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									Chapter 20 - External Growth through Mergers




                                     Chapter 20
                          External Growth through Mergers
Discussion Questions
20-1.           Name three industries in which mergers have been prominent.

                Computers, telecommunications, public utilities, pharmaceuticals, and energy.


20-2.           What is the difference between a merger and a consolidation?

                In a merger two or more companies are combined, but only the identity of the
                acquiring firm is maintained. In a consolidation, an entirely new entity is
                formed from the combined companies.


20-3.           Why might the portfolio effect of a merger provide a higher valuation for the
                participating firms?

                If two firms benefit from opposite phases of the business cycle, their variability
                in performance may be reduced. Risk-averse investors may then discount the
                future performance of the merged firms at a lower rate and thus assign a higher
                valuation than was assigned to the separate firms.


20-4.           What is the difference between horizontal integration and vertical integration?
                How does antitrust policy affect the nature of mergers?

                Horizontal integration is the acquisition of competitors, and vertical integration
                is the acquisition of companies that produce goods and services used by the
                company.

                Antitrust policy generally precludes the elimination of competition. For this
                reason, mergers are often with companies in allied but not directly related
                fields.




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Chapter 20 - External Growth through Mergers




20-5.           What is synergy? What might cause this result? Is there a tendency for
                management to over- or underestimate the potential synergistic benefits of a
                merger?

                Synergy is said to occur when the whole is greater than the sum of the parts.
                This “2 + 2 = 5” effect may be the result of eliminating overlapping functions in
                production and marketing as well as meshing together various engineering
                capabilities. In terms of planning related to mergers, there is often a tendency to
                overestimate the possible synergistic benefits that might accrue.
20-6.           If a firm wishes to achieve immediate appreciation in earnings per share as a
                result of a merger, how can this be best accomplished in terms of exchange
                variables? What is a possible drawback to this approach in terms of long-range
                considerations?

                The firm can achieve this by acquiring a company at a lower P/E ratio than its
                own. The firm with a lower P/E ratio may also have a lower growth rate. It is
                possible that the combined growth rate for the surviving firm may be reduced
                and long-term earnings growth diminished.


20-7.           It is possible for the postmerger P/E ratio to move in a direction opposite to that
                of the immediate postmerger earnings per share. Explain why this could
                happen.

                If earnings per share show an immediate appreciation, the acquiring firm may
                be buying a slower growth firm as reflected in relative P/E ratios. This
                immediate appreciation in earnings per share could be associated with a lower
                P/E ratio. The opposite effect could take place when there is an immediate
                dilution to earning per share. Obviously, a number of other factors will also
                come into play.


20-8.           How is goodwill now treated in a merger?

                It is placed on the books of the acquiring company, but it is not amortized. It is
                only written down if it is impaired.




                                               20-2
Chapter 20 - External Growth through Mergers




20-9.           Suggest some ways in which firms have tried to avoid being part of a target
                takeover.

                An unfriendly takeover may be avoided by:

                a. turning to a second possible acquiring company—a “White Knight.”
                b. moving corporate offices to states with tough pre-notification and protection
                   provisions.
                c. buying back outstanding corporate stock.
                d. encouraging employees to buy stock.
                e. staggering the election of directors.
                f. increasing dividends to keep stockholders happy.
                g. buying up other companies to increase size and reduce vulnerability.
                h. reducing the cash position to avoid a leveraged takeover.




20-10.          What is a typical merger premium paid in a merger or acquisition? What effect
                does this premium have on the market value of the merger candidate and when
                is most of this movement likely to take place?

                Typically a merger premium of 40-60 percent is paid over the premerger price
                of the acquired company. The effect of the premium is to increase the price of
                the merger candidate and most of this movement is likely to take place before
                public announcement.


20-11.          Why do management and stockholders often have divergent viewpoints about
                the desirability of a takeover?

                While management may wish to maintain their autonomy and perhaps keep
                their jobs, stockholders may wish to get the highest price possible for their
                holdings.


20-12.          What is the purpose(s) of the two-step buyout from the viewpoint of the
                acquiring company?

                The two-step buy-out provides a strong inducement to target stockholders to
                quickly react to the acquiring company’s initial offer. Also, it often allows the
                acquiring company to pay a lower total price than if a single offer is made.




                                               20-3
Chapter 20 - External Growth through Mergers



Chapter 20

Problems
1.    Tax loss carryforward (LO1) Boardwalk Corporation desires to expand. It is considering
      a cash purchase of Park Place Corporation for $2,400,000. Park Place has a $600,000 tax
      loss carryforward that could be used immediately by the Boardwalk, which is paying taxes
      at the rate of 35 percent. Park Place will provide $300,000 per year in cash flow (aftertax
      income plus depreciation) for the next 20 years. If the Boardwalk Corporation has a cost of
      capital of 11 percent, should the merger be undertaken?


20-1. Solution:
                                   Boardwalk Corporation
          Cash outflow:
          Purchase price                                                      $ 2,400,000
          Less tax shield benefit from tax
            loss carry-forward ($600,000 × 35%)                               – 210,000
          Net cash outflow                                                    $ 2,190,000

          Cash inflows:
          $300,000, n = 20, i = 11% (Appendix D)
          $3000,000 × 7.963 =                                                 $ 2,388,900

              Cash inflows                            $ 2,388,900
              Cash outflow                              2,190,000
              Net present value                       $ 198,900

          The positive net present value indicates the merger should be
          undertaken.




                                               20-4
Chapter 20 - External Growth through Mergers


2.    Tax loss carryforward (LO1) Assume that Western Exploration Corp. is considering the
      acquisition of Ogden Drilling Company. The latter has a $400,000 tax loss carryforward.
      Projected earnings for the Western Exploration Corp. are as follows:
                                                                                 Total
                                            2011        2012       2013          Values
     Before-tax income ................. $160,000     $200,000   $320,000       $680,000
     Taxes (40%) .......................... 64,000      80,000    128,000        272,000
     Income available
       to stockholders ................... $96,000    $120,000   $192,000       $408,000
      a. How much will the total taxes of Western Exploration Corp. be reduced as a result of
         the tax loss carryforward?
      b. How much will the total income available to stockholders be for the three years if the
         acquisition occurs? Use the same format as that in the text.


20-2 Solution:
                                Western Exploration Corp.
           a. Reduction in taxes due to tax loss carry forward =
              loss × tax rate
                       $400,000 × 40% = $160,000
           b. Western Exploration Corp.(with merger and associated tax
              benefits)
                                          2011     2012              2013      Total
      Before tax income                 $160,000 $200,000           $320,000 $680,000
      Tax loss carry-
      forward                            160,000      200,000         40,000        400,000
      Net taxable income                       0            0        280,000        280,000
      Taxes (40%)                              0            0        112,000        112,000
      Aftertax Income
      available to
      stockholders                      $160,000 $200,000 $208,000* $568,000**


           * Before-tax income – taxes ($320,000 – $112,000 = $208,000)
          ** Before-tax income – taxes ($680,000 – $112,000 = $568,000)



                                               20-5
Chapter 20 - External Growth through Mergers




3.    Cash acquisition with deferred benefits (LO2) J & J Enterprises is considering a cash
      acquisition of Patterson Steel Company for $4,000,000. Patterson will provide the
      following pattern of cash inflows and synergistic benefits for the next 20 years. There is no
      tax loss carryforward.

                                                                       Years
                                                           1–5          6–15       16–20
        Cash inflow (aftertax) ........................ $440,000      $600,000   $800,000
        Synergistic benefits (aftertax) ............      40,000        60,000     70,000
      The cost of capital for the acquiring firm is 12 percent. Should the merger be undertaken?
      (If you have difficulty with deferred time value of money problems, consult Chapter 9.)


20-3 Solution:
                                        J & J Enterprises
          Cash outflow (Purchase price)                            $4,000,000

          Cash inflows
          PV factors for the analysis (12%) (Appendix D)
          Years                (1-5)                          (6-15)               (16-20)
                              3.605              1-15          6.811        1-20     7.469
                                                 –1-5         –3.605       –1-15     6.811
                                               6 to 15         3.206      16 to 20    .658

          Year (1-5)
            Cash inflow                                   $440,000
            Synergistic benefits                            40,000
            Total cash inflow                             $480,000

                  P.V. $480,000 × 3.605 =                                        $1,730,400

          Years (6-15)
            Cash inflow                                   $600,000
            Synergistic benefits                            60,000
            Total cash inflow                             $660,000


                                                  20-6
Chapter 20 - External Growth through Mergers



            P.V. $660,000 × 3.206 =                                             $2,115,960
20-3. (Continued)
          Years (16-20)
            Cash inflow                                   $800,000
            Synergistic benefits                            70,000
            Total cash inflow                             $870,000
               P.V. $870,000 × .658 =                                            $ 572,460

              Total present value of inflows                                    $4,418,820

              Cash inflows                                                     $4,418,820
              Cash outflow                                                      4,000,000
              Net present value                                                $ 418,820

          The positive net present value indicates the merger should be
          undertaken.

4.    Cash acquisition with deferred benefits (LO2) Worldwide Scientific Equipment is
      considering a cash acquisition of Medical Labs for $1.5 million. Medical Labs will provide
      the following pattern of cash inflows and synergistic benefits for the next 25 years. There is
      no tax loss carry forward.

                                                                    Years
                                                           1–5       6–15         16–25
        Cash inflow (aftertax) ........................ $100,000   $120,000     $160,000
        Synergistic benefits (aftertax) ............      15,000     25,000       45,000
      The cost of capital for the acquiring firm is 9 percent. Should the merger be undertaken?


20-4 Solution:
                            Worldwide Scientific Equipment
          Cash outflow (Purchase price)                                  $1,500,000

          Cash inflows



                                                  20-7
Chapter 20 - External Growth through Mergers



          PV factors for the analysis (9%) (Appendix D)

         Years             (1-5)                      (6-15)               (16-25)
                          3.890           1-15         8.061    1-25         9.823
                                          1-5         –3.890    1-15         8.061
                                        6 to 15        4.171   15 to 20      1.762

          Year (1-5)
            Cash inflow              $100,000
            Synergistic benefits       15,000
            Total cash inflow        $115,000
             P.V. $115,000 × 3.890 =                                      $ 447,350

          Years (6-15)
            Cash inflow              $120,000
            Synergistic benefits       25,000
            Total cash inflow        $145,000
             P.V. $145,000 × 4.171 =                                      $604,795

20-4. (Continued)
          Years (16-20)
            Cash inflow              $160,000
            Synergistic benefits       45,000
            Total cash inflow        $205,000
             P.V. $205,000 × 1.762 =                                 $ 361,210

           Total present value of inflows                            $ 1,413,355

              Cash inflows                                           $ 1,413,355
              Cash outflow                                             1,500,000
              Net present value                                        ($–86,645)

          The negative net present value indicates the merger should not be
          undertaken.


                                               20-8
Chapter 20 - External Growth through Mergers


5.    Impact of merger on earnings per share (LO3) Assume the following financial
      data for Rembrandt Paint Co. and Picasso Art Supplies:
                                                                           Rembrandt         Picasso
                                                                             Paint Co.     Art Supplies
                                                                            $300,000
         Total earnings ............................................................           $900,000
         Number of shares of stock outstanding .....................          100,000           500,000
         Earnings per share ..................................................... $3.00           $1.80
         Price-earnings ratio (P/E) .......................................... 12×                  20×
         Market price per share .................................                    $36            $36
      a. If all the shares of Rembrandt Paint Co. are exchanged for those of Picasso Art
         Supplies on a share-for-share basis, what will postmerger earnings per share be for
         Picasso Art Supplies?
      b. Explain why the earnings per share of Picasso Art Supplies changed.
      c. Can we necessarily assume that Picasso Art Supplies is better off after the merger?



20-5. Solution:
                  Rembrandt Paint Co. and Picasso Art Supplies
                                 (approach similar to Table 20-3)
          a. Total earnings                       Rembrandt                                     $ 300,000
                                                  + Picasso                                     $ 900,000
                                            Combined earnings                                   $1,200,000

                 Shares outstanding Original Picasso shares                                      500,000
                                     + New Picasso shares                                        100,000
                          Postmerger Shares Outstanding                                          600,000

                 New earnings per share for Picasso Art Supplies

                   $1, 200,000
                               $2.00
                    600,000




                                                        20-9
Chapter 20 - External Growth through Mergers



20-5. (Continued)
          b. Earnings per share of Picasso Art Supplies increased because
             it has a higher P/E ratio than Rembrandt Paint Co. (20x
             versus 12x). Any time a firm acquires another company at a
             lower P/E ratio than its own there is an immediate increase in
             postmerger earnings per share.

          c. Although earnings per share for Picasso Art Supplies went
             up, we can not automatically assume the firm is better off.
             We need to know whether the Rembrandt Paint Co. will
             increase or decrease the future growth in earnings per share
             for Picasso Art Supplies and how it will influence its
             postmerger P/E ratio. The goal of financial management is
             not just immediate growth in earnings per share, but
             maximization of stockholder wealth over the long-term.
6.    Impact of merger on earnings per share (LO3) Assume the following financial data for
      the Noble Corporation and Barnes Enterprises:
                                                                                  Noble        Barnes
                                                                              Corporation    Enterprises
                                                                              $1,200,000
          Total earnings.............................................................         $3,600,000
          Number of shares of stock outstanding ......................             600,000     2,400,000
          Earnings per share ...................................................... $2.00          $1.50
          Price-earnings ratio (P/E) ........................................... 24×                 32×
          Market price per share ......................................                $48          $48
      a. If all the shares of the Noble Corporation are exchanged for those of Barnes Enterprises
         on a share-for-share basis, what will postmerger earnings per share be for Barnes
         Enterprises? Use an approach similar to that in Table 20–3 on page627.
      b. Explain why the earnings per share of Barnes Enterprises changed.
      c. Can we necessarily assume that Barnes Enterprises is better off after the merger?


20-6 Solution:
                     Noble Corporation and Barnes Enterprises
                                (approach similar to Table 20–3)



                                                      20-10
Chapter 20 - External Growth through Mergers



          a. Total earnings                       Noble          $ 1,200,000
                                                  + Barnes       $ 3,600,000
                                          Combined earnings      $ 4,800,000

                Shares outstanding Original Noble Shares 2,400,000
                                    + New Noble shares     600,000
                         Postmerger shares outstanding 3,000,000

                New earnings per share for Barnes Enterprises

                    $4,800,000
                               $1.60
                     3,000,000

20-6. (Continued)
         b. Earnings per share of Barnes Enterprises increased because it
            has a higher P/E ratio than Noble Corporation (32x versus
            24x). Any time a firm acquires another company at a lower
            P/E ratio than its own there is an immediate increase in
            postmerger earnings per share.

         c. Although earnings per share for Barnes Enterprises went up,
            we can not automatically assume the firm is better off. We
            need to know whether Noble Corporation will increase or
            decrease the future growth in earnings per share for Barnes
            Enterprises and how it will influence its postmerger P/E ratio.
            The goal of financial management is not just immediate
            growth in earnings per share, but maximization of stockholder
            wealth over the long-term.

7.    Mergers and dilution (LO3) The Nebraska Corporation is considering acquiring the
      Lincoln Corporation. The data for two companies are as follows:




                                               20-11
Chapter 20 - External Growth through Mergers




                                                                               Lincoln     Nebraska
                                                                                Corp.        Corp.
            Total earnings ................................................   $500,000   $2,000,000
            Number of shares of stock outstanding .........                    200,000    1,000,000
            Earnings per share .........................................         $2.50        $2.00
            Price-earnings ratio (P/E) ..............................               16           20
            Market price per share ...................................             $40          $40
      a. The Nebraska Corp. is going to give Lincoln Corp. a 50 percent premium over Lincoln
         Corp.’s current market value. What price will it pay?
      b. At the price computed in part a, what is the total market value of Lincoln Corp.? (Use
         the number of Lincoln Corp. shares times price.)
      c. At the price computed in part a, what is the P/E ratio Nebraska Corp. is assigning
         Lincoln Corp.?
      d. How many shares must Nebraska Corp. issue to buy the Lincoln Corp. at the total value
         computed in part b? (Keep in mind Nebraska Corp.’s price per share is $40.)
      e. Given the answer to part d, how many shares will Nebraska Corp. have after the
         merger?
      f. Add together the total earnings of both corporations and divide by the total shares
         computed in part e. What are the new postmerger earnings per share?
      g. Why has Nebraska Corp.’s earnings per share gone down?
      h. How can Nebraska Corp. hope to overcome this dilution?



20-7 Solution:
                              Nebraska Corp. and Lincoln Corp.
       a.          $40                               current price
                 ×1.50                               50% premium
                  $60                                price paid

       b.        $60                                 price paid
                 ×200,000                            shares
                 $12,000,000                         total market value

                  Price   $60
       c.                     24 P/E ratio
                  EPS $2.50




                                                           20-12
Chapter 20 - External Growth through Mergers



20-7. (Continued)
              $12,000,000 total market value of Lincoln Corp.
        d.                                                     300,000 new shares
                     $40 Nebraska Corp.'s share price

        e.      1,000,000 old shares + 300,00 new shares = 1,300,000
                total shares

        f.      Lincoln Corp. earnings                               $500,000
                Nebraska Corp. earnings                             2,000,000
                Total earnings                                     $2,500,000
                New postmerger                     total earnings $2,500, 000
                EPS =                          =                              $1.92
                                                    total shares   1,300, 000
        g. Nebraska Corp. paid a higher P/E ratio (24) for Lincoln Corp.
           than its own (20). This will always cause a dilution in EPS.
        h. Through more rapid future growth in earnings


8.    Two-step buyout (LO2) The Hollings Corporation is considering a two-step buyout of the
      Norton Corporation. The latter firm has 2 million shares outstanding and its stock price is
      currently $40 per share. In the two-step buyout, Hollings will offer to buy 51 percent of
      Norton’s shares outstanding for $68 per share in cash and the balance in a second offer of
      980,000 convertible preferred stock shares. Each share of preferred stock would be valued
      at 45 percent over the current value of Norton’s common stock. Mr. Green, a newcomer to
      the management team at Hollings, suggests that only one offer for all Norton’s shares be
      made at $65.25 per share. Compare the total costs of the two alternatives. Which is better
      in terms of minimizing costs?


20-8. Solution:




                                                   20-13
Chapter 20 - External Growth through Mergers



                                     Hollings Corporation
                                          Two Step Offer


          1. 51% × 2,000,000 shares = $1,020,000 shares
             1,020,000 shares × $68 cash =            $69,360,000


          2. 980,000 shares of convertible preferred stock ×
             $40 (1.45) = 980,000 × $58=                 $56,840,000
             Cost of two-step offer                     $126,200,000

                                               Single Offer

                2,000,000 shares at $65.25                                 $130,500,000

           The two-step offer is preferred because its cost is
           $4,300,000 less.

9.    Future tax obligation to selling stockholder (LO1) Al Simpson helped start Excel
      Systems in 2005. At the time, he purchased 100,000 shares of stock at $1 per share. In
      2010 he has the opportunity to sell his interest in the company to Folsom Corp. for $50 a
      share in cash. His capital gains tax rate would be 15 percent.
      a. If he sells his interest, what will be the value for before-tax profit, taxes, and aftertax
         profit?
      b. Assume, instead of cash, he accepts Folsom Corp. stock valued at $50 per share. He
         pays no tax at that time. He holds the stock for five years and then sells it for $88.50
         (the stock pays no cash dividends). What will be the value for before-tax profit, taxes,
         and aftertax profit in 2015? His capital gains tax is once again 15 percent.
      c. Using an 9 percent discount rate, compare the aftertax profit figure in part b to that in
         part a (that is, discount back the answer in part b for five years and compare it to the
         answer in part a.



20-9 Solution:




                                                 20-14
Chapter 20 - External Growth through Mergers



                                           Excel Systems
          a.    Sales amount       100,000 Shares. × $50                        $5,000,000
                Purchase amount 100,000 Shares. × $1                                100,000
                Before-tax profit                                               $ 4,900,000
                Capital Gains Taxes (15%)                                           735,000
                Aftertax profit                                                 $ 4,165,000

          b. Sales amount       100,000 Shares. × $88.50 $8,850,000
             Purchase amount 100,000 Shares. × $1           100,000
             Before-tax profit                           $8,750,000
             Capital Gains Taxes (15%)                    1,312,500
             Aftertax profit                             $7,437,500

          c.    Discount back $7,437,500 for 5 years at 9 %
                $7,437,500, n = 5, i = 9% (Appendix B)
                $7,437,500 × .650 = $4,834,375

                This value of $4,834,375 clearly exceeds the value in part (a)
                of $4,165,000. Deferring the tax appears to be the more
                desirable alternative.
10.   Premium offers and stock price movement (LO1) Chicago Savings Corp. is planning to
      make an offer for Ernie’s Bank & Trust. The stock of Ernie’s Bank & Trust is currently
      selling for $40 a share.
      a. If the tender offer is planned at a premium of 60 percent over market price, what will be
          the value offered per share for Ernie’s Bank & Trust?
      b. Suppose before the offer is actually announced, the stock price of Ernie’s Bank & Trust
          goes to $56 because of strong merger rumors. If you buy the stock at that price and the
          merger goes through (at the price computed in part a), what will be your percentage gain?
      c. Because there is always the possibility that the merger could be called off after it is
          announced, you also want to consider your percentage loss if that happens. Assume you
          buy the stock at $56 and it falls back to its original value after the merger cancellation,
          what will be your percentage loss?
      d. If there is a 80 percent probability that the merger will go through when you buy the
          stock at $56 and only a 20 percent chance that it will be called off, does this appear to
          be a good investment? Compute the expected value of the return on the investment.




                                               20-15
Chapter 20 - External Growth through Mergers




20-10. Solution:
                                    Chicago Savings Corp.
            a. Market price of Ernie’s Bank & Trust                        $40
               + Premium of 60%                                             24
               Value offered per share                                     $64
            b. Value offered per share                                     $64
               Purchase price                                               56
               Gain                                                        $ 8
                                                                           $8
                  Percentage gain                                               14.29%
                                                                           $56
            c. Value after cancellation (original value)                   $40
               Purchase price                                               56
               Loss                                                        $16
                                                                           $16
                 Percentage loss                                                28.57%
                                                                           $56
            d. Return             Probability                     Expected Value
               +14.29               .80                              $11.43%
               –28.57               .20                               – 5.71%
               Expected value of return                                 5.72%
               It appears to be a good investment.

11.   Portfolio effect of a merger (LO4) Assume the Shelton Corporation is considering the
      acquisition of Cook, Inc. The expected earnings per share for the Shelton Corporation will
      be $3.00 with or without the merger. However, the standard deviation of the earnings will
      go from $1.89 to $1.20 with the merger because the two firms are negatively correlated.
      a. Compute the coefficient of variation for the Shelton Corporation before and after the
         merger (Consult Chapter 13 to review statistical concepts if necessary.)
      b. Comment on the possible impact on Shelton’s postmerger P/E ratio, assuming investors
         are risk-averse.




                                               20-16
Chapter 20 - External Growth through Mergers




20-11. Solution:
                                        Shelton Corporation
            a.                             Premerger      Postmerger
                      Standard deviation      $1.89        $1.20
                  V=                                .63         .40
                     Mean or expected value $3.00          $3.00

            b. Risk averse investors are being offered less risk and may
               assign a higher P/E ratio to postmerger earnings.
12.   Portfolio consideration and risk aversion (LO4) General Meters is considering two
      mergers. The first is with Firm A in its own volatile industry, the auto speedometer
      industry, whereas the second is a merger with Firm B in an industry that moves in the
      opposite direction (and will tend to level out performance due to negative correlation).
      a   Compute the mean, standard deviation, and coefficient of variation for both investments
          (refer to Chapter 13 if necessary).


                  General Meters Merger                        General Meters Merger
                              with Firm A                                   with Firm B
                     Possible                                     Possible
                     Earnings                                     Earnings
                 ($ in millions)                 Probability   ($ millions)               Probability
                   $40........................     .30            $10................. .     .25
                     50 .......................    .40             50 ................. .    .50
                     60 ....................... . .30              90 ................. .    .25

      b. Assuming investors are risk-averse, which alternative can be expected to bring the
         higher valuation?

20-12. Solution:




                                                    20-17
Chapter 20 - External Growth through Mergers



                                          General Meters
            a. Merger with A (answer in millions of dollars)

                                               D   DP

                                   D            P             DP
                                   40           .30           12.0
                                   50           .40            20.0
                                   60           .30            18.0
                                                               50.0 = D

                                          (D  D)2 P

20-12. (Continued)
                  D         D        (D – D )            (D – D )2     P (D – D )2P
                  40        50        –10                 100         .30    30
                  50        50          0                   0         .40     0
                  60        50        +10                 100         .30    30
                                                                             60
                                               60  7.75  

                                                             7.75
            Coefficient of variation =                             .155
                                                    D          50

            Merger with B (answer in millions of dollars)




                                                 20-18
Chapter 20 - External Growth through Mergers




                                               D   DP
                                   D            P     DP
                                   10           .25    2.5
                                   50           .50   25.0
                                   90           .25   22.5
                                                      50.0 = D

                                          (D  D)2 P

                  D         D        (D – D )           (D – D )2     P (D – D )2P
                  10        50        –40                1,600       .25  400
                  50        50          0                    0       .50     0
                  90        50        +40                1,600       .25  400
                                                                          800

                                           800  28.28  



20-12. (Continued)
                                                            28.28
            Coefficient of variation =                             .566
                                                   D          50


            b. Though both alternatives have an expected value of $50
               (million), the lower coefficient of variation, and thus lower
               risk in merger A, should call for a higher valuation by risk
               averse investors.




                                                20-19

								
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