What are some of the motivations for leveraged and management buyouts of the
In a leveraged buyout (LBO) or management buyout (MBO), all public shares are
repurchased and the company ÔÇťgoes private.ÔÇŁ LBOs tend to involve mature businesses with
ample cash flow and modest growth opportunities. LBOs and other debt-financed takeovers
592 SECTION SIX
are driven by a mixture of motives, including (1) the value of interest tax shields; (2)
transfers of value from bondholders, who may see the value of their bonds fall as the firm
piles up more debt; and (3) the opportunity to create better incentives for managers and
employees, who have a personal stake in the company. In addition, many LBOs have been
designed to force firms with surplus cash to distribute it to shareholders rather than plowing
it back. Investors feared such companies would otherwise channel free cash flow into
www.secdata.com/ Good source of merger data
www.mergernetwork.com/ Information about mergers and acquisitions
Links http://viking.som.yale.edu/will/finman540/acquira3.htm A sample case looking at an acquisi-
www.lens-inc.com/ Active corporate governance strategies
www.corpgov.net/ The Corporate Governance Network
proxy contest acquisition poison pill
Key Terms merger leveraged buyout (LBO) white knight
tender offer management buyout (MBO) shark repellent
1. Merger Motives. Which of the following motives for mergers make economic sense?
Quiz a. Merging to achieve economies of scale.
b. Merging to reduce risk by diversification.
c. Merging to redeploy cash generated by a firm with ample profits but limited growth op-
d. Merging to increase earnings per share.
2. Merger Motives. Explain why it might make good sense for Northeast Heating and North-
east Air Conditioning to merge into one company.
3. Empirical Facts. True or false?
a. Sellers almost always gain in mergers.
b. Buyers almost always gain in mergers.
c. Firms that do unusually well tend to be acquisition targets.
d. Merger activity in the United States varies dramatically from year to year.
e. On the average, mergers produce substantial economic gains.
f. Tender offers require the approval of the selling firmÔÇ™s management.
g. The cost of a merger is always independent of the economic gain produced by the merger.
4. Merger Tactics. Connect each term to its correct definition or description:
A. LBO 1. Attempt to gain control of a firm by winning the votes of its
B. Poison pill stockholders.
C. Tender offer 2. Changes in corporate charter designed to deter unwelcome
D. Shark repellent takeover.
E. Proxy contest 3. Friendly potential acquirer sought by a threatened target firm.
Mergers, Acquisitions, and Corporate Control 593
F. White knight 4. Shareholders are issued rights to buy shares if bidder acquires
large stake in the firm.
5. Offer to buy shares directly from stockholders.
6. Company or business bought out by private investors, largely
5. Empirical Facts. True or false?
a. One of the first tasks of an LBOÔÇ™s financial manager is to pay down debt.
b. Shareholders of bidding companies earn higher abnormal returns when the merger is fi-
nanced with stock than in cash-financed deals.
c. Targets for LBOs in the 1980s tended to be profitable companies in mature industries
with limited investment opportunities.
6. Merger Gains. Acquiring Corp. is considering a takeover of Takeover Target Inc. Acquiring
Problems has 10 million shares outstanding, which sell for $40 each. Takeover Target has 5 million
shares outstanding, which sell for $20 each. If the merger gains are estimated at $20 million,
what is the highest price per share that Acquiring should be willing to pay to Takeover Tar-
7. Mergers and P/E Ratios. If Acquiring Corp. from problem 6 has a price-earnings ratio of
12, and Takeover Target has a P/E ratio of 8, what should be the P/E ratio of the merged
firm? Assume in this case that the merger is financed by an issue of new Acquiring Corp.
shares. Takeover Target will get one Acquiring share for every two Takeover Target shares
8. Merger Gains and Costs. Velcro Saddles is contemplating the acquisition of Pogo Ski
Sticks, Inc. The values of the two companies as separate entities are $20 million and $10 mil-
lion, respectively. Velcro Saddles estimates that by combining the two companies, it will re-
duce marketing and administrative costs by $500,000 per year in perpetuity. Velcro Saddles
is willing to pay $14 million cash for Pogo. The opportunity cost of capital is 10 percent.
a. What is the gain from merger?
b. What is the cost of the cash offer?
c. What is the NPV of the acquisition under the cash offer?
9. Stock versus Cash Offers. Suppose that instead of making a cash offer as in problem 8, Vel-
cro Saddles considers offering Pogo shareholders a 50 percent holding in Velcro Saddles.
a. What is the value of the stock in the merged company held by the original Pogo share-
b. What is the cost of the stock alternative?
c. What is its NPV under the stock offer?
10. Merger Gains. Immense Appetite, Inc., believes that it can acquire Sleepy Industries and
improve efficiency to the extent that the market value of Sleepy will increase by $5 million.
Sleepy currently sells for $20 a share, and there are 1 million shares outstanding.
a. SleepyÔÇ™s management is willing to accept a cash offer of $25 a share. Can the merger be
accomplished on a friendly basis?
b. What will happen if SleepyÔÇ™s management holds out for an offer of $28 a share?
11. Mergers and P/E Ratios. Castles in the Sand currently sells at a price-earnings multiple of
10. The firm has 2 million shares outstanding, and sells at a price per share of $40. Firm
594 SECTION SIX
Foundation has a P/E multiple of 8, has 1 million shares outstanding, and sells at a price per
share of $20.
a. If Castles acquires the other firm by exchanging one of its shares for every two of Firm
FoundationÔÇ™s, what will be the earnings per share of the merged firm?
b. What should be the P/E of the new firm if the merger has no economic gains? What will
happen to CastlesÔÇ™s price per share? Show that shareholders of neither Castles nor Firm
Foundation realize any change in wealth.
c. What will happen to CastlesÔÇ™s price per share if the market does not realize that the P/E
ratio of the merged firm ought to differ from CastlesÔÇ™s premerger ratio?
d. How are the gains from the merger split between shareholders of the two firms if the mar-
ket is fooled as in part (c)?
12. Stock versus Cash Offers. Sweet Cola Corp. (SCC) is bidding to take over Salty Dog Pret-
zels (SDP). SCC has 3,000 shares outstanding, selling at $50 per share. SDP has 2,000
shares outstanding, selling at $17.50 a share. SCC estimates the economic gain from the
merger to be $10,000.
a. If SDP can be acquired for $20 a share, what is the NPV of the merger to SCC?
b. What will SCC sell for when the market learns that it plans to acquire SDP for $20 a
share? What will SDP sell for? What are the percentage gains to the shareholders of each
c. Now suppose that the merger takes place through an exchange of stock. Based on the
premerger prices of the firms, SCC sells for $50, so instead of paying $20 cash, SCC is-
sues .40 of its shares for every SDP share acquired. What will be the price of the merged
d. What is the NPV of the merger to SCC when it uses an exchange of stock? Why does
your answer differ from part (a)?
13. Bootstrap Game. The Muck and Slurry merger has fallen through (see Section 6.3). But
World Enterprises is determined to report earnings per share of $2.67. It therefore acquires
Problems the Wheelrim and Axle Company. You are given the following facts:
World Wheelrim Merged
Enterprises and Axle Firm
Earnings per share $2.00 $2.50 $2.67
Price per share $40.00 $25.00 _____
Price-earnings ratio 20 10 _____
Number of shares 100,000 200,000 _____
Total earnings $200,000 $500,000 _____
Total market value $4,000,000 $5,000,000 _____
Once again there are no gains from merging. In exchange for Wheelrim and Axle shares,
World Enterprises issues just enough of its own shares to ensure its $2.67 earnings per share
a. Complete the above table for the merged firm.
b. How many shares of World Enterprises are exchanged for each share of Wheelrim and
c. What is the cost of the merger to World Enterprises?
d. What is the change in the total market value of those World Enterprises shares that were
outstanding before the merger?
Mergers, Acquisitions, and Corporate Control 595
14. Merger Gains and Costs. As treasurer of Leisure Products, Inc., you are investigating the
possible acquisition of Plastitoys. You have the following basic data:
Leisure Products Plastitoys
Forecast earnings per share $5.00 $1.50
Forecast dividend per share $3.00 $.80
Number of shares 1,000,000 600,000
Stock price $90.00 $20.00
You estimate that investors currently expect a steady growth of about 6 percent in PlastitoysÔÇ™s
earnings and dividends. You believe that Leisure Products could increase PlastitoysÔÇ™s growth
rate to 8 percent per year, without any additional capital investment required.
a. What is the gain from the acquisition?
b. What is the cost of the acquisition if Leisure Products pays $25 in cash for each share of
c. What is the cost of the acquisition if Leisure Products offers one share of Leisure Prod-
ucts for every three shares of Plastitoys?
d. How would the cost of the cash offer and the share offer alter if the expected growth rate
of Plastitoys were not increased by the merger?
1 a. Horizontal merger. IBM is in the same industry as Apple Computer.
b. Conglomerate merger. Apple Computer and Stop & Shop are in different industries.
Self-Test c. Vertical merger. Stop & Shop is expanding backward to acquire one of its suppliers,
Questions d. Conglomerate merger. Campbell Soup and IBM are in different industries.
2 Given current earnings of $2.00 a share, and a share price of $10, Muck and Slurry would
have a market value of $1,000,000 and a price-earnings ratio of only 5. It can be acquired
for only half as many shares of World Enterprises, 25,000 shares. Therefore, the merged
firm will have 125,000 shares outstanding and earnings of $400,000, resulting in earnings
per share of $3.20, higher than the $2.67 value in the third column of Table 6..2.
3 The cost of the merger is $4 million: the $4 per share premium offered to Goldfish share-
holders times 1 million shares. If the merger has positive NPV to Killer Shark, the gain
must be greater than $4 million.
4 Yes. Look again at Table 6.4. Total market value is still $540, but Cislunar will have to issue
1 million shares to complete the merger. Total shares in the merged firm will be 11 million.
The postmerger share price is $49.09, so Cislunar and its shareholders still come out ahead.
McPhee Food Halls operated a chain of supermarkets in the west Almost nobody anticipated a bid coming from Fenton, a di-
of Scotland. The company had had a lackluster record and, since versified retail business with a chain of clothing and department
the death of its founder in late 1998, it had been regarded as a stores. Though Fenton operated food halls in several of its de-
prime target for a takeover bid. In anticipation of a bid, McPheeÔÇ™s partment stores, it had relatively little experience in food retail-
share price moved up from ┬ú4.90 in March to a 12-month high ing. FentonÔÇ™s management had, however, been contemplating a
of ┬ú5.80 on June 10, despite the fact that the London stock mar- merger with McPhee for some time. They not only felt that they
ket index as a whole was largely unchanged. could make use of McPheeÔÇ™s food retailing skills within their
596 SECTION SIX
FentonÔÇ™s shares opened lower and drifted down ┬ú.10 to close the
department stores, but they believed that better management and
day at ┬ú7.90. McPheeÔÇ™s shares, however, jumped to ┬ú6.32 a share.
inventory control in McPheeÔÇ™s business could result in cost sav-
FentonÔÇ™s financial manager was due to attend a meeting with
ings worth ┬ú10 million.
the companyÔÇ™s investment bankers that evening, but before doing
FentonÔÇ™s offer of 8 Fenton shares for every 10 McPhee shares
so, he decided to run the numbers once again. First he reesti-
was announced after the market close on June 10. Since McPhee
mated the gain and cost of the merger. Then he analyzed that
had 5 million shares outstanding, the acquisition would add an
additional 5 ├— (8/10) = 4 million shares to the 10 million Fenton dayÔÇ™s fall in FentonÔÇ™s stock price to see whether investors be-
shares that were already outstanding. While FentonÔÇ™s manage- lieved there were any gains to be had from merging. Finally, he
ment believed that it would be difficult for McPhee to mount a decided to revisit the issue of whether Fenton could afford to
successful takeover defense, the company and its investment raise its bid at a later stage. If the effect was simply a further fall
bankers privately agreed that the company could afford to raise in the price of Fenton stock, the move could be self-defeating.
the offer if it proved necessary.
Investors were not persuaded of the benefits of combining a
supermarket with a department store company, and on June 11
Foreign Exchange Markets
Some Basic Relationships
Exchange Rates and Inflation
Inflation and Interest Rates
Interest Rates and Exchange Rates
The Forward Rate and the Expected Spot Rate
Hedging Exchange Rate Risk
International Capital Budgeting
Net Present Value Analysis
The Cost of Capital for Foreign Investment
Avoiding Fudge Factors