Acquisition Scenarios (40 points)

Note that from the diversification folly example that the cash flows of any new acquisition should be value at the risk of those cash flows.

Hint #1: The valuation of a companys stock can be expressed in the following formula. If the company in question is generating a dividend that is growing at a constant and perpetual rate of g:

P₀ = D₁ / (Ke - g)

Where: P₀ = Current share price today (year 0)

D₁ = Expected dividend paid at end of the upcoming year (year 1)

Ke = required investor return on equity

g = perpetual growth rate in dividends

Differences in the level of Ke are determined by differences in risk between earnings streams for companies. If we know P₀ , D₁ and g, we can solve for Ke.

Example: P₀ = 20 , D1 = 3.00, g = 0 implies 20 = 3 / (Ke 0) and Ke = .15 or 15%

Hint #2: Assume that the stock market is efficient and that investors all agree on the expected dividends and earnings in the future. This means that the impact of any merger announcement will be accurately reflected in the current stock price immediately.

Hint #3: Apply the value additivity concept from the diversification folly example in class. (Firm value equals sum of the valuation pieces) with the pieces including value of the target firm before acquisition and the bidder firm before acquisition and present value of merger synergies.

Hint #4: Estimating a weighted cost of equity for the new post merger firms in the below questions is not really needed to get valuations. Just add together the valuation pieces. Value of acquirer, value of target, value of extra cash flows from deal.

Acquisitions Inc is looking to expand its reach via acquisition. It feels that it has some assets that when combined with other businesses could yield some synergies. We are currently in year 0. The firm currently pays all earnings in a year as dividends.

Below is some additional information on Acquisitions Inc:

Debt = None

Market Value of Equity = $ 10,000 million

Shares outstanding = 100 million

Current share price = $100

Expected Earnings for year 1 = D₁ = $10.00 per share

Growth rate (g) in perpetuity is zero for dividends and earnings.

Acquisitions Inc is mulling a number of acquisition ideas. Answer the questions below.

1. Acquisition Candidate E:

Acquisitions has negotiated with firm E on an acquisition of E. Acquisitions Inc. would give firm E shareholders .58 shares of stock in Acquisitions Inc. for each share outstanding of firm E.

Here is some information about firm E:

Debt = None

Market Value of Equity = $ 5,000 million (before acquisition offer is known)

Shares outstanding = 100 million

Current share price = $50

Expected Earnings for year 1 = D₁ = $6.00 per share

Growth rate (g) in perpetuity is zero for dividends and earnings

The rationale (synergy) for the merger is that Firm Es excellent products can be sold through the distribution channels of Acquisition Inc and generate extra profits and dividends starting very quickly (with no extra investment). In fact, the assumption is that the earnings and dividends of the joint firm will increase in the upcoming year (time 1) by $72 million and stay at that higher level in perpetuity. The risk of these extra earnings is thought to be similar to the risk of firm Es cash flows today. So, we would use the discount rate for E to value the synergies. Firm E is in a more cyclical (riskier) line of business than Acquisitions Inc.

Will a merger between these two companies result in a greater combined value of the two firms? Please show with numbers.

What is the new Price of one share of Acquisitions Inc stock immediately after the merger is done?

Will the EPS (earnings per share) of Acquisitions Inc rise or fall in year 1 if this acquisition is done? What would the new EPS be?

What is the new price to earnings ratio (P / E₁) for Acquisitions Inc after the merger closes?

If Acquisitions Inc management simply required that any new merger to be approved must increase EPS and must have some synergy, would this merger qualify under these two criteria for approval?

Does the share price of acquisitions Inc and the EPS go in the same direction as a result of the merger? Can you explain why or why not (without just resorting to simple math arguments (e.g., shares went up more than earnings or shares went down more than earnings, etc) give me some economic intuition).

Is this a good deal for Acquisitions Inc. shareholders?

Is this a good deal for Candidate E shareholders?