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a) No premium
Your earnings = $4 × 1 M = $4 M
Target earnings = $2 × 1 M = $2 M
Total earnings = $6 M
Purchase price = $25 × 1 M = $25 M
New shares issued = $25 M / $40 = 0.625 M
Total shares = 1.000 M + 0.625 M = 1.625 M
Post-merger EPS = $6 M / 1.625 M = $3.69
b) 20% premium
Premium price = $25 × 1.20 = $30/share → cost = $30 M
New shares = $30 M / $40 = 0.75 M
Total shares = 1.000 M + 0.750 M = 1.750 M
EPS = $6 M / 1.75 M = $3.43
c) Why EPS changes? Are shareholders better or worse off?
Dilution: You pay for a lower-EPS business (Target EPS = $2) with higher-EPS equity (Your EPS = $4), and no synergies → EPS falls.
Value to shareholders: In a static, no-synergy world, dilution means lower EPS (and likely lower share price), so shareholders are worse off on a per-share basis. Only if synergies or growth opportunities exist would they benefit.
d) Post-merger P/E (no premium)
Pre-merger P/E (you) = $40 / $4 = 10.0×
Pre-merger P/E (target) = $25 / $2 = 12.5×
Post-merger EPS = $3.69 (from part a)
If the market keeps the share price at $40, then
Post-mergerP/E =
40
3.69
≈
10.8
×
Post-mergerP/E=
3.69
40
≈10.8×
Comparison:
Your P/E has ticked up from 10.0× to 10.8×
It still sits below TargetCo’s 12.5×
Find out tmrw.
A) True, both because it minimizes entrenchment, but also because it signals that…
B)
❌ False
Free riding occurs when shareholders refuse to tender, expecting to benefit from a higher future price without participating.
This discourages bidders, making takeovers less likely to succeed.
It’s a classic problem in tender offers where dispersed shareholders wait for gains without acting.
c) “Two-tier tender offers are allowed by courts because they produce gains for the target.”
❌ False
Two-tier tender offers offer a high price to early sellers, and a lower price later — which is seen as coercive.
Courts often scrutinize or disallow such structures, even if they might result in short-term gains.
The concern is fairness and coercion, not just value.
d)✅ True
Staggered boards mean only a portion of directors are elected each year.
This delays hostile takeovers, since it takes multiple years to replace a majority.
Empirical evidence shows they reduce takeover success and are considered anti-takeover defenses.
What are the reasons most often cited for a takeover? Identify and explain each of the reasons. Also explain which of these reasons are good justifications for a takeover intended to increase shareholder wealth and which are likely to destroy shareholder wealth
Large Synergies
Cost reductions and revenue enhancements (increase shareholder wealth)
Economies of scale & scope
Can bring down costs, but can also destroy shareholder wealth - large companies more diff. to manage
Vertical integration
Refers to the merger of two companies in the same industry
that make products required at different stages of the production cycle - increased coordination
Expertise
Can be destructive - very important to keep on talent - high pay packages etc. required
Monopoly gains
only the merging company pays the associated costs (from, for instance, managing a larger corporation).
This may be why, along with existing antitrust regulation, that
there is a lack of convincing evidence that monopoly gains result from the reduction of competition following takeovers.
Efficiency gains
Another justification acquirers cite for paying a premium for a target is efficiency gains, which are often achieved through an elimination of duplication.
* Acquirers often argue that they can run the target organization
more efficiently than existing management could.
* Although identifying poorly performing corporation is easy - fixing is entirely different (cite Roll’s hubris hypothesis (1986)
Diversification
Risk reduction: Like a large portfolio, large firms bear less unsystematic risk, so often mergers are justified on the basis that the combined firm is less risky.
* A problem with this argument is that it ignores the fact that investors can achieve the benefits of diversification themselves by purchasing shares in the two separate firms.
Debt Capacity and Borrowing Costs:
* All else being equal, larger firms are more diversified and, therefore, have a lower probability of bankruptcy.
* The argument is that with a merger, the firm can increase leverage and thereby lower its costs of capital.
* Due to market imperfections like bankruptcy, a firm may be able to
increase its debt and enjoy greater tax savings without incurring
significant costs of financial distress by merging and diversifying.
* Gains must be large enough to offset any disadvantages of running a larger, less focused firm.
Earnings growth
It is possible to combine two companies with the result that
the earnings per share of the merged company exceed the
pre-merger earnings per share of either company, even when the merger itself creates no economic value
A) When managers have more information about the firm’s value than outside investors (i.e., asymmetric information), issuing equity can be perceived as a negative signal.
Investors may interpret an equity issuance as:
→ “Management thinks the stock is overvalued.”
As a result, stock prices may fall when new shares are announced.
To avoid this negative signal, firms often prefer to issue debt, which is less affected by information gaps.
This is the logic behind the Pecking Order Theory:
Use internal funds first
Then debt
Issue equity only as a last resort
B)
✅ Answer: Partly True, but incomplete — needs nuance.
Explanation:
True that:
Corporate taxes make debt attractive (interest is tax-deductible → creates a tax shield)
So some leverage increases firm value However, higher leverage also increases:
Probability of financial distress
Bankruptcy costs, agency costs, and loss of flexibility
Therefore, the optimal leverage balances:
Valuefromtaxshield vs. Costoffinancialdistress
✅ The Trade-off Theory says:
Optimal capital structure is not maximum leverage, but somewhere in between, where marginal benefit = marginal cost.
.
Outline of Answer:
rd is more appropriate when the debt level is kept constant.
ra is more appropriate when the D/V ratio or leverage ratio is kept constant and debt levels are adjusted with changes in firm performance.
What are the most widely used mechanisms for implementing good governance in firms?
Identify and explain at least two ways of mitigating agency conflicts for widely-held firms.
Identify and explain at least two ways of mitigating agency conflicts for firms with at least one large block-holder / shareholder.
Please state whether the following sentences are true. In each case, provide a brief explanation for your answer.
a) When a board of directors is staggered, it is more difficult to replace a majority of the directors because different members have different rights and responsibilities.
b) One of the benefits of active, external monitors is that they can gather prospective information which leads to an increase in the pledge-able income for the firm.
c) Two main drivers of value creation by a leveraged buyout (LBO) are the additional debt tax shield from the increased debt, and improvements in operational efficiency of the target firm.
What is a poison pill?
Poison pills are securities that provide (friendly) shareholders
with special rights to buy new shares at a discount price
Most pills have the following characteristics:
* Give special rights to existing shareholders with the exclusion of the bidder
* Rights are triggered by either an accumulation of shares or by an announcement of intent to take over
* Board has an option to redeem these rights at a low price
* Poison pills do not have to be approved by shareholders at adoption
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