Firm B (Bidder) is considering a merger with Firm T (Target). The CFO in firm B has prepared the following pro forma Income statement for the target firm assuming the merger takes place. The following income statement includes all synergistic benefits from the merger. If firm B buys firms T, an immediate dividend of $55 million would be paid from the target firm to the bidder firm. Stock in Firm B currently sells for $87 per share, and the company has 18 million shares outstanding. Firm T has 8 million shares outstanding. Both firms can borrow at an 8% interest rate. The CFO in firm B believes the current cost of capital for the bidding firm is 11%. The cost of capital for the target firm is 12.4%, and the cost of equity is 16.9%. In five years, the value of target firm is expected to be $235 million. You are asked to analyze the financial aspects of the potential merger and provide answers for the following questions.

1. suppose shareholders of the target firm agree to a merger price of $23. Should the bidding firm proceed with the merger?

2. What is the highest merger price per share that the bidder is willing to pay for the target?

Hint: The highest share price = Highest Cash Amount paid to target firm/#shares outstanding target firm. The highest Cash Amount paid to target firm is the total cash outflow in year 0 that completely offsets the PV of all future cash flows generated by the merger.

3. Suppose Bidder is unwilling to pay cash but will consider a stock exchange. What exchange ratio would make the merger terms equivalent to the merger price of $23?

Hint: exchange ratio = merger price per share/stock price post cash offer; stock price post cash offer = (MV of bidder firm + NPV)/#shares Bidder firm

4. What is the highest exchange ratio the bidder firm should be willing to pay and still undertake the merger?

Hint: The highest exchange ratio the bidder firm would accept is an exchange ratio that results in a zero NPV acquisition in which case the stock price of bidder firm=stock price post cash merger

Pro Forma Income Statement Year o Year 1 Year 2 Year 3 Year 4 Year 5 24885000 27255000 31995000 33180000 41475000 0 16000000 19000000 21000000 25000000 235000000 Net Income Additions to retained earnings Dividends from Hybrid (= Net income - Additions to retained earnings) Terminal value of Target firm Cash amount paid to Target firm in year 0 (= merger price * #shares in Target firm) Dividends received By bidder from Target in year 0 Cash flow in Year 0 (=Cash amount paid - Dividends from Target in year 0) Present value of Cash flow Each Year (=Dividend (or Terminal Value) in year t/(1+discount rate)^t) NPV of the Merger (=sum of all the present values of cash flows) Based on the NPV, should the Bidder firm proceed with the merger (yes or no)? Highest Cash Amount paid to target firm #shares outstanding target firm Highest merger price per share merger price per share Stock price post cash offer exchange ratio Highest merger price per share Stock price post cash offer exchange ratio Pro Forma Income Statement Year o Year 1 Year 2 Year 3 Year 4 Year 5 24885000 27255000 31995000 33180000 41475000 0 16000000 19000000 21000000 25000000 235000000 Net Income Additions to retained earnings Dividends from Hybrid (= Net income - Additions to retained earnings) Terminal value of Target firm Cash amount paid to Target firm in year 0 (= merger price * #shares in Target firm) Dividends received By bidder from Target in year 0 Cash flow in Year 0 (=Cash amount paid - Dividends from Target in year 0) Present value of Cash flow Each Year (=Dividend (or Terminal Value) in year t/(1+discount rate)^t) NPV of the Merger (=sum of all the present values of cash flows) Based on the NPV, should the Bidder firm proceed with the merger (yes or no)? Highest Cash Amount paid to target firm #shares outstanding target firm Highest merger price per share merger price per share Stock price post cash offer exchange ratio Highest merger price per share Stock price post cash offer exchange ratio