Class On Merger and Acquisition

Merger and Acquisition
THE USE OF CAPITAL BUDGETING TECHNIQUES

IN APPRAISING THE ACQUISITION
Hint: In deciding whether to buy another business, capital budgeting may be used. Also, the
effect of the new capital structure on the firm’s overall cost of capital has to be projected.
EXAMPLE 1
W Company is contemplating purchasing P Company for $95,000. W’s current cost of capital is
12%. P’s estimated overall cost of capital after the acquisition is 10%. Projected cash inflows
from years one through eight are $13,000. (Assume no residual value.)
EXAMPLE 2
C Company wants to buy some fixed assets of B Company. However, the latter wants to sell out
its business. The balance sheet of B Company follows:
Assets
Cash $ 4,000
Accounts receivable 8 ,000
Inventory 10 ,000
Equipment 1 16 ,000
Equipment 2 28 ,000
Equipment 3 42 ,000
110,000
Building
$218,000
Total assets
Liabilities and Stockholders’ Equity

Total liabilities 80 ,000
Total equity 138,000
Total liabilities and equity $218,000
C wants only equipment 1 and 2 and the building. The other assets excluding cash, can be
sold for $24,000. The total cash received is thus $28,000 ($24,000 + $4,000 initial cash balance).
B desired $50,000 for the whole business. C will thus have to pay a total of $130,000 which is
$80,000 in total liabilities and $50,000 for its owners. The actual net cash outlay is therefore
$102,000 ($130,000 - $28,000). It is expected that the after-tax cash inflows from the new
equipment will be $27,000 per year for the next five years. The cost of capital is 8%. (Assume
no residual value.)
EXCHANGE RATIO
T Company buys B Company. T Company’s stock sells for $75 per share while B’s stock sells
for $45. As per the merger terms, T offers $50 per share. The exchange ratio is 0.667 ($50/$75).
Thus, T exchanges 0.667 shares of its stock for one share of B.
EFFECT OF MERGER ON EARNINGS PER SHARE AND

MARKET PRICE PER SHARE
A merger can have a positive or negative impact on net income and market price per share of
common stock.
EXAMPLE 3
Relevant information follows:
Company A Company B
Net income $50,000 $84,000
Outstanding shares 5,000 12,000
EPS $10 $7
P/E ratio 7 10
Market price $70 $70
Company B acquires Company A and exchanges its shares for A’s shares on a one-for-one basis.
The effect on EPS follows:
B Shares EPS before EPS after

Owned after Merger Merger Merger
A stockholders 5,000 $10 $7.88*
B stockholders 12,000 7 7.88*
Total $17,000
*Total net income is determined as:
5,000 shares x $10 $50,000

12,000 shares x $7 84,000
$134,000
EPS = Net income = $134,000 = $7.88
Total shares 17,000
EPS decreases by $2.12 for A stockholders and increases by $0.88 for B stockholders.
The effect on market price is not clear. Assuming the combined entity has the same P/E
ratio as Company B, the market price per share will be $78.80 (10 x $7.88). The stockholders
experience a higher market value per share. The increased market value occurs because net
income of the combined entity is valued at a P/E ratio of 10, the same as Company B, while
before the merger Company A had a lower P/E multiplier of 7. However, if the combined entity
is valued at the lower P/E multiplier of 7, the same as Company A, the market value would be
$55.16 (7 x $7.88). In this case, the stockholders in each firm experience a reduction in market
value of $14.84 ($70.00 - $55.16).
EXAMPLE 4
The following situation exists:
Market price per share of acquiring company $100

Market price per share of acquired company $20
Price per share offered $24

The exchange ratio equals:
Required: What will be exchange ratio?
EXAMPLE 5
M Company wants to buy J Company by issuing its shares. Relevant information follows:
M Company J Company
Net income $40,000 $26,000
Outstanding shares 20,000 8,000
The exchange ratio is 2 to 1. The EPS based on the original shares of each company
follows:
EPS of combined equity = Combined net income/Total shares
EPS
66000 = 66000 =1.83
20,000 + (8,000 x 2) 36,000 shares
EPS of M = $1.83
EPS of J = $1.83 x 2 = $3.66
Since the effect of the merger on market value per share is not clear, the crucial
consideration is EPS.
Example 6
Question
Required:
i. Based on the information please find out the takeover and target company based on the
share price?
ii. How many shares will be outstanding of the takeover company post-merger?
iii. What will be post-merger Earning Per Share?
iv. What will be the post-merger market price per share?

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Merger and Acquisition

THE USE OF CAPITAL BUDGETING TECHNIQUES

Liabilities and Stockholders’ Equity

EFFECT OF MERGER ON EARNINGS PER SHARE AND

B Shares EPS before EPS after

5,000 shares x $10 $50,000

EPS = Net income = $134,000 = $7.88

Total shares 17,000

Market price per share of acquiring company $100

Price per share offered $24

Required: What will be exchange ratio?

EPS of combined equity = Combined net income/Total shares

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