Questions 1-7 are simple background questions whose answers are in the class notes:
Question 1. What is a synergy and where do they come from?
Question 2. Which kind of merger could be blocked by anti-trust authorities?
Question 3. Can synergies be negative? If so, how could this happen?
Question 4. What is the acquisition premium?
Question 5. How would you calculate the NPV (to the acquirer) of an all cash acquisition?
Question 6. How would you calculate the NPV (to the acquirer) of an all stock acquisition?
Question 7. How would you calculate the value of a merger synergy if you know the pre-merger market values of the acquirer and target, and have an estimate of the post-merger value of the combined firm?
Question 8. Suppose that firm A’s EPS have been stagnant over the last few years and shareholders exert pressure on management to boost EPS. Firm A is a potential acquirer and firm T is a potential target whose pre-merger information is provided below:
Firm A
Firm T
EPS
$2.00
$2.00
Share price
$40
$20
P/E
20
10
# shares
100,000
100,000
Earnings
$200,000
$200,000
Market value
$4,000,000
$2,000,000
Assume that a merger between A and T would create no synergies and the acquirer would acquire the target in an all stock transaction with an exchange ratio e = .5.
a) Why does firm T have a lower P/E ratio than firm A before the merger?
b) Do managers of A have reasons to acquire firm T? If so, why?
c) What do you learn from this?
Solution
a) Why does firm T have a lower P/E ratio than firm A before the merger?
The P/E ratio is the ratio of the stock price, which captures the present value of future earnings per share, and current earnings per share. In general, the P/E ratio is higher for firms with more growth opportunities (high future earnings and low current earnings), so Firm A has high growth potential and Firm T has low growth potential.
b) Do managers of A have reasons to acquire firm T? If so, why?
Check what happens if firm A acquires firm T and both are unified in a merger:
Firm A
Firm T
Combined A + T
EPS
$2.00
$2.00
$2.67
Share price
$40
$20
$40
P/E
20
10
$15
# shares
100,000
100,000
150,000
Earnings
$200,000
$200,000
$400,000
Market value
$4,000,000
$2,000,000
$6,000,000
Note i) the merger creates no value, so the post-merger value of the combined firm is the sum of the values of the two separate companies; ii) the post-merger earnings of the combined firm are the sum of the earnings of the two separate companies; iii) the e=.5 reflects the ratio of the share prices of the two firms; iv) the number of shares of A issued is 50,000 and so the post-merger number of shares is 150,000; v) the share price of Firm A after it combines with T is the same as the pre-merger price; vi) the EPS of firm A increase after it combines with T; and vii) the P/E of firm A falls after the merger.
We see that EPS of firm A increase as a result of the merger and its P/E decreases, even when the merger creates not value. The example shows that merging a company with high growth potential (high P/E) and one with little growth potential (low P/E) can raise EPS. Since the merger creates no value, all that happened is that the high-growth company, whose value lies in its potential to generate future earnings, has purchased a company for which most of the value lies in its current ability to generate earnings. The lower P/E ratio and high EPS after the merger reflects this reality. But if for some reason investors are willing to pay more for firm A’s shares when its EPS are growing, then A’s management has an incentive to acquire firm T solely to boost EPS. Of course, to keep fooling investors firm A has to continue to expand by merger, but this cannot be done forever.
c) What do you learn from this?
People often cite EPS growth as a reason to merge. Of
