Acme Alarm Systems

Andrew Carter, the CEO of Acme Alarm Systems, could not hide his irritation from Becky Garcia over the proposed buyout of Internet Security, Inc. Becky, a recent graduate from the MBA program at the Darden School at the University of Virginia, knew what was bothering Andrew, and decided to discuss the key issues with him over lunch. She suspected that Andrew was still not use to having a high powered MBA with a six figure salary on his payroll, but the board of directors for Acme Alarm Systems insisted that Andrew hire more young, sophisticated talent to meet the competitive pressures the firm would be facing in the future.

The Proposed Merger

Becky, who was in charge of the firms mergers and acquisitions development program, had given Andrew a proposal for Acme Alarm Systems to make a buyout offer for Internet Security, Inc. The logic behind Beckys thinking was that Acme Alarm Systems was too tied to the past with its emphasis on home and office alarm systems and needed to move into the growing area of providing security for documents that were transferred online.

The basic stock market information on the two firms is shown in Figure 1.

Figure 1 Stock Market Data

		Acme Alarm Systems		Internet Security Systems
Total earnings		$50,000,000		$10,000,000
Number of shares outstanding		20,000,000		8,000,000
Earnings per share		$2.50		$1.25
Price-earnings ratio (P/E)		16X		24X
Market price per share		$40		$30

Because Internet Security Inc. was in a more appealing area to investors than Acme Alarm Systems, it had a higher P/E ratio (24x vs. 16x). Also, in order to attract Internet Security as a potential candidate, Becky proposed that Acme make a buyout offer at 40 percent over the stocks current value. Such premiums over market value are common in mergers.

Internet Security Inc. current price	$30
40 percent premium	$12
Proposed offer price	$42

If the offer were made at $42 for the 8,000,000 shares of Internet Security, Inc., the total price would be $336,000,000. Becky suggested offering shares of Acme Alarm Systems to cover the cost and this would require 8,400,000 new shares of Acme stock based on its current price of $40.

Number of new Acme Shares	=	Total purchase price of Internet Security	=	$336,400,000	=	8,400,000
		Share value of Acme Stock		$40

After the merger, Acme would have 28,400,000 shares outstanding (the original 20,000,000 in Figure 1 plus the 8,400,000 shares as part of the merger). The combined earnings of the two firms would be $60,000,000 (based on line 1 of Figure 1). The postmerger earnings per share for Acme Alarm Systems would be $2.11.

Postmerger combined earnings	=	$60,000,000	=	$2.11
Postmerger Acme shares outstanding		28,400,000

The $2.11 is the number that caught Andrew Carters attention. When he and Becky arrived at the restaurant for lunch he said, I cant believe you are recommending a merger which will dilute Acmes earnings per share by $.39 (see Figure 1 for premerger earnings per share of $2.50). He further said, The analysts on Wall Street will kill us for this decrease in earnings per share.

Answer 3 and 4

3. If, in addition to the 15 percent increase in the P/E ratio, total earnings increased by 10 percent because of synergy, should Andrew be satisfied in terms of the stock price effect.

Recompute earnings per share based on new total earnings and multiply this figure by the new P/E ratio computed in question 2.

4. Assume a 15 percent increase in the P/E ratio and a 10 percent increase in total earnings (as covered in questions 2 and 3), but that Acme paid a premium of 60 percent instead of 40 percent over the market value of Internet Security, Inc. Should Andrew be satisfied in terms of the stock price effect for Acme?

First, recompute the price per share of Internet Security and the total price that must be paid for its 8 million shares. Then, compute the number of premerger shares that Acme must issue to pay this price. Based on the new total number of shares outstanding, compute postmerger earnings per share (assuming the 10 percent synergy for total earnings).

Multiply this value by Acmes postmerger P/E ratio (the P/E ratio is up 15 percent as indicated in question 2). The final value will give you the anticipated stock price for Acme. Should Andrew be satisfied with this value?