Consider a value enhancing deal between two firms A and B. Firm A has 100,000 shares outstanding priced at $2 each, and firm B 200,000 shares priced at $1 each. If a merger takes place, the new firm could make cost savings in SG&A of $4,000 each year indefinitely. The cost of capital is 10%.

(a) Suppose firm A proposes a bid for firm Bs shares worth $1.2 each, and also suppose the bid is going to be accepted for sure by all of Bs shareholders. Work out the price-response to the bid announcement by a rational market who take the announcement as a complete surprise. Do you think firm A is overpaying for firm Bs shares? Explain your answer.

(b) Suppose now that the two firms have agreed to a merger where each share in firm A will be converted into 2 shares in the merged firm, and each share in firm B will be converted into 1 share in the merged firm. Work out the price-response to the announcement of the merger, making similar assumptions as in (a).