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CHAPTER 23
MERGERS AND ACQUISITIONS
Learning Objectives

LO1 The different types of mergers and acquisitions, why they should (or shouldn’t)
take place, and the terminology associated with them.
LO2 Taxable versus tax-free acquisitions.
LO3 How accountants construct the combined statement of financial position of a new company.
LO4 The gains from a merger or acquisition and how to value the transaction.
LO5 Some financial side effects of mergers and acquisitions.LO6 How to finance and estimate the NPV of a
merger or acquisition.
LO7 The use of different defensive tactics by the target firm’s management
LO8 The effect a merger or acquisition has on the involved companies.
LO9 Divestitures involving equity carve-outs and spin-offs.

Answers to Concepts Review and Critical Thinking Questions

1. (LO7)
a. Greenmail refers to the practice of paying unwanted suitors who hold an equity stake in the firm a
premium over the market value of their shares, to eliminate the potential takeover threat.
b. A white knight refers to an outside bidder that a target firm brings in to acquire it, rescuing the
firm from a takeover by some other unwanted hostile bidder.
c. A golden parachute refers to lucrative compensation and termination packages granted to
management in the event the firm is acquired.
d. The crown jewels usually refer to the most valuable or prestigious assets of the firm, which in the
event of a hostile takeover attempt, the target sometimes threatens to sell.
e. Shark repellent generally refers to any defensive tactic employed by the firm to resist hostile
takeover attempts.
f. A corporate raider usually refers to a person or firm that specializes in the hostile takeover of other
firms.
g. A poison pill is an amendment to the corporate charter granting the shareholders the right to
purchase shares at little or no cost in the event of a hostile takeover, thus making the acquisition
prohibitively expensive for the hostile bidder.
h. A tender offer is the legal mechanism required by the exchange when a bidding firm goes directly
to the shareholders of the target firm in an effort to purchase their shares.
i. A leveraged buyout refers to the purchase of the shares of a publicly-held company and its
subsequent conversion into a privately-held company, financed primarily with debt.

2. (LO5) Diversification doesn’t create value in and of itself because diversification reduces unsystematic, not
systematic, risk. As discussed in the chapter on options, there is a more subtle issue as well. Reducing
unsystematic risk benefits bondholders by making default less likely. However, if a merger is done purely to
diversify (i.e., no operating synergy), then the NPV of the merger is zero. If the NPV is zero, and the
bondholders are better off, then stockholders must be worse off.

3. (LO1) A firm might choose to split up because the newer, smaller firms may be better able to focus on their
particular markets. Thus, reverse synergy is a possibility. An added advantage is that performance evaluation
becomes much easier once the split is made because the new firm’s financial results (and stock prices) are no
longer commingled.

4. (LO7) It depends on how they are used. If they are used to protect management, then they are not good for
stockholders. If they are used by management to negotiate the best possible terms of a merger, then they are

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 good for stockholders. To get around a poison pill, the acquiring firm typically has to bribe the target’s firm
managers with either handsome golden parachutes or by increasing its offer price for stock.

5. (LO2) One of the primary advantages of a taxable merger is the write-up in the basis of the target firm’s assets,
while one of the primary disadvantages is the capital gains tax that is payable. The situation is the reverse for a
tax-free merger.

The basic determinant of tax status is whether or not the old stockholders will continue to participate in the
new company, which is usually determined by whether they get any shares in the bidding firm. An LBO is
usually taxable because the acquiring group pays off the current stockholders in full, usually in cash.

6. (LO4) Economies of scale occur when average cost declines as output levels increase. A merger in this
particular case might make sense because Eastern and Western may need less total capital investment to handle
the peak power needs, thereby reducing average generation costs.

7. (LO7) Among the defensive tactics often employed by management are seeking white knights, threatening to
sell the crown jewels, appealing to regulatory agencies and the courts (if possible), and targeted share
repurchases. Frequently, antitakeover charter amendments are available as well, such as poison pills, poison
puts, golden parachutes, lockup agreements, and supermajority amendments, but these require shareholder
approval, so they can’t be immediately used if time is short. While target firm shareholders may benefit from
management actively fighting acquisition bids, in that it encourages higher bidding and may solicit bids from
other parties as well, there is also the danger that such defensive tactics will discourage potential bidders from
seeking the firm in the first place, which harms the shareholders.

8. (LO4) In a cash offer, it almost surely does not make sense. In a stock offer, management may feel that one
suitor is a better long-run investment than the other, but this is only valid if the market is not efficient. In
general, the highest offer is the best one for shareholders. Management, on the other hand, may prefer an offer
because it keeps their job safe, gives larger pay outs, etc.

9. (LO4) Various reasons include: (1) Anticipated gains may be smaller than thought; (2) Bidding firms are
typically much larger, so any gains are spread thinly across shares; (3) Management may not be acting in the
shareholders’ best interest with many acquisitions; (4) Competition in the market for takeovers may force
prices for target firms up to the zero NPV level; and (5) Market participants may have already discounted the
gains from the merger before it is announced.

10. (LO8) An equity carve-out is a type of divestiture wherein the parent firm creates an entirely new company
through an IPO and the new shareholders become the owners of the public company. In a spin-off, the parent
company distributes subsidiary shares to existing stockholders and no new equity is raised. In a carve-out the
parent is attempting to gain some value from a business unit that does not necessarily fit into its strategic plan.
In a spin-off the parent is simply distancing itself from a subsidiary by transferring ownership to existing
shareholders. When Wendy’s sold a portion of Tim Horton’s through a carve-out, it was able to raise new
funds to finance other operations. The spin-off of Allstate by Sears made sense since Sears did not want to
continue in the insurance business and divested itself of its insurance division through this restructuring
mechanism.

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Solutions to Questions and Problems

NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to
space and readability constraints, when these intermediate steps are included in this solutions manual, rounding
may appear to have occurred. However, the final answer for each problem is found without rounding during any
step in the problem.

Basic

1. (LO4) For the merger to make economic sense, the acquirer must feel the acquisition will increase value by at
least the amount of the premium over the market value, so:

Minimum synergistic value = $357,000,000 – 319,000,000 = $38,000,000

2. (LO4) The maximum cash price per share for Devonshire that should be paid is the existing share price plus the
one-time benefit per share:

Maximum share price = $70 + ($120,000,000 / 4,000,000)

Maximum share price = $100

3. (LO3)
With the purchase method, the assets of the combined firm will be the book value of Firm X, the
acquiring company, plus the market value of Firm Y, the target company, so:

Assets from X = 35,000($7) = $245,000 (book value)

Assets from Y = 12,000($19) = $228,000 (market value)

The purchase price of Firm Y is the number of shares outstanding times the sum of the current stock
price per share plus the premium per share, so:

Purchase price of Y = 12,000($19 + 6) = $300,000

The goodwill created will be:

Goodwill = $300,000 – 228,000 = $72,000

And the total asset of the combined company will be:

Total assets XY = Total equity XY = $245,000 + 300,000 + 72,000 = $617,000

XY Co., post-merger
Assets $545,000
Goodwill 72,000 Equity $617,000
Total $617,000 $617,000

4. (LO3) In the pooling method, all accounts of both companies are added together to total the accounts in the
new company, so the post-merger balance sheet will be:

Amherst Co., post-merger

Current assets $18,600 Current liabilities $ 6,800
Fixed assets 45,700 Long-term debt 12,200

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 Equity 45,300
Total $64,300 $64,300

5. (LO3) Since the acquisition is funded by long-term debt, the post-merger balance sheet will have long-term
debt equal to the original long-term debt of Amherst’s balance sheet, plus the original long-term debt on
Essex’s balance sheet, plus the new long-term debt issue, so:

Post-merger long-term debt = $10,100 + 2,100 + 17,300 = $29,500

Goodwill will be created since the acquisition price is greater than the book value. The goodwill amount is
equal to the purchase price minus the market value of assets, plus the market value of the acquired company’s
liabilities and debt. Generally, the market value of current assets is equal to the book value, so:

Goodwill = $17,300 – ($9,500 market value FA) – ($3,600 market value CA) + ($1,400 + 2,100)
Goodwill = $7,700

Equity will remain the same as the pre-merger balance sheet of the acquiring firm. Current assets and debt
accounts will be the sum of the two firm’s pre-merger balance sheet accounts, and the fixed assets will be the
sum of the pre-merger fixed assets of the acquirer and the market value of fixed assets of the target firm. The
post-merger balance sheet will be:

Amherst Co., post-merger

Current assets $18,600 Current liabilities $ 6,800
Fixed assets 48,500 Long-term debt 29,500
Goodwill 7,700 Equity 38,500
Total $74,800 $74,800

6. (LO3) In the pooling method, all accounts of both companies are added together to total the accounts in the
new company, so the post-merger balance sheet will be:

Knapps Enterprises, post-merger

Current assets $6,700 Current liabilities $4,560

Other assets 2,070 Long-term debt 7,800

Net fixed assets 25,300 Equity 21,710

Total $34,070 Total $34,070

7. (LO3) Since the acquisition is funded by long-term debt, the post-merger Statement of Financial Position will
have long-term debt equal to the original long-term debt of Knapp’s Statement of Financial Position plus the
new long-term debt issue, so:

Post-merger long-term debt = $7,800 + 15,000 = $22,800

Equity will remain the same as the pre-merger Statement of Financial Position of the acquiring firm. Current
assets, current liabilities, long-term debt, and other assets will be the sum of the two firm’s pre-merger
Statement of Financial Position accounts, and the fixed assets will be the sum of the pre-merger fixed assets of
the acquirer and the market value of fixed assets of the target firm. Note, in this case, the market value and the
book value of fixed assets is the same. We can calculate the goodwill as the plug variable that makes the
Statement of Financial Position balance. The post-merger balance sheet will be:

Knapp’s Enterprises, post-merger

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 Current assets $6,700 Current liabilities $4,560

Other assets 2,070 Long-term debt 22,800

Net fixed assets 27,000 Equity 13,800

Goodwill 5,390
Total $41,160 Total $41,160

8. (LO6)
a. The cash cost is the amount of cash offered, so the cash cost is $57 million.

To calculate the cost of the stock offer, we first need to calculate the value of the target to the
acquirer. The value of the target firm to the acquiring firm will be the market value of the target plus the
PV of the incremental cash flows generated by the target firm. The cash flows are a perpetuity, so

V* = $41,000,000 + $1,900,000/.10 = $60,000,000

The cost of the stock offer is the percentage of the acquiring firm given up times the sum of the
market value of the acquiring firm and the value of the target firm to the acquiring firm. So, the equity
cost will be:

Equity cost = .40($79,000,000 + 60,000,000) = $55,600,000

b. The NPV of each offer is the value of the target firm to the acquiring firm minus the cost of
acquisition, so:

NPV cash = $60,000,000 – 57,000,000 = $3,000,000

NPV stock = $60,000,000 – 55,600,000 = $4,400,000

c. Since the NPV is greater with the stock offer, the acquisition should be in stock.

9. (LO1)
a. The EPS of the combined company will be the sum of the earnings of both companies divided by
the shares in the combined company. Since the stock offer is one share of the acquiring firm for three
shares of the target firm, new shares in the acquiring firm will increase by one-third. So, the new EPS
will be:

EPS = ($180,000 + 810,000)/[210,000 + (1/3)(90,000)] = $4.125

The market price of Dover will remain unchanged if it is a zero NPV acquisition. Using the PE
ratio, we find the current market price of Dover stock, which is:

P = 21($810,000)/210,000 = $81

If the acquisition has a zero NPV, the stock price should remain unchanged. Therefore, the new
PE will be:

P/E = $81/$4.125 = 19.64

b. MV of Tilbury = $180,000(13.5) = $2,430,000

The cost of the acquisition is the number of shares offered times the share price, so the cost is:

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 Cost = (1/3)(90,000)($81) = $2,430,000

By assuming NPV of the acquisition equal to zero, we can calculate value of synergy as:
NPV = 0 = MV + V – Cost = $2,430,000+ V – 2,430,000
V = $0

Although there is no economic value to the takeover, it is possible that Dover is motivated to
purchase Tilbury for other than financial reasons.

10. (LO6)
a. The NPV of the merger is the market value of the target firm, plus the value of the synergy, minus
the acquisition costs, so:

NPV = 1,500($19) + $8,700 – 1,500($21) = $5,700

b. Since the NPV goes directly to stockholders, the share price of the merged firm will be the market
value of the acquiring firm plus the NPV of the acquisition, divided by the number of shares outstanding,
so:

Price per Share = [5,400($47) + $5,700]/5,400 = $48.06

c. The merger premium is the premium per share times the number of shares of the target firm
outstanding, so the merger premium is:

Merger premium = 1,500($21 – 19) = $3,000

d. The number of new shares will be the number of shares of the target times the exchange ratio, so:

New shares created = 1,500(1/2) = 750 new shares

The value of the merged firm will be the market value of the acquirer plus the market value of the
target plus the synergy benefits, so:

VBT = 5,400($47) + 1,500($19) + 8,700 = $291,000

The price per share of the merged firm will be the value of the merged firm divided by the total
shares of the new firm, which is:

P = $291,000/(5,400 + 750) = $47.317

e. The NPV of the acquisition using a share exchange is the market value of the target firm plus
synergy benefits, minus the cost. The cost is the value per share of the merged firm times the number of
shares offered to the target firm shareholders, so:

NPV = 1,500($19) + $8,700 – 750($47.317) = $1,712.20

Intermediate

11. (LO6) The stock offer is better for the target firm shareholders since they receive only $21 per share in cash .
In the stock offer, the target firm’s shareholders will receive:

Equity offer value = (1/2)($47.31) = $23.655 per share

From Problem 10, we know the value of the merged firm’s assets will be $291,000. The number of shares in
the new firm will be:

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 Shares in new firm = 5,400 + 1,500x

that is, the number of shares outstanding in the bidding firm, plus the number of shares outstanding in the
target firm, times the exchange ratio. This means the post merger share price will be:

P = $291,000/(5,400 + 1,500x)

To make the target firm’s shareholders indifferent, they must receive the same wealth, so:

1,500(x)P = 1,500($21)

This equation shows that the new offer is the shares outstanding in the target company times the exchange ratio
times the new stock price. The value under the cash offer is the shares outstanding times the cash offer price.
Solving this equation for P, we find:

P = $21 / x

Combining the two equations, we find:

$291,000/(5,400 + 1,500x) = $21 / x

x = .437 or in other words 3 new shares in merged company for 7 shares of the target company.

There is a simpler solution that requires an economic understanding of the merger terms. If the target firm’s
shareholders are indifferent, the bidding firm’s shareholders are indifferent as well. That is, the offer is a zero
sum game. Using the new stock price produced by the cash deal, we find:

Exchange ratio = $21/$48.05 = .437

12. (LO1) The cost of the acquisition is:

Cost = 300($49) = $14,700

Since the stock price of the acquiring firm is $43, the firm will have to give up:

Shares offered = $14,700/$43 = 341.8605 shares (assuming NPV = 0)

a. The EPS of the merged firm will be the combined EPS of the existing firms divided by the new
shares outstanding, so:

EPS = ($3,150 + 1,000)/(1,500 + 341.8605) = $2.25316

b. The PE of the acquiring firm is:

Original P/E = $43/($3,150 /1,500) = 20.4762 times

Assuming the PE ratio does not change, the new stock price will be:

New P = $2.25316 (20.4762) = $46.1362

c. If the market correctly analyzes the earnings, the stock price will remain unchanged since this is a
zero NPV acquisition, so:

New P/E = $43/$2.25316 = 19.0843 times

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 d. The new share price will be the combined market value of the two existing companies divided by
the number of shares outstanding in the merged company. So:

P = [(1,500)($43) + 300($47)]/(1,500 + 341.8605) = $42.674

And the PE ratio of the merged company will be:

P/E = $42.674/$2.25316 = 18.940 times

At the proposed bid price, this is a negative NPV acquisition for A since the share price declines.
They should revise their bid downward until the NPV is zero.

13. (LO6) Beginning with the fact that the NPV of a merger is the value of the target minus the cost, we get:

NPV = VB* – Cost

NPV = V + VB – Cost
NPV = V – (Cost – VB)
NPV = V – Merger premium

14. (LO4, 6)
a. The present value of the merger gain is the value of the perpetual savings:

Present value of merger gain = $800,000 / .14

Present value of merger gain = $5,714,285.71

b. The cost of the cash offer is the total price paid for shares:

Cost = $25 x 2,500,000

Cost = $62,500,000

c. The NPV of the offer is the PV of the merger gain plus the PV of the shares minus the cash cost:

NPV of cash offer = $18 x 2,500,000 + $5,714,285.71 – $62,500,000 = $50,714,285.71 – $62.5M

NPV of cash offer = -$11,785,714.29

15. (LO4, 6)
a. The synergy will be the present value of the incremental cash flows of the proposed purchase. Since the
cash flows are perpetual, the synergy value is:

Synergy value = $425,000 / .08

Synergy value = $5,312,500

b. The value of Harwich to Raleigh is the synergy plus the current market value of Harwich, which is:

Value = $5,312,500 + 8,800,000

Value = $14,112,500

c. The cost of the cash option is the amount of cash paid, or $12 million. The cost of the stock acquisition is
the percentage of ownership in the merged company, times the value of the merged company, so:

Stock acquisition value = .35($14,112,500 + 22,000,000)

Stock acquisition value = $12,639,375

d. The NPV is the value of the acquisition minus the cost, so the NPV of each alternative is:

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 NPV of cash offer = $14,112,500 – 12,000,000
NPV of cash offer = $2,112,500

NPV of stock offer = $14,112,500 – 12,639,375

NPV of stock offer = $1,473,125

e. The acquirer should make the cash offer since its NPV is greater.

16. (LO4, 6)
a. The number of shares after the acquisition will be the current number of shares outstanding for the
acquiring firm, plus the number of new shares created for the acquisition, which is:

Number of shares after acquisition = 5,000,000 + 1,200,000

Number of shares after acquisition = 6,200,000

And the share price will be the value of the combined company divided by the shares outstanding, which
will be:

New stock price = $185,000,000 / 6,200,000

New stock price = $29.83870968

b. Let  equal the fraction of ownership for the target shareholders in the new firm. We can set the
percentage of ownership in the new firm equal to the value of the cash offer, so:

($185,000,000) = $50,000,000
 = .27027 or 27.027%

So, the shareholders of the target firm would be equally as well off if they received 27.027 percent of the
stock in the new company as if they received the cash offer. The ownership percentage of the target firm
shareholders in the new firm can be expressed as:

Ownership = New shares issued / (New shares issued + Current shares of acquiring firm)
.27027 = New shares issued / (New shares issued + 5,000,000)
New shares issued = 1,851,849.31

To find the exchange ratio, we divide the new shares issued to the shareholders of the target firm by the
existing number of shares in the target firm, so:

Exchange ratio = New shares / Existing shares in target firm

Exchange ratio = 1,851,849.31/ 2,000,000
Exchange ratio = .9259

An exchange ratio of .9259 shares of the merged company for each share of the target company owned,
or in other words 25 new shares in merged company for 27 shares of the target company, would make
the value of the stock offer equivalent to the value of the cash offer.

Challenge

17. (LO4, 6)
a. To find the value of the target to the acquirer, we need to find the share price with the new growth
rate. We begin by finding the required return for shareholders of the target firm. The earnings per share
of the target are:

EPSP = $640,000/175,000 = $3.66 per share

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 The price per share is:

PP = 9.2($3.66) = $33.646

And the dividends per share are:

DPSP = $310,000/175,000 = $1.77

The current required return for Orford shareholders, which incorporates the risk of the company is:

RE = [$1.77(1.05)/$ 33.646] + .05 = .105281929

The price per share of Orford with the new growth rate is:

P0 = $1.77(1.07)/(.1052 – .07) = $53.72236226

The value of the target firm to the acquiring firm is the number of shares outstanding times the
price per share under the new growth rate assumptions, so:

VT* = 175,000($53.72236226) = $9,401,413.31

b. The gain to the acquiring firm will be the value of the target firm to the acquiring firm minus the
market value of the target, so:

Gain = $9,401,413.39– 175,000($33.646) = $3,513,413.31

c. The NPV of the acquisition is the value of the target firm to the acquiring firm minus the cost of
the acquisition, so:

NPV = $9,401,413.39 – 175,000($38) = $2,751,413.31

d. The most the acquiring firm should be willing to pay per share is the offer price per share plus the
NPV per share, so:

Maximum bid price = $38 + ($2,751,413.39/175,000) = $53.72236222

Notice, this is the same value we calculated earlier in part a as the value of the target to the
acquirer.

e. The price of the stock in the merged firm would be the market value of the acquiring firm plus the
value of the target to the acquirer, divided by the number of shares in the merged firm, so:

PFP = ($56,550,000 + 9,401,413.39)/(1,300,000 + 100,000) = $47.1081524

The NPV of the stock offer is the value of the target to the acquirer minus the value offered to the
target shareholders. The value offered to the target shareholders is the stock price of the merged firm
times the number of shares offered, so:

NPV = $9,401,413.39 – 100,000($47.1081524) = $4,690,598.07

f. Yes, the acquisition should go forward, and Ridgetown should offer the 100,000 shares since the
NPV is higher.

g. Using the new growth rate in the dividend growth model, along with the dividend and required
return we calculated earlier, the price of the target under these assumptions is:

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 PP = $1.77(1.06)/(0.1052 – 0.06) = $41.46718819

And the value of the target firm to the acquiring firm is:

VP* = 175,000($41.46718819) = $7,256,757.93

The gain to the acquiring firm will be:

Gain = $7,256,757.93 – 175,000($33.646) = $1,368,757.93

The NPV of the cash offer is now:

NPV cash = $7,256,757.93 – 175,000($38) = $606,757.93

And the new price per share of the merged firm will be:

PRO = [$56,550,000 + 7,256,757.93]/(1,300,000 + 100,000) = $45.57625567

And the NPV of the stock offer under the new assumption will be:

NPV stock = $7,256,757.93 – 100,000($45.57625567) = $2,699,132.37

Even with the lower projected growth rate, the stock offer still has a positive NPV. Ridgetown
should pursue the purchase Orford with a stock offer of 100,000 shares.

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