company) = PV(Velcro) + PV(Pogo) + Gain = 20 + 10 + 5 = 35 (million $)
cost(stock offer) = value of stock paid PV(Pogo) = 0.5*35 10 = 7.5 (million $)
(d) NPV(cash offer) = gain cost = 5 4 = 1 (million $)
(e) NPV(stock offer) = 5 7.5 = - 2.5 (million $)
Ex.5 (Exam Question February 2006)
Hill, Inc., plans to merge with Ravine Corp. Currently, the market value of Hill is 8 million euro,
and the market value of Ravine is 1 million euro if the companies are valued separately. After the
merger, the company will enjoy economies of scale of 50000 euro per year, which will last for
10 years, and then 20000 euro per year forever. Hill will buy Ravine at a 20% premium in cash.
The cost of capital for both companies is 10%.
(a) What are the cost, gain and NPV of the merger?
(b) Ravine Corp. has 250000 shares outstanding. What will be the price per share of Ravine
Corp. right after the merger is announced? Hint: the cost of a merger is the gain realized by
the shareholders of the acquired company.
(c) Hill, Inc., has 1 million shares outstanding. Instead of paying cash, it makes a stock offer.
What share of the joint company should Hill propose to Ravine to pay the same premium on
Ravine as in (a)? How many new shares should be issued? Compute the share price of the
joint company.
Answer
(a) cash paid = 1 * 1.2 = 1.2 (million )
cost = cash paid - PV(Ravine) = 1.2 1 = 0.2 (million )
50'000
1 20'000
gain = PV(economies of scale) =
= 384 '337
1 10 +
0.1 1.1 0.1 1.110
NPV = gain - cost = 384337 - 200000 = 184337
(b) Pold = 1000000 / 250000 = 4
gain per share = 200000 / 250000 = 0.8
Pnew = 4 + 0.8 = 4.8
(c) PV(joint company) = PV(Hill) + PV(Ravine) + gain = 8mio + 1mio + 384337 = 9384337
Hill pays same premium on Ravine as in (a) cost of the merger should stay at 200000
Let X denote the share of the joined company to be paid to Ravines stockholders:
cost = X * 9384337 - 1000000 = 200000 X = 0.1279

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Investment and Finance (ABWL1)

SS 2010

O.Kolokolova / Z.Guo / A.Mattes

Ravines shareholders get 0.1279 of the joint company

Hills shareholders have (1 - 0.1279) = 0.8721 of the joint company and have 1mio shares:
0.8721 * total number of shares = 1mio total number of shares = 1146622
Number of new shares issued = 1146622 - 1000000 = 146622
Pnew = 9384337/1146622 = 8.18
Ex.6
Explain how the following strategies, which can be employed by a target company to prevent a
hostile acquisition, work: poison pills, poison put, and golden parachute. Do there exist further
strategies for the same purpose?
Answer
Poison pills Existing shareholders get rights, which are triggered when there is a significant
purchase of the firms shares, to buy company shares at a low price. This will make the raiders
shares lose value.
Poison put Bondholders get rights to sell the bonds back to the company, when there is a
change in control as a result of a takeover. This would make a takeover very expensive if the
acquisition was very costly and used extensive loans.
Golden parachute is an extremely generous compensation package for managers who lose
their jobs because of a takeover. The availability of the golden parachute will ensure that the
managers will not have any inventive to fight any takeover at the cost of the shareholders. On
the other hand golden parachute increases the cost of an acquisition.
Yes, there are several further strategies. For example, a White knight is a friendly potential
acquirer sought out by a target company which is threatened by a less welcome suitor.

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