FIN516WEEK 6 HOMEWORK

Problem 28-9 on Acquisition Analysis Based on Chapter 28 Mergers

and Acquisitions
(Excel file included)
Your company has earnings per share of $4. It has 1 million shares
outstanding, each of which has a price of $40. You are thinking of buying
TargetCo, which has earnings per share of $2, 1 million shares outstanding,
and a price per share of $25. You will pay for TargetCo by issuing new shares.
There are no expected synergies from the transaction.
a) If you pay no premium to buy TargetCo, what will your earnings per
share be after the merger?
$ 6,000,000
=$ 3.69/share
1,625,000 shares

b) Suppose you offer an exchange ratio such that, at current

preannouncement share prices for both firms, the offer represents a
20% premium to buy TargetCo. What will your earnings per share be
after the merger?
$ 6,000,000
=$ 3.43/share
1,750,000 shares

c) What explains the change in earnings per share in part a)? Are your
shareholders any better or worse off?
The change is the result of our company issuing shares of stock to buy
another company with a higher price-to-earnings ratio.
d) What will your price-earnings ratio be after the merger (if you pay no
premium)? How does this compare to your P/E ratio before the merger?
How does this compare to TargetCos premerger P/E ratio?
$ 40,000,000+ $ 25,000,000
=10.83
$ 4,000,000+ $ 2,000,000

FIN516WEEK 6 HOMEWORK

Problem 16-8 on Managerial Decision Based on Chapter 16 Financial

Distress, Managerial Incentives, and Information
(Excel file included)
As in Problem 1, Gladstone Corporation is about to launch a new product.
Depending on the success of the new product, Gladstone may have one of
four values next year: $150 million, $135 million, $95 million, or $80 million.
These outcomes are all equally likely, and this risk is diversifiable. Suppose
the risk-free interest rate is 5% and that, in the event of default, 25% of the
value of Gladstones assets will be lost to bankruptcy costs. (Ignore all other
market imperfections, such as taxes.)
a) What is the initial value of Gladstones equity without leverage?
0.25150+135+ 95+80
=$ 109.52 million
1.05

Now suppose Gladstone has zero-coupon debt with a $100 million face value
due next year.
b) What is the initial value of Gladstones debt?
0.25100+100+ 950.75+ 800.75
=$ 78.87 million
1.05

c) What is the yield-to-maturity of the debt? What is its expected

return?
YTM =

100
1=26.79
78.87

FIN516WEEK 6 HOMEWORK
d) What is the initial value of Gladstones equity? What is Gladstones
total value with leverage?
0.25150+135+ 950.75+ 800.75
=$ 99.11 millio n
1.05

Suppose Gladstone has 10 million shares outstanding and no debt at the

start of the year.
e) If Gladstone does not issue debt, what is its share price?
109.52
=$ 10.95/ share
10

f) If Gladstone issues debt of $100 million due next year and uses the
proceeds to repurchase shares, what will its share price be? Why
does your answer differ from that in part e)?
99.11
=$ 9.91/share
10
Problem 16-9 on Financial Distress Based on Chapter 16 Financial
Distress, Managerial Incentives, and Information
Kohwe Corporation plans to issue equity to raise $50 million to finance a new
investment. After making the investment, Kohwe expects to earn free cash
flows of $10 million each year. Kohwe currently has 5 million shares
outstanding, and it has no other assets or opportunities.
Suppose the appropriate discount rate for Kohwes future free cash flows is
8%, and the only capital market imperfections are corporate taxes and
financial distress costs.
a) What is the NPV of Kohwes investment?

FIN516WEEK 6 HOMEWORK
10
50=$ 75,000,000
0.08

b) What is Kohwes share price today?

75
=$ 15 /share
5

Suppose Kohwe borrows the $50 million instead. The firm will pay interest
only on this loan each year, and it will maintain an outstanding balance of
$50 million on the loan. Suppose that Kohwes corporate tax rate is 40%, and
expected free cash flows are still $10 million each year.
c) What is Kohwes share price today if the investment is financed with
debt?
75+ 0.40.50
=$ 19/share
5

Now suppose that with leverage, Kohwes expected free cash flows will
decline to $9 million per year due to reduced sales and other financial
distress costs. Assume that the appropriate discount rate for Kohwes future
free cash flows is still 8%.
d) What is Kohwes share price today given the financial distress costs
of leverage?
9
50+ 0.450
0.08
=$ 16 /share
5