Chapter 32 – Answers 9. a. This is a version of the diversification argument. The high interest rates reflect the risk inherent in the volatile industry. However, if the merger allows increased borrowing and provides increased value from tax shields, there will be a net gain. b. The P/E ratio does not determine earnings. The efficient markets hypothesis suggests that investors will be able to see beyond the ratio to the economics of the merger. c. There will still be a wealth transfer from the acquiring shareholders to the target shareholders. 10. Suppose the market value of the acquiring firm is $150 million and the value of the firm with a merger is $200 million. If the probability of a merger is 70%, then the market value of the firm pre-merger could be: ($150  0.3) + ($200  0.7) = $185 million If the acquiring managers used this value, they would underestimate the value of the acquisition. 11. This is an interesting question that centers on the source of the information. If you obtain the information from someone at Backwoods Chemical whom you know has access to this valuable information, then you are guilty of insider trading if you act upon it. However, if you come across the information as a result of analysis you have done or research you have performed (which anyone could have done, but did not do), then you are free to act upon the information.12. a. Assume 4,000,000PVAB11 )PV(PVPVGainBAAB 0$12,000,00Gain b. Because this is a cash acquisition: Cost = Cash Paid – PVB = $3,000,000 c. Because this acquisition is financed with stock, we have to take into consideration the effect of the merger on the stock price of Leisure Products. After the merger, there will be 1,200,000 shares outstanding. Hence, the share price will be: $114,000,000/1,200,000 = $95.00 Therefore: Cost = $7,000,000 d. If the acquisition is for cash, the cost is the same as in Part (b), above: Cost = $3,000,000 If the acquisition is for stock, the cost is different from that calculated in Part (c). This is because the new growth rate affects the value of the merged company. This, in turn, affects the stock price of the merged company and, hence, the cost of the merger. It follows that: PVAB = ($90  1,000,000) + ($20  600,000) = $102,000,000 The new share price will be: $102,000,000/1,200,000 = $85.00 Therefore: Cost =