Adapted from CFA Level II program curriculum (Volume 3 Corporate Finance)

Modern Auto, an automobile parts supplier, has made an offer to acquire Sky Systems, creator of software for the airline industry. The offer is to pay Sky Systems shareholders the current market value of their stock in Modern Autos stock. The relevant information it used in those calculations is given below:

	Modern Auto	Sky Systems
Share price	$40	$25
Number of outstanding shares (millions)	40	15
Earnings (millions)	$100	$30

Although the total earnings of the combined company will not increase and are estimated to be $130 million, Charles Wilhelm (treasurer of Modern Auto) argues that there are two attractive reasons to merge. First, Wilhelm says, The merger of Modern Auto and Sky Systems will result in lower risk for our shareholders because of the diversification effect. Second, Wilhelm also says, If our EPS increases, our stock price will increase in line with the EPS increase because our P/E will stay the same.

Sky Systems managers are not interested in the offer by Modern Auto. The managers, instead approach HiFly, Inc., which is in the same industry as Sky Systems, to see if it would be interested in acquiring Sky Systems. HiFly is interested, and both companies believe there will be synergies from this acquisition. If HiFly were to acquire Sky Systems, it would do so by paying $400 million in cash.

1. The acquisition of Sky Systems by Modern Auto and the acquisition of Sky Systems by HiFly, respectively, would be examples of a

1. vertical merger and a horizontal merger.
2. conglomerate merger and a vertical merger
3. conglomerate merger and a horizontal merger.

2. If Sky Systems were to be acquired by Modern Auto under the terms of the original offer, the post-merger EPS of the new company would be closest to

1. $2.00
2. $2.32
3. $2.63

3. Which of the following defenses best describes the role of HiFly in the acquisition scenario?

1. Crown jewel
2. Pac-Man
3. White knight

4. Suppose HiFly acquires Sky Systems for the stated terms. The gain to Sky Systems shareholders resulting from the merger transaction would be closest to

1. $25 million
2. $160 million
3. $375 million