Solutions Manual

CHAPTER 30

MERGERS AND ACQUISITIONS;

DIVESTITURES

SUGGESTED ANSWERS TO THE REVIEW QUESTIONS

I. Questions

1. 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.
2. 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.
3. Horizontal integration is the acquisition of competitors, and vertical
integration is the acquisition of buyers or sellers of goods and services to
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.
4. 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.
5. The firm can achieve this by acquiring a company at a lower P/E ratio
than its own. The firm with 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.
6. 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.

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7. Under the pooling of interests, the financial statements of the firms are
combined subject to some minor adjustments and no goodwill is created.
Under a purchase of assets, the difference between purchase price and
adjusted book value is established on the statement of financial position
as goodwill and must be written off over a maximum period of 40 years.
8. 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 equity share.
d. Encouraging employees to buy equity share.
e. Staggering the election of directors.
f. Increasing dividends to keep shareholders happy.
g. Buying up other companies to increase size and reduce
vulnerability.
h. Reducing the cash position to avoid a leveraged takeover.
9. While management may wish to maintain their autonomy and perhaps
keep their jobs, shareholders may wish to get the highest price possible
for their holdings.
10. The advantages of using convertible securities as a method of financing
mergers are as follows:
a. Potential earnings dilution may be partially minimized by issuing
a convertible security. If such a security is designed to sell at a
premium over its conversion value, fewer common shares will
ultimately be issued. For example, if the acquirers share
currently has a market price of P50 per share, and the price of the
acquisition is P10 million, using ordinary equity share would
require issuing 200,000 shares. In comparison, a convertible
preferred issue could be designed to sell at P100 with a 1.7
conversion ratio, which would mean a conversion value of P85.
The P10 million price would be realized by issuing 100,000
preferred shares convertible into 170,000 shares of ordinary
equity share. The purchaser would have decreased the eventual

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number of shares to be issued, thereby reducing the dilution in

earnings per share that could ultimately result.
b. A convertible issue may allow the acquiring company to comply
with the sellers income objectives without changing its own
dividend policy. If the two firms have different dividend payout
policies and the acquirer does not want to commit its ordinary
equity share to a dividend rate that suits the seller, convertible
preferred share may be an appropriate solution.
c. Convertible preferred share also represents a possible way of
lowering the voting power of the acquired company. This
reduction of voice in management can be important, especially if
the seller is a closely held corporation.
d. The convertible preferred debenture or equity share may appear
more attractive to the firm being acquired because it combines
senior security protection with a portion of the growth potential
of ordinary equity share.
11. The deferred payment plan, which has come to be called an earn-out,
represents a relatively recent approach to merger financing. The
acquiring firm agrees to make a specified initial payment of cash or
equity share and, if it can maintain or increase earnings, to pay additional
compensation.
12. The amount of the future payments will be determined by three factors:
a. the amount of earnings in the forthcoming years in excess of the
base-period profits;
b. the capitalization rate (discount rate) agreed upon by the parties;
and
c. the market value of the acquiring organization at the end of each
year.
13. Refer to pages 840 through 841.

II. Multiple Choice Questions

1. C 5. B 9. B 13. A
2. D 6. D 10. A 14. C
3. A 7. D 11. D 15. D
4. D 8. C 12. B

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