Chapter 17 Mergers, LBOs, Divestitures, and Business Failure

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1 Chapter 17 Mergers, LBOs, Divestitures, and Business Failure Solutions to Problems P17-1. LG 1, 3: Tax Effects of Acquisition s Earnings Tax Liability After-Tax Earnings 1 15 $280,000 $112,000 $168,000 (b) Tax liability = $112, = $1,680,000 s Earnings after Write-off Tax Liability Tax Savings 1 $280,000 $280,000 = 0 $0 $112,000 2 $280,000 $280,000 = ,000 3 $280,000 $240,000 = $40,000 16,000 96, $280,000 0 = $280, ,000 0 Total = $320,000 (c) With respect to tax considerations only, the merger would not be recommended because the savings ($320,000) are less than the cost ($350,000). The merger must also be justified on the basis of future operating benefits or on grounds consistent with the goal of maximizing shareholder wealth.

2 414 Part 6 Special Topics in Managerial Finance P17-2. LG 1, 3: Tax Effects of Acquisition Net Profits Before Taxes (1) Taxes [ 0.40 (1)] (2) Net Income [(1) (2)] (3) 1 $150,000 $60,000 $90, , , , , , , , , , , , ,000 Total taxes without merger $880,000 (b) Net Profits Before Taxes (1) Taxes [0.40 (1)] (2) 1 $150,000 $ = 0 $0 2 $400,000 $400,000 = $450,000 $450,000 = $600,000 $600,000 = $600,000 $200,000 = $400, ,000 Total taxes with merger $160,000 (c) Total benefits (ignoring time value): $880,000 $160,000 = $720,000 (d) Net benefit = Tax benefits (cost liquidation of assets) = ($1,800, ) ($2,100,000 $1,600,000) = $220,000 The proposed merger is recommended based on the positive net benefit of $226,060. P17-3. LG 1, 3: Tax Benefits and Price Reilly Investment Group Net Profit Before Tax (1) Taxes [0.40 (1)] (2) Tax Advantage (3) 1 $200,000 $200,000 $0 $80,000 2 $200,000 $200, ,000 3 $200,000 $200, ,000 4 $200,000 $200, , $200,000 80,000 0 Total Tax Advantage $320,000

3 Chapter 17 Mergers, LBOs, Divestitures, and Business Failure 415 (b) Webster Industries Net Profit Before Tax (1) Taxes [0.40 (1)] (2) Tax Advantage (3) 1 $80,000 $80,000 $0 $32,000 2 $120,000 $120, ,000 3 $200,000 $200, ,000 4 $300,000 $300, ,000 5 $400,000 $100, ,000 40,000 6 $400, , $500, ,000 0 Total Tax Advantage $320,000 (c) Reilly Investment Group PV of benefits: PV 15%,4 Yrs. = $80, = $228,400 (Calculator solution: $228,398.27) Webster Industries PV of benefits: Cash Flow PV Factor (15%, n yrs.) PV of Benefits 1 $32, = $27,840 2 $48, = 36,288 3 $80, = 52,640 4 $120, = 68,640 5 $40, = 19,880 Total $205,288 Reilly would pay up to $228,400. Webster would pay no more than $205,288. Calculator solution: $205, (d) Both firms receive $320,000 in tax shield benefits. However, Reilly can use these at an earlier time; therefore, the acquisition is worth more to this firm. P17-4. LG 3: Asset Acquisition Decision Effective cost of press: = $60,000 + $90,000 $65,000 = $85,000 NPV 14%,10yrs. = ($20, ) $85,000 = $19,320 Calculator solution: $19, (b) Zarin should merge with Freiman, since the NPV is greater than zero. (c) NPV 14%,10yrs. = ($26, ) $120,000 = $15,616 Calculator solution: $15, Since the NPV of the acquisition is greater than the NPV of the new purchase, the firm should make the acquisition of the press from Freiman. The advantage of better quality from the new press would have to be considered on a subjective basis.

4 416 Part 6 Special Topics in Managerial Finance P17-5. LG 3: Cash Acquisition Decision PV of cash inflows Cash Flow PVA Factor (15%) PV Calculator Solution 1 5 $25, $83,800 $83, $50,000 ( ) 83,350 53, Total present value of cash inflows $167,150 $167, Less Cost of acquisition 125, , NPV $42,150 $42, Since the NPV is positive, the acquisition is recommended. Of course, the effects of a rise in the overall cost of capital would need to be analyzed. (b) PV of equipment purchase (12%, 10yrs.): PV = $40, = $226,000 Calculator solution: $226, (c) NPV = $226,000 $125,000 = $101,000 The purchase of equipment results in a higher NPV ($101,000 versus $42,150). This is partially due to the lower discount factor (12% versus 15%). The equipment purchase is recommended. PV of cash inflows Cash Flow PVIFA 12% PV Calculator Solution 1 5 $25, $90,125 $ 90, $50,000 ( ) 102, , Total present value of cash inflows $192,375 $192, Less Cost of acquisition 125, , NPV $67,375 $67, No, the recommendation would not change. The NPV of the equipment purchase ($101,000) remains greater than the NPV of the acquisition ($67,375). P17-6. LG 3: Ratio of Exchange and EPS Number of additional shares needed = 1.8 4,000 = 7,200 EPS of merged firm = $28,000 (20, ,200) = $1.029 EPS of Marla s = $1.029 EPS of Victory = $ = $1.852 (b) Number of additional shares needed = 2.0 4,000 = 8,000 EPS of merged firm = $28,000 (20, ,000) = $1.00 EPS of Marla s = $1.00 EPS of Victory = $ = $2.00

5 Chapter 17 Mergers, LBOs, Divestitures, and Business Failure 417 (c) Number of additional shares needed = 2.2 4,000 = 8,800 EPS of merged firm = $28,000 (20, ,800) = $0.972 EPS of Marla s = $0.972 EPS of Victory = $ = $2.139 (d) P/E calculations: Price paid per share: $ = $21.60 Price paid per share $21.60 P/E paid = = = 10.8 EPS of target $2.00 (b) Price paid per share: $ = $24.00 Price paid per share $24.00 P/E paid = = = 12.0 EPS of target $2.00 (c) Price paid per share: $ = $26.40 Price paid per share $26.40 P/E paid = = = 13.2 EPS of target $2.00 When the P/E paid (10.8) is less than the P/E of the acquiring firm (12.0), as in, the EPS of the acquiring firm increases and the EPS of the target firm decreases. When the P/E paid (12.0) is the same as the P/E of the acquiring firm (12.0), as in (b), the EPS of the acquiring and target firms remain the same. When the P/E paid (13.2) is more than the P/E of the acquiring firm (12.0), as in (c), the EPS of the acquiring firm decreases and the EPS of the target firm increases. P17-7. LG 3: EPS and Merger Terms 20, = 8,000 new shares (b) ($200,000 + $50,000) 58,000 = $4.31 per share (c) $ = $1.72 per share (d) $4.31 per share. There is no change from the figure for the merged firm. P17-8. LG 3: Ratio of Exchange Case Ratio of Exchange Market Price Ratio of Exchange A $30 $50 = 0.60 ($ ) $25 = 1.20 B $100 $80 = 1.25 ($ ) $80 = 1.25 C $70 $40 = 1.75 ($ ) $60 = 1.17 D $12.50 $50 = 0.25 ($ ) $10 = 1.25 E $25 $25 = 1.00 ($ ) $20 = 2.50 The ratio of exchange of shares is the ratio of the amount paid per share of the target firm to the market price of the acquiring firm s shares. The market price ratio of exchange indicates the amount of market price of the acquiring firm given for every $1.00 of the acquired firm.

6 418 Part 6 Special Topics in Managerial Finance P17-9. LG 3: Expected EPS-Merger Decision Graham & Sons Premerger Earnings EPS 2006 $200,000 $ $214,000 $ $228,980 $ $245,009 $ $262,160 $ $280,511 $2.805 (b) (1) New shares issued = 100, = 60,000 Earnings/Shares EPS 2006 [($800,000 + $200,000) 260,000] 0.6 = $ [($824,000 + $214,000) 260,000] 0.6 = $ [($848,720 + $228,980) 260,000] 0.6 = $ [($874,182 + $245,009) 260,000] 0.6 = $ [($900,407 + $262,160) 260,000] 0.6 = $ [($927,419 + $280,511) 260,000] 0.6 = $2.788 (2) New shares issued = 100, = 80,000 Earnings/Shares EPS 2006 [($800,000 + $200,000) 280,000] 0.8 = $ [($824,000 + $214,000) 280,000] 0.8 = $ [($848,720 + $228,980) 280,000] 0.8 = $ [($874,182 + $245,009) 280,000] 0.8 = $ [($900,407 + $262,160) 280,000] 0.8 = $ [($927,419 + $280,511) 280,000] 0.8 = $3.451

7 Chapter 17 Mergers, LBOs, Divestitures, and Business Failure 419 (c) Merger Impact on Earning per Share Postmerger,.8 Exchange Ratio 3.2 EPS ($) Postmerger,.6 Exhange Ratio Premerger (d) Graham & Sons shareholders are much better off at the 0.8 ratio of exchange. The management would probably recommend that the firm accept the merger. If the ratio is 0.6, between 2010 and 2011, the EPS falls below what the firm would have earned without being acquired. Here management would probably recommend the merger be rejected. P LG 3: EPS and Postmerger Price Market price ratio of exchange: ($ ) $50 = (b) Henry Company EPS = $225,000 90,000 = $2.50 P/E = $45 $2.50 = 18 times Mayer Services EPS = $50,000 15,000 = $3.33 P/E = $50 $3.33 = 15 times (c) Price paid = Ratio of exchange Market price of acquirer Price paid = 1.25 $45 = $56.25 P/E = $56.25 $3.33 = times (d) New shares issued = ,000 = 18,750 Total shares = 90, ,750 = 108,750 EPS = $275, ,750 = $2.529 (e) New market price = New EPS P/E = $ = $45.52 The market price increases due to the higher P/E ratio of the acquiring firm and the fact that the P/E ratio is not expected to change as a result of the acquisition.

8 420 Part 6 Special Topics in Managerial Finance P LG 4: Holding Company Total assets controlled: $35,000 ($500,000 + $900,000) = 2.5% (b) Outside company s equity ownership: (c) $5,250 ($500,000 + $900,000) = 0.375% By gaining voting control in a company for a small investment, then using that company to gain voting control in another, a holding company provides control for a relatively small investment. (d) Total assets controlled: $35,000 ($500,000 + $900,000 + $400,000 + $50,000 + $300,000 + $400,000) = 1.37% (b) Outside company s equity ownership: % = 0.206% P LG 5: Voluntary Settlements Basic Composition (b) Extension (c) Combination P LG 5: Voluntary Settlements Basic Extension (b) Composition (with extension of terms) (c) Composition (d) Extension P LG 5: Voluntary Settlements-Payments $75,000 now; composition (b) $75,000 in 90 days, $45,000 in 180 days; composition (c) $75,000 in 60 days, $37,500 in 120 days, $37,500 in 180 days; extension (d) $50,000 now, $85,000 in 90 days; composition P Ethics Problem These employees and suppliers may believe that the company s problems are only temporary, and that management will somehow make it up to them if they are supportive throughout the proceedings. They may worry about finding new jobs or sales contracts. On the CEO s part, being open and honest before, during, and after reorganization proceedings is paramount. The big dilemma the CEO faces is being honest but not crying wolf too early. Should she do so, this may cause an exodus of customers, employees, and suppliers, and hasten the demise of the company. If the company is turned around, an ethical CEO may somehow reward loyal employees and suppliers. Best of all, she will make up all back wages and unpaid invoices regardless of what the reorganization settlement was.