FI-561 MERGERS & ACQUISITIONS

WEEK 1 -

HOMEWORK ANSWER KEY

1.5
An arbitrage firm (A) notes that a bidder (B) whose stock is selling at $30 makes an offer for a
target (T) selling at $40 to exchange 1.5 shares of B for 1 share of T. Shares to T rise to $44; B stays at
$30. A sells 1.5 B short for $45 and goes long on T at $44. One month later the deal is completed with B
at $30 and T at $45. What is As dollar and percentage annualized gain, assuming a required 50% margin
and 8% cost of funds on both transactions?
(Weston 16-17)

Question 1.5 (Chapter 1 p. 16)

A sells 1.5 B for $45 and buys T at $44. Assuming 50% margin, the investment is .5 ($45 + $44)
= $44.5. In one month, A uses T to cover 1.5 B. The dollar gain is $1. The percentage gain is
[($1/$44.5)] * 12 = 26.97% less the interest on the $44.5 borrowed on margin. If A invested the
full $89, the gain would be ($1/$89) * 12 = 13.48%.

Case 2.8 (Chapter 2 pp. 57-58)

Case 2.8 UNITED AIRLINES AND US AIRWAYS

On July 27, 2001, the U.S. Department of Justice blocked the merger of United Airlines and US Airways.
According to Attorney General John Ashcroft, if this acquisition were allowed to proceed, millions of
customers would have little choice but to pay higher fares and accept lower-quality air service.
Legislators on Capitol Hill applauded the decision of the DOJ to block the merger. The view was that
competition along the East Coast would be greatly reduced because United Airlines and US Airways are
the only two airlines in many markets offering connecting services between cities up and down the coast.
When the merger was announced in May 2000, the stock price of US Airways increased from $26.31 to
$49.00, nearly doubling in price. The bid by United Airlines was for $60 in cash. As investors expected
the deal to take a considerably long time to complete, and because there was a good chance that the deal
might be rejected by the regulations, the stock price of US Airways traded at a fairly large spread relative
to the agreed-upon price. When the DOJ blocked the merger, the stock price of US Airways immediately
dropped into the teens, and in August 2002, the company filed for federal bankruptcy protection.
Interestingly, before the year 2002 had ended, United Airlines had also filed for federal bankruptcy
protection. As of early 2003, the surviv-ability of both firms is questionable.
QUESTIONS
C2.8.1
The DOJs blocking of the merger rested on the case that it would greatly reduce
competition along the East Coast because the merging parties were often the only two major
airlines in some markets. Should potential competition, for example, arising from Southwest
Airlines, a mover into the East Coast market, factor into the DOJs decision?

C2.8.2
US Airways is a failing firm and has a substantial probability of bankruptcy.
Should the antitrust authorities consider a failing firm defense from the merging parties?
That is, should mergers be allowed to occur if otherwise the target firm faces bankruptcy?
(Weston 57-58)

C2.8.1 UAL & US Airways

Yes, potential competition is relevant and is often factored into DOJs decisions regarding merger
approval. Apparently in this case, DOJ held the view that United Airlines and US Airways
would have such a strong lock on the East Coast market that another airline such as Southwest
Airlines would be dissuaded from entering the market.
C2.8.2 UAL & US Airways
The antitrust authorities should, and often does, consider a failing firm defense from the merging
parties. In many cases, a merger is the only outcome that will save the target firm from outright
failure. The issue is not that the target firm should not be permitted from failing, rather that if the
merger creates value that otherwise would be destroyed in case of the target being forced to go it
alone, then there is economic value to allowing the merger to proceed. There are numerous cases
of negative shocks to industries whereby many of the firms are negatively impacted such that
mergers are an efficient reallocation of assets. Such appears to be the case in the airline industry
which has been undergoing immense pressure due to high union wage rates and reduction in air
travel demand due to the tragic events of September 2001. Indeed, since the time that DOJ
disqualified the merger of US Airways and United Airlines, both firms have filed for bankruptcy.