Chapter 020 External Growth through Mergers

True / False Questions

1. In a merger, two or more companies are combined to form an entirely new entity.
FALSE

Bloom's: Knowledge
Difficulty: Medium
Learning Objective: 1

2. A tax loss carryforward is a benefit to the acquired firm's shareholders.

FALSE

Bloom's: Knowledge
Difficulty: Easy
Learning Objective: 1

3. Risk averse investors may discount the future earnings of the merged firm at a higher rate if
they move in different directions during business cycles.
FALSE

Bloom's: Knowledge
Difficulty: Medium
Learning Objective: 4

4. One potential advantage of a merger to the acquiring firm is the Portfolio Effect which
attempts to achieve risk reduction while perhaps maintaining the rate of return for the firm.
TRUE

Bloom's: Knowledge
Difficulty: Easy
Learning Objective: 4

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 Chapter 020 External Growth through Mergers

5. The potential of a tax loss carryforward has no effect when considering the acquisition of a
company.
FALSE

Bloom's: Knowledge
Difficulty: Medium
Learning Objective: 1

6. Too much diversification has led many companies to sell off companies previously
acquired during the merger boom.
TRUE

Bloom's: Knowledge
Difficulty: Medium
Learning Objective: 4

7. Mergers often improve the financing flexibility that a larger company has available.
TRUE

Bloom's: Understanding
Difficulty: Easy
Learning Objective: 1

8. A tax loss carryforward of $1,000,000 for company ZZZ is not usually worth $1,000,000 in
present value to a firm that might acquire company ZZZ.
TRUE

Bloom's: Knowledge
Difficulty: Medium
Learning Objective: 1

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 Chapter 020 External Growth through Mergers

9. The stock market reaction to divestitures may actually be positive if the divestiture is
perceived to rid the company of an unprofitable business, or if it seems to sharpen the
company's focus.
TRUE

Bloom's: Understanding
Difficulty: Easy
Learning Objective: 4

10. The portfolio effect of a merger is greatest for the selling stockholders.
FALSE

Bloom's: Knowledge
Difficulty: Medium
Learning Objective: 4

11. The desire to expand management and marketing capabilities is a direct financial motive.
FALSE

Bloom's: Knowledge
Difficulty: Medium
Learning Objective: 1

12. Synergy is said to take place when the whole is less than the sum of the parts.
FALSE

Bloom's: Knowledge
Difficulty: Medium
Learning Objective: 1

13. Vertical integration represents acquisition of a competitor.

FALSE

Bloom's: Knowledge
Difficulty: Easy
Learning Objective: 1

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Chapter 020 External Growth through Mergers

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 Chapter 020 External Growth through Mergers

14. Antitrust policy can preclude the acquisition of a competitor.

TRUE

Bloom's: Knowledge
Difficulty: Medium
Learning Objective: 1

15. Most mergers are horizontal in nature in order to avoid the potential antitrust
complications involved with the elimination of competition.
FALSE

Bloom's: Knowledge
Difficulty: Medium
Learning Objective: 1

16. In a horizontal merger, the integration that occurs comes from acquiring companies that
supply resources to the company's production process.
FALSE

Bloom's: Knowledge
Difficulty: Medium
Learning Objective: 1

17. While a horizontal merger may improve profitability, it will not necessarily reduce the
portfolio risk of the acquiring company.
TRUE

Bloom's: Understanding
Difficulty: Medium
Learning Objective: 4

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 Chapter 020 External Growth through Mergers

18. Vertical integration is usually prohibited or severely restricted by government antitrust

regulations.
FALSE

Bloom's: Knowledge
Difficulty: Easy
Learning Objective: 1

19. Synergy is the greatest and most easily measured nonfinancial benefit in a merger.
FALSE

Bloom's: Knowledge
Difficulty: Medium
Learning Objective: 1

20. Selling stockholders are often anxious to sell because of the potential of higher profits.
FALSE

Bloom's: Knowledge
Difficulty: Medium
Learning Objective: 3

21. Selling stockholders may receive a price well above current market or book value.
TRUE

Bloom's: Knowledge
Difficulty: Easy
Learning Objective: 3

22. A motive for selling stockholders may be the bias against smaller companies.
TRUE

Bloom's: Knowledge
Difficulty: Easy
Learning Objective: 3

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 Chapter 020 External Growth through Mergers

23. A cash purchase is similar to a capital budgeting decision.

TRUE

Bloom's: Understanding
Difficulty: Medium
Learning Objective: 2

24. Following a merger, the change in the risk profile of the merged companies may influence
the P/E ratio as much as the change in the overall growth rate.
TRUE

Bloom's: Knowledge
Difficulty: Medium
Learning Objective: 3

25. Stockholders of acquired firms in mergers tend to be more concerned with future earnings
and dividends exchanged than with the market value exchanged.
FALSE

Bloom's: Knowledge
Difficulty: Easy
Learning Objective: 3

26. By using cash instead of stock, a company may diminish the perceived dilutive effects of
a merger.
TRUE

Bloom's: Knowledge
Difficulty: Easy
Learning Objective: 2

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 Chapter 020 External Growth through Mergers

27. If the acquiring firm's P/E ratio is greater than the P/E of the acquired firm, the surviving
firm will automatically get an increase in E.P.S.
TRUE

Bloom's: Understanding
Difficulty: Medium
Learning Objective: 3

28. The earnings per share impact of a merger is influenced by relative price-earnings ratios
and the terms of exchange.
TRUE

Bloom's: Knowledge
Difficulty: Medium
Learning Objective: 3

29. A Tender Offer describes the attempted purchase of a firm with the consent of that firm's
management.
FALSE

Bloom's: Knowledge
Difficulty: Easy
Learning Objective: 5

30. A takeover tender offer lets a company attempt to acquire a target firm against its will.
TRUE

Bloom's: Knowledge
Difficulty: Medium
Learning Objective: 5

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 Chapter 020 External Growth through Mergers

31. For mergers occurring after 2001, goodwill must be amortized over 40 years or less.
FALSE

Bloom's: Knowledge
Difficulty: Medium
Learning Objective: 1

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 Chapter 020 External Growth through Mergers

32. Existing management of a firm is almost always ready to accept an offer for the purchase
of the firm at a price above the market.
FALSE

AACSB: Analytical Skills

Bloom's: Evaluation
Difficulty: Medium
Learning Objective: 3

33. If an acquiring firm's merger proposal was initially rejected by a target firm's management
and board of directors, the acquiring firm could utilize a tender offer to gain control of the
target firm.
TRUE

Bloom's: Knowledge
Difficulty: Medium
Learning Objective: 5

34. Leveraged Takeovers occur to firms that have an unusually large cash/total assets
position.
TRUE

Bloom's: Knowledge
Difficulty: Easy
Learning Objective: 5

35. "Poison pills" are strategies which reduce the value of a firm if it is taken over by a
corporate raider.
TRUE

Bloom's: Knowledge
Difficulty: Easy
Learning Objective: 5

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 Chapter 020 External Growth through Mergers

36. Leveraged buyouts are restricted to "outside" tender offers.

FALSE

Bloom's: Understanding
Difficulty: Easy
Learning Objective: 5

37. The two step buy-out procedure allows the acquiring firm to pay a lower total price than if
a single offer is made.
TRUE

Bloom's: Knowledge
Difficulty: Medium
Learning Objective: 5

38. The two step buy-out procedure induces stockholders to delay their reaction to the offer,
since they will receive a higher price later.
FALSE

Bloom's: Knowledge
Difficulty: Medium
Learning Objective: 5

39. After a merger has been announced, subsequent cancellation generally causes the potential
acquiree's stock to decline in value.
TRUE

Bloom's: Knowledge
Difficulty: Easy
Learning Objective: 5

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 Chapter 020 External Growth through Mergers

40. Although corporate managers have a responsibility to act in shareholders' best interest,
management frequently opposes acquisitions due to personal motives.
TRUE

AACSB: Ethical Understanding & Reasoning Abilities

Bloom's: Understanding
Difficulty: Medium
Learning Objective: 5

41. One of the reasons that companies merge with other companies is to secure access to a
competing industry.
TRUE

Bloom's: Understanding
Difficulty: Medium
Learning Objective: 1

42. Multinational mergers provide economic and political diversification which can lead to a
higher cost of capital for the new firm.
FALSE

AACSB: Analytical Skills

Bloom's: Evaluation
Difficulty: Medium
Learning Objective: 4

43. Selling stockholders generally receive a price below the current market value of their prior
stock during a merger.
FALSE

Bloom's: Understanding
Difficulty: Medium
Learning Objective: 1

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 Chapter 020 External Growth through Mergers

44. It is possible to merge with a company which results in the same earnings per share but
still lowers the new firm's cost of capital.
TRUE

AACSB: Analytical Skills

Bloom's: Evaluation
Difficulty: Hard
Learning Objective: 4

Multiple Choice Questions

45. A business combination of two or more companies in which the resulting firm maintains
the identity of the acquiring company is defined as a
A. consolidation.
B. holding company.
C. conglomerate.
D. merger.

Bloom's: Knowledge
Difficulty: Easy
Learning Objective: 1

46. Which of the following types of mergers is most likely to lead to diversification benefits?
A. horizontal merger
B. vertical merger
C. tax free exchange
D. conglomerate

Bloom's: Understanding
Difficulty: Easy
Learning Objective: 4

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 Chapter 020 External Growth through Mergers

47. When a tobacco firm merges with a steel company, it would be called
A. a horizontal merger.
B. a vertical merger.
C. a conglomerate merger.
D. a consolidation.

Bloom's: Understanding
Difficulty: Medium
Learning Objective: 4

48. Which of the following is not a potential benefit of a merger?

A. Improved Financing Posture
B. Portfolio Effect
C. Dilution of Earnings Per Share
D. Tax Loss Carryforward

Bloom's: Knowledge
Difficulty: Easy
Learning Objective: 3

49. The rising ratio of divestitures to new acquisitions which occurred in the past suggests
that
A. poison pills are no longer effective as a defense against takeovers.
B. too much diversification strained the operating capabilities of many firms.
C. the portfolio effect has been a highly successful method of reducing risk.
D. multinational firms are increasingly considered highly risky investments.

AACSB: Analytical Skills

Bloom's: Evaluation
Difficulty: Easy
Learning Objective: 4

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 Chapter 020 External Growth through Mergers

50. The direct financial motives for merger activity include all of following EXCEPT
A. the portfolio effect.
B. improved financial posture and greater debt.
C. the utilization of tax loss carryforwards.
D. vertical integration.

Bloom's: Knowledge
Difficulty: Easy
Learning Objective: 1

51. The Celluloid Collar Corporation has $360,000 in tax loss carryforwards. The Bowstring
Shirt Company, a firm in the 30% tax bracket, would be willing to pay (on a nondiscounted
basis) the sum of ______________ for the carryforward alone.
A. $108,000
B. $252,000
C. $350,000
D. $1,200,000

AACSB: Analytical Skills

Bloom's: Application
Difficulty: Medium
Learning Objective: 1

52. Synergy is said to occur when the whole is

A. equal to the sum of the parts.
B. less than the sum of the parts.
C. greater than the sum of the parts.
D. greater than or equal to the sum of the parts.

Bloom's: Knowledge
Difficulty: Easy
Learning Objective: 1

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 Chapter 020 External Growth through Mergers

53. Synergy is
A. the 2 + 2 = 3 effect.
B. the 2 + 2 = 4 effect.
C. the 2 + 2 = 5 effect.
D. always present in a merger.

Bloom's: Knowledge
Difficulty: Easy
Learning Objective: 1

54. In planning mergers, there is a tendency to _____ synergistic benefits.

A. overestimate.
B. underestimate
C. correctly estimate
D. not estimate

Bloom's: Knowledge
Difficulty: Easy
Learning Objective: 1

55. Which of the following is not a motive for selling by the stockholder's of the acquired
company?
A. opportunity to diversify
B. tax advantage
C. attractive price
D. avoid bias against smaller businesses

Bloom's: Understanding
Difficulty: Medium
Learning Objective: 1

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 Chapter 020 External Growth through Mergers

56. Which of the following type of merger decreases competition?

A. horizontal merger
B. vertical merger
C. cash purchase
D. stock-for-stock exchange

Bloom's: Understanding
Difficulty: Medium
Learning Objective: 1

57. Which of the following is not a financial motive but rather an operating motive for merger
and consolidation?
A. The portfolio diversification effect
B. Tax-loss carryforward
C. Greater financing capability
D. Synergy

Bloom's: Knowledge
Difficulty: Medium
Learning Objective: 1

58. An example of a horizontal merger would be

A. Pepsi and Sears.
B. McDonalds and Pillsbury.
C. Pepsi and Frito Lay.
D. Coca Cola and Dr. Pepper.

AACSB: Analytical Skills

Bloom's: Analysis
Difficulty: Easy
Learning Objective: 1

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 Chapter 020 External Growth through Mergers

59. The elimination of overlapping functions and the meshing of two firms' strong areas or
products creates the managerial incentive for mergers known as
A. horizontal integration.
B. vertical integration.
C. synergy.
D. the portfolio effect.

Bloom's: Understanding
Difficulty: Medium
Learning Objective: 1

60. Selling stockholders who are offered cash or another company's stock in a merger may be
willing to part with the shares they hold because
A. the offered shares may be more marketable.
B. the price they are offered for their shares may be above market value.
C. they can attain a greater degree of diversification as a result.
D. all of these

Bloom's: Knowledge
Difficulty: Easy
Learning Objective: 1

61. Nonfinancial motives for mergers include:

A. synergy.
B. the portfolio effect.
C. vertical integration.
D. A and C.

Bloom's: Understanding
Difficulty: Medium
Learning Objective: 1

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 Chapter 020 External Growth through Mergers

62. Which of the following terms is not specifically related to an unfriendly buyout?
A. takeover tender offer.
B. white knight.
C. Saturday night special.
D. synergy.

Bloom's: Understanding
Difficulty: Easy
Learning Objective: 5

63. Aardvark Software, Inc. can purchase all the stock of Zebra Computer Services for
$1,000,000 in cash. Zebra is expected to generate net after-tax cash flows of $100,000 per
year for each of the next ten years. Based solely on the cash flow analysis, Aardvark should
A. not purchase Zebra Computer Services.
B. purchase Zebra Computer Services.
C. purchase Zebra only if Aardvark's cost of capital is between 5% and 10%.
D. purchase Zebra only if Aardvark's cost of capital is above 10%.

AACSB: Analytical Skills

Bloom's: Application
Difficulty: Medium
Learning Objective: 3

64. Which of the following is not a form of compensation that selling stockholders could
receive?
A. Stock
B. Cash
C. Stock Options
D. Fixed Income Securities

Bloom's: Knowledge
Difficulty: Easy
Learning Objective: 2

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 Chapter 020 External Growth through Mergers

65. The Prad Corporation is considering a merger with the Stone Company which has 400,000
outstanding shares selling for $25. An investment banker has advised that to succeed in its
merger Prad Corp. would have to offer $45 per share for Stone's stock. Prad Corp. stock is
selling for $30. How many shares of Prad Corp. stock would have to be exchanged to acquire
all of Stone's stock?
A. 266,667
B. 600,000
C. 720,000
D. none of these

AACSB: Analytical Skills

Bloom's: Application
Difficulty: Medium
Learning Objective: 2

66. Dilution in earnings per share occurs when a company with

A. a high P/E ratio buys a company with a low P/E ratio.
B. a low P/E ratio buys a company with a high P/E ratio.
C. a high growth rate in earnings per share buys a company with a low growth rate in earnings
per share.
D. a low growth rate in earnings per share buys a company with a high growth rate in earnings
per share.

AACSB: Analytical Skills

Bloom's: Analysis
Difficulty: Medium
Learning Objective: 3

67. In the event that Active Corp., which has a low P/E ratio, acquires Basic Corp., which has
a higher P/E ratio, we could be assured one of the following would occur.
A. Active Corp. will have an immediate increase in E.P.S.
B. Active Corp. will have an immediate decrease in E.P.S.
C. Active Corp. will have an immediate increase in the growth rate of E.P.S.
D. Active Corp. will have an immediate decrease in P/E.

AACSB: Analytical Skills

Bloom's: Analysis
Difficulty: Medium
Learning Objective: 3

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 Chapter 020 External Growth through Mergers

68. The portfolio effect in a merger has to do with

A. increasing EPS.
B. reducing risk.
C. creating tax advantages.
D. writing off goodwill.

Bloom's: Understanding
Difficulty: Easy
Learning Objective: 4

69. White Knights

A. advise companies on ways to avoid being taken over.
B. offer a higher purchase price and more friendly offer in the event of an unsolicited and
unfriendly takeover attempt.
C. attempt to make money in the stock market on stocks that are likely merger candidates.
D. buy depressed stock of quality companies when merger talks are discontinued.

Bloom's: Knowledge
Difficulty: Easy
Learning Objective: 5

70. Which of the following is a tender offer that utilizes borrowed funds and the acquired
firm's assets as collateral?
A. unfriendly take-over
B. divestiture
C. two-step buy-out
D. leveraged buy-out

Bloom's: Knowledge
Difficulty: Medium
Learning Objective: 5

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 Chapter 020 External Growth through Mergers

71. The price that a company has to pay to purchase another firm is usually
A. the book value.
B. the market value.
C. some premium over current market value.
D. some discount of current market value.

Bloom's: Understanding
Difficulty: Easy
Learning Objective: 2

72. The typical merger premium is

A. 0-20%
B. 40%
C. 40-60%
D. 60-80%

Bloom's: Understanding
Difficulty: Medium
Learning Objective: 3

73. The two step buy-out is a recent merger ploy that has of the following characteristics?
A. It is negotiated in a social, rather than a business setting.
B. The acquiring firm offers to pay a very high price for the target company's stock, and a
short time later announces another price which may be higher or lower.
C. The acquiring firm offers to pay a very high price for the target company's stock for a
limited time only, after which it will pay a considerably lower price.
D. It forces stockholders to sell out.

Bloom's: Knowledge
Difficulty: Medium
Learning Objective: 5

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 Chapter 020 External Growth through Mergers

74. Under a two step buy-out procedure

A. shareholders receive a higher total price than if a single offer is made.
B. the second offer is at a higher price per share.
C. shareholders are encouraged to react quickly to the offer.
D. two of the above are correct.

Bloom's: Knowledge
Difficulty: Medium
Learning Objective: 5

75. In regard to two step buyouts,

A. the SEC highly approves of them.
B. the FTC highly approves of them.
C. the SEC is keeping a close eye on them.
D. the FTC is keeping a close eye on them.

Bloom's: Understanding
Difficulty: Medium
Learning Objective: 5

76. All of the following are potential challenges or downsides to mergers except:
A. anti-trust laws
B. dilution
C. firm valuation
D. synergies

AACSB: Analytical Skills

Bloom's: Analysis
Difficulty: Medium
Learning Objective: 1

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 Chapter 020 External Growth through Mergers

77. Under SFAS 141 and 142, the following occurred

A. goodwill is now amortized
B. at least 4 times per year, goodwill must be tested to determine if impaired
C. allowed a one time write-down of all past goodwill impairment
D. created pooling of interests accounting

Bloom's: Understanding
Difficulty: Hard
Learning Objective: 1

78. All of the following are methods of avoiding takeovers except:

A. increasing the firm's cash level
B. moving corporate offices to advantageous states
C. staggering election of boards of directors
D. buying back shares

Bloom's: Understanding
Difficulty: Medium
Learning Objective: 5

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 Chapter 020 External Growth through Mergers

Essay Questions

79. Match the following to the items below:

a. consolidation
b. merger premium
c. White knight
d. market value maximization
e. merger
f. portfolio effect
g. two step buyout
h. tax-loss carryforward
i. terms of exchange
j. synergy
k. Saturday night special

1. _____ A loss that can be extended for a number of years to offset taxable income.
2. _____ The combination of two or more firms to form an entirely new entity.
3. _____ The combination of two or more firms in which one firm acquires the others,
causing them to lose their identity.
4. _____ The recognition that the whole may be equal to more than the sum of the parts.
5. _____ Value paid over the existing price of the acquired firm.
6. _____ The buy-out ratio or terms of trade in a merger or an acquisition.
7. _____ A merger price offer that takes place in two stages.
8. _____ A third firm that management calls on to avoid the initial unfriendly takeover.
9. _____ The impact of a given investment on the overall risk-return composition of the firm.
10. _____ The concept of maximizing the wealth of the stockholders.
11. _____ A surprise offer made just before the market closes for the weekend and takes the
target company's officers by surprise.

(1.) h (2.) a (3.) e (4.) j (5.) b (6.) i (7.) g (8.) c (9.) f (10.) d (11.) k

Bloom's: Understanding
Difficulty: Medium
Learning Objective: 1
Learning Objective: 2
Learning Objective: 3
Learning Objective: 4
Learning Objective: 5

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 Chapter 020 External Growth through Mergers

80. Match the following to the items below:

a. vertical integration
b. tender offer-take over
c. market value maximization
d. two step buy-out
e. merger premium
f. merger arbitrageur
g. synergy
h. horizontal integration

1. _____ An unfriendly acquisition which is not initially negotiated with the management of
the target firm.
2. _____ Acquiring competitors which is often curbed by antitrust policy.
3. _____ A type of takeover in which two offers are made: an initial offer to buy 51% of the
stock at a price above current market value for a limited time only, after which a price below
the current market value will be paid.
4. _____ The acquisition of buyers and sellers of goods and services to the company.
5. _____ The concept of maximizing the wealth of the stockholders.
6. _____ A specialist in merger investments who attempts to capitalize on the difference
between the value offered and the current market value of the acquisition candidate.
7. _____ 2 + 2 = 5 effect.
8. _____ That part of a buy-out or exchange offer which represents a value over and above
the market value of the acquired firm.

(1.) b (2.) h (3.) d (4.) a (5) c (6.) f (7.) g (8.) e

Bloom's: Understanding
Difficulty: Medium
Learning Objective: 1
Learning Objective: 3
Learning Objective: 5

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 Chapter 020 External Growth through Mergers

81. The King Solomon Mining Company is contemplating a cash tender offer for the
outstanding shares of Roanoke Coal Corporation. Roanoke Coal is expected to provide
$162,500 in after-tax cash flow (after-tax income plus depreciation) each year for the next 20
years. In addition, Roanoke has a $630,000 tax loss carryforward which King Solomon
Mining can use over the next two years ($315,000 per year).

If King Solomon Mining's corporate tax rate is 34% and its cost of capital is 12%, what is the
cash price it should be willing to pay to acquire Roanoke based solely on it's cash-flow benefit
over the next 20 years?

AACSB: Analytical Skills

Bloom's: Application
Difficulty: Medium
Learning Objective: 1
Learning Objective: 2
Learning Objective: 5

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 Chapter 020 External Growth through Mergers

82. Simon Manufacturing Co. is planning to acquire Garfunkel Engineering in a two-step

buyout. Garfunkel has 3,000,000 shares of common stock currently outstanding, and the
market price is currently at $25 per share. The first step of the buyout would offer to purchase
51% of Garfunkel Engineering common stock for $34 per share, The second step would be to
exchange each remaining share of Garfunkel common for $5 in cash and a newly issued share
of Simon Manufacturing convertible preferred stock, valued at $27.50 per share.

Simon Manufacturing's investment banker has suggested, as an alternative, a single-stage

buyout at $32.50 per share for all of Garfunkel's common stock.

a) What is the total cost of the two-step buyout?

b) What is the total cost of the single step proposal?
c) If it wants to minimize the total cost of the acquisition, what should Simon Manufacturing
do?

c) The best alternative is to try to complete the one step buyout. In this particular case, the
single step buyout is estimated to cost $2,295,000 less than the two step buyout, which is
typically not the case.

AACSB: Analytical Skills

Bloom's: Application and Evaluation
Difficulty: Medium
Learning Objective: 2
Learning Objective: 5

20-28